Predicting the Cost of Financial Reform

Higher capital and liquidity requirements for banks will likely have only a small effect on lending rates and will not cause the economy to contract catastrophically, according to a recent report released by the International Monetary Fund (IMF).

The report follows on the heels of several other studies that have also attempted to estimate the economic cost of more stringent financial regulations and that have produced what the IMF report’s authors describe as “serious disagreement about how much the additional safety margins will cost.”

In response to the 2008 financial crisis that exposed banks’ excessive risk-taking, various central banks agreed to require higher capital levels and liquidity requirements according to a global standard known as Basel III. Banks, however, have complained that the new regulations would hurt their ability to lend to businesses and that the entire economy would suffer. They point to a study produced by the Institute of International Finance (IIF), a trade association comprising banks from different countries, that found that regulatory reforms would spike up lending rates by 5 percent and shrink the economy by 3 percent.

Although the IMF researchers say that the IIF analysis “provides the most detailed estimate of the overall impact of comprehensive financial reforms,” the IMF study predicts that the impact will be much smaller. The IMF researchers estimate that the lending rates will increase by a mere 0.28 percent in the U.S., barely more than a single increment by which the Federal Reserve adjusts interest rates. Europe and Japan would see even smaller changes of 0.17 percent and 0.08 percent, respectively.

The IMF explains the discrepancies between its predictions and those of the IIF by pointing to a number of factors:

• First, the IMF study focuses on long-term costs, whereas the IIF study examined more short-term effects — i.e., 2011-15.
• Second, the IMF researchers use a more conservative baseline scenario than the IIF. They reason that the financial sector, alarmed by the 2008 financial crisis, has already turned to a less risky model of investment and has self-enforced higher safety margins, such as capital and liquidity requirements. Thus, the IMF researchers argue, the regulatory reforms would cause only a small hike in the required capital and liquidity rates.
• Third, the IMF researchers predict that the participants in the financial market will adjust to the stringent regulations by cutting expenses (banks) and expecting a reduced rate of return on bank equity (investors).

The authors concede that their economic model has some limitations. Because the report focuses on long-term effects, it does not account for potential transition costs of moving to a new regulatory system. Also, the report only makes claims about the expected impact on lending rates, not the economy as a whole.

In the end, the authors of the IMF report conclude by suggesting that, if a consensus develops around the belief in the economic soundness of the proposed reforms, they should be adopted “to increase safety and reduce the uncertainty about rules that creates inefficiencies.”