Yesterday, the Federal Reserve Bank of Minneapolis (FRBM) issued a proposal to further tighten regulations on U.S. banks. Using the FRBM’s own analytic approach, including key estimates in the studies they cite, we calculate that the proposal would be so costly for the U.S. economy that it would cost every man, woman, and child in the United States about $13,0001, even after taking into account the benefits it claims in terms of financial crises avoided.
Under the FRBM proposal, all banks with more than $250 billion in assets would be required to hold 23.5 percent equity as a percent of risk-weighted assets and 15 percent equity as a percent of average assets – more than double the current (and already quite robust) standards. To satisfy this requirement, the banking system as a whole would have to increase its common equity-to-risk weighted asset ratio by 8 percentage points.
The FRBM says its plan would reduce the annual probability of a financial crisis from 1.1 percent to 0.5 percent (or, as they state it on page 1 of the proposal, from 67 percent to 39 percent over 100 years). It reaches that conclusion using the analytical approach and data of a 2016 IMF study that is well-accepted as a credible framework for assessing these issues.
To calculate the proposal’s benefit, you need an estimate of how expensive a crisis is when it occurs. The FRBM uses 158 percent of GDP as its estimate, which it attributes a 2010 BIS study. This is somewhat puzzling; although the BIS study does indeed include the 158 percent figure, it referenced it only as an outlier, and indicated it was prudent to focus on other estimates (footnote 14 on p.13 of the BIS study).
Using the BIS’s actual (and already conservative) cost estimate of 63 percent, together with the FRBM’s own probability numbers, the current annual cost of a potential crisis is 0.69 percent of GDP and the annual cost after the FRBM plan is introduced would be .32 percent of GDP. Thus, the benefit of the proposal is that it would reduce the annual cost of potential financial crises by 0.375 percent of GDP.
To calculate the proposal’s cost, the FRBM roughly follows the approach used by the Bank for International Settlements in the 2010 study, concluding that the cost of its proposal is a permanent reduction in GDP of 0.6 percent. When we use cost estimates the BIS suggests in the 2010 study we come up with a higher figure, but we will use the FRBM estimate here.
Putting these benefits and costs side by side, the proposal would have a permanent cost of 0.6 percent of GDP and a permanent benefit of 0.375 percent of GDP forever – in other words, using the FRBM’s own analytical approach, the proposal would, on net, reduce GDP by 0.22 percent forever. If we assume that nominal GDP grows at 4 percent and use a discount rate of 5 percent, then the plan would cost $11.1 trillion and yield a benefit of $6.9 trillion. The net “benefit” would be negative $4.2 trillion. That’s $13,167 for every man, woman, and child in the United States.
There are a number of other serious problems with the proposal, including:
- The problems caused by having such a high leverage ratio (see TCH research note),
- The fact that, by the IMF’s calculations (figure 7 in the report), 15 percent of the bank bailouts in the crisis would still have been needed under the FRBM proposal, and
- The proposal to address shadow banking through a leverage tax would miss money funds (which use no leverage) and the leverage embedded in structured products, and so would miss important causes of the recent financial crisis.
But given the clear direction of the math, we don’t pursue them further here. We thank the Minneapolis Fed for finding an error in the original post. See “The Minneapolis Plan to End Too Big to Fail,” pp. 9
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.