Financial Regulation and the Federal Budget
To explore how changes to financial regulation might affect the federal budget, CBO analyzed three illustrative policies. The agency found that the policies’ largest budgetary effects would stem from macroeconomic feedback. Watch the narrated presentation.
Financial institutions, such as banks, play a vital role in the economy by channeling funds from investors to households and businesses that need financing. By doing so, such institutions support economic activity, including household consumption and business investment, and thereby contribute to economic growth and job creation. But instability in the financial industry can spill over into the economy and may even cause severe recessions, as demonstrated by the financial crisis of 2007 to 2009. Financial regulation and government guarantees, such as deposit insurance, are intended to protect consumers and investors and to ensure that the financial system remains stable and continues to make funding available for investments that support the economy.
Regulations and guarantees can, however, reduce efficiency and competition or have other unintended consequences. Excessive regulation can inhibit economic activities that support growth and that pose little risk to the economy. Underpriced guarantees can encourage activities that shift risk to taxpayers and make the economy more volatile and a crisis more likely. When making decisions about regulation, policymakers thus face a trade-off between increased safety and stability on the one hand, and lower costs of financing and faster economic growth on the other.
Financial regulation affects the federal budget directly through spending on programs that support the stability of financial institutions as well as through the revenues generated by the taxes and fees that those institutions pay. Regulation also affects the budget indirectly through its effects on the economy: Under the baseline economic conditions outlined in CBO’s economic forecast, regulation influences the cost and availability of financing and affects not only the likelihood of a future financial crisis but also how severe such a crisis might be. Those economic effects in turn feed back into the federal budget (see figure below).
What Are the Main Components of Federal Financial Regulation Under Current Law?
Federal financial policy falls under three main categories:
- Safety and soundness regulation;
- Guarantee, lending, and resolution authorities; and
- Consumer and investor protection.
Regulations promoting the safety and soundness of individual institutions support financial stability and protect households who place their savings in the financial system; such regulations directly affect the cost of federal programs such as deposit insurance. The federal government’s authority to guarantee deposits, make loans to financial institutions, and resolve failing institutions limits the consequences for the financial system and for households when institutions fail. Regulations aimed at consumer and investor protection discourage or even prohibit practices that might harm consumers of financial products and investors in financial securities.
In this report, CBO analyzes the following illustrative policies to demonstrate how changes in each of those three categories might affect the budget:
- Reduce the ratio of capital to total assets that a bank must use to finance its operations by 1 percentage point;
- Eliminate orderly liquidation authority, which allows the Federal Deposit Insurance Corporation (FDIC) to lend to financial institutions when the stability of the financial system is at stake; and
- Repeal the ability-to-repay rule governing mortgage lending, which requires lenders to make a good-faith determination that borrowers are able to repay before they originate loans.
The three illustrative policies were chosen to represent a broad range of proposals that policymakers have considered or might consider in the future. For simplicity, the three policies all reduce the government’s involvement in the financial sector. But the analysis is also relevant for changes that would increase the government’s involvement or that would have effects that were somewhat similar in size to those of the illustrative policies. (The three policies were not designed to have effects of the same magnitude as one another.)
What Are the Direct Effects of the Three Illustrative Policies on Spending and Revenues?
The three policies affect the costs of government guarantees and of other payments that the government makes to mitigate the consequences of failing financial institutions. Lowering capital requirements would increase the risk of financial institutions’ failing, and if more institutions went under, the cost to the FDIC of resolving such failures—whether by invoking its orderly liquidation authority or by issuing payments from the Deposit Insurance Fund (DIF) to individuals who have deposits at the failed institutions—would rise. If repealing the ability-to-repay rule resulted in financial institutions’ issuing more risky mortgages than they do under current law, that policy would also increase the risk of institutions’ failing. In addition, those two policies would raise offsetting receipts and revenues by increasing premiums for deposit insurance and the fees charged to financial institutions to offset the higher costs stemming from the higher rate of bank failure. Eliminating orderly liquidation authority would remove from the budget the net costs associated with it under current law, but those savings would be partially offset by increases in the costs of maintaining the DIF.
What Are the Economic Effects of the Three Illustrative Policies?
When the financial system is stable, lower capital requirements and the loosened mortgage standards brought about by repealing the ability-to-repay rule would increase the availability—and lower the cost—of financing for investments, thus raising gross domestic product (GDP). Lowering capital requirements would allow depository institutions to finance more of their assets with debt, which would lower the after-tax cost of financing. Repealing the ability-to-repay rule would allow more people to take out mortgages, which would in turn increase residential investment. Both of those changes in policy would, under baseline economic conditions, raise GDP.
Those two policies would, however, also increase the likelihood of a financial crisis, and such a crisis would substantially lower GDP and raise the deficit. Similarly, eliminating orderly liquidation authority would get rid of a tool that policymakers might wish to use to respond to a future crisis. The absence of that tool could raise the severity of an economic downturn that stemmed from a financial crisis that other tools available under current law could not quickly contain. When all possible outcomes are weighted on the basis of their probability of occurring, the negative effects on the economy that the illustrative policies could bring about in some cases more than fully offset the projected positive effects of the policies under baseline economic conditions.
What Are the Budgetary Consequences of Those Economic Effects?
The economic effects of the illustrative policies would feed back into the budget. Under baseline economic conditions, the effects of such macroeconomic feedback on tax revenues would be mixed. By allowing banks to finance more of their operations with debt instead of equity, lowering capital requirements would induce a shift to debt financing that would reduce corporate tax revenues. But by raising GDP, it would also raise both individual and corporate income tax revenues under baseline economic conditions, though by a lesser amount.
Loosening mortgage standards by repealing the ability-to- repay rule would slightly raise productivity and income. But the increase in economic activity would be concentrated primarily in the housing sector, and categories of gross income in that sector, including depreciation and imputed rent, are taxed at lower rates than overall income. The increases in productivity and income from repealing the ability-to-repay rule would thus lead to relatively small changes in total revenues.
Eliminating orderly liquidation authority would give rise to offsetting factors, making both the direction and the magnitude of the policy’s economic effects under baseline economic conditions uncertain. CBO estimates that the macroeconomic feedback from implementing that policy would have no effect on the budget, but it is possible that eliminating orderly liquidation authority could either increase or decrease financial institutions’ incentive to engage in risky behavior, which would affect economic activity under baseline conditions and change the likelihood of a financial crisis. The precise effects depend on how market participants expect policymakers to use orderly liquidation authority and whether their expectations cause them to take on more or less risk. In addition, the effectiveness of orderly liquidation authority in a crisis would depend on whether the FDIC’s exercising that authority increased stability as intended or instead resulted in further uncertainty among market participants.
All three illustrative policies would increase the likelihood and potential severity of a financial crisis. Implementing any of the policies would also increase the likelihood that deficits would rise substantially, because if a financial crisis occurred, revenues would drop, safety-net spending would rise, and the government would incur direct costs to stabilize the financial system. The reduction in tax revenues brought about by a crisis would contribute much more to deficits than would the direct costs of resolving such a crisis, CBO estimates. That projection is based on analysis of the 2007–2009 crisis, whose impact on the budget came primarily through the large drop in tax revenues (both in nominal dollars and as a percentage of GDP) rather than through the costs of resolution through the deposit insurance system. The Troubled Asset Relief Program (TARP), which was created through legislation to stabilize the financial system, is estimated to have cost the federal government a total of $32 billion: Programs that supported financial institutions resulted in a net gain of $12 billion, and mortgage programs and activities that assisted the automotive industry together cost $44 billion. Legislation enacted after the crisis to stimulate the economy with government spending and tax relief generated substantially larger budgetary costs.
One key takeaway of this analysis is that the largest effects of changes to financial regulation policies on the federal budget stem from macroeconomic feedback (see figure below). Although in CBO’s projections the magnitude of that macroeconomic feedback exceeds the direct effects of policy changes, projections of the economic effects of changes to financial regulations and federal guarantees—and thus the consequences of those effects on the budget—are subject to greater uncertainty than are projections of the direct budgetary effects of such policies.
This report highlights the effects of financial regulation on the federal budget, but those effects are not the only—nor necessarily even the primary—consideration in evaluating financial regulation. In addition to the effects on economic variables and the federal budget, the Congress and the public might wish to consider the effects of financial regulation on large and small businesses or the consequences of financial crises on the well-being of families, homeowners, and communities— including increased rates of foreclosure and eviction, sluggish growth in wages, and losses in household wealth. Furthermore, a crisis would affect not only the budget of the federal government but those of state, local, and tribal governments as well. Such effects could have long-lasting social consequences.
Other studies of financial regulation have used a benefit-cost framework to analyze financial regulation, but such an analysis is beyond the scope of this report. Such an analysis would provide a full inventory of the benefits and costs of alternative policies and would typically highlight the trade-off between improved stability in the financial system and the costs of regulation: Tighter regulation leads to a financial system with lower rates of failure but with higher costs to businesses and consumers. A benefit-cost analysis evaluates policy proposals on the basis of whether the value of the improved efficiency (during stable economic conditions) expected to result from implementing the proposal outweighs the cost of the estimated increase in the likelihood of a crisis stemming from the change. That trade-off between safety and cost is characteristic of efforts to regulate financial markets.
How Uncertain Are the Estimates of Economic and Budgetary Effects?
Because this analysis required numerous assessments about how participants in financial markets might react to policy changes and how their changes in behavior would affect the economy, the estimates are uncertain. All the underlying parameters used to generate those estimates are also, to varying degrees, uncertain. In large part, that uncertainty arises because the probability of a financial crisis is difficult to estimate: Such crises are rare, and federal policy has continued to change over the past century, so the historical data from times when such policy was similar to what it is today are very limited. Furthermore, the next crisis may differ significantly from previous crises, adding even more uncertainty to historically based parameters.
To establish the parameters used in this analysis, CBO drew on academic literature on the causes and consequences of financial crises, the effects of financial regulation, and the predictors of failure for individual financial institutions. In some cases—such as the relationship between banks’ levels of capital and rates of failure— the values that CBO used for the parameters are from academic studies. In other cases, the literature does not provide direct evidence to support a particular value for a parameter, but it nevertheless informed the agency’s judgments about the parameter. For example, no empirical study of the relationship between orderly liquidation authority and the severity of crises exists because no crisis has occurred since that authority was established; thus, there are no data on which to base such a study. In that case, CBO reviewed studies of the economic performance of countries that resolved their banking crises using different approaches, and it also considered ways that orderly liquidation authority might be used in future crises.
Two Caveats About This Analysis
In accordance with the conventions the agency uses to prepare cost estimates, CBO conducted this analysis under the assumption that current laws governing spending and revenues will generally remain unchanged. The projections provide estimates of how the illustrative policies would affect the budget during and after a crisis if the Congress did not pass any emergency legislation to address it. That limitation is especially significant in the analysis of the scenario in which orderly liquidation authority is eliminated. For that analysis, CBO compared the crisis response that would occur through orderly liquidation authority under current law with the response that would be likely to occur if that authority was eliminated and the government relied on other mechanisms in place under current law. The analysis does not include the effects of legislation that the Congress might pass after a crisis was already under way to address unforeseen problems. Although CBO’s projections reflect the assumption that current law remains unchanged, the agency takes into account assessments about how market participants’ behavior would be affected by their anticipating policy decisions, including possible changes in law, during a crisis.
Also by convention, this report projects the budgetary effects of the illustrative policies on a cash basis over 10 years. That timeframe gives a truncated picture of the long-run budgetary effects of the illustrative policies. For example, the FDIC determines premiums and assessments to ensure that they are high enough to recoup costs over the long run. Sometimes the lag between when the FDIC experiences losses and when it charges premiums to cover them is greater than 10 years. In that situation, long-run costs would be lower than those indicated by the 10-year projections because revenues would be received after the projection period ended. Similarly, the 10-year cash estimates give a truncated picture of the economic effects of the illustrative policies. Policies that change the cost of financing investment may take more than a decade to fully affect the stock of productive capital.