NOT WHAT THEY MEANT / THE ECONOMIST BUTTONWOOD COLUMN ( VERY HIGHLY RECOMMENDED READING )

Buttonwood

Not what they meant

Jan 28th 2010
From The Economist print edition

The unintended consequences of past financial reforms

Illustration by S. Kambayashi

BARACK OBAMA’S new plan for the banks is unlikely to achieve his stated aim that “Never again will the American taxpayer be held hostage by a bank that is too big to fail.” But whether or not the proposed measures fall short of that ambitious goal, one thing is sure. If the plan is implemented, it will have unintended consequences. That has been the history of previous financial reforms.

Take Regulation Q, a rule established by the American authorities in the 1930s to restrict the interest rate that banks could pay on deposits. It had several motives, including a desire to boost banks’ profits (and thereby help pay for deposit insurance) and a belief that competition to pay high deposit rates would encourage banks to take too many risks. The rule was extended to thrifts (savings-and-loans institutions) in the 1960s.

With rates held below their natural level, American savers eventually turned elsewhere. The biggest institutions looked abroad. As dollars accumulated outside America, the Euromarket, where lenders and borrowers were free to set rates between them, developed in London. Small investors moved their savings out of banks and thrifts and into money-market funds, which did not face a limit on the rates they could pay. The devisers of Regulation Q did not intend to boost the money-market fund industry or to prop up London as a global financial centre but that is the effect they had.

In the 1970s and 1980s “Big Bang” reforms at the New York and London stock exchanges opened up the business of equity market-making to outsiders. The Thatcher and Reagan administrations also abolished capital controls which had been put in place at a time of fixed exchange rates. Money was allowed to flow freely across borders and, in an era of floating exchange rates, the constraints on credit growth were much reduced.

As capital flows accelerated, the banks were encouraged to bulk up like fitness freaks taking to steroids. Offering advice was no longer enough for investment banks. They began to put their capital at risk on behalf of their clients, taking the other side of deals when pension funds and insurance companies wanted to rearrange their portfolios. That meant banks had to drop the old partnership structures and raise new capital, going public in the process. It also encouraged commercial banks into the securities business, triggering the eventual abolition of the Glass-Steagall law that had kept the two apart.

The Basel rules, designed to ensure that banks have enough capital to cope with economic crises, present another example of unintended consequences. The rules created an incentive for banks to hold AAA-rated securities, which require less capital to be held against them. But there was a shortage of genuine AAA-rated bonds. So that gave financial whizzkids a motive to create complex securities like collateralised debt obligations (CDOs) based on subprime mortgages. The top tier of CDO debt was usually rated AAA because all the other classes had to default before it got hit. Of course, the worst then happened. In the end, rules designed to make the banking system safer led European banks to become exposed to defaulting homeowners in places like Florida and Nevada.

You could also argue that the hedge-fund and private-equity industries are both the unintended result of regulations. Hedge funds owe their appeal to their ability to go short, and thus make money even in falling markets. That marks them out from mutual funds, which are not allowed to short. And private equity would find it much more difficult to function without the rule that allows interest to be tax-deductible.

All these examples illustrate the general rule that capital, like water, tends to flow around obstacles. Try to dam its movement at one point, and slowly but remorselessly it will find its way around.

So what might be the unintended consequences of Mr Obama’s plan? The main impact will be on proprietary trading, the desks that attempt to profit from market movements with the bank’s own money. If more of these desks are shut down, the markets will become less liquid. That will mean wider spreads and higher dealing costs for other investors, though that may be a price worth paying for safer banks. It is more likely, however, that the prop traders will move to hedge funds. The big hedge funds will get bigger and will have more impact on the markets. The unregulated part of the finance sector will become more important systemically, something the authorities may regret when the next crisis comes along.

Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.