Regulating problems away doesn’t work

By ‘regulating’ the symptoms one does not cure the underlying disease. A few more examples in the press of this phenomenon that I keep describing:

– It’s no news that banks are being pressurised from all sides by regulation and lawsuits. The results? Banks aren’t that profitable anymore and remuneration stalls or even falls. Victory then? Wait a minute. Bloomberg reports that there is increased demand for young bankers by private equity funds, which are unsurprisingly more lightly regulated. This is part of a bigger trend that sees investors, funding and, as a result, credit, fleeing the traditional banking system towards the higher-yielding shadow banking system.

The Economist also reports the same rebalancing towards shadow banking in China. I have already called China a ‘Spontaneous Finance Frankenstein’ given its strong, unnatural, regulatory-driven financial sector. This is typical:

China’s cap on deposit rates at banks is causing money to flood into shadow-banking products such as those offered by “trust” companies in search of higher yields. Offerings by internet firms, with their large existing customer bases, have opened the spigots wider. […]

Some see these online firms as a serious long-term threat to banks and the government’s ability to control the financial sector, prompting noisy demands (mostly by banks) to regulate the upstarts. Regulators have not yet expressed a clear view, but some observers see signals of a looming regulatory crackdown in attacks by the official media; a financial editor on the state-run television network recently branded online financial firms vampires and parasites.

What would be the effects of regulators successfully regulating those various areas of the shadow financial sector? A ‘shadow shadow’ banking sector would emerge. Liquidity, when in abundance, always finds its way. Regulation drives financial innovations, creating systemic risks through complex shadowy interlinked financial products and entities.

One does not regulate symptoms away. Market actors are the only natural, and the best, regulators.

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