The Post-Madoff, Post-TARP Future of Financial Regulation

We have reached a historic juncture in the regulation of American financial markets, and not just because Mary Schapiro will soon become the first female chair of the Securities Exchange and Commission. She inherits an agency that missed the Bernard Madoff scandal, not to mention Enron and WorldCom. At the same time a scathing Congressional Oversight Panel (COP) report excoriates the US Treasury Department for its ad hoc disposition of the $700 billion Emergency Economic Stabilization Fund, questioning whether it even has a strategy for repairing the financial system.

As the SEC and Treasury are taken to task for these systemic failures, there is an even bigger failure and bigger question for regulators to grapple with: the apparent failure of regulation itself, and the question of how to reform financial markets so they never again inflict such damage on the wider economy.

The financial system provides a valuable service: it collects and mobilizes savings in order to channel them into productive investments, which in turn give rise to economic growth and higher incomes. But it does no more than that, and should really be thought of as subservient to the needs of the real economy of production and employment.

Making sure the financial sector served the real economy, not the other way around, was the impulse behind the creation of the Securities and Exchange Commission in 1934. But today, judging from the disposition of bailout funds, financial markets are treated like an end in themselves, and seem to trump automakers, homeowners, job seekers and the rest of the real economy.

There is nothing wrong with robust, diverse, innovative financial markets. They are and should be deep. For them to function well, savers must have a deep reservoir of different ways to make their funds available to potential lenders. Borrowers must also be able to choose among numerous mechanisms for accessing funds. When the system is working, savers are encouraged to save, and their funds find productive outlets.

But depth can also be excessive and dysfunctional. Today we are suffering the consequences of too much of a good thing: deep markets with too many complex instruments encouraging too much risk-taking.

The quest for deeper markets led us down the path of "securitization" - packages of mortgages and other loans that were collected together and sold, becoming so opaque as to be unintelligible. Investors, driven by herd behavior, nevertheless bought them without understanding their terms. Too late they discovered that what they owned contained loans that would default when the housing bubble burst. This misjudgment was so extensive it resulted in credit all but drying up; lenders ceased making credit available as doubt was cast on repayment of existing loans.

When investors can make system-threatening bets without even knowing what they're buying, it is clear that regulation has failed, and needs rethinking. It is no longer adequate to ensure that financial transactions are done in an arms-length manner, which was the innovation of New Deal-era regulation. Regulators today must protect the real economy from the existential threats that financial market depth itself can pose.

That's why we need to start thinking of and regulating the financial system less like a key sector of the economy whose mission is to grow and deepen in its own right, and more like a public utility whose mission is to serve the public good by encouraging wider economic growth and fuller employment.

Regulating financial markets more like a public utility would mean, among other things, imposing some reasonable limits on market depth. When financial instruments become so complex and inscrutable that it's impossible to make a reasonable assessment of their risks, it isn't enough to just watchdog how they are traded; they should not be traded at all. They should be banned. Packages of opaque mortgages should be the first among the financial "products" to go.

In this age of deregulation, it has been unfashionable to regulate even such things as power plants like public utilities, let alone financial markets. But it is time for that sort of regulation to come back into style. Even in a free market system, when a sector is so critical to the wider economy or to national security that its failure becomes a potential threat, regulators need to do what it takes to safeguard the overriding public interest, even if it means imposing some limits.

Admittedly, treating financial markets this way would constrain them to a level below their theoretical growth potential. But that is a small price to pay to stop the financial tail from wagging the economic dog, and to protect against more meltdowns like the one we're living through.

Comments

[dow2200]

Two comments: Re: "Savers must have a deep reservoir of different ways..." No. Savers ("investors" in Warren Buffet's terminology) must have a deep reserve of trust, that their principal is safe, and that their interest will reliably be paid. Speculators, willing to risk both principal and interest, may do what they wish. Confusing investing with speculation, and investment grade, with speculative, vehicles is a prime source of unexpected financial loss. And I'm not even talking about outright fraud. But let's. Bernard Sadoff - perpetrator of the greatest investment fraud in history. The man stole $50 Billion, bankrupted entire foundations, and drove one "investor!" (so far) to suicide. Why is this man under "House Arrest", in his luxury apartment, when the starving 18 year-old who smashes a window and grabs what he can, rots in jail, if he can't make bond? Let's get real! I'm sure there's a maximum security cell at Statesville with Mr. Sadoff's name on it. Too harsh? Are you kidding?

[veracity]

To (badly!) paraphrase President Harry Truman (on his 1948 election RR tour), "HOW MANY TIMES do you people need to be ripped-off by ENRON ACCOUNTING, before you demand HONEST ACCOUNTING and verifiable oversight?"

[Libarchist]

How many of the derivate -- or swap contracts are off the books? If there are some off the books, where are they traded?

[Sykon]

Excellent article, Jay. I really like your suggestion that:

...we need to start thinking of and regulating the financial system less like a key sector of the economy whose mission is to grow and deepen in its own right, and more like a public utility whose mission is to serve the public good by encouraging wider economic growth and fuller employment.

I have been against this bailout of mismanaged financial institutions from the very start simply because they, of all institutions, should have known better than to get themselves into this predicament. They violated the most basic tenet of the banking industry, i.e., extending credit to only the trustworthy customer.

What is also unconscionable and to me, unforgivable, is that they all appear to have engaged in a calculated scheme of bundling what they had to have known were trash loans with little prospect of repayment. They then deceptively resold tranche after tranche of this junk investment as something almost as secure as a Treasury bill. In any other industry such unethical behavior would be regarded as the criminal conduct it is and prosecutions would ensue.

Instead, the executives and boardrooms of these irresponsible "bookie houses" are getting billions of Treasury dollars to cover their losses for the most egregious, unethical and criminal violation of their fiduciary responsibility. It boggles the rational mind.

Regulate, again, these titans of finance? Most certainly.

[TJCole]

Deregulation flew in the face of human nature itself, and it was really only the swindlers and scoundrels who objected to those regulations that protected the American people and our entire financial system..so they could plunder it as they have both comin and goin...!

You don't need an economics degree to know this just some history and common sense..!

Who was always against regulation...the crooks...that's who..!

[brassminnie]

And the lenders say, "Sorry, but we can't refinance your mortgage to avoid foreclosure because we don't know who and how many own pieces of it." There could be, and often are, thousands, due to the way risk was 'bundled.' Now the financial institutions 'bailed out' refuse to answer questions about what was done with the money. They didn't keep track of it. Say what?! Obviously, they didn't consider billions in losses a reason to change 'business as usual,' and plan to continue the arrogance, opacity and gambling with other people's money that caused it. I agree with this article.

[djgonebad]

REGULATIONS!!! DO YOU WANT THE NEO-CON REPUGS TO CRY ABOUT OUR CONTRY BECOMING SOCIALIST!!!

[CatoTheCensor]

I like this, because it's finally asking the right question. The larger paradigm question. What does the financial sector really exist to do, and does it serve our overarching economic interests, or have our economic interests been subsumed in the ever-more-intricate fabrications of the financial sector?

When FDR did a cold reboot of the entire system in 1931, he doubled the Securities Turnover Excise Tax and regulated the market. We need to bring the Securities Turnover Excise Tax back, in part because it discourages these stupidly dangerous levels of speculation, and in part because around 3% of our GDP revenues come from excise taxes according to the 2008 Financial Report of the United States Government, and that number is going to have to be a lot higher. The STET, revived and set at a mere 0.25% of each stock and derivative traded, would net the Treasury between $125 billion and $150 billion a year by the best estimates.

Once upon a time, we funded the entire Spanish American War, a good chunk of the Civil War, WWI and WWII with the STET. We nixed it in the sixties in the initial wave of deregulation. We need it back. Wall Street is going to have to become a pay-to-play system again, and it needs to be able to finance its own bailouts.

[Sykon]

If there is a flaw in your argument for reviving the Securities Turnover Excise Tax, it would be that you suggest setting it at a mere 0.25%. I'd double that to a mere 0.5%. After all, the Treasury could use the extra income after this latest fiasco by the financial sector.

That said, you make an excellent case for adding this arrow to the quiver of stock market speculation controls.

[Liberal2]

Securities Turnover Excise Tax ? Absolutely.

But one other point: The stock market has been sold as a way of getting rich and it isn't and shouldn't be described as such. That's one reason investors have been chasing the craziest schmes to make the extra buck.

Stocks should only be considered a bank account offering a higher ROR to account for time cost and risk. The key for the investor should be a corporation's income as seen in dividends, with an option to reinvest those dividends back into the company. Not the stock price. It's not the way the market works, but it should be because it emphasizes rational management.

(Not to mention we need to get rid of compensation boards. Let directors set compensation. So stockholders have more control over exec pay. And end tax deductability of exec perks. They can fly coach just as easily. I don't believe the argument their time is so value a wait at the airport is a loss. Pay them what they're actually worth ($250,000) not $10,000,000 + bonuses and those jets will be seen as the insane luxury they really are.)

"Stock market winners" should be the entrepreneur who finally takes his company public.

[za2008]

Of course, according to the WSJ every day for years, the most important threat to the financial system was allowing the Sarbanes-Oxley (SOX) legislation to continue to require companies to report their results.

[satyriasis]

Ah the WSJ. A trade paper for hedge fund managers dictating the national economic dialog. There is something very wrong with that and it's brought capitalism to it's knees. Will the financial community wake up? For years they've pushed policies, politicians, and agendas which are now crucifying them. I hope their mindset has changed.