Removing ‘Red Tape’ Regulation in an Uncertain Environment

Abstract

The following report is the result of collaborative research between UTS and the Centre of Policy Studies, funded by the Centre for International Finance and Regulation (CIFR) in order to assist the Murray Financial System Inquiry (FSI).

Initial discussions with both CIFR and the FSI defined the scope of enquiry so that we report on any general guiding principles for the removal of low quality regulation (‘red tape’) rather than on a set of specific cost-benefit analyses for the removal of specific regulations.

The main benefit of removing regulation is the freeing up of resources.

The main cost of removing regulation is the increased chance of financial recession.

The effects of removing regulation on the character of any recession – for example its depth or duration – are not quantified, since we have eschewed specific measure cost-benefit analyses. This implies we understate the costs of removing regulation.

We model a reduction in red tape as a 1% productivity increase in the financial sector and then conduct two sets of simulations to show the macroeconomic effects. The first set is under ABS conventions in which financial services are sold to households and as an input into current production. In the second set we adjust the ABS conventions to recognize the role of financial services in investment.

In both sets of simulations a 1% improvement in productivity in financial services translates into a 0.05% productivity increase for the economy.

Reducing the cost of financial services stimulates employment in the short run, especially under ABS conventions. It stimulates investment throughout the simulation period, especially under our adjusted convention.

The long run effect on GDP of a 1% improvement in productivity in financial services is around 0.070% under our adjusted conventions, and around 0.06% under the ABS conventions, giving an average of 0.065%. Therefore, for a given recession that costs 10% of GDP, a reduction of regulation costs equivalent to a 1% financial services productivity improvement is unjustifiable if it increases the chance of recession by 0.000065 or more.

In welfare terms (measured by private consumption) the effect of a 1% improvement in productivity in financial services is approx. twice that of the GDP effect, between 0.14 and 0.12%.

Wherever regulation performs a ‘quality control’ service for the financial system, removing it may increase the chance of a recession in a nonlinear way. The relevant feature of quality control is that it uses the surprising power of statistical independence to generate very small probabilities of failure by the multiplication of probabilities.

We argue below that if regulation is independent and optimal, it is very costly to remove, and if the regulation is independent but its optimality is unknown, it is risky to remove.

We recognize that regulatory measures may not be independent of each other. Framing the policy choice about low quality regulation (‘red tape’) solely in terms of ‘disband or leave in place’ sets aside an important third alternative: to make regulation more independent.

Making regulation more independent may involve having different agents – not necessarily different organizations – examine the same issues and monitor the same behaviours independently

This may create a false impression of ‘inefficiency’ but fashioning information-rich regulation of the financial sector is rather different to straightforward cost minimization.

Part I simulates a positive productivity shock. Part II examines the possibility that the probability of a recession may increase non-linearly with linear reductions in regulation costs.