The perversities of regulation are fast becoming all too clear. Trade is the engine of global economic growth and the means by which indebted Europe and the US can haul themselves out of their malaise.
But, in its wisdom, the Basel Committee has decided that banks should hold 100% of capital against off-balance-sheet commitments - including trade finance instruments such as letters of credit - up from 20% under Basel II.
In its clampdown on off-balance-sheet finance, the committee has taken a broad-brush approach that fails to distinguish highly structured long-term instruments from shorter term, less risky trade finance. This could translate into a 6% reduction in trade finance capacity as well as a 40% increase in pricing at a time when expanding trade volumes require increased financing needs.
The Dodd-Frank effect
If nothing changes, the most extraordinary results will be that governments will have to step in to provide a service that the market can no longer deliver, thanks to wrong-headed regulation.
In proprietary trading, the rule-makers are doing only slightly better. As a result of the Dodd-Frank Act in the US, the major investment banks are retreating from proprietary trading - or at least they would be if anyone could figure out an exact definition. Where proprietary trading stops and market-making begins is unclear, and the outcome could be a loss of liquidity in markets that are already suffering from a lack of it.
None the wiser
It seems the banks may not be too unhappy about the loss of proprietary trading as it makes their risk management task easier and their earnings less volatile. But when the proprietary traders leave the banks, where do they go? To hedge funds, of course. And will their activities be less of a threat to financial stability if they carry them out at a less august institution?
The argument is that hedge funds will not be too big to fail - but they may be in due course. As a method for expunging risk from the system, the Volcker Rule, as this part of Dodd-Frank is known, is hardly any wiser than Basel's statement on trade finance.
We await with interest to see what the regulators can come up with next.
