Thu, Sep 30, 2010 - Page 9 News List

Finding the most cost-effective solution to crisis prevention


Two years have passed since the global financial crisis erupted, and we have only started to realize how costly it is likely to be. Andrew Haldane, an executive director at the Bank of England, estimates that the present value of the corresponding losses in future output could well reach 100 percent of world GDP.

This estimate may look astonishingly high, but it is relatively conservative, as it assumes that only one-quarter of the initial shock will result in permanently lower output. According to the true doomsayers, who believe that most, if not all, of the shock will have a permanent impact on output, the total loss could be two or three times higher.

One year of world GDP amounts to US$60 trillion, which corresponds to about five centuries of official development assistance or, to be even more concrete, 10 billion classrooms in African villages. Of course, this is no direct cost to public budgets (the total cost of bank rescue packages is much lower), but this lost output is the cost that matters most when considering how to reduce the frequency of crises.

Assume that, absent adequate preventive measures, a crisis costing one year of world GDP occurs every 50 years (a rough but not unreasonable assumption). It would then be rational for the world’s citizens to pay an insurance premium, provided its cost remains below 2 percent of GDP (100 percent/50).

A simple way to reduce the frequency of crises is to require banks to rely more on equity and less on debt so that they can incur more losses without going bankrupt — a measure that is currently being considered at the global level. Thanks to reports just released by the Financial Stability Board and the Basel Committee — one on the long-term implications of requiring higher capital-to-asset ratios, and one on the transitory effects of introducing them — we know more now about the likely impact of such regulation.

The first report finds that, starting from the current low level of bank capitalization, a 1 percentage point increase in capital ratios would permanently reduce the frequency of crises by one-third, while increasing interest rates by about 13 basis points (banks would need to charge more because it costs them more to raise capital than to issue debt). In other words, the price of losing one year of income every 75 years instead of every 50 years would lead banks to increase the rate on a loan from 4 percent to 4.13 percent. Such an insignificant increase would at most lead a few bank customers to turn to alternative sources of finance, most likely with no discernible effect on GDP.

It is stunning to find that a regulation can do so much good at such a small cost — much smaller than in many other fields where public policy imposes economically costly safety requirements. Think, for example, of the environment or public health, where the precautionary principle guides decision-making.

So much for the long term. The hotly debated question nowadays is whether the transition to higher mandatory reserves would involve excessive short-term costs, as banks will likely increase lending spreads and reduce credit volumes. Subjecting banks — some of which are still ailing — to new regulation may lead them to curtail lending even more, thereby further weakening the pace of economic recovery. Sound judgment is needed regarding the speed and timing of regulatory tightening.

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