"Bringing Back Regulation's Good Name"

This is from Felix Salmon (if you are unfamiliar with rules based versus principles based regulation, see here):

Bringing Back Regulation's Good Name, by Felix Salmon: Jesse Eisinger's column this month is about the different regulatory structures in London and New York, and how they both failed. I asked him about it... His rather excellent response:

...Laissez-faire regulation on both sides of the Atlantic has clearly failed. I'm trying to understand why and think about how to fix things.

Here in the U.S. the Reaganite experiment of financial deregulation reached its apogee roughly in the 2004 to 2006 period. That wasn't supposed to happen. The pendulum was supposed to swing back to a more regulation in the aftermath of the stock market bubble, the accounting fraud pandemic and the Wall Street research scandals. Yet after SOX was passed and the Spitzer-inspired reforms, The Wall Street Journal edit page and the US Chamber of Commerce et al spent years railing about the regulatory overreach. Sarbanes-Oxley purportedly was having malign effects on American competitiveness and New York was threatened by London and Hong Kong. We were strangling technological innovation. The reality is that we were blowing another bubble, while the SEC and the Fed shirked their regulatory duties. I have no doubt that a concerted regulatory effort starting around 2004 or 2005 to regulate mortgage lending and to examine leverage in the system would have helped enormously, had the regulators been given the mandate. But the Bush-era SEC and a Greenspan-led Federal Reserve had no interest.

One point about London, which I think is underappreciated in the States, is that they were running an even purer laissez-faire financial experiment. I was puzzled how that happened, but the reason turns out to be fairly obvious: The FSA, the British super-regulator, was created when the financial services industry was strong. And the British economy is even more dependent on the financial services sector than the U.S.

What's interesting is that even though we have two different structures and two different approaches, we both got into very similar problems. We have a deeply overleveraged financial system and a bursting housing bubble. ...

I think "principle"-based regulation is pretty much a crock. But it's beside the point. The "principle" approach is a euphemism for being hands-off. As you see from my column, the FSA has virtually no enforcement staff or budget. So the British regulators couldn't enforce principles if they wanted to.

I think we should stick to rules. Principles are what firms need to adhere to themselves, by creating internal cultures that respect the rules, the regulator, and their customers. For instance, some firms have in-house risk management departments that are the "risk police" and some have risk management sitting at the table as a partner. At the Risk Police firms, you push deals you can get away with. That's bad for the firms and bad for the markets. Our regulators could try to find ways to encourage the creation of internal cultures that reward high principles as well..

Regulators need to enforce the rules. This is the problem. It's been exacerbated by our ridiculously Byzantine regulatory structure. It's obvious to most people that we need a radical overhaul of our regulatory structure, but if it's not back by a regulatory attitude change then it will be for naught. ...

[T]he main point of the column is that regulators have to regulate. We need to bring back regulation's good name. ...

Comments

[Jas Jain]

--
One set of crooks are busy creating the mess and other set of crooks and their agents are busy proposing fixes. Moral bankruptcy prevades the Anglo-American econo-poliical system and its operators.

Born-and-bred American dopes can only watch from the sidelines and vote for one of the agents of the crooks. What a system!

Jas

[Francois]

There is a simple analogy that should resonate with anyone: in any living system, growth without regulation is cancer.

I've never heard anyone call cancer a good thing; it's a disease, and a bad one at that.

What we have in the financial sector now is a serious disease.

And there is no guarantee the "patient" will survive without severe damage.

[Eric Dewey]

While I definitely agree with the points Eisinger makes, he seems to miss that what's being regulated is basic human behavior. We are perhaps hardwired to seek out additional risks until we get burned sufficiently to learn not to do something - and even then, each generation has to learn the same lesson again (the fire analogy extended).

Another good analogy is ice - if people have to cross the river in winter but don't want to use the bridge (because it's too far to go or has a toll), a few smart ones will try to see if they can get across on the ice. One or two will carefully find a way, then others will notice and the level of traffic will grow - until finally the combined weight becomes too much, the ice breaks, and some people hit the water.

Unless the government is willing to spend what it takes to monitor the whole riverbank, this pattern will be endlessly repeated in each generation.

Having lived through the last ten years as a compliance staff member at US financial institutions, I can tell you that the changes were quite slow at the beginning, then picked up speed over the past 5 years or so - until the ice broke.

The only thing that has the effect of teaching people not to do stupid things is that they get burned or frozen - some of them fatally.

The challenge really is making sure that the right people get roasted or frozen, and not the wrong people. The right people are those who publicized that the ice was thick enough for everyone, saying this time it's different, and encouraging more and more people to walk out on the ice - but of course, these are exactly the same people who are being bailed out by governments all over the world.

Until those people feel the flames licking at the feet and/or the chill of the icy water freezing them to death, things won't change, no matter how many economists come up with clever ways to postpone paying the piper.

I'm definitely not against taking risks, trying to get across the river on the ice if we can do so safely - but I've seen too much of the idiots who think everybody can do it and who are trying to profit from it...

[gordon]

Eisinger: "Principles are what firms need to adhere to themselves, by creating internal cultures that respect the rules..."

I've said it before; people go into business to get rich, not to solve interesting problems in management or marketing. Plunder is a very good way to get rich quick. Creating new wealth is much slower and less certain. Internal cultures of honest practice are always under threat by pirates.

Francois: "I've never heard anyone call cancer a good thing..."

It's a very good thing if you're in the pharmaceutical business.

[Lafayette]

Curb Cupidity

Article: I think we should stick to rules

Yes, so let's name them:
1) A firewall between Investment and Commercial Banking if both are owned and managed by the same entity.
2) Establishment for Investment Banking operations of solid requirements levels for all futures trading operations. Real-time auditing of trader positions.
3) Rating agencies that are audited regularly for a report card of "good conduct" in the assessment of worthiness of the ratings given.
4) A Financial Services audit, by Central Banks, of ALL credit and loan market agents to assure that borrowings are allowed according to documented worthiness considerations of the loanee -- who assumes a part of the total cost of purchase for residential property loans.
5) "Teach the cheats" interdiction of recidivist credit-card delinquents with minimum card revocation tenures of a year.

And, finally, the only measure that will work to Curb Hi-Finance Cupidity: Restoration of marginal tax rates at upper income levels that will take the temptation out of greed.

The base premise of this article is spot-on. The Finance industry has been insisting on "principles based" regulatory environments, which have clearly failed. The actors have behaved systematically like the fox in the hen-house with exaggerated greed to accumulate individual wealth.

Such is NOT the raison d'etre of an economy's banking system, that is, to generate ginormous wealth for those who manage its operations (badly).

Nobody deserves such wealth that warps the Income Disparity of a nation.

[reason]

I think this is all well and good, but there are two things missing for me:
1. We need to embrace de-leveraging as a general policy. A highly leveraged economy is not only unstable, it is unsustainable in a world that may suffer a real growth shock
2. we need to remove the asymmetrical reward structure encouraging excessive risk taking that is the result of
a. limited liability
b. agency problems
c. too big to fail.

Asking for, or even enforcing good behaviour is not enough.

[hari]

@ Eric Dewey -

Finally someone with courage and gumption to call the game by its real name! Thanks.

[gordon]

Once again, I like Lafayette's "to do" list in principle, but I fear it is actually addressing the wrong problems.

The difficulty is that it is too focussed on the financial system which has caused the current credit crisis. This system is too corrupt and too removed from the real economy for a purely financial "fix" to be effective. It is necessary to look at the real circumstances of real people in the real economy and work back from there. Getting lost in the financiers' Hall of Mirrors will achieve little or nothing.

Where to start? I have in the past suggested that the Economic Policy Institute's Agenda for Shared Prosperity is the only comprehensive programme of action which I can find in the US for addressing the real economy's problems - there may be others, but I don't know about them. It is a very moderate - perhaps self-consciously moderate - programme.

To this programme I would add debt cancellation on a large scale. In a situation where many Americans (and people in other Anglophone countries too) are labouring under a vast weight of debt (including mortgage and credit card debt), the engine of recovery will cough and die. The workers who made the products purchased with this debt have been paid already. Continuing payments of these debts will only keep a dangerously corrupt financial elite in caviar and champagne. Cancel mortgage and credit card debt now!

[euroquisling]

All you lovers of regulation are dealing in wishful thinking mixed with lousy analogies. Sure unregulated markets are not for faint of heart. The problem is that regulation *always* imposes greater marginal cost than marginal improvement.

A friend of mine who works at Freddie Mac calls SOX "the stupidest law ever". All in all, it might not be a bad thing - that is, the costs that SOX imposes are so huge, and protection so nil, that companies switch away from corporate model towards private investment. But that's like making markets more efficient by selective killing half of its participants.

All will be nice with regulation until the actual effects kick in. Look at how European economies fare in comparison to US - this just in, European economies contracted slightly y-to-y. If US wants to have the same disease, be my guest (not my problem).

[The Political Stray]

There's nothing difficult here except figuring out which politicians regularly work against the public. Restore regulation that was placed to protect the public from white collared, hit and run profiteers. Throw the same from office. Tar and feather Gramm. Take a good look at the Federal Reserve's new "solutions".

Seize assets from the profiteers the same way we do from drug dealers. That money would come in handy right now.

[Lafayette]

Gordon: Getting lost in the financiers' Hall of Mirrors will achieve little or nothing.

I am convinced that the decades long experience (of it having been in place) has taught us that the firewall between too very different business models (investment and commercial banking) is absolutely necessary. The former is performed almost wholly within a risk environment, whilst the latter is (or should be) quite the opposite, that is, avoiding risk at all costs.

You may be very right about the Financial Engineering "Hall of Mirrors". Fix one mirror, and they will simply set up another. Which is what they did to get us into the sub-prime mess.

Which is also why it is key to get at hallucinatory and excessive compensation rewards by means of confiscatory taxation.

Nothing less will be a real solution if we do not remove the temptation from cupidity. This seems so perfectly obvious to me ... I guess I must be whistling in the dark.