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Friday, September 24, 2010

"The Price of Crisis Prevention"

How much did the financial crisis cost in terms of lost GDP?

The Price of Crisis Prevention, by Jean Pisani-Ferry, Project Syndicate: Two years have passed since the financial crises erupted, and we have only started to realize how costly it is likely to be. Andrew Haldane of the Bank of England estimates that the present value of the corresponding losses in future output could well reach 100% 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 $60 trillion... 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% of GDP (100%/50).

How much would it cost to reduce the frequency of financial crises?:

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 ... 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 one-percentage-point increase in capital ratios would permanently reduce the frequency of crises by one-third, while increasing interest rates by some 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% to 4.13%. 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...

The article does hedge a bit on implementing the new requirements, expressing worry that imposing them too soon could raise capital costs and stall the recovery -- a worry I think is overblown -- but "There is no doubt that the long-term price of insuring against crises is worth paying." Stabilizing the financial sector will require more than just raising capital requirements, something I'll write more about early next week, but these requirements need to be part of the overall package of reforms.

    Posted by on Friday, September 24, 2010 at 11:52 AM in Economics, Financial System, Regulation | Permalink  Comments (11)


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