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the real cost of financial reform

May 26, 2010

Yesterday Mark Gongloff of the Wall Street Journal ran a story describing how the looming passage of financial reform legislation will almost certainly lead to substantial downgrades in the credit ratings, and corresponding increase in costs of borrowing to, the very large financial institutions such as Citigroup and Bank of America. Others implicated, though to a lesser extent, would be Wells Fargo and Goldman Sachs Group. Though its exact implications are contested, Gongloff’s report rightly highlights the fact that financial reform will likely cost the (very large) banks real money.

So will financial reform hurt the economy? That’s the prevailing claim of financial industry players and their lobbyists — and on their terms they are right. But a one-sided focus on the costs to the financial sector overlooks both the extent to which its rich bottom line is taxpayer subsidized and the great cost of doing nothing.

It’s clear that reform comes with a price tag. Increased market transparency would require many derivatives to be traded on exchanges and greater disclosures in consumer financial products. Intensified capital requirements and supervision would reduce the amount of leverage available to financial firms. More rigorous underwriting standards would make it harder for banks to lend. Stricter divisions between deposit taking and proprietary trading (the “Volcker Rule”) would reduce revenue opportunities. All of these measures, and probably many others, would dampen the growth of the financial services sector, reduce its profitability, and perhaps even slow down its capacity to increase credit and introduce new products.

This is not a bad result. First, it cannot be assumed that continued growth from the status quo is a net benefit. In the past 40 years the financial sector’s share of GDP more than doubled. While we debate whether and why this rate of financial sector growth is desirable, we can surely agree on one thing: Americans became overextended as total consumer credit and personal debt service capacity grew at alarming rates between 1995 and 2008. This was unsustainable.

The fact that financial players for whom the party never really ended would like to keep it going is not a justification for backing off reform. Providing a mechanism to enforce greater transparency in disclosures and prevent abusive credit practices will help avoid a situation in which consumers cannot understand or afford the credit enticements they are offered. Likewise, forcing greater transparency in the derivatives markets will promote competition and reduce margins earned only from privileged access to information.

Second, focusing solely on the cost to the financial sector overlooks the alternative costs to the economy in general if we don’t reform. The fact is that financial services are highly subsidized. Subsidies come from a variety of sources, including deposit insurance, Federal Reserve credit and liquidity, regulatory protections, TARP funds and more. The benefits to financial institutions flowing from the TARP funds alone have been estimated by the Center for Economic Policy and Research to run at $34 billion a year. Some of the bigger institutions have repaid loans, and the Treasury stands to make a profit on some of its capital investments. This does not alter the reality of the subsidy, nor does it offset the massive costs of the stimulus and the looming deficit, triggered in large part by the financial crisis. As described above, ratings agencies have indicated that reductions to these government subsidies will lead to significant credit downgrades and raise the cost of borrowing, but the alternative is government-subsidized financial services.

And, third, in an industry in which real costs of doing business are externalized way beyond the executives and shareholders, the benefits that the industry itself enjoys from maintaining the status quo are massively outweighed by the costs to which the public (meaning taxpayers) are exposed. The social and economic costs might well be far greater, particularly if financial behemoths are allowed to continue unchecked. A recent high-level study at the Bank of England strongly suggests the very large global financial institutions, including American ones, are actually imposing a substantial drag on economic recovery, perhaps to the tune of $60 billion per institution.

In his recent letter to shareholders, JP Morgan Chase & Co’s CEO Jamie Dimon, suggested that only banks of Morgan’s size can provide the services and efficiency necessary to America’s large corporations and they will simply go elsewhere if they can’t get those services in America. This argument evades reforms that are also underway abroad. In any event, large financial institutions, including Dimon’s, regularly syndicate their services with other banks. Few large companies entrust their financial services to only one bank. And there is simply no evidence to suggest that such large banks are more efficient than their smaller counterparts; on the contrary, the weight of accumulating evidence demonstrates they are significantly less efficient. (More on bank efficiency to come in a later post.)

Giving regulators the power to restrict and even break up these large institutions when they become systemic risks to the economy will help prevent the prevalence of financial institutions that are too big to fail yet also too big to manage, regulate or afford.

Done right, the real costs of reform will rightly be borne by industry players, where in a capitalist economy they belong. Decrying the “costs” of reform is the canard of industry free loaders. For the economy and the public at large, the real costs of not engaging in strong reform will be far greater.

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