Jan 20, 2014

Financial regulation: a hidden gem

Fortunately for financiers, financial regulation is mostly retrospective in nature - that is, it is aimed to fix deficiencies that are evident in hindsight; and almost never anticipatory - meaning that it is not designed to address the areas that have not experienced troubles in the past. Even post-major-crisis regulation barely catches up with financial system development, still leaving vast areas of finance subject to circumvention, innovation, and even deregulation.

Market participants, and in particular shadow banks, are quick to respond to changing regulatory environment. Like lava that spreads rapidly to unoccupied areas, market participants are always on the move into unregulated and loosely regulated areas, perpetually searching for new profit opportunities.

Take, for example, the vast deregulation of derivatives that took place in 2000, during which both the federal and state government were banned from regulating over-the-counter (OTC) derivatives. Since then, the OTC derivatives market grew from around $100 trillion in notional amount to $673 trillion in 2008 (Bank for International Settlements, 2013). When the crisis hit, the opaqueness in derivatives instruments transferred into increased uncertainly around the OTC derivatives market as a whole, around large financial firms that acted as dealers in the derivatives business, and the stock market in general.

It is important to understand that the financial industry is a very powerful business that has a long-standing history of getting what it wants from its regulators - namely, deregulation. Thanks to the US Supreme Court’s 2010 decision known as the Citizens United v. Federal Election Commission, which lifted restrictions on how much money firms could channel to political contributions, Wall Street bankers ended up being the largest political contributors in 2012 (Blinder, 2013). Given that politicians have to raise money to run for public office, bankers have gained additional influence on the way key details of laws are written.

Innovative and money-hungry financiers go to work every day with the goal of finding opportunities that make them as much profit as possible. Bankers do not want to miss a single chance to capitalize on either small or big opportunities. Keeping that in mind, a very LT investor should thus remember that one of the best predictors, one of the best forward-looking indicators of upcoming booms - and busts - is found exactly where regulation is nonexistent or scarce. A very LT investor would thus first and foremost be an expert on financial regulation, and on the areas that lack sufficient regulatory coverage.


Sources

Blinder, A. (2013). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York, NY: The Penguin Press.

Bank for International Settlements (2013). Retrieved from http://www.bis.org/statistics/derstats.htm

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