Earlier this week I attended a panel discussion at my alma mater, the UCLA Anderson School of Management, on regulatory reform. It's always lovely to bask as a member of the audience in the cacophony of lively academic discussion covering subjects that tickle the fancy of financial engineers. Like all open forums, the most fun part is watching people dance around anything substantive, actionable, liable or prohibited from mention because of their "day jobs" so for me it's the prefaces, adjectives and adverbs of the speakers that tend to raise my deeper probative interests.
One word uttered halfway through the session caught my interest. "Suitability" is a term used to denote the legal obligation to ensure that an investment vehicle is "suitable" for the investor. In the United States, a private self-regulatory organization (SRO) named the Financial Industry Regulatory Authority, Inc., or FINRA that oversees brokerages, dealers and securities licensees is responsible for assuring that suitability tests are adhered to. Suitability is entirely the responsibility of the securities professional and it's supposed to be incumbent upon them not to place their clients -- who are presumed to not have the technical skills to accomplish meaningful caveat emptor -- into situations clearly not in their interests. These regulatory guidelines are fundamental tenets of the industry so it struck me a rather odd a couple of months back listening to the CAO of the City of Los Angeles explaining to Richard Alarcon's committee how Los Angeles managed to wind up with an underwater Interest Rate Swap created before the Federal Reserve shifted rates radically beyond the modeling limits of the swap were costing the city millions of dollars per year. The industry tends to solve these "mismatches" on an exception basis.
Still, hearing the word "suitability" uttered in Korn Hall made my mind meander back to another self-policing organization, the AICPA, that at one time allowed the degradation of the adequacy of internal controls to atrophy to such an extent that it required the passage of Sarbanes-Oxley and the creation of a government agency, the PCAOB, to begin to finally remedy. The thought stream naturally seems to apply to things like getting OTC derivatives cleaned up into some more accountable form of exchange controlled environment. Not some of them, all of them. Some just means it's window dressing and the business of invisible casino banking can go on. Investment bankers are after all masters of the art of fitting elephants through keyholes.
But much more important to the many ill positioned investors whose confidence is critical to America's future economic recovery, I continue to wonder if there isn't a massive inventory of mismatched and unsuitable investments out there that needs cleaning up systematically instead of by exception to get the US back on cleaner footing.
There was also some interesting discussion about various forms of financial products and risk control strategies that might be applied as part of a set of regulatory reforms. Ultimately all these discussions conclude that we live in some sort of band aid stuck on top of band aid regulatory universe that revels in complex rules that somehow have the macabre outcome of protecting special interests more often than impeding them. It's like looking at toxic murky soup in a big pond; the kind that turns swans swimming upon them a darker shade of bird. It all adds up to one question for me. Why isn't one of the pillars of emerging financial regulatory reform the institution of a "Black Swan" test that examines new financial product innovation and subjects it to some form of systemic risk consequence test? I'm just saying, given all we've learned, why do we have to keep on figuring out our messes after the damage is done?
If you look back at most of these innovations gone bad in finance you'll find that the people who set up these risks knew the music wouldn't last from the get go. They just didn't care. Heck, some of them apparently even went into the classic "bookie" business betting one client against another with the house always taking a cut. There's an open request for comment from the SEC right now asking for input about how much "skin in the game" should be required when finance innovates and issues new risk laden products. It deserves elevation to the front burner of regulatory reform analysis. The skin in the game should weigh about the same as a duck.