What the sinking of the Titanic can teach us about financial regulations

SUNDAY marked the 100-year anniversary of the sinking of the Titanic, and the deaths of over 1,500 passengers. But the tragedy did not end there.

The SS Eastland was a Chicago-based passenger ship that sunk in 1915, with over 800 people drowning. It was a popular tour boat that was known to be top-heavy, and following the Titanic was required by Federal law to increase the number of lifeboats carried. Unfortunately, this additional weight compounded the problem and on 24 July it rolled over soon after boarding. Those who had already gone below deck were either trapped or crushed and despite being close to shore it resulted in one of America’s worst nautical disasters.

I’m obviously not suggesting that government regulations alone caused the boat to sink, but it is a reminder that everything has costs. There is little use having more lifeboats if by doing so you increase the chance of needing them. A lesson that financial regulators would do well to heed.

In 2008 it was partially revealed that banks held lots of dodgy assets on their balance sheets. The typically bureaucratic response to this – exemplified by Basel II – has been to raise capital requirements and force banks to hold higher quality (i.e. “safer”) assets. If you want to understand why there’s little lending to the sectors of the economy that really need it – for example SMEs – it is because banks are being incentivised to park their cash with less risky investments.

Of course, politicians talk a lot about trying to improve credit conditions and quantitative easing (QE) was undertaken with the aim of passing this liquidity on to borrowers. But studies of the impact of QE tend to find that it is almost entirely offset by the restrictions on lending brought about by higher capital requirements. Banks are used to being the middlemen between savers and borrowers, but now they’re caught with tough financial regulation on one side and loose monetary policy the other. It is hard not to sympathise.

One of the biggest criticisms of capital requirements is that they are counter-cyclical – they give a boost to the economy when times are good, but take money out when there is a downturn. Yes, stronger balance sheets may have mitigated the crisis, but that option is no longer available. The discussion now should be about cure, not prevention.

Basel II is as misguided as forcing all boats to carry more lifeboats even if the extra weight capsizes them. But it is even worse than this. In the case of banking regulations these “lifeboats” come in the form of “risk free” government bonds. It is as if the people mandating the purchase of lifeboats are the same people trying to sell them. And indeed it is because government bonds are considered “risk free” that they resemble lifeboats to the typical investor. The government is wont to pat itself on the back for keeping borrowing costs low, but there are two reasons why we might see a spike in demand for lifeboats. One is a better understanding of risk, and a benevolent desire to improve the safety of one’s passengers. The other is because people think the boat is about to sink. If I were a lifeboat seller I’m not sure I’d be boasting that a boom in business is a good sign for the economy as a whole.

Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School: anthonyjevans@gmail.com www.anthonyjevans.com