Another Bad Idea From The Regulators

The federal Office of Financial Research says that the financial system is actually riskier now than it was a year ago. American Banker has the details:

OFR said the market anticipates the Fed will increase interest rates eventually, but a sudden or drastic increase in rates beyond what the market is prepared for could devalue long-dated investments and drive many depositors toward higher-yielding investments.

 

The report also said the ongoing migration of certain financial activities away from banks to lightly regulated nonbanking sectors—so called shadow banks—is another growing threat to financial stability. The trend of banks selling mortgage servicing rights to nonbanks to avoid new capital restrictions and the securitization of single-family rental properties by investment firms are two examples of services previously managed by banks that have migrated to unregulated areas.

 

“If the regulatory playing field is not level across the financial system, the shift of certain activities to more lightly regulated sectors could increase risk-taking and reduce transparency in market practices,” the OFR report said.  [Emph. added]

 

Thus you have in front of you the self-defeating logic of regulators just about everywhere: Step 1. Increase regulation of various activities and businesses (Boost capital requirements here; restrict trading activities there, and so on). Step 2. Regulated entities seek to exit those re-regulated activities and businesses, and they’re taken up by non-regulated entities. Step 3. Regulators try to regulate the non-regulated entities. Repeat until madness ensues.

The irony here is too rich to not savor. Congress passes Dodd-Frank in order teach the banking industry a lesson and strengthen the financial system generally, and, according to the OFR, the effect has been to make things worse. Surprise! What did lawmakers think would happen when they essentially commanded that banks get out of the mortgage servicing business? Are they really surprised that, thanks to the Volcker rule, bond market liquidity has plummeted? And are they surprised, too, that higher capital requirements have served to curtail lending in certain segments? Who could have anticipated?

This is not the first time that regulation (of banking or any other industry) is having consequences that the regulators didn’t count on. Nor is it the first time that regulators have responded to those unintended consequences with a call for additional regulation.

Note to the OFR:  your regulate-even-more idea won’t work. I’ll even stipulate your conclusion that the move of so many erstwhile-banking activities into the shadow sector has made the system less stable. Guess what? That happened because of increased regulation. Why anyone would believe that even tighter regulation wouldn’t have even more unintended consequences is beyond me. Or to put it another way if you think it’s tough maintaining oversight on a domestic non-bank mortgage servicer, try to keep tabs on one based in Ireland.

The fact that banks have been forced to exit or curtail many of their key businesses is bad for the financial system, in my view. The strongest financial institutions are the ones that tend to have broadly diversified books of businesses, so that when one business turns down (subprime mortgage lending, say) the others will be there to pick up the slack. That is precisely why just about all the big banks (and all the well-run ones) came through the panic with hardly a scratch. Yet the effect of Dodd-Frank has been to force a number of key, highly profitable banking activities out of the industry altogether. And—who could have seen this?—the system is less stable as a result.

It is the story of over-regulation and it always turns out the same.

What do you think? Let me know!