Regulation Reform?

Two news stories caught my eye in the past two weeks. One reported on the Securities and Exchange Commission's decision to join with 12 investment banks in seeking to curb the 2003 reforms on Wall Street research. The second was a report on Alan Greenspan's speech to the Brookings Institution last week. They both reminded me of a conversation that I'd had with a friend who works for a hedge fund a few weeks ago. But let me give a little more context.

The story about the SEC was disturbing, I have to admit. I've been admiring Mary Schapiro's return to the SEC and her leadership as Chairman of the Commission for the past year. She's put many changes in place at the SEC, and although I've heard some of my former colleagues (who still work at the SEC) complain about some of them, overall I'm pleased that she is tackling the issues that need to be tackled - mostly my own gripes (shared by others I've heard in the media) that the Commission is staffed by lawyers, most of whom have never worked in the industry. Chairman Shapiro has made enormous efforts to bring on experienced staff, and create a new group to examine new products and risks in the marketplace (her strategic plan is a good read). She is working to bring more transparency to the marketplace and address the protections of financial consumers in a way that Banking Committee has not.

So the story I read last week was a let-down. After over a decade of "de-regulation" of the securities markets by our Congress, why was Chairman Shapiro joining with the banks to further emasculate our regulations? This was also a personal interest of mine - I had spent a year at an investment bank implementing those 2003 provisions of the law that required banks to separate their research teams from their business teams, required separate research compliance departments. and imposed extensive disclosures on research reports, among other things. Given the events that occurred during the Internet bubble in the late 90's, of whom Henry Blodgett was the poster child, the provisions of the Research Settlement of 2003 seemed like a good thing to me.

Greenspan's comments at the Brookings Institution reinforced some thoughts I had expressed to my friend recently. Greenspan criticized the regulatory system and the role (or lack thereof) it played in the Financial Crisis of 2008. Correctly, he cites the fact that the regulators more or less lived inside most of the leading financial institutions in the years leading up to the financial crisis, and yet the banks were still able to engage in activities that "brought them to their knees."

The fact of the matter is that you need two things for effective regulation. One, you need rules to keep the industry from engaging, or trying to engage, in behaviors that take on excessive risk. Two, you need regulators who are incented to look for these aberrant behaviors. The problem is, we lack both.

Eighteen months after September 2008, we still don't have any meaningful regulatory reform. Derivatives are still unregulated, and most OTC transactions are not transparent to anyone but those involved in the transactions (and even then, clarity is not guaranteed). There is no way for our regulators to know who is doing what right now. The means to do so exist, they are just not available to the government right now. (Although there are efforts on different fronts to make this happen. See the website for the Committee to Establish the National Institute of Finance.)

And even though Chairman Shapiro is doing what she can to beef up her troops, the fact of the matter is that those who work for the government are in a very different place from the people they regulate. As I said to my friend over lunch, no matter how hard-driving the staff of the SEC, they are not motivated by money. Government regulators work for the government because it allows them to work regular hours, have a family, and coach their kid's soccer team. On the other hand, the folks they regulate work crazy hours and take home huge bonuses. Bankers are highly incented to make money, and lots of it. Your basic government employee gets a a salary. Period. And maybe the satisfaction of seeing their case of the past year make the front pages of the Wall Street Journal. There's just no contest there.

As long as we don't have laws, and we don't have regulators who are incented to make those laws stick, I'm not sure we can say that there's any way to prevent another 2008 (or 2003, or 2000, or 1998....). Another naked emperor steps forward.