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False Alarms About Regulation’s Cost

New IMF research contradicts claims that tough new bank regulations will damage the economy.

Future of Finance

Financial regulations such as Basel III are unlikely to have a significant impact on bank lending rates or the global economy. That’s the determination of a recent paper by staff of the International Monetary Fund, a conclusion in accord with the new, tougher mood among global banking regulators but which is out of line with previous research on the subject that has played up, sometimes quite luridly, the potentially damaging consequences of regulation — not to mention the warnings of bankers whose oxen the rules would gore.

Senior IMF economist André Oliveira Santos, a senior economist at the Washington, D.C.–based organization, and Douglas Elliott, a fellow at the Brookings Institution and an IMF consultant, estimate that in the long term average bank lending rates are likely to increase by 28 basis points in the U.S., by 17 basis points in Europe and by 8 basis points in Japan. “Banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy,” they wrote in the staff discussion note, which does not necessarily represent the views of the IMF, published September 11.

By contrast, the banking industry’s lobbying group, the Institute of International Finance (IIF) in Washington, argued in a published report  that the price of credit in the U.S. would increase by 5 percent on average over 2011–'15, while GDP would shrink by 3 percent over the same period. Research by other institutions in the past two years, notably the Organization for Economic Cooperation and Development, in Paris, and the Bank for International Settlements, in Basel, has also suggested that costs will climb much higher, even if they discounted any major economic impact.

Cumulative Impact of Regulatory Reforms on Lending Rates (In basis points)
Europe Japan U.S.
Capital requirements 19 13 40
Modigliani-Miller pass-through
(savings due to increased safety)
-9 -7 -20
Liquidity Coverage Ratio (LCR) 8 1 11
Net Stable Funding Ratio (NSFR) 10 11 16
Overlap of LCR and NSFR actions (half of smallest) -4 0 -5
Derivatives 1 N/A 3
Taxes and fees 6 0 4
Total gross effects 31 18 48
Expense cuts (at 5% for Europe, 10% for US) 8 8 15
Other aggregate adjustments 5 3 5
of which: Planned capital mitigating actions 3 N/A 2
Total adjustments 13 10 20
Net cost 18 8 28
Source: International Monetary Fund

In a conference call with journalists, Elliott noted that the IIF hadn’t taken into account the market pressure on banks to raise their levels of capital, regardless of regulation, following the financial crisis and that there remains more scope for cost-cutting measures by banks. He conjectured that investors will accept lower returns if they accompany more-conservative behavior by banks. Santos and Elliott’s detailed quantitative analysis, representing more than a year of research, supports similar arguments widely made by economists such as Simon Johnson, a former IMF chief economist who is now a fellow at the Peterson Institute for International Economics in Washington.

Overall, Elliott said, the costs — estimated by examining funding costs, the cost of allocated capital, credit losses, administrative costs and other factors — “cannot possibly exceed the benefits.” The report can only encourage regulators, whose patience is wearing thin following revelations of Libor fixing, money laundering and sanctions busting, to take more-radical action. Opportunities could arise in the coming months as yet more commissions of enquiry are set to make recommendations about how to tame banks. At the European Union level, the Liikanen Group is due to report in October on options for reforming the banking sector. In the U.K. a parliamentary commission currently under way is due to report on banking culture by the end of the year.

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