Fisher Investments Editorial Staff

Merlin’s Unintended Magic

By, 02/10/2011

Story Highlights:

  • The UK's government and banks reached an agreement Tuesday on executive bonuses and lending levels.
  • Known as Project Merlin, this is just the latest in a series of financial regulations passed globally aimed at addressing the presumed causes of 2008's financial crisis.
  • But such legislation is frequently misguided and may have unintended deleterious consequences.

Not surprisingly, in the aftermath of 2008's financial crisis, many have sought a single scapegoat. The most popular choice seems to be the banking sector, as evidenced by the US Financial Crisis Inquiry Commission's recent report blaming reckless Wall Street lending practices and global moves to pass legislation (e.g., Dodd-Frank and Basel III) aimed at preventing similar future situations. 

We are huge believers in free markets. The freer the better. But we recognize sensible regulation can be a necessary precondition for efficiently and fairly operating markets, helping maintain ready access to a competitive playing field, increasing transparency, etc.—all generally good things. Yet the recent spate of legislation seems more bent on retribution than sensibly regulating the financial industry.  

The most recent examples are Project Merlin and new bank levies announced by the UK's Chancellor of the Exchequer on Tuesday. The pain UK taxpayers are experiencing is understandable—they're facing severe austerity measures and a stubbornly sluggish economy. And mandating the size of bank executives' bonuses may make some feel better, but it seems highly unlikely to fix the larger issues (since there's no evidence big bonuses were the root cause of the financial crisis). There have been similar calls to limit bonuses and pay in the US, but with so many financial services TARP recipients already returning profits to the US Treasury (and some economists expect its UK equivalent to do the same), such legislated retribution seems even more feckless.   

A key provision of Project Merlin mandates banks' lending levels. Proponents believe this will make banks lend more, thus greasing the wheels of commerce. But it ignores a few pesky details: First and foremost, there must be demand for lending if banks are to meet the requirements, so it only addresses half the equation—supply. It also introduces the possibility banks could lend to less credit-worthy operations in order to meet mandated quotas—introducing the risk of poor capital allocation. (Weren't people up in arms about subprime loans not 18 months ago?) All in all, unless Project Merlin wields similar magic powers to the mythological wizard (which we're unaware of), it seems more like political symbolism than well-reasoned regulation.  

Politicians forget: There are almost always unintended consequences of such legislation. For example, on this side of the pond, lawmakers approving Dodd-Frank seemingly had a murky understanding of all its implications. Lumped in with regulation purportedly targeting the widespread use of much-maligned derivative securities by sophisticated, Gordon Gecko-ish, Wall Street traders were…farmers. We guess those inside the Beltway didn't realize complicated financial products can be critical agri-business tools for those in the Heartland. More examples? New regulations limiting the card swipe fees banks are allowed to charge retailers may result in diminished services to customers. Still others impact the flexibility of financing. And, back in London, bankers tired of being bashed are leaving their jobs en masse—migrating to jobs (inside and outside financial services) where they can negotiate bigger upfront salaries to avoid future bonus brouhahas.  

We've said repeatedly, well-debated and thoroughly considered regulation can be additive to healthily functioning capital markets. But passing willy-nilly regulations aimed at hurting the scapegoat du jour is at best ill-advised. And we're pretty sure London's bankers and Nebraska's farmers agree.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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