Why Regulation Does Not Always Work

“The real solution involves the hard work of creating a climate of honesty, honor and integrity”

It is astonishing to see how so many people think unbalanced markets can be regulated into order. They think that stopping abuses with straitjacket regulations will solve all problems. In the case of frenzied markets, this usually addresses the effects not the causes of financial instability. Moreover, most regulations, however good-intentioned, are often circumvented by the very offenders that gave rise to the restrictions in the first place.

The need for regulations usually involves moral not economic issues. People become engaged in what might be called frenetic intemperance, which incites them to have everything, instantly and effortlessly. It causes people to scorn the traditional restraints of markets and get involved in fast-paced financial activities without links to moral principles and even economic reality.

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One recent example of how frenetic intemperance is harming markets is China’s corporate bond market. It is a typical case that shows how regulations don’t always work because they do not address causes.

The communist Chinese have long mastered the art of circumventing regulations. When formal economic banking instruments are prohibited, they often resort to informal “shadow banking” substitutes that are unregulated by authorities. Shadow banking system volumes often come to exceed those of the formal banking system before regulators finally shut them down. However, each time the Chinese government tries to cut off the shadow schemes, other avenues always appear to take up the slack.

The latest and fastest growing Chinese shadow banking scheme is called entrusted banking which circumvents the prohibition of corporation-to-corporation lending. The way it works is that cash-rich firms—many of them government owned—find a willing bank to serve as middleman to lend to a struggling credit-hungry company. The obliging bank gets a cut in the profit but shares none of the risks.

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And the risks are great. Most loan candidates are only given a minimum vetting for creditworthiness by the lending corporations. These loans harm the economy because it prevents these rich companies from reinvesting in their own operations, since they prefer to receive tantalizing interest payments of up to twenty percent.

Entrusted loans are usually the last recourse of blacklisted companies that would not qualify for normal loans. The economic slowdown in China has only increased the number of these credit-starved companies since many industries are operating at overcapacity. Indeed, the amounts lent by this method went from less than 1 trillion yuan in 2004 to 13.2 trillion yuan in 2016. Almost a third of new loans are made through this serpentine system.

Finally, the loans serve to throw the economy out of balance since the inefficient sectors are artificially propped up, and the credit money would be better used elsewhere. The loans often hide corruption and failed government projects that overburden the economy. They also add to the nearly $18 trillion in corporate debt already outstanding.

The entrusted loan scheme now running rampant in China only points to the real cause of financial instability worldwide. When economy becomes unmoored from moral principles and ethics, anything becomes possible. Loopholes and sweetheart deals appear and are exploited. Gluts are subsidized and throw world markets into disarray. It creates financial bubbles that has repercussion on all parts of the economy. It is no wonder that Western bankers are beginning to feel anxious about the bad effects of this latest scheme in China’s economy and asking that measures be taken against it.

Of course, the offending practices should be banned and restrictions put in place to prevent their return. However, it does no good to simply ban the practices without addressing the cause found in the frenetic intemperance of modern economy. In this case, regulations usually penalize the honest and small businessmen who are the least capable of dealing with the burden of restrictions.

The real solution involves the hard work of creating a climate of honesty, honor and integrity that naturally tempers economy. It also involves strengthening the God-given regulating institutions of family, community and faith that produce the social capital necessary for sound economy to flourish. Until this is done, regulation will not always work since there will be an ever-growing number of those who will find ways to operate in the dark shadows of economy to the detriment of all.