New Financial Regulation Is Only Half The Battle

Several other observers have written at length about the sort of financial regulatory reform the U.S. needs to adopt in order to achieve sustainable health.  In general, recommendations tend to include big-picture concepts. While I think all of these goals are admirable both individually and as a whole, the devil is, as always, in the details.

Here are some of the kinds of concepts being discussed:

- Unifying regulatory/enforcement authority under one office, as opposed to the hodge-podge, over(under?)-lapping hierarchy we currently suffer from.

- Increasing bank capital requirements to cushion against tail/systemic risk.

- Establishment of resolution authority to wind-down institutions that are (or are becoming) too big or too interconnected to fail.

- Creating policies to reduce system-wide moral hazard (and means of forcing adherence to them in times of stress).

- Establishment of a consumer protection agency/authority.

As mentioned, such ideas sound pretty good. But in this author's semi-humble opinion, our government has proven, beyond a shadow of a doubt, that it cannot even enforce existing financial regulation.  What, then, leads anyone to believe any new-fangled regulations will be enforced with much greater success?  Similarly, the government consistently adopts regulations and policies that, once Wall Street figures out how to bend the rules, end up having more holes in them than Swiss cheese.  Why, then, should we expect it to be different this time around?

Back in February, I was lucky enough to attend a FT Alphaville event, headlined by Richard Bookstaber, a man far, far more intelligent and accomplished than myself.  It was at this event where I argued (or attempted to, that is) that no matter how much data we provide regulators, no matter how well-intended the laws and policies, until we address the massive, myriad incentive structure asymmetries between Wall Street and its regulators, nothing will change.  Unfortunately, I doubt my argument stuck much in the head of Dr. Bookstaber or many of those in attendance, but I have, and continue to believe my point to be as true now as ever, even though the SEC actually (a step in the right direction!?) hired Dr. Bookstaber as a Senior Policy Adviser to the Director in the newly-established Risk, Strategy and Financial Innovation division. 

How, prey tell, should we expect regulators to out-smart (or out-whatever) Wall Street? The latter hires the best & brightest -- and pays them accordingly -- while the former hires those who couldn't get jobs with the latter, and pays them accordingly, the few recent additions aside?  

I posit that so long as regulatory agencies -- and employees thereof -- suffer from paycheck envy, regulatory capture, institutionalized bureaucracy (too many masters and conflicting goals), etc., we're crazy to think there's one iota of a chance that government will be able to rein-in Wall Street's opportunistic ways.

Call me a cynic, but for each of the bullet-points above, I can imagine less-than-ideal, yet highly likely outcomes, respectively:

- The various agencies currently tasked with financial regulation will fight tooth-and-nail to retain authority, despite having exhibited an utter inability to handle it.  Any roll-up, single-authority that gets created -- if we even get that far -- will be just as inept and bureaucratically complex as the sum of its parts, if not more.

- If the government (via BASEL, SEC, Fed, Treasury, or whatever) mandates banks to maintain X metric at Y levels, the banks will simply create new mechanisms/products/avenues/etc. to game the system, allowing them to give-off the appearance of safety while still effectively maintaining -- or worse, increasing -- leverage and risk.  I call this compliance by obfuscation, and I think there's more than enough, especially recent, historical precedent to expect the trend to continue.

- I'm astoundingly skeptical of the government's ability to establish, track, and enforce any policies that attempt to avoid and/or wind-down too big/interconnected to fail institutions.  While Dr. Bookstaber is correct that giving regulators far greater pools of data and the tools to analyze them is a major step in the right direction, the G.I. Joe mantra -- "Knowing is only half the battle" -- seems to dictate such endeavors will inevitably fall short of regulators' best intentions.  I loathe beating a dead horse, but if the SEC couldn't figure out the Madoff scam when the entire case was handed to them on a silver platter, I find it hard to believe regulators will be able to beat Wall Street at its own far more ambiguous and complex games.

- I'm not even going to touch the moral hazard issue, although some of The Atlantic's other writers and contributors have posted some great analysis for those interested in the subject.

- I'm a proponent of caveat emptor as an over-reaching philosophy, whether we're talking about MBS or children's toys; don't buy something you don't understand. But if you insist on doing so, at least be prepared to deal with the consequences of your ill-informed actions.  This does not mean we should ignore blatantly predatory sales practices, not in the slightest; however, there is no way Wall Street is going to let the government destroy the sales/distribution cash machine it has enjoyed for so long.  I've seen first-hand brokers sell clients expensive/underperforming products when cheaper/as-good-or-better alternatives exist, even though such practices are technically already governed under existing regulations.  Until these are enforced, cramming-down any additional legislation is pointless, unless, of course, the point is to simply create the impression that the government is doing something, or anything for that matter....

While my views may represent some of the most cynical (short of Taibbi-esque conspiracy theory) out there, they're based on historical precedent. And unlike those of stock returns, prior government actions -- absent massive structural change -- tend to predict future results.