Banking regulation may have negative side-effects

The EU wants to prevent speculation on credit defaults by banning short- or naked-selling of Credit Default Swaps.

Unintended consequences could be either that the entities that wanted to take the short positions would then switch to shorting other instruments, such as government bonds or bank equity, which pushes government borrowing costs up. And/or that the entities wanting to take the opposite position would no longer be able to do so and so would either have to pass on their risk through higher interest rates or tighter loans — to businesses, banks, and governments.

The relatively small size of the CDS market does make it more open to manipulation than the five times larger government bond market, so the bankers may to an extent be crying wolf.

But whatever happens, it does seem that re-regulation of the financial markets is likely to have unintended consequences for the real economy and businesses, just as deregulation has done.

It also seems that there is a certain amount of underlying ‘volatility’ or risk-seeking inherent in the system that, if it cannot find an outlet in one area, will seek an outlet in another. If market players are restricted from short-selling CDSs they will either switch into short-selling government bonds; or the entities that would have taken a contrary position will be unable to manage their risk and so will either restricting or reduce their own lending to business and government.

Fundamentally there must be a balance between the desirable and undesirable impacts of any set of regulation. Finding a new balance will not only be a tricky job for regulators but will also have unpredictable outcomes for business, banking and government.

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