Modest Proposals for Financial Reform: Regulation as Grade-Grubbing

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Guest post by Dr. Manhattan, a lawyer in New York City who represents, among others, clients in the investment management industry.

The holy grail of regulation, in my opinion, is to harness the power of private sector competition to provide, and constantly improve on, the regulation's goals.

Can this be done for financial regulation? Hell yes. My own field of investment adviser regulation is ideal for this approach, if only the SEC would dare (they won't, for reasons listed below). Specifically, the SEC should approach investment adviser regulation - and I think other types of financial regulation - like NYC's restaurant inspections, including grades. Yes, really.  Specifically, regulated entities should be graded on specified relevant criteria, and their report cards should be publicly available (together with the regulator's comments, scrubbed for confidential information). And to make things even better, the regulated entities can be graded on a curve: wouldn't it be great if banks had to compete for one of the few "A"s available?

I can say that for investment adviser regulation, this approach would be multiple times better than the current regime, where: (a) the SEC spends so much time on paperwork and compliance with policies and procedures that they have trouble noticing major violations that the policies and procedures are designed to guard against (like, say, running the biggest Ponzi scheme in history); (b) every regulated entity gets a letter noting deficiencies (that's not a real exaggeration - well over 90% of advisers have deficiencies upon inspection), but those letters are not publicly available - so an investor has no way of knowing whether an adviser got nailed for peccadillos or just-short-of-enforcement violations; and (c) the regulators "get tough" by, in the infamous words of Hank Greenberg of AIG, turning foot faults into murder charges. A good grading system would force regulators to focus on the important stuff - like whether an adviser is stealing from its clients - and would provide more information to the public. As another side benefit, a grading system might force the regulators to update obsolete regulations more frequently (of which, at least on the investment adviser side, there are MANY).  I would have a lot of fun designing the grading system for investment advisers.

A similar format could at least improve on other financial regulatory regimes. (And to be clear, none of this would or should interfere with the regulators' ability to inspect for or take action against fraud or other violations.) At the very least, regulators should be thinking of ways to harness private-sector competition to further their goals rather than thinking of regulation solely as something forcibly hoisted on an unwilling audience who will invariably focus on circumvention, like sullen teenagers and a newly-applied curfew.  For investment advisers, the SEC will never contemplate anything like this, not least because the political blowback will be catastrophic the next time they give a passing grade to the next Bernie Madoff.  But it'd still be a good idea.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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