Banking Relations: IMF Study Suggests Smaller Impact of Bank Regs

Regulatory effect will not crimp lending rates as banks and others have claimed.

A new IMF study shows that financial reform will have only a “modest” impact on bank lending rates in the US, Europe, and Japan in the long term. This refutes banks’ claims that excessive capital requirements could put a damper on the ability of banks to lend and conduct other activities.

The report, Estimating the Costs of Financial Regulation, said new rules will have only slightly increase bank lending rates – by 28 basis points in the US, 17 bps in Europe, and 8 bps in Japan – in the long term. This is for three reasons, IMF economist Andre Oliveira Santos and Douglas Elliott, a fellow at the Brookings Institution who worked as a consultant for the IMF, wrote in the report. 

1. the baseline scenario implies a smaller regulatory effect, with market forces accounting for some of the expected increases in safety margins.
2. banks are expected to absorb part of the higher costs by cutting expenses.
3. 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.

Perhaps the argument against number one is that market forces are really not at work lately and likely won’t be for some time what with the regulatory uncertainty and other government intervention. Number two has already been witnessed in many financial sectors, particularly in New York, where thousands of bankers have been laid off; this also will likely continue. Number three is interesting as it suggests investors will expect less and will act accordingly. While this may be true for healthy banks and their investors in the US, many might question the ability of European banks, many of which are struggling to both stay afloat and comply with capital rules, to even attract any investment at all. Since many of these banks are straining to generate the capital they need from profits, they may simply try to reduce the size of their loan books instead of raising more capital.

The report does acknowledge the limitations its analysis. For instance it doesn’t address the unknown transition costs as banks adjust to the new regulations. Nor does it take into account any economic benefits of financial reforms. “A number of regulatory reforms are not modeled; judgment has been required in making many of the estimates; and the modeling approach is relatively simple,” the authors wrote. “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.”

All this said, banks will continue to be cagey when it comes to lending to those companies that are risky credits, and will pass on any new costs to any company they can.