When regulators face spontaneous finance

This is what I read a few days ago: ‘Shadow banking morphs and grows, confounding authority’

Despite their high-profile and tough stance (see Mark Carney here, but there are literally hundreds of other speeches and articles like this one available), regulators now admit that “after 10 years of being a hot topic there isn’t a consensus yet” on shadow banking, and that “is it banking or is it part of market-based finance? What are we going to do about it? We are nowhere near the finishing line.”

As Reuters reports:

Authorities are nowhere near to fully understanding “shadow banking” as the $75 trillion sector morphs and grows under the influence of new technology and regulation, a top markets supervisor said on Wednesday.

Regulators indeed struggle to make a sense of the Hayekian spontaneous financial order that free markets generate. Unlike banking, which has been a heavily-protected industry in most countries for more than a century, therefore making its business model quite stable, predictable and uniform, non-banking finance (what we now called shadow banking) is relatively informal and evolves all the time, driven by market actors’ needs and preferences as well as regulatory arbitrage.

We here get to a contradiction in terms. Regulators are trying to regulate entities designed to evade…regulation. This sounds quite tricky to me, and even possibly dangerous given the distortions this can bring about. I have once said that this type of financial innovation represented ‘bad’ (or ‘unnatural’) innovations. The whole cycle of regulation/regulatory evasion/re-regulation produces very opaque structures that market actors cannot make sense of, disturbing price signals and risk assessment and leading to catastrophe.

But regulating ‘good’ innovations, the ones effectively driven by customers’ needs and technological shocks, isn’t necessarily a good idea either. It is pretty much impossible, by definition, to regulate hundreds of different business models with a single regulatory toolkit. Which implies micro-regulating each firm with a discretionary set of rules that regulators believe those particular firms should follow. Economic micro-management doesn’t work and there is no reason that it should work this time.

Reuters goes on describing what’s typically happening right now:

Advances in technology – which mean there are far more ways of linking credit with borrowers, such as the use of mobile phones in Africa – have also created a new set of financial actors in what Alder dubs “modern” shadow banking.

He cited other developments such as Chinese e-commerce giant Alibaba teaming up with Lending Club to offer peer-to-peer lending for U.S. customers.

P2P lending (consumer finance, SME lending, real estate…), P2P securitization, equity and product crowdfunding, ETFs, mutual and hedge funds lending, Bitcoin and cryptocurrencies, alternative payment companies, money market funds, mobile payments, alternative currencies… All those growing financial instruments allow for hundreds of possible combinations. No wonder regulators are confused. Good luck to them.