The Regulation Gap

If Washington is “dithering” about anything these days, it’s the slow pace of financial regulatory reform. What does it take to get this show on the road? Maybe an understanding that the sensational scandals are just reflections of a larger reality.

Bernie Madoff obviously represents one of the extreme cases of financial chicanery in our history. But I’m fascinated by all the attention given to the investors who lost money with Madoff.  Sometimes they are described (not without relish) as complete investment boobs, whose ignorance is exceeded only by their social and celebrity status.

My hunch is that their behavior, in fact, mirrors that of some of the top executives in some of the most important financial corporations in the world. Call the behavior an irresistible urge to “follow the leaders even if you don’t understand what they are doing.” 

When somebody is making significant amounts of money, or when a whole industry is booming, everybody wants to get in on the act.  Recently, for example, big banks and insurance companies all wanted to buy mortgage brokers and mortgage-backed security firms. Few seemed to reflect on the historical fact that housing prices are ALWAYS cyclical. More generally, these folks seemed blind to the iron reality that high returns virtually always reflect high risks.

Financial firms met the demand for high returns by designing increasingly complex instruments filled with risk. And few wanted to sound like idiots by asking how they really worked. For the financial engineers, front-loading fees and selling off complex instruments to others (greater fools?) became a routine business practice. New computer tools and spreadsheets enabled the “manufacturers” of new securities to project big earnings way out into the future.

Those free-wheeling days are over—at least for the foreseeable future. Given the current degree of financial distress, the question before the country is not whether there will be a strengthened regulatory regime in 2009 – there will be. The question is what form will that regime take and how effective will it be. Will the new regime restore confidence by reducing risk and fraud, and will the new arrangements also permit market innovation and stimulate financial flows?

It is important to remember than plans for regulatory reform will not start with a blank slate. We will need to adapt the system we have and not scrap all the precedents, rules of the road, and knowledge of how things work so that we don’t set back our effort to rebuild confidence in the midst of the worst economic crisis since the 1930s.

One regulatory issue involves the fact that the federal government is going to be an owner in many private corporations. Who will oversee those investments? It is important to set up a structure that becomes an enduring model for non-political government management of these activities. One of the first steps the new president could take is to announce a plan for independent governance and monitoring of these public investments. The appointments of oversight boards should be shared by the president and bipartisan congressional leadership, with the chairs possibly designated by the Chairman of the Federal Reserve. This marriage of government and industry is shotgun, but the knot has been tied and the government has responsibilities.  The ultimate goal is an orderly "re-privatization" of our beat-up banks, insurance companies, car manufacturers, and others.

There are, in fact, dozens of measures that can assist in sustaining orderly markets in the future, including changes in the way the rating agencies function, narrowing the focus of Fannie and Freddie, etc. But at heart, there are three categories of reforms that could make a big difference:

One, new financial products need an approval process. Most need to be traded on exchanges -- self-regulatory organizations overseen by government agencies. We should not let financial intermediaries invent and sell new contracts and securities without any vetting process.  That process should preserve rewards for innovation, but should not permit financial institutions to "clear-cut" opportunities creating conditions for later financial landslides.  

Two, there need to be strict limits on the sorts of transactions permitted by banks, insurance companies, non-profits, pension funds, and other government guaranteed or fiduciary firms.

Three, controls on leverage are a must. We have gone from firms that had 2-1 margins, to 12-1 leverage, to 30-1 leverage, to 100-1 leverage! Not to put to fine a point on it, that is financial insanity.

For firms that are privately held and deal only with high net worth individuals the Wild West may still return. But for the great mass of institutions and investors, we must insist on rules that identify damage early and limit it