11 September 2012

IMF Discussion Note: Estimating the Costs of Financial Regulation

This study shows that financial reform is likely to result in a modest increase in bank lending rates in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders' operating costs, affecting bank customers, employees and investors.

In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth.

A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors. There is considerable uncertainty about these cost assumptions, but a sensitivity analysis shows that reasonable changes in assumptions do not dramatically alter the conclusions of this study. Cost estimates are based on several references, including academic theory, empirical analyses from industry and official sources, as well as financial disclosures by large banks.

The findings are based on methodologies that were used in previous studies by academics and the official sector. This study, however, estimates that lending rate increases will likely be significantly smaller, for the following reasons. First, the baseline scenario implies a smaller regulatory effect, with market forces accounting for some of the expected increases in safety margins. Second, banks are expected to absorb part of the higher costs by cutting expenses. Third, investors are expected to reduce their required rate of return on bank equity modestly as a result of the safety improvements. Debt investors are expected to follow suit, although to a much lesser extent.

There are important limitations to the analysis presented here. It does not address the potential transition costs as banks adjust to the new regulations. Nor does it assess the economic benefits of financial reforms. A number of regulatory reforms are not modeled; judgement has been required in making many of the estimates; and the modelling approach is relatively simple. Nevertheless, the results appear to be a balanced, albeit rough, assessment of the likely effects on bank lending. Further research would be useful to translate these credit impacts into effects on economic output.

Despite these limitations, the results appear to be a balanced, albeit rough, assessment of the likely credit costs. In addition, the results are also broadly in line with previous studies from the official sector, partially because similar methodologies are employed. This study finds similar first-order effects to those from the official BIS assessments of Basel III (BCBS (2010) and MAG (2010)) and the analysis at the OECD by Slovik and Cournède (2011).

Three extensions of the methodologies from the official studies, though, lead to substantially lower net economic costs. The base case figures show increases in lending rates of roughly a third to a half of those found in the BIS and OECD studies, despite important common modelling approaches between all of these studies. First, the baselines chosen here assume a greater increase in safety margins due solely to market forces, and therefore less of a regulatory effect, than the OECD study and certainly than the industrysponsored IIF study. Second, this study explicitly assumes that banks will react by reducing costs and taking certain other measures that have little or no effect on credit prices and availability, in addition to the actions assumed in the other studies. The official studies do not assume expense cuts and other adjustments of this type and the IIF study assumes a fairly low level of change. This accounts for 13 bps of cost reduction in Europe, and 10 bps in Japan, 20 bps in the United States. Third, this study explicitly assumes that investors will reduce their required rate of return on bank equity as a result of the safety improvements. Debt investors are assumed to follow suit, although to a much lesser extent. For conservatism, the official studies assume zero benefit from investor reactions and the IIF study essentially assumes that these benefits, although real, will arise over a longer timeframe than is covered by their projections.

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy.

Full discussion note

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