Let's Stop Complaining About Business Fleeing to Unregulated Firms

When it comes to overly burdensome regulation, we have more to worry about than the shadows

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Excessive regulation can harm firms in a number of legitimate ways. It increases costs. It moves business overseas to nations with different regulatory regimes. But a common complaint these days is that business could flee to the dark, unregulated corners of the market. This isn't necessarily true, and it actually ignores the bigger problem.

The Too-Popular Complaint

This week, critics used this worry as a crutch in response two separate new rules. The first was the new Basel III capital requirements. Citigroup CEO Vikram Pandit complains that stricter capital requirements could do more harm than good:

Paradoxically, the higher we set capital requirements for banks, the more money flows into unregulated or less regulated sectors of the system, thereby increasing systemic risk.

The details of how the new Volcker Rule for securities trading also provide a new provision that has bankers fuming. The rule seeks to ban proprietary trading at depository institutions, but makes an exception for market making -- so long as several conditions are met. One of those conditions is that trader pay must be based on fees and a transaction's spread. The appreciation on the securities that are traded cannot be part of the equation.

As you might guess, traders want to be paid based on the performance of their portfolio as well. So they have the following criticism, reported by Cheyenne Hopkins and Phil Mattingly at Bloomberg:

A forced change to pay structure "could have the effect of driving people out of the regulated industry to the unregulated industry," said Douglas Landy, a partner at Allen & Overy LLP who once worked at the Federal Reserve Bank of New York.

The logic here is simple enough: if regulation is ramped up in one subsector, then business will flee to a different subsector where it can escape the new regulation. Naturally, market participants will seek the path of least resistance.

But It Doesn't Hold Up

Here's the thing: it isn't really that simple. First of all, there aren't really any truly unregulated sectors. There are some that are less regulated than others. But no subsector within finance is completely devoid of regulation. If hedge funds suddenly become the industry's market makers, for example, then that sector's regulators will take note.

If the market making business that flows into hedge funds poses some new systemic risk, then regulators will need to ramp up regulation in this industry accordingly. But such a move may not be necessary. Hedge funds tend not to be quite as systemically relevant as the big banks -- but that could change over the years if a couple of funds become very gigantic.

So regulators can just keep chasing the business until there's no under-regulated sectors for it to flee to. The financial industry is finite. But this chase might not be necessary. The Volcker and capital requirements are in place at banks for a reason: because regulators say that banks need to be relatively low-risk institutions for the sake of the financial system. So even if business does flee elsewhere, that might be perfectly okay -- the regulation's purpose was still fulfilled.

What the Fear Should Be

In the case of the Volcker Rule's limits on trading, the real fear should be business fleeing overseas. Other nations have not signed onto the Volcker Rule. So if banks are better market makers, then we'll begin to see trading activity growth in markets like Singapore or elsewhere. Firms won't bother looking for an inferior less regulated sector in the U.S. if it they simply find a less regulated banking sector in a market overseas. The global financial landscape makes such a transition relatively easy.

In the case of Basel III, however, there isn't much of a downside to where business might flee. The core business of banks will mostly likely remain at banks. After all, they're the ones with banking expertise. What you'll probably see happen under Basel III is that big banks begin losing a little bit of their competitive advantage over smaller banks, due to its forcing big banks to hold more capital. I would argue that leveling the playing field is a good thing. But since the Basel III rules are internationally coordinated, it doesn't run into the problem the Volcker Rule creates. Essential banking services will just become more expensive.

The problems that these two regulations run into may differ in part due to their relative reasonableness. I would argue that higher capital requirements are justified, in light of the damage that financial crises cause. But we have little reason to believe that the Volcker Rule is necessary. That may be why we're seeing better international coordination on one and not the other.

But in both cases, the unregulated market shouldn't be the real worry. If it turns out to be a problem, then policymakers can just regulate that market too. They just need to be a more vigilant this time around.

Image Credit: Lachlan Hardy