A Lesson in the Law of Unintended Consequences

Story Highlights:

• Last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act was hailed by legislators as a law designed to protect Main Street from Wall Street.
• New regulations could mean less job-and wealth-creating lending activity and reduced competition between banks—ultimately, bad for Main Street.
• Well-debated and thoroughly considered regulation can be additive to healthy capital markets. But politically driven regulations like many provisions of Dodd-Frank are often poorly conceived and their ramifications even more poorly understood by their creators.

As its name implies, last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act was hailed by legislators as a law designed to protect Main Street from Wall Street and its supposedly risky wheeling-and-dealing. While it’s convenient for legislators to create a mystical Wall Street that’s utterly separated from average Joe, there’s a big problem with this theory: It isn’t very accurate. And legislation interfering with free markets can and frequently does have completely unintended consequences. In the case of Dodd-Frank, it may in fact end up hurting Main Street.

As part of their effort to shape a “safer” and “less risky” banking sector (a perfectly fine theoretical goal), federal banking regulators broadened their view of capital ratios—aiming to reduce risk. Before Dodd-Frank, capital ratios—a measure of capital relative to risk-weighted assets (like loans)—were viewed in context of an entire bank regardless of the official country of domicile. Now it appears regulators may choose to view US operations as independent and separate from their foreign parents. That could force some foreign banks to boost the reserves of their US operations greatly. While this might seem prudent, for businesses, the potential reward has to outweigh the likely costs—or they’ll probably adapt to deal with new regulation.

For example, a large, foreign-domiciled bank recently had the option of adding $20 billion to meet the capital requirements for a US subsidiary or reorganize the subsidiary back under auspices of the foreign parent organization. The bank’s response? They chose the latter. This narrow view of capital rules could result in other foreign banks restructuring their lending organizations or choosing not to do business in the US altogether. That means less job and wealth-creating lending activity and reduced competition between banks—ultimately, bad for Main Street. And consider, if other nations responded with similar policies, it could impact US financial firms’ operations abroad—with similar effects for Pierre “sur la rue de Main.”

Another way Dodd-Frank was to supposedly “protect” Main Street was strict regulation of those much-maligned derivatives. Sure, some investors used derivatives to make risky bets seeking huge returns, but that’s not the sole or even the primary use of derivatives—many financials firms used (and continue to use) derivatives to diversify risk. But derivatives are also prudent tools used to help control costs for many non-financial firms. For example, airlines use derivatives to hedge fuel prices. Likewise, brewers hedge aluminum prices, hops, and energy. Farmers use them en masse to hedge fluctuating produce prices. Derivatives in these instances (when used correctly) are used to help businesses better project future expenditures and prevent wild price volatility for inputs. Which means wild price swings don’t necessarily have to be passed along to consumers in the guise of higher end-product prices. And if derivative use boosts profitability while keeping consumer costs relatively lower (ultimately the aim), isn’t that a good thing?

Dodd-Frank introduces the possibility of increased margin requirements for derivative hedging—which could require non-financial companies to post more capital at banks to offset their hedges. That doesn’t constitute a productive use of free capital that could otherwise be used to hire more employees, build out new factories, or improve existing factories. But, increasing the cost of a hedge also reduces its effectiveness in keeping prices low, so the impact could mean more volatile prices or additional costs for consumers. This would be bad for Joe Six-Pack, who could end up parting with a few more quarters for beer, soda, or whatever flavor he prefers. We greatly doubt many politicians understood that a blanket application of “derivatives are bad” could have this effect.

Well debated and thoroughly considered regulation can be additive to healthy capital markets. But politically driven regulations like many provisions of Dodd-Frank are often poorly conceived, and their ramifications even more poorly understood by their creators. And that is exactly how an act designed to reform Wall Street for consumer protection can actually stick it to Main Street.