The wrong sort of regulation can hurt you

The aftermath of the recession has brought with it a desire to regulate the financial system.

The severity of the economic downturn was caused, in part, by poor financial regulation in key areas.

However, there has been little serious attempt to coordinate regulation globally — or even regionally.

Any change, especially in so significant a sphere as the banking sector, will have economic repercussions. Using the most basic of definitions, banks exist to bring together people who want to invest, and people who want to borrow. The bank takes on a certain risk with every loan it arranges, and charges a fee or spread to compensate for the costs and risks it incurs.

There are, therefore, two main consequences of regulating banks:

• Regulation will impact the ease with which money can be borrowed, and

• Regulation will affect the price at which money can be borrowed

This is because regulation changes either the willingness of banks to take on risk, or the costs of managing the lending process, or both.

None of this is to say that regulation is a bad thing. Regulation can be good. Lack of regulation can be bad. (The last two years have painfully demonstrated that latter point).
Accepting that regulation can be a force for good, however, we must also acknowledge that
regulation will incur a cost.

If regulation makes it more difficult to use certain instruments (including derivatives) to manage risk, then the risk must be paid for in other ways. This could raise the cost of borrowing, as banks pass on the risk costs to their borrowers.

That in turn reduces the amount of borrowing that takes place, reducing the amount of investment that takes place, reducing the rate of economic growth.

Similarly, changing the amount of capital banks must hold may improve the “safety” of banks.
In achieving this objective, however, regulators will reduce the amount of money that banks can lend. Reducing the supply of loans (reducing the supply of anything) raises the price.

Financial regulation will therefore raise the cost of borrowing and reduce the amount of borrowing. That may be a prudent response to the crisis. However, regulating the financial sector in an uncoordinated way raises the cost of borrowing unnecessarily, and reduces lending more than is necessary.

One simple way to think about this is through the cost of managing regulation. A bank that deals with more regulation at home has to hire more lawyers. A bank that deals with more regulation abroad has to hire even more lawyers. Those lawyers cost money, and banks will pass on those costs to their customers.

Thus uncoordinated financial regulation will raise the cost of borrowing and reduce the amount of money available for lending worldwide.

There are two consequences that arise from this, as long term concerns. Investment requirements and emerging market development will both be key issues. The fact that there is less money available for investment comes at a bad time. The global population is predicted to rise to nine billion people by 2050.

This will put an increased strain on global resources. The world must become more efficient in its use of energy, water and other resources if it is to be able to provide an acceptable standard of living for its citizens.

Greater efficiency requires greater investment. Not just building new power plants to meet new demand (for example), but replacing old power plants that are no longer suitable for resource constrained times. In other words, the world needs to embark on a major upgrade of its capital at exactly the same time that regulation is making it more costly and more difficult to find the funding for that capital.

The second consideration is emerging markets. The one defining characteristic of every emerging market (in Asia, Latin America, Europe or Africa) is that it has limited capital and limited infrastructure. Emerging markets transform into developed economies as they acquire capital and infrastructure.

Ten years into the future there could be constraints on emerging markets’ ability to transition into developed economies, if the capital that they need is not readily available.

This is less because of constraints on banks in the emerging markets, and more due to the fact that the global cost and availability of capital is changing. Banking regulation should not be resisted just because it limits capital and raises the cost of capital. Bad, uncoordinated banking regulation that unnecessarily limits borrowing and raises the cost of capital should be resisted.

The world will need to invest significantly more money in the next 20 years if it wants to keep today’s standards of living. Emerging markets will have to invest massively if they aspire to become developed economies. Regulators might like to bear this in mind, and consider the economic consequences of their failure to cooperate.



The writer is deputy head, Global Economics, UBS Investment Bank.