Unintended (intended?) consequences

In my previous post, I described how politicians (in this case, Vince Cable) were confused by the impacts of banking regulations. The large amount of new and modified rules that have been striking the financial sector over the past few years are bringing their lot of unintended consequences. Unless some of those consequences were actually perfectly intended…

About a week ago, The Economist reported the collapsing global financial links:

One of the main casualties of the cringe is the very institution of correspondent banking. This is the informal mesh of arrangements allowing the customer of a bank in one country to send money to someone in another country, even if the bank in question does not have a branch there. The system is as old as international finance itself, dating back to the earliest promissory notes and letters of credit written by banks in classical times. Yet it is now being threatened by an overzealous interpretation and enforcement of rules aimed at preventing money-laundering and starving terrorists of funds. […]

The exact size of the retreat is difficult to gauge because of a dearth of recent global data, but executives at such firms say they are dropping as many as a third of their correspondent relationships. One big firm says it is cutting or scaling back about 1,000 linkages; another, 1,800. Such ruthlessness will have a dramatic impact because these institutions are the main nodes through which the world’s banks link up with one another. […]

It is not just in distant and benighted places that the consequences of this severity are being felt. In Britain students from Iran, Sudan and Syria cannot open bank accounts. In America, foreign diplomats and embassies complain that they too are being denied access to banking.

Do-gooders are being caught in the net, too. Charities such as Save the Children, the Red Cross and Christian Aid have struggled to transfer funds to places like Syria due to sanctions. Even after obtaining explicit approval from American regulators, some have found it difficult to convince banks to send money.

We’re indeed on our way to the de-globalisation of banking, with all the systemic risks this involves. Whether or not the outcome of this particular policy was intended by regulators is something I cannot answer. But in general, regulators have been actively working on the fragmentation of the global banking system, as we’ve recently seen.

Meanwhile, the FT also reports that a new LSE Systemic Risk Centre study seems to show that new clearing house settlement rules for derivative trading poses… financial stability risks:

The research paper from the London School of Economics found the daily changes in the valuation of margin, which traders are required to post, may rise tenfold by using central clearing houses. That compared to banks being allowed to clear the same deals between themselves.

The paper’s conclusion that banks may face greater operational risks and more demands on their liquidity underlines regulators’ and market participants’ concerns that a post-crisis global political accord designed to strengthen the financial system may only succeed in shifting risk.

I haven’t read the study yet (and actually couldn’t even find it on the LSE SRC website), but it does look like the outcome of those new rules is going to be reduced interlinks (through derivative contracts) between banks.

Let’s sum up. New rules that favour a fragmented banking system are:

1. Ringfencing different parts within individual banks/legal entities
2. Asking for separate capital and funding structures between subsidiaries of a same group
3. Reducing the ability of various entities of a same banking group to transfer liquidity and capital
4. Reducing interconnectivity and financial agreements between banks of different countries
5. Making derivative trading and settlements more expensive
6. I’m surely forgetting a lot of other things

My guess is that it will take a few years (possibly early 2020s) to find out what kind of monster this magic regulatory potion really created.