Regulation's Razor's Edge
Whether it is Basel 3 or the Dodd-Frank bill - or the projected increased share of government in the economy, we need to understand the impact of regulation. The following is a summary of my remarks to a Finance Symposium on Regulation.
We need to address structural problems
There is a fundamental structural issue that should not be overlooked. The U.S. has 7,830 FDIC insured banks. There is no good economic reason for 7,830 banks. They exist because of the legal structure in the U.S. Some banks are federally chartered and some banks are state chartered. It creates a regulatory nightmare.
If the U.S. is going to competitive in the global banking landscape and hope to have effective regulations, we need to seriously re-examine a basic structural issue. All banks should be federal.
Currently there are 829 banks on the FDIC watch list. We hear about "extend and pretend" strategies being pursued by many banks. The Duke CFO Survey in September showed that 30% of small and medium sized businesses considered credit conditions worse now than a year ago.
The financial system will have difficulty facilitating growth in the economy until we purge the weak banks. These weak banks are denying loans to businesses that present them with good projects -- projects that could increase employment well into the future. Purging the weak banks also has a positive effect on the other banks. High quality assets are usually redistributed to strong banks making them even stronger. Instead of the usual Friday announcement of a handful of failures - let's get it over with quickly.
There are two ideas, in particular, that deserve some extra discussion. The Basel 3 does not provide details on these ideas but they are in the mix.
The first is the idea of having stricter capital requirements for banks that pose systemic risks. Essentially, a bank is penalized for being too big and, as a result, there is an incentive not to become too big. Of course, the problem is where do you draw the line. In the U.S., the list of banks that pose systemic risk is fairly clear. However, what about other countries? One can imagine country A's banks complaining to country A's regulators that they are operating at a competitive disadvantage to country B's banks because the country B did not deem their own banks systemically risky.
The second idea is that of a counter-cyclical buffer. This is unambiguously a good idea and I wish it had been part of the package released this week. The idea is that in good times banks must build capital reserves over and above the usual levels. When a recession arrives, they can dip into the buffer. One of the main problems with the current financial crisis was that banks were undercapitalized. Extreme (and flawed) measures like TARP had to be implemented at great cost to taxpayers. The countercyclical buffer essentially means that the banks need to put more of their profit into a rainy day reserve in good times.
Regulation and cash hoards
The Duke-CFO Survey tried to examine why U.S. firms were sitting on $1.845 trillion in cash (Federal Reserves's Flow of Funds report). Part of the problem is the lack of faith in the financial system. Many firms are hoarding cash because they fear a second wave of the financial crisis. In addition, there is considerable policy uncertainty (both regulatory and economic). 50% of firms have no intention of deploying that cash over the next year.
On the other side, financial institutions have about $1 trillion in excess reserves sitting at the Fed earning 25 basis points. Ideally, some of this cash should be deployed to loans to businesses. However, financial institutions - with the same mindset of the CFOs - perhaps believe this conservative strategy puts them in a stronger position if a second financial crisis unfolds.
We also asked the CFOs about Dodd-Frank. Only 4.9% had a positive view. The 4.9% strips out financial institutions - which had an even more negative view. You might think that the low proportion is biased by political views. I am sure that is a factor -- but it cannot explain 4.9%.
Why don't they like it? Mainly two reasons.
First, the implementation induces a lot of policy uncertainty. There is a lot we don't know about how this massive bill will be implemented. The bill provides a framework. Implementation will determine the new regulations.
Second, CFOs are worried about the cost of debt increasing. Higher cost of debt means that fewer projects have positive present value. It means less investment and lower growth opportunities.
The Razor's Edge
It is simple.
Too little regulation and things can get out of control. For example, many painfully learned during the financial crisis that large parts of the financial system were completely unregulated.
Too much regulation can hurt the entire economy. Financial institutions become more conservative and effectively increase the cost of debt for corporations. This leads to less investment. The group of businesses hardest hit are the small and medium sized businesses. They are deemed more risky because they are small and often relatively new. In most cases, there is less of a track record for the small business. However, these are precisely the businesses the generate the bulk of the jobs in the U.S. economy. If we make it more difficult for them to borrow, this substantially hinders future job creation.
There is no doubt that financial institutions need to be regulated. Given all the guarantees (like explicit FDIC and implicit too big to fail), many would argue they are already quasi-government institutions. However, we need to be very careful not to cross into a territory that destroys future growth opportunities.
One of the reasons that the U.S. economy has been so successful is that the financial system has facilitated ideas to production. That is, if you have a great idea, you can go to a venture capitalist or a bank and get a loan. The loan is risky but the project gets financed. Implementing these ideas leads to jobs. In the end, many of these ideas are failures. Yet some are big winners driving both returns for shareholders as well as opportunities for employment. Regulation can impact the propensity to innovate in an economy. This cost is difficult to measure and is long-term in nature. However, it must be considered.