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1.9%: The added annual economic output that tougher banking regulations could generate, according to the Bank for International Settlements.
Bankers and Wall Street economists typically present financial regulation as a trade-off: If we want a safer banking system, we'll also have to give up the robust economic growth that bankers' risk-taking facilitates.
But as much as the argument seems to make intuitive sense, a new and rather extensive study from the Bank for International Settlements – a sort of central bank for central bankers — suggests it's not quite right.
The study concludes that if regulators around the world require banks to set aside more capital as a buffer against losses and hold more cash as insurance against panics, annual economic output could actually be 1.9% higher in the long run. That's because the benefit of having fewer banking crises would far outweigh the costs of the added regulatory burden.
What's more, the study suggests that the optimal capital ratio — the amount of money a bank's own shareholders put in compared to the total assets it buys, weighted by their riskiness — would be 13%, much higher than the historical average of about 7%.
Bankers don't like higher capital requirements, which limit banks' ability to use borrowed money to boost the returns on investments. To maintain their profitability, banks would likely charge higher interest on loans — a move that could dampen economic activity by making companies less willing to invest and expand.
The BIS estimates that a 13% capital ratio combined with tougher cash requirements would lead to about a one-percentage-point increase in interest rates on loans, assuming banks held their profitability at pre-crisis levels. The study notes, however, that bankers could mitigate the impact by cutting costs: A 4% reduction in operating expenses would allow the typical bank to absorb a one-percentage-point increase in its capital ratio without raising the interest rates on its loans.
The BIS calculations allow for an interesting thought experiment. As of 2006, average wages in finance were about 72% higher than in other professions – largely due to the massive salaries and bonuses commanded by executives, traders and others at the top end of the salary range. If that gap were erased (it didn't exist 30 years ago), the average bank could reduce its operating costs by about 19% — enough to raise capital ratios to almost the optimal level with zero increase in interest rates.
In any case, there's a massive potential benefit in avoiding banking crises and all the human suffering they entail. When panic and credit troubles lead people to cut back on spending and companies to lay off workers, much of the lost economic activity is never recovered. Among various studies, the median estimate of the total loss is more than three fifths of an entire year's economic output. One central banker, Andy Haldane of the Bank of England, estimates that the costs of the most recent financial crisis could amount to 3.5 years of economic output.
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Numbers: Good numbers, net result questionable. But for it to work, you will need more numbers; but 2/3 of politicians will lose their job over. The center will remain solid.
Real Time Economics offers exclusive news, analysis and commentary on the economy, Federal Reserve policy and economics. The Wall Street Journal’s Phil Izzo and Sudeep Reddy are the lead writers, with contributions from other Journal reporters and editors. Send news items, comments and questions to realtimeeconomics@wsj.com.
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