A shipping disaster's lessons for Dodd-Frank

Financial Times
Opinion

July 30, 2015 6:31 pm 

Randall Kroszner 

Beware of unintended consequences and cost-benefit trade-offs, writes Randall Kroszner 

One hundred years ago this month, 2,500 passengers in a festive mood boarded the SS Eastland for a picnic cruise on Lake Michigan. Just as the ship was to leave its mooring in the Chicago river, the Eastland suddenly capsized and 841 passengers lost their lives — more than in the Titanic disaster. 

The fate of the Eastland is one of America’s great unremembered tragedies, yet it carries important lessons for policymakers today, specifically about how a regulatory response to one disaster can unleash unintended consequences that could contribute to another. The fifth anniversary this month of the Dodd-Frank Act reforming financial regulation seems like a particularly good time to consider this.

  • After the Titanic’s sinking in 1912, an International Conference on Safety of Life at Sea was convened to develop a global response. Sensible reforms included taking more southerly transatlantic routes to reduce the likelihood of encountering icebergs and creating an iceberg patrol, still operating today, to monitor and warn of the risks. 

Similarly, after the 2008-2009 financial crisis, the Group of 20 leading nations, Financial Stability Board, the Basel Committee and other international regulatory bodies convened to provide a co-ordinated global response, promoting rules to reduce banks’ risk exposure and to increase macroprudential monitoring. 

But an important response to the Titanic was “lifeboats for all”. If only the Titanic had had enough lifeboats for all its passengers and crew, perhaps no one would have perished. What could be more sensible and obvious? 

The measure was adopted in the 1914 International Convention relating to Safety of Life at Sea. It was immediately clear to some, however, that this policy might have unwanted ramifications. In testimony to Congress, A A Schantz, the general manager of the Detroit & Cleveland Navigation Company, questioned whether such a requirement should be applied to ships plying the Great Lakes. 

“The extra weight of the lifeboatsand rafts would make [ships on the Great Lakes] top-heavy and unseaworthy, and  . . . some of them would turn turtle [capsize] if you attempted to navigate them with this additional weight on the upper decks,” he said. 

While Congress did not mandate “lifeboats for all” for ships on the Great Lakes, the 1915 La Follette Seaman’s Act significantly increased the requirements. The Eastland had already increased its number of rafts in 1914, as federal inspectors tightened the rules. 

Just three weeks before the tragedy, and after the passage of the act, the Eastland added more life boats and rafts to boost its licensed capacity to accommodate 2,500 passengers for the ill-fated picnic cruise. The ship was designed in 1903 with six lifeboats. When the catastrophe occurred, it had 11 lifeboats and 37 life rafts. (Each raft weighed some 1,100  pounds.)   

The additional weight of the lifeboats and rafts may have been only one factor contributing to this calamity, but it illustrates how powerful unintended consequences can be of even the most sensible-seeming regulatory reforms. So what is to be learnt from the Eastland disaster? 

First, even if a rule solves some problems, it does not necessarily solve them all. In some cases, new regulations can undermine their own goals, creating new sources of instability. New rules can interact with other weaknesses in the system. “Lifeboats for all” can bring a false sense of comfort, and inspectors and supervisors may not look as carefully for other vulnerabilities. 

Second, one-size-fits-all regulation may not be appropriate. Higher capital and liquidity requirements for the largest global banks relative to smaller banks may be appropriate, just as “lifeboats for all” may be more appropriate for transoceanic ships but not for steamships on the Great Lakes. 

Third, costs and benefits need to be taken seriously. The anniversary of the Dodd-Frank act is an excellent moment to gather data to assess the benefits and costs, their interactions and potential unintended consequences. Have activities moved into the shadows and how has this affected the robustness of the system? What has been the impact on liquidity of markets? As with icebergs, it is not what you can see but what you cannot that is often most dangerous. 

The key lesson from the Eastland tragedy is certainly not that regulation is inevitably counterproductive but that we always need to consider unintended consequences and cost-benefit trade-offs, even for extremely well-motivated rules, to protect us from turbulence in financial markets — and on the seas. 

The writer is a professor of economics at the University of Chicago and former governor of the US Federal Reserve