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The Costliest Regulation You’ve Never Heard Of

Thursday, June 21, 2012

A proposed regulation could cost the U.S. banking system hundreds of billions of dollars, in turn costing our economy billions of dollars, and achieving no discernible benefits for banks, depositors, taxpayers, or the U.S. economy.

One of the costliest regulations to come down the pike of late has nearly managed to escape detection. Earlier this year, the Treasury Department published its “Guidance on Reporting Interest Paid to Nonresident Aliens,” which would require banks to report to the Internal Revenue Service the amount of interest they pay to non-resident aliens with a U.S. bank account. While the Treasury and the regulatory apparatus insist that the cost and inconvenience of adhering to this law are next to nothing, the reality is that this rule could cost the U.S. banking system hundreds of billions of dollars in lost deposits. In turn, this will cost our overall economy billions of dollars, while achieving no discernible benefits for banks, depositors, taxpayers, or the U.S. economy.

The Encroaching Regulatory State

Foreigners have never paid taxes to the U.S. Treasury on their interest earned in U.S. banks and would continue being exempt under the new regulation. The sole requirement would be that the banks report the interest paid to these account holders to the IRS, primarily to conform to international regulations that call for more transparency by financial institutions.

A much bigger problem than the compliance costs—for banks and the economy—is the threat of capital flight.

The Treasury Department estimates that the costs of the regulation would be minimal, with banks needing no more than 15 minutes to comply with the reporting requirements, summing to a total (when multiplied by the roughly 8,000 banks and other depository institutions affected) of 2,000 hours of employee time, or somewhere just south of $100,000 annually. The de minimus cost it projects means that the regulation is not subject to Executive Order 12,866, which requires a detailed cost-benefit analysis for all regulations that have an impact of greater than $100 million.

If a few hours of filling out paperwork were the only costs incurred, then the lack of attention would be altogether appropriate. However, a much bigger problem than the compliance costs —for banks and the economy—is the threat of capital flight.

The United States is a very popular place for foreigners to park their savings, for a variety of reasons: It offers a stable government that can be trusted to keep its hands off deposits—something that appeals greatly to residents of Venezuela, Argentina, Ecuador, and many other countries. Additionally, the United States offers a modern financial market; banks offer federally insured deposits, inflation rates have been low and stable for decades, and the odds are low (but certainly far from guaranteed) of another financial crisis on these shores (and well below the odds in most other countries).

Deposits held by nonresident alien individuals add up to over $3.7 trillion.

As a result, a large amount of savings from abroad is currently in U.S. banks. The Treasury states that “deposits held by nonresident alien individuals are a very small percentage of the [total] deposits held by U.S. financial institutions.” But that very small percentage adds up to over $3.7 trillion, according to a 2011 Bureau of Economic Analysis report—hardly a pittance.

Banks turn around and lend that massive amount of foreign capital, mainly to U.S. companies. Back in 2002, Jay Cochran, an economist at George Mason University, studied the impact that less stringent reporting requirements than those proposed today would have on the banking system. He estimated that it would have resulted in nearly $100 billion in deposits leaving the U.S. banking system. Today’s more stringent requirements could result in two or three times more capital flight.

The impact of such a capital decrease would be enormous. The decline in profits in the banking sector alone would be somewhere in the range of $5 billion to $10 billion.

The losses would be most acutely felt in banks such as those in Miami and Los Angeles, which have close ties to overseas communities. For example, the Florida Office of Financial Regulation surveyed 16 state chartered banks and found that an average of 41 percent of their deposits were from non-resident aliens, with one bank reporting that number to be more than 92 percent.

Our fractional-reserve banking system means that one dollar of deposits supports a multiple of loans throughout the economy.

Also, our fractional-reserve banking system means that one dollar of deposits supports a multiple of loans throughout the economy, so that a withdrawal of two or three hundred billion dollars in deposits would result in a diminution of total loans in the economy of somewhere in the ballpark of $1.5 to $2 trillion.

Not surprisingly, mandatory reporting of non-resident alien interest has a disproportionate impact on banks in states with large immigrant populations, and the Florida and Texas congressional delegations are apoplectic over the administration’s regulation. Senator Marco Rubio (R-Florida)—joined by his state Democratic counterpart, Bill Nelson, and 20 other senators—introduced legislation (S. 1506) that would rescind the regulation. In the House of Representatives, every member of the Florida delegation, including Democratic National Committee Chair Debbie Wasserman-Schultz, opposes this new rule.

At a minimum, the rule would significantly reduce the $3.7 trillion in savings deposited by non-resident foreigners, creating a significant drag on the economy at a time when we can least afford it.

Ike Brannon is director of economic policy and Sam Batkins is director of regulatory policy at the American Action Forum.

FURTHER READING: Along with Matt Thoman, Ike Brannon also writes “About Those Better Roads in China,” “Why Unemployment Is Worse Than You Think,” and “European Disunion.” Peter J. Wallison contributes, “Does Shadow Banking Require Regulation?” and “Dodd-Frank's Too-Big-To-Fail Dystopia.” Alex J. Pollock says “Heed a Banking Champion's Words on Loan Loss Reserves.”

Image by Darren Wamboldt / Bergman Group

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