Bringing Back Regulation’s Good Name

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:

Jesse, you travelled to London for your latest column, and came away

with the conclusion that neither the UK’s principles-based regulatory

approach nor the US’s rules-based system have worked very well in

practice. That said, you do seem to think that a principles-based

approach might be the way to go:

Britain has the right structure but the wrong approach to remedy its

problems. The U.S. has the wrong structure and, in recent years, the

wrong approach.

We can still learn from the rest of the world. An F.S.A. would work

in the States, provided it had teeth.

Are you saying that the US should scrap thousands of rules and

regulations, and give a super-regulator teeth to punish financial

companies for transgressions which might not be against any particular

written law? Is there any precedent, anywhere in the world, of such a

regulator really working, and not being captured by those it would

regulate?

His rather excellent response:

Ask leading questions much?

The answer to your question is: No.

I’m happy to expand on that. 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.

To go to your question, I’ll concede that the words "structure" and

"approach" are doing a lot of work in those sentences that you quoted from

my column. By "structure," I am referring to the super-regulator structure

of the FSA, with its wide-ranging jurisdiction. By "approach," I’m referring

to the laissez faire hands-off nature of the FSA, versus the enforcement

orientation of the SEC. The FSA prefers to have open dialogue and

historically the SEC — much less so under the Bush/Cox regime — was more

aggressive. File the "principle-based" vs. "rules-based" debate under

"approach."

To answer your question: 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.

Here’s where I would start: The US needs a significant amount of regulatory

consolidation, and I think the FSA is a decent enough starting point. We

need to wipe out the CFTC and combine it with the SEC. We don’t need myriad

bank regulators or state insurance regulation, so let’s consolidate those.

We need to bring derivatives and most off-exchange contracts under the SEC

umbrella explicitly. And just maybe our elders were onto something with

Glass-Steagall and we should consider bringing it back. I can’t see how that

would work, to be honest.

In addition, I like the idea that the FSA, rather than the Bank of England,

has regulatory authority over banks. I’m inclined to think that monetary

policy is a hard enough job without having to think about bank regulation

too. But I’m open to hearing opposing views on whether the Federal Reserve

here should be stripped of its banking regulatory authority. At a minimum,

we should have a radical consolidation of our bank regulators, as I say. And

if we keep the current system, investment banks should — and will be, I

expect — brought under the Fed’s jurisdiction. Then we need to have

regulators much more focused on leverage and capital requirements.

But the main point of the column is that regulators have to regulate. We

need to bring back regulation’s good name. Everything follows from that, um,

principle.

In my October column for the magazine, I’m going to propose a non-regulatory

fix that we need in addition. Stay tuned!

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