Unintended Consequences of Regulation

The recent financial crisis has led to a spate of regulation in the US. As with any major change - the question remains: will this solve what it was meant to solve or will it create other unforeseen problems?


One of the key focus of regulation is to reduce risk in the financial system. Reducing risk will likely help reduce future busts. Risk can be reduced by many ways like forcing banks to give less risker loans, making sure traders make less riskier trades, etc. Now there are two broad sets of financial firms - regulated companies like the banks, capital market firms, insurers, etc. The other type are the unregulated players like private equity firms, hedge funds, etc. also known as the shadow banking system.


Regulation will ensure that risk will be reduced – but only for the regulated companies. Now what happens if a trader at an investment bank is told to take less risk? It reduces his/her chances of getting higher returns (Risk-Return tradeoff). How long will it take for the trader to try to find another job at an unregulated company like a hedge fund? Similarly when banks deny loans to risky businesses, the businesses have to turn to private equity players or hedge funds for money.


Thus risk may not be getting reduced. It may just be getting moved from the regulated firms to shadow banking! The shadow banking system is not regulated so by definition things can go very bad very soon. So will regulation end up making the financial system more risky??