The Cobra Effect

Banking in the Shadows: Part 3

@CharlieLongren

TLDR: Regulation contributed to the proliferation of the Eurodollar system by incentivizing balance sheet expansion through money creation.

When Great Britain ruled over colonial India, Delhi was overpopulated with venomous snakes. To deal with the issue they put a bounty on the snakes offering a cash reward for any cobra skins turned in. When people saw how lucrative this government sponsored snake trade could be, the entrepreneurs in India began farming cobras instead of capturing them. Government officials realized that their policy was ineffective because the snake population was not decreasing. Eventually they also realized that their policy was actually a subsidy for cobra farms rather than a program to decrease the population of wild snakes, and they discontinued the program. After the government stopped paying for the snake skins, the cobra farmers had no use for their “inventory”, so they released the cobra’s back out into the city. The snake population increased dramatically and the city of Delhi was far worse off because of the snake skin bounty. German economist Horst Siebert coined this type of perverse incentive as the cobra effect.

The Eurodollar system of money creation has become such an important part of bank financing partly because nothing that the banks have been doing is illegal. Quite the contrary. Many of the bank regulations enacted by governments incentivize banks to focus on expanding their balance sheets through any “legal” means available. A bank’s primary benefit to society is to effectively and efficiently allocate capital. When regulation incentivizes activities opposed to a bank’s primary raison d'etre, the few benefit at the expense of the many (I believe that ineffective and counterproductive regulation is extremely detrimental to society and should be avoided at all cost, but in all honesty, I would rather be part of the few than the many.).

Often governments attempt to enact regulation in order to benefit society, but there are unintended consequences that have the opposite effect. This is not a criticism of government regulation, but rather a critique. It is my belief that government regulation is necessary in every society… to a certain extent. However, the cobra effect has always been a common side effect of regulation. As an entrepreneur, investor, or manager it is important to know how regulation impacts industry and economy and how you can use regulation to your benefit.

One sequence of regulations that contributed to the proliferation of the Eurodollar system was the Basel Accords. After Richard Nixon “temporarily” suspended the U.S. dollar's peg to gold, the key tenant of the Bretton Woods agreement was broken. The G10 countries sought to build a new global financial structure to regulate banking in place of Bretton Woods. The Basel Accords are meant to prevent cavalier and risky behaviors by banks thereby increasing the amount of financial stability in the global economy. However, policy makers of leading world governments were unaware that money creation was the true arbiter of financial instability. ( To this day, money creation remains the primary reason for disastrous economic outcomes and policy makers remain either blissfully unaware or unwilling to improve the flaws in their system.)

In order to reduce risk in banking, The Basel Committee on Bank Supervision (BCBS) categorized investments into buckets and raised/created the capital requirements for each bucket of assets. For example, for a bank to invest $100 in structured AAA rated mortgage backed securities, it had a capital requirement of 4%. Meaning, that bank must have at least $4 in restricted cash on its balance sheet. Per the Basel Accords the riskier the asset the higher the capital requirement to invest in that asset. The Basel Accords would have been an effective set of regulations under the gold standard, but in the Eurodollar system it created a cobra effect.

Again, the primary purpose of banking, as an industry, is to be an institution for saving and to be an efficient and effective allocator of capital. But individual banks as businesses are primarily focused on expanding their balance sheets. They want to become bigger. The larger a bank is the more it benefits from the network effects of deal flow, information flow, and capital flow. When the world was on the gold standard, the only way a bank could expand its balance sheet was to be an institution for saving and efficiently and effectively allocating capital!

When the U.S. finally followed the world and broke its peg to gold, banks had a new way to expand their balance sheets. They could create dollars out of thin air using the Eurodollar System. The Basel Accords incentivized bankers to invest in assets because they had the smallest reserve requirement, while they should have chosen to invest in assets because they were good investments. Investing in assets with low reserve requirements allowed them to make sure their balance sheets were as large as possible, while still obeying regulatory guidelines. The Accords incentivized banks against the activity that provided the most value to society; capital allocation. Further, banks no longer relied on deposits for bank activities because of repo markets. They could now use pristine collateral and interbank repo agreements for most of their liquidity requirements. This meant they did not need to be savings institutions either, evidenced by savings rates that are currently well below the rate of inflation.

This game of balance sheet expansion through money creation led to bankers packaging riskier securities and labeling them as AAA rated low risk securities. I do not attribute this act by bankers to malice because I can just as easily attribute it to greed. They believed that their math was correct and that by packaging risky securities together they could reduce the level of risk inherent in the asset. And they were not completely wrong.

As much as we like to villainize the banking industry and, rightfully, condemn bankers for their role in economic recessions and depressions, banks provide an indispensable service for society. Banks are most valuable when they help individuals save excess capital and allocate that capital to where it can be effectively put to use. I repeat, they should direct capital away from people who are unable to use it and toward people who can. As I stated in, How to Build Wealth, effective allocation of resources is a skill that will remain valuable even as we transition into the Knowledge Age. In fact, there are already banks dedicated to saving and allocating attention. We call them platforms. Much like the banks of old, they are becoming the biggest companies in the world i.e. Meta, Alphabet, ByteDance, WeChat. We now depend on policy makers to properly regulate the banks of the future, but if the past and present are indicators of the future, regulators have a huge challenge.

...I think that it is important to understand the past only insofar as it helps us succeed in the future. In my next post I will pull us one step closer to the future and address the world financial condition in the 2000s and 2010s.