By Verne O. Sedlacek, President and Chief Executive Officer, Commonfund
Overview
Financial booms and busts are a natural part of capitalism. The present crisis took place in the banking and broker/dealer industries, the most heavily regulated sector of the U.S. economy and no amount of additional regulation could have prevented this. There is no need to create an 'uber-regulator' to prevent the next crisis, we just need to make sure the people and agencies tasked with finding illegal and unethical activities have the resources to do so.
Booms happen. Busts happen. Companies succeed and companies fail. This is the nature of capitalism. It has happened before and it will happen again. While these simple phrases might not capture the pain suffered by individuals, it is fundamental to the system that has underpinned the economic success of the U.S. economy. However, when the inevitable bust happens there is always the totally predictable effort to try and regulate away the chance of “this” (whatever “this” is), from ever happening again. Remember the bust of 2001: Sarbanes-Oxley was the cure, which resulted in a reduction of public listings in the United States and enhanced the wealth of the public accounting firms. It also did nothing to prevent the current economic crisis. As we scrutinize the efforts now going on in Washington, we are observing once again the tendency to “fight the last war.” The fact is that the next crisis will be very different than what happened in 2008. So as we think about revising our regulatory structure to prevent the next bust we must ask the questions: did the regulatory regime fail; was it the regulators that failed; was it just the normal boom and bust cycles that are part of capitalism; and as we fight the last war will we create the underpinnings for the next crisis?As we perform a quick survey of the where the crisis originated, there are a couple of very compelling facts. It wasn’t the unregulated part of the economy that was the origin of the crisis; it was the most regulated and heavily overseen portion of the economic infrastructure that led to the panic of 2008. What happened took place in the banking and broker/dealer segments. It is this part of the economic infrastructure that helped to drive the economy for the last 25 years and as always seem to happen, exuberance and the misplaced belief that asset prices will always rise led to a failure of market discipline. No amount of additional regulation could have prevented this. The regulators already had all the necessary tools in their bag to prevent the excessive leverage at the banks; to rein in Freddie and Fannie; even to raise flags and limit damage at AIG. As the crisis unfolded the Fed, FDIC, the SEC and the Treasury reacted quickly to protect a financial system that had become hopelessly over-extended and if not for the failure of Lehman would have muddled through without the amount of pain that we did experience.So what is the solution? The tendency is to look at the laundry list of regulators and assume that they need to be consolidated into one super regulatory authority that mystically will be more efficient as a single bureaucracy. When you observe the patchwork of regulatory bodies from the Fed, SEC, CFTC, FDIC, OTS, FINRA and others, we automatically assume that companies must be dancing between the raindrops to avoid being regulated. There is little evidence to suggest that was the case – that what the IMF has called the “shadow banking system” played a massive shell game to intentionally mask risk from regulators by shifting it to unregulated or loosely regulated entities. Many point to AIG as the poster child for obfuscation, a seemingly rogue financial institution that went largely unsupervised at (now) taxpayers’ expense. In fact, the trading operations of AIG Financial Products (the subsidiary that effectively brought down AIG), was subject to regulation by the Office of Thrift Supervision, a branch of the Treasury Department.The fact is that the legal structure for regulation could have worked to prevent the underlying disease that infected the economy. It didn’t! The question is why not? It wasn’t because regulation was lacking or because the regulators were necessarily asleep at the switch. It was because we didn’t effectively resource the regulatory agencies we have. The SEC budget, for example, has essentially been flat over the last four years and staff turnover has been at historic highs, while the demands on the Commission have grown exponentially. Throughout the early stages of this crisis, the SEC has had to freeze needed hiring as budget allocations have not kept pace with year-to-year expense increases for existing staff.So as we attempt to find a villain in all of this, we just need to look in the mirror. Everybody contributed to the problem. The men and women who work tirelessly for the regulatory agencies should not be blamed. They are hard working (over worked) individuals that take their responsibilities very seriously. While certainly there was one very high profile fraud in Madoff, there will always be crooks no matter how many laws are enacted or how many police there are on the streets. It shouldn’t be the employees of the financial services industry – a vast majority of them worked hard to create shareholder value and provide services demanded by the consumer. It shouldn’t be hedge funds which in general operated quite effectively through the crisis under intense pressure and for their efforts they are now facing new regulation even though they were victims of the crisis as opposed to the cause. (By the way, adding a large number of hedge funds for oversight puts more stress on the already over-stretched people who actually have to do the work.)As we look forward, there is no need to create the uber-regulator, and therefore the Obama proposal makes some sense in that it doesn’t make massive changes to an industry which is already heavily regulated. The addition of a more agencies to oversee various parts of the financial services sector will not solve any long-term issues, and could add to the very jurisdictional disputes they are intended to fix. When was the last time a federal agency actually “facilitated information sharing and coordination,” and didn’t add to turf wars and bureaucratic malaise? We need to make sure that men and women who are on the ground working to find illegal and unethical activities have the resources to do their jobs. This requires the addition of staff, enhanced compensation, effective prioritization and training.You can’t outlaw stupidity and you can’t proscribe bubbles that will eventually burst. All you can do is ensure that firms and individuals have the right incentives and a robust group of people that are overseeing what these firms are doing.
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