New Regulations Set to Backfire, Decrease Financial Stability

Norbert Michel /

New banking rules set to take effect January 1, 2015, are already starting to prove the law of unintended consequences is alive and well. The main culprit is the new liquidity coverage ratio rule, a requirement that (most) banks hold enough high-quality assets to fund their operations for 30 days during stressed economic conditions.

The Wall Street Journal reports:

The new U.S. rules, designed to make bank balance sheets more resistant to the types of shocks that contributed to the 2008 financial crisis, will likely have little effect on retail deposits, insured up to $250,000 by federal deposit insurance. But the rules do affect larger deposits that often come from big corporations, smaller banks and big financial firms such as hedge funds.

The notion that financial markets can actually discipline themselves is all but gone from our regulatory framework, even though the current structure has a less-than-stellar track record. Markets do work, especially when they’re allowed to penalize failure.

Instead of promoting market discipline, U.S. regulators will continue with business as usual and simply institute new rules. Basically, the idea is to force banks to hold larger amounts of highly liquid assets, such as cash, in reserve.

While such a requirement may appear perfectly sensible on the surface, it amounts to forcing banks to hold onto more high-quality assets even though they won’t be able to put those assets to use earning a profit. (There’s also the trickier problem of what it means to have a useable cushion versus a pile of perpetually idle reserves.)

Somebody will have to pay for those lost profit opportunities, so it’s not surprising that banks are starting to discuss higher fees with clients who are directly affected by the new rules.

What’s worse, the Journal points out that “the rule potentially magnifies problems in a recession by encouraging banks to hoard high-quality assets, potentially paralyzing markets for these assets such as Treasury securities and some corporate bonds.”

Another problem is that these corporate clients don’t have to use banks because they can park their cash in other short-term financing vehicles. The long-term trend in the traditional banking business shows that a greater share of funds has been moving to the non-banking sector (the so-called shadow banks) for decades, and this rule could easily speed that trend up.

If so, these funds will likely end up in riskier investments, thus defeating the ostensible purpose of the rule. Of course, this sort of outcome is really nothing new when it comes to financial market regulations.

One of the main reasons Congress easily passed the massive Dodd–Frank bill, for example, was that the public seems to have bought into the demonstrably false notion that deregulation caused the crisis.

If we want to have a safer, more stable financial system, adding increasingly complex leverage, liquidity, and capital ratio rules won’t get us there. If Congress really wants to increase financial stability they have to stop putting taxpayers on the hook—even implicitly—for private companies’ losses.

A good start down this path would be to implement the following changes:

No related posts.