Ragnar E. Juelsrud
Avdeling for pengepolitikk/ Monetary Policy Department
The global financial crisis caused a wave of regulatory reforms. The reforms aimed at making the financial system safer and less prone to both creating and reinforcing an economic downturn. Now, a decade later, a debate taking place on whether more, less, or different regulation is needed going forward. Motivated by this, Norges Bank organized the workshop “Prepared for the next crisis? The costs and benefits of financial regulation” on the 11th and 12th of November. The workshop, organized together with the International Banking, Economics, and Finance Association (IBEFA), was held in Oslo and brought together researchers from all across the globe.
Eric Rosengren, President at the Federal Reserve Bank of Boston, gave a keynote address. In his speech, titled “Financial Stability and Regulatory Policy in a Low-Interest Rate Environment,” Rosengren argued that it is vital to assess whether our economies are prepared for the next downturn and to consider whether policymakers have built sufficient resilience into the financial system. He argued that more is needed. A primary reason for this is the low-interest-rate environment most Western economies currently face, with key policy rates of central banks being either close to zero or close to even negative. These low interest rates may bring limitations to how much monetary policy stimulus central banks can deliver in the next downturn. Such a diminished capacity of monetary policy to offset shocks implies, according to Rosengren, that policymakers also need to consider regulatory and financial stability tools. While much has been done since the financial crisis, it is not obvious that the policies and tools that would have been appropriate for a downturn in a high-interest rate environment are sufficient in a low-interest-rate environment. For several reasons, Eric Rosengren argued, a low-interest-rate environment makes it more difficult to exit recessions. This difficulty is due not just to the smaller monetary policy buffer, but also to the fact that a low-interest-rate environment encourages greater leverage for households and firms. This can potentially amplify the severity of a downturn.
What would be an appropriate policy response? President Rosengren argued that one crucial area of focus should be more capital in banks. He explained that while this is true for the United States, it may be even more true in Japan and Europe. Steps that increase capital would put banks in a better position to handle an economic downturn. This could, hopefully, help compensate for limited monetary and fiscal policy buffers.
In addition to the keynote address, the workshop contained ten presentations of research related to financial stability and financial regulation. Several papers focused on various consequences of increasing capital requirements. Skander Van Den Heuvel (from the Federal Reserve Board) presented a paper evaluating optimal capital requirements from a theoretical perspective. In his article, he also considered a potential complement to capital requirements, namely liquidity requirements. Whereas capital requirements regulate how much capital banks need to cover the risk in their assets, liquidity requirements aim at ensuring that banks hold at least some minimum amount of liquid assets to deal with the outflow of funding in times of market stress. In his model, having some amount of liquidity and capital regulation is optimal from society’s point of view, as these regulations increase financial stability. However, they can also be costly because they can induce banks to lend less and hence reduce the size of the economy. Skander van den Heuvel argued that capital requirements have larger financial stability benefits compared to liquidity requirements, but that they are also costlier. A take-away from his analysis was that liquidity and capital requirements are not substitutes for each other and that a good policy mix requires a combination of the two.
Giovanni Favara (also from the Federal Reserve Board) presented an analysis of the impact of higher capital requirements for globally systemically important banks in the U.S. on bank lending. The capital requirement for globally systemically important banks is an additional capital requirement levied on some of the very largest U.S. banks. A takeaway from his study was that higher capital requirements lead to a reduction in bank lending by these systemically important banks but firms borrowing from these affected banks were able to compensate for this by switching to other, not systemically important banks. The impact of the extra capital requirements therefore did not translate into real economic consequences for firms, suggesting that the economic costs of higher capital requirements can be lower than perhaps expected – at least if it only affect some banks.
Emilio Bisetti (Hong Kong University of Science and Technology) focused on the gains from higher supervision. In his paper “The Value of Regulators”, he showed that a sudden removal of Federal Reserve supervision lead to losses in the market valuation of banks. His interpretation of this – for which he presented empirical support– was that banking supervision benefits shareholders of banks because reduces misreporting in the banks and the need for shareholders to spend time on internal monitoring of banks.
Adrien Alvero (Columbia Business School) analyzed the compliance cost of the Dodd-Frank Act. The Dodd-Frank Act was implemented in the U.S. after the financial crisis, and constitutes a substantial change in the regulation of U.S. financial institutions. Many financial institutions have argued that the Dodd-Frank Act led to a large increase in the cost of compliance for banks, potentially undermining the objectives of the reform. The law, however, exempts banks with a value of total assets below USD 10 billion from several components of the regulation. Empirically, there are indications that banks “bunch” below these thresholds, or put differently, that there is an unnatural amount of banks with size just below them. Since shrinking assets to get below these thresholds also means that banks forego some profits, Adrien argued that it is possible to infer the compliance costs of parts of the Dodd Frank Act. This is because – if affected banks behave as profit maximizing institutions – they would never shrink assets unless the total gain from doing so were positive. His estimates suggest compliance costs are approximately USD 1.5 million for banks below the USD 10 billion threshold – substantially less than self-reported estimates in surveys from banks.
The remaining papers focused on questions such as: do capital requirements in one country spill over to other countries? Does trading increase or decrease systemic risk of banks? What are the consequences of regulatory forbearance? The full program is available here.