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Financial Regulation and the Federal Budget © Marek Masik/Shutterstock.Com SEPTEMBER 2019 at a Glance CONGRESS OF THE UNITED STATES CONGRESSIONAL BUDGET OFFICE Financial Regulation and the Federal Budget © Marek Masik/Shutterstock.com SEPTEMBER 2019 At a Glance Financial regulation affects the federal budget directly through spending for programs that support the stability of financial institutions and through the taxes and fees that those institutions pay. Regulation also affects the budget indirectly through its effects on the economy, which generate a trade-off: Increased financial regulation may lower the likelihood of a financial crisis and mitigate the severity of any crisis that occurred, but it may also raise the cost of financing for investments. Those economic effects feed back into the federal budget. Federal financial regulation generally falls into three categories: safety and soundness regulation; guarantee, lending, and resolution authorities; and consumer and investor protection. To explore how changes to regulation of all three types might affect the federal budget, in this report the Congressional Budget Office provides a dynamic analysis—that is, it estimates both the direct budgetary effects and the macroeconomic feedback—of the following three illustrative policies, which represent a broad range of proposals affecting the financial sector: • Reduce banks’ capital requirements by 1 percentage point (an example of safety and soundness regulation); • Eliminate the Federal Deposit Insurance Corporation’s orderly liquidation authority, which allows the agency to lend to financial institutions when the stability of the financial system is at stake (an example of the government’s guarantee, lending, and resolution authorities); and • Repeal the ability-to-repay rule, which requires mortgage lenders to make a good-faith determination that borrowers have the ability to repay the loans that they originate (an example of consumer and investor protection). CBO found that the largest effects on the budget of implementing the policies would stem from macroeconomic feedback. Estimating the economic con- sequences of the policies required the agency to make numerous assessments about how participants in financial markets might react to changes and how those behavioral changes would in turn affect the economy. Such assessments are inherently uncertain, so when possible, CBO has included ranges of alternative values along with its central estimates. Because of that uncertainty, the estimates of the total effects of the policies on the federal budget, though informative, are nevertheless highly uncertain. www.cbo.gov/publication/55586 Contents Summary 1 What Are the Main Components of Federal Financial Regulation Under Current Law? 1 What Are the Direct Effects of the Three Illustrative Policies on Spending and Revenues? 2 What Are the Economic Effects of the Three Illustrative Policies? 3 What Are the Budgetary Consequences of Those Economic Effects? 3 How Uncertain Are the Estimates of Economic and Budgetary Effects? 4 Two Caveats About This Analysis 5 Financial Regulation Under Current Law 7 Goals and Challenges of Financial Regulation 7 1 BOX 1-1. THE EFFECTS OF THE 2007–2009 CRISIS ON STATE AND LOCAL FINANCES 10 Safety and Soundness Regulation 11 Financial Guarantee, Emergency Lending, and Resolution Authorities 12 BOX 1-2. MEASURING THE COST OF THE FEDERAL DEPOSIT INSURANCE CORPORATION’S ACTIVITIES: CASH VERSUS ACCRUAL ACCOUNTING 15 Consumer and Investor Protection 17 Direct Effects of CBO’s Three Illustrative Policies on Spending and Revenues 19 Lowering Capital Requirements 19 2 Eliminating Orderly Liquidation Authority 21 Repealing the Ability-to-Repay Rule for Mortgages 22 Effects of the Three Illustrative Policies on the Economy 25 Effects Under Baseline Economic Conditions 25 3 Effects on the Likelihood and Severity of Financial Crises 32 Budgetary Consequences of the Policies’ Economic Effects 43 Macroeconomic Feedback Under Baseline Economic Conditions 43 4 Macroeconomic Feedback Stemming From Changes in the Likelihood and Severity of Financial Crises 43 Lowering Capital Requirements 44 Eliminating Orderly Liquidation Authority 45 Repealing the Ability-to-Repay Rule for Mortgages 46 II FINANCIAL REGULATION AND THE FEDERAL BUDGET SEPTEMBER 2019 Sensitivity of the Results to the Parameters Used in This Analysis and to Provisions of Tax Law 49 5 An Overview of the Models and Parameters Used in This Analysis 49 Sensitivity of the Estimates of the Direct Effects on Spending and Revenues 50 Sensitivity of the Estimates of Macroeconomic Feedback 51 Appendix: The Cost of Capital Requirements and the Modigliani and Miller Theorem 55 List of Tables and Figures 57 About This Document 59 Notes Unless otherwise indicated, all years referred to in describing budgetary estimates are federal fiscal years, which run from October 1 to September 30 and are designated by the calendar year in which they end. Years referred to in describing economic variables are calendar years. Numbers in the text, tables, and figures may not add up to totals because of rounding. Supplemental materials for this analysis—including an interactive tool, the computer code used to generate the estimates, and a narrated slide deck—are available on CBO’s website (www.cbo.gov/publication/55586). Summary Summary inancial institutions, such as banks, play a vital What Are the Main Components of Federal role in the economy by channeling funds from Financial Regulation Under Current Law? investors to households and businesses that Federal financial policy falls under three main categories: need financing. By doing so, such institutions Fsupport economic activity, including household con- • Safety and soundness regulation; sumption and business investment, and thereby contrib- ute to economic growth and job creation. But instability • Guarantee, lending, and resolution authorities; and in the financial industry can spill over into the economy and may even cause severe recessions, as demonstrated by • Consumer and investor protection. the financial crisis of 2007 to 2009. Financial regulation and government guarantees, such as deposit insurance, Regulations promoting the safety and soundness of are intended to protect consumers and investors and individual institutions support financial stability and to ensure that the financial system remains stable and protect households who place their savings in the finan- continues to make funding available for investments that cial system; such regulations directly affect the cost of support the economy. federal programs such as deposit insurance. The federal government’s authority to guarantee deposits, make loans Regulations and guarantees can, however, reduce effi- to financial institutions, and resolve failing institutions ciency and competition or have other unintended limits the consequences for the financial system and for consequences. Excessive regulation can inhibit economic households when institutions fail. Regulations aimed activities that support growth and that pose little risk at consumer and investor protection discourage or even to the economy. Underpriced guarantees can encour- prohibit practices that might harm consumers of finan- age activities that shift risk to taxpayers and make the cial products and investors in financial securities. economy more volatile and a crisis more likely. When making decisions about regulation, policymakers thus In this report, CBO analyzes the following illustrative face a trade-off between increased safety and stability on policies to demonstrate how changes in each of those the one hand, and lower costs of financing and faster three categories might affect the budget: economic growth on the other. • Reduce the ratio of capital to total assets that a bank Financial regulation affects the federal budget directly must use to finance its operations by 1 percentage through spending on programs that support the stability point; of financial institutions as well as through the revenues generated by the taxes and fees that those institutions • Eliminate orderly liquidation authority, which allows pay. Regulation also affects the budget indirectly through the Federal Deposit Insurance Corporation (FDIC) its effects on the economy: Under the baseline economic to lend to financial institutions when the stability of conditions outlined in the Congressional Budget Office’s the financial system is at stake; and economic forecast, regulation influences the cost and availability of financing and affects not only the likeli- hood of a future financial crisis but also how severe such a crisis might be.1 Those economic effects in turn feed 2019 to 2029 (August 2019), www.cbo.gov/publication/55551. The estimates in this report were finalized before the agency’s back into the federal budget (see Summary Figure 1). August 2019 baseline projections became available; they are based on the agency’s May 2019 baseline projections. See Congressional 1. For the agency’s latest economic forecast, see Congressional Budget Office, Updated Budget Projections: 2019 to 2029 Budget Office, An Update to the Budget and Economic Outlook: (May 2019), www.cbo.gov/publication/55151. 2 FINANCIAL REGULATION AND THE FEDERAL BUDGET SEPTEMBER 2019 Summary Figure 1 . How Policy Changes Related to Financial Regulation Affect Projections of the Federal Budget Macroeconomic Feedback Direct Budgetary Macroeconomic From Changes in Eects Feedback Likelihood and Severity Under Baseline of Financial Crises Changes in projections of Economic Conditions Total FDIC’s net spending and of Changes in projections of Budgetary
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