Regulation and the Cost and Availability of Credit
4:14 AM PST, November 2, 2009
An influential view explains the transmission of the business cycle by the effects of a primary shock on balance sheets, income and liquidity of households, companies, financial institutions and the government. Internal financing of families is provided by savings, assets and liquid deposits while external financing consists of credit unsecured or collateralized with assets such as home equity. Internal financing of companies consists of retained earnings and liquid assets while external financing consists of unsecured or collateralized bank loans and issue of debt securities and equity. A primary shock in the form of lack of confidence could reduce the value of assets that households and business could pledge to lenders in raising external financing. The weakening of balance sheets of debtor households and companies would raise the credit default probabilities of loan portfolios of financial institutions, resulting in further contraction of external financing as lenders become more selective in providing credit. Declines in wealth and income of households, business and financial institutions lower the revenue of government, which may raise taxes. Consider the credit/dollar crisis and global recession. Central banks caused the credit crisis by lowering interest rates to nearly zero, inducing households, companies and financial institutions to take high leverage and risk and low liquidity, while Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages. The official, misleading version of the cause of the resulting credit/dollar crisis and global recession by the G20 was an alleged "era of irresponsibility" by financial institutions instead of actual regulatory errors in the form of zero interest rates and purchase or guarantee of nonprime mortgages by Fannie and Freddie. Intrusive proposals of financial regulation are creating adverse expectations that restrict the conditions and increase the interest rates of external financing to households and companies. Reduced external finance at higher cost restricts expenditure and production, which would move the economy out of recession. The effect is the same as that of the new credit card law, CARD, which caused reduction in credit limits and increase in fees for everybody. The cost of bank capital is significantly increased by proposals of full powers to government agencies controlling executive compensation, consumer credit, systemic risk, volume and structure of assets, cyclical capital, bankruptcy insurance fees and general management decisions. Imperfect knowledge on the functioning of regulation prevents success in fostering stability. Financial institutions would not be effectively managed by regulators with excessive work burdens, without superior business acumen and subject to political/corporate influence. The increase in costs of capital of financial institutions will restrict external financing to families and private companies, preventing recovery of full employment output. Regulation should induce balanced risks but without frustrating innovation promoting growth and effective bank management.

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