A law of unintended consequences haunts those who rewrite the rules

Marc Sidwell
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WHEN rival financial centres rewrote their rulebooks to their own disadvantage, London pounced. If current proposals are mishandled, the City’s competitors will be more than ready for the chance to steal back some of the UK’s financial thunder.

In the last half-century, America’s regulators have unwittingly been some of the City’s best friends. Their generosity began with the introduction of America’s Interest Equalisation Tax in 1964 as a temporary measure – subsequently extended again and again. It was intended to reduce the balance of payments deficit by taxing Americans for acquiring foreign-issued stocks and debt obligations. In practice, US investors decided that they wanted to free their offshore dollars from the onerous US controls. Capital outflows continued, with London’s eurodollar market the main beneficiary, while the US capital market saw sales by European and Japanese issuers decline from $326m in the first half of 1963 to under $40m in 1964. Subsequent tax changes were too late to slow the development of the market that had been created in London.

In 2002, American regulation once again gave London an inadvertent helping hand with Sarbanes-Oxley (Sarb-Ox). Under pressure after the Enron and WorldCom scandals, politicians passed Sarb-Ox to enhance US accounting standards. The increased weight of compliance drove companies elsewhere, and to London in particular. Notably, the flourishing of London’s Alternative Investment Market has been linked to the fallout from Sarb-Ox. In 2007, Senator Charles Schumer and New York’s Mayor Michael Bloomberg warned that New York could lose its status as a major financial centre within 10 years.

Professor Niall Ferguson, author of The Ascent of Money, told City A.M. that history shows just how careful regulators need to be. “Financial history is littered with the unintended consequences of regulatory changes. From the Interest Equalisation Act to Sarb-Ox, New York has repeatedly suffered setbacks because of mistakes made in Washington. It is too early to tell if Dodd-Frank will have similar damaging effects. A lot will depend on how uniformly Basel III is applied and on what the EU and national governments decide to do. If I had to make a bet it would be that London will end up being hurt more by new European rules than New York is hurt by the new American rules.”

London cannot rely on American mistakes to keep it competitive. With risks from new European regulations in play, there is all the more reason not to add to the danger by rushing through changes at home.