Don’t Think Wall Street Regulation Reform Will Cost As Much As ObamaCare? Look Closer.

There is a perception out there that overhauling Wall Street regulations won’t carry the same cost as health care or energy reforms. Towards the end of a Politico story about Obama giving up on the public option was this:

Also this fall, Obama wants to slap new regulations on Wall Street firms, a goal that is now considered a higher priority than cap-and-trade energy legislation in the West Wing. White House officials think the legislation will show voters, especially wavering independents, that he is serious about making the culprits of the economic crisis pay. It also helps that it doesn’t carry a big price tag, like other Obama priorities.

It is understandable that financial services reform isn’t seen as being as costly as other initiatives. It’s hard for Main Street to identify with credit default swaps, macroprudential oversight concerns, cubed collateralized debt obligations, or risk-based capital requirements. The cost of offering insurance to 20 million people through a public option or fears over government rationing of health care are much easier for the American population as a whole to wrap their minds around and make their voice heard.

But just because Wall Street regulations don’t carry a price tag on the front end doesn’t mean it won’t be costly to Americans on the back end.

  • The cost of Waxman-Markey is relatively easy to quanitfy: “Waxman-Markey would cost the economy $161 billion in 2020, which is $1,870 for a family of four. As the bill’s restrictions kick in, that number rises to $6,800 for a family of four by 2035.”
  • The cost of health care also has a price tag, though even the CBO admits much of the calculus for these numbers is guess work: “The cost of extending coverage to the working poor — more than $1 trillion over 10 years.”
  • The cost of Wall Street reform: that’s a little harder to explicitly lay out. However, by looking at the different pieces, we can see where the costs add up.

First, consider the recently signed into law Credit Card Responsibility Accountability and Disclosure Act (CARD). The CARD bill tries to protect consumers by restricting the way companies can charge interest, requires simpler contract language and restricts the types of fees lenders can use. The unintended consequence of this is that the regulations could very well increase the cost of credit, and limit it to others, since firms can no longer charge market rates. While the legislation may wind up making credit card offers easier to read, the cost of credit—particularly to lower income individuals—has increased.

High fees and high interest rates to those with a higher potential to be delinquent is how credit card companies balance the risk of lending to otherwise unqualified buyers. Restricting this practice restricts the access that lower-income families have to credit. It doesn’t impact those with stellar credit scores who pay off their bills every month much at all. And this will be a big part of the effect of Wall Street regulation change as a whole. The proposed Consumer Financial Protection Agency will issue rules similar to the CARD Act that will increase the costs of corporations, who will then pass those down to their customers.

Second, the goal of financial services regulation reform should be to make it easier for firms to compete with each other, and to shift the risk of private sector failure from the government to firms taking the risk themselves. Unfortunately, the Obama plan being developed in the House right now not only fails to get rid of the policy of too big to fail, but embraces it, and builds it into the new regulatory structure. The three tiered system for identifying financial institutions would create a top level of firms deemed too interconnected to the market to fail, and those would have bailouts guaranteed.

The cost of the bailout could reach $23 trillion by the time it is all said and done, according to a July estimate by the Congressional Budget Office. That is staggeringly higher than the proposed cost of ObamaCare. While future bailouts are unlikely to cost this, much, even a fraction of the cost will still be a lot of money. Leaving taxpayers on the hook for the potential failure of big Wall Street firms is not a number than can be shouted at at town hall, but it is a reality that should be just as terrifying as waiting lines for health care.

Third, maintaining the policy of too big to fail by creating a Tier 1 list of financial institutions will also decrease competition. And any time the government picks winners and losers in the marketplace, favoring an institution or group of firms over others, costs rise. Less competition means higher costs for consumers, and higher costs mean slower growth in economic gains, and that translates into an overall negative for the economy as a whole, likely hitting low-income families the hardest.

The Tier 1 category will decrease competition because it gives the big firms a competitive advantage. Being put on a guaranteed bailout list would make a bank the best possible credit risk in the market. The Tier 1 institutions will be backed by the full faith and credit of the U.S. government (read: taxpayers), and will be the best place to invest since it would be nearly impossible to lose the whole investment. This guarantee status will mean Tier 1 firms will have the cheapest access to credit to build their empires and become more “systemically important.” The cost of credit (interest rates on loans) goes down the better credit risk you are, and Tier 1 firms would be able to get rates at the same price that the U.S. government does.

This is not mere speculation. The reality is that we’ve seen this happen before: Fannie Mae and Freddie Mac. Those mortgage companies were perceived by the market to be the best possible credit risk. They had the implicit backing of the U.S. government. As such, they got very low rates when borrowing money, and attracted lots of investment from those who thought the GSEs were a safe bet. The bailout of the FMs proved lenders right, that losses wouldn’t be bore by the risk taking enterprise, but rather by the taxpayers as a safety net. Turning JP Morgan and Citigroup into JP Mae and Citi Mac will only increase costs to consumers as other financial institutions have to charge higher rates for services while trying to compete with Tier 1s.

Fourth, a whole series of regulatory changes are likely to increase costs for higher end consumers. Many of the proposed regulations will require increased reporting, and are expanding rules beyond traditional areas of regulation. The ideas for regulating hedge funds, private equity, derivatives, securities, etc. will increase compliance costs for firms. Compliance costs for smaller hedge funds may increase so dramatically that many fear they will have to shut down. In the end, increased compliance costs will just be passed off to customers, which will decrease investor profits, slowing the economy as a whole just one more notch.

Fifth, many of the regulation proposals are looking to standardize procedures. Reforms in consumer protection, banking regulation, and over-the-counter insurance contracts all would seek to standardize product offerings. The problem is that many of the financial products offered today are profitable because they are unique. Forcing “plain vanilla” on companies will not only reduce profits, but it has the potential to hurt consumers. Maybe a customer wants a different type of mortgage than a standard 30-year fixed loan. Maybe two firms want to trade a complex credit-default swap to meet both their needs. Regulations for different types of banks are understandably different and shouldn’t be jammed into an one-size fits all system.

In the late 1990s, Jersey City created a unique security from pools of collateralized residential tax liens. Investors, buying up millions of this special derivative (and thus the liens), wound up keeping the city from going into bankruptcy because the city was struggling under the weight of unpaid liens. Standardizing financial product offerings would be very damaging to financial institution business models, and it would create unknown costs and losses for the private sector. Without complex product innovation, Jersey City might have gone bankrupt. And this is but one anecdote.

Sixth, (and I promise this is the last one) as necessary as they may be, increased capital requirements and reserve ratios are going to decrease the profit margins of banks. Having to hold more capital relative to debt ultimately might be necessary under a tiered structured regulatory regime, but it will nevertheless decrease the ability of financial institutions to invest. And the less money firms are investing, the less money that small businesses, new business ventures, or expanding companies will have access to in order to grow. Over all, this will slow economic growth down just a little bit more. It will have unseen costs to the American public, as perhaps a company that would have created a cost saving product is unable to get off the ground due to lack of investors. The costs may not be visible, but they will be there.

So after all of that, do I have a number? No. I’d like to be able to offer a number equivalent to the $28 per ton of carbon the Waxman-Markey cap and trade bill will cost. I’d like to be able to put a round, $1 trillion figure on it like health care. But that is not the way financial services regulation costs work. The economic models for determining these kinds of costs would be very complex, but ultimately, it may not be necessary to have the number. Because we don’t have to think of costs in just hard numbers. Simply look through all of the increased costs. Realize that, especially with this kind of a reform, there will be so many unseen losses and costs that we’ll never really know the full damage bad regulations will do.

It is impossible to know how much wealth was destroyed, or potential wealth was lost, by Glass-Steagall over its 70 year reign. But we know that since Gramm-Leach-Biley repealed it there have been massive, exponential gains in the market as a direct result of banks being freer to compete. That is the way it is. That is how costs should be perceived. On the whole, the collective costs of Wall Street regulation reform if not done properly will have just as much if not more impact on every American as health care or energy reform… even if we don’t have the exact number.