Financial Regulation and the Real Economy

Transcription

1 Financial Regulation and the Real Economy Federal Reserve/IMF/World Bank Conference, June 2014 Douglas J. Elliott The views expressed are solely my own and do not necessarily reflect those of the Brookings Institution or the IMF

2 2 Key Points The financial sector will be safer because of reform This safety comes at a cost to growth in non-crisis years The cost should be more than offset over time by the reduction in the economic damage from crises Some users of finance will be hit harder than others, meriting policy responses New or increased systemic risks will arise in certain areas Some regulations may cost more than they help; recalibration will be necessary over time

3 3 Finance is safer post-crisis Markets went through a natural self-correction post-crisis» Investors and funders demanded higher capital» Over-reliance on short-term market funding was punished» Badly constructed or opaque products vanished» Extremely low risk aversion reversed Governments and regulators established many new rules and toughened many others Supervisors cracked down on riskier practices

4 4 Categories of policy responses Bigger and higher-quality buffers at individual institutions» Capital» Liquidity Fixes to market practices» Derivatives (CCPs, exchanges, margin, capital)» Securitization» Ratings Structural reforms Macroprudential policy (structural and cyclical) Improved regulatory designs and supervision practices

5 5 Safety usually comes at a price There can be reforms that improve efficiency and safety at the same time, such as eliminating compensation incentives for excessive risk taking However, most regulatory safety improvements raise the price of financial products and reduce their availability For example, higher liquidity has a price» Longer-term liabilities are usually costlier» Shorter-term assets usually yield less» Higher quality and more liquid assets yield less Higher margin requirements raise costs by forcing a higher level of high-quality short-term assets

6 6 Capital does come at a cost Equity is more expensive for a bank to issue than debt The Modigliani-Miller theorem says this is fully offset, under specific assumptions But, the real world violates the M-M assumptions» Tax benefits of debt» Cheap deposit insurance and possible TBTF benefits» Issuance costs, including adverse selection costs» Agency problems» Low-risk anomaly in equity markets Managements and investors clearly act as if M-M is only a partial offset, which can lead to regulatory arbitrage

7 7 Benefits should more than offset costs I believe the best studies, including my own for the IMF, show that the societal costs are low enough that the reduction in crisis damage should more than offset them However, this calculation only holds if one believes, as I do, that the reforms are fairly effective in reducing overall systemic risk There are reasonable arguments that convince some that systemic risks will remain high or even increase We will not know the answer for certain for years The uncertainty should not dissuade us from reform, but should encourage an appropriate caution

8 8 There are relative losers from reform Banks and affiliated broker/dealers are substantially more affected by new and toughened regulation than other subsectors of finance, and big banks even more so» They will lose market share» Their customers will get less and pay more» Their decreased role in financial markets will increase volatility and transaction costs Non-banks and financial markets will gain share, which will somewhat temper the overall effect on customers

9 Some customers may be hit most Customers particularly reliant on banks, like SME s Customers whose type of business will be hit particularly hard by bank capital and liquidity rules changes» Sponsors of infrastructure projects» Emerging market government debt issuers Customers particularly reliant on market liquidity provision who are not priority clients of banks» Smaller asset managers and institutional investors» Smaller, less creditworthy issuers on the markets Extent of impacts is not yet clear, partly because of easy monetary policies 9

10 10 Systemic risks will be transformed There should be substantially less risk directly at banks Regulatory arbitrage may shift considerable business to riskier non-banks or market structures» Mortgage REITs as an example?» Leveraged credit funds, in the future?» Finance companies again, someday?» Lending by big firms to customers and suppliers? The desirable shift to CCPs also creates new systemic risks We do not yet know the extent of these various potential risks

11 11 There should be a recalibration of the reforms as we learn more over time It is not conceivable that we have avoided all significant errors in designing the reforms A particular concern is the interactions between important categories, which are not well understood» Multiple capital requirements with differing incentives» Multiple liquidity rules which interact with them A few reforms may be outright mistakes, in which I include the Volcker Rule and European compensation rules

12 12 Key Points The financial sector will be safer because of reform This safety comes at a cost to growth in non-crisis years The cost should be more than offset over time by the reduction in damage from crises Some users of finance will be hit harder than others, meriting policy responses New or increased systemic risks will arise in certain areas Some regulations may cost more than they help; recalibration will be necessary over time

13 13 Selected papers of mine IMF paper on likely changes in credit price and availability from the global financial reformswww.imf.org/external/pubs/cat/longres.aspx?sk= Brookings paper arguing there are costs to higher capital Brookings paper on macroprudential policy and the economy, drawing lessons from US history macroprudential-policy-lessons-american-history-elliott