Financial Regulation Only As Good As The Enforcer

Andrew Jackson illustrated his disdain towards international bankers in 1832 with this eloquent excerpt:

“Gentlemen, I have had men watching you for a long time, and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I intend to rout you out, and by the eternal God, I will rout you out.”

Not surprisingly, Andrew Jackson was never the most popular guy in town. Since nothing much has changed since that outburst nearly two centuries ago, I don’t think Obama should attempt to be forceful in dealing with our modern bankers. The stakes are too high to have the general economy slide into Great Depression because of a “den of vipers and thieves”.

However, Obama has slain one sacred cow while placing the other on a pedestal. Rick Wagoner of General Motors was asked to step aside and Obama is inclinded towards structured bankruptcy. Thumbs up to Obama for being decisive but it shows up the contrast in his preferential treatment of financial institutions so far.

We are told they have attained “too big to fail” status (that should be the mantra for future coporations if they want to survive). For General Motors, a bankruptcy may resolve conflicting claims and burdensome contracts while shifting control away from incumbent management. But in a financial bankruptcy, the dense web of derivatives spread the toxic far beyond US shores, affecting investors, pension funds, government entities, etc. in Europe and Asia, as we saw in the case of Lehman Brothers.

Put in a clearer manner, it means US taxpayers can only wring their hands and pick up the tab. They can vent their frustrations but the bankers are not going to sacrifice their huge bonuses (there will be ways to get around the political pressure and legislation). It is a mentality of entitlement for those running the show, and if they happen to run the finanical institutions or economy into the ground, that is too bad but their time and effort must be compensated.

That is the way things supposedly work in our current model of a free market. Rewards are privatised but the risks are socialised. People are encouraged to behave like gamblers and only a fool will save money in the bank. A saver doesn’t share in the spoils but they certainly share in the cost of fixing the mess left by speculators.

How we tweak the free market to accomodate capitalism and responsibility is anothet topic altogether. My main concern is to avoid another financial crisis, and to do that, it is high time we get serious about financial regulation.

The ways things are developing, (look at the chart below, the monetary base has expanded nearly twice in this crisis alone), there will come a point when investors have had enough of paper backed by the US government, which is already trillions of dollars in debts. The US dollar’s status as a reserve currency is under siege, who knows, the Federal Reserve may not be able to contain the next financial crisis and may require a bailout of its own.

monetary base

Before the gold standard was abolished, the United States had modest debt and Americans were frugal and productive. Borrowings were used wisely to create tangible and useful products which translated into wealth. However, with unlimited fiat currency, it became much easier to use debt as a way of life. The wildly expansionary government policy encouraged ever-more complex ways to invent credit out of thin air.

Wall Street catered to this new appetite for debt and risk and inflated a series of financial bubbles which attracted a great deal of capital. Prices of assets soar and the most aggressive investors got rich beyond imagination. Unfortunately, such bubbles have been occuring with alarming frequency. In the 1980s, it was junk bonds. In the 1990s, it was tech stocks and this decade is about housing. Each bubble was bigger than the last (we progressed from billion to trillion dollars bailout, what is next?).

The current G20 summit has lots of noise, ranging from protectionism, reserve currency to regulation. Gordon Brown calls for strengthening of financial regulation while Nicolas Sakorzy threatened to boycott the event if no concrete actions materialize. Timothy Geithner, in anticipation of the belligerent reception America will be receiving, set the tone for a “meaningful” US participation last Thursday with some commendable proposals to tighten up the financial regulatory system.

Derivatives will be “standardised” while hedge funds and private-equity firms will be subjected to greater scrutiny by registering and providing confidential information to the federal government. A super-regulator will also be created to ensure against any systemic risk that menaces the financial system. This will likely to result in higher capital standards for large banks and nonbank financial institutions.

The Treasury Department also requested for resolution authority to seize and dismantle large financial institutions such as investment banks or bank holding companies, much like the Federal Deposit Insurance Corp.

All very promising indeed, but trust in the financial sector has plummeted to an all-time low and will not recover based on empty declarations. Though all these measures are formative steps in the right direction, the devil is in the details. Will the rules be crafted to appease Main Street but allow the grand larceny of Wall Street to continue? Even if Obama administration manage to make the rules watertight, will the regulators enforce them?

Fact is, the quality of the rules is only as good as the person who enforce them. Once the market goes on a bull run, it is like a locomotive travelling at top speed, whoever stands in the way gets flattened. It is hard to imagine a super-regulator having enough gumption to gatecrash the party and risk incurring the wrath of Wall Street.

A case in point is Bernard Madoff’s $50 billion Ponzi scheme. The SEC has reliable and comprehensive evidence virtually handed over on a platter. Its regulatory framework is well-established, given its birth out of the crucible of the 1929 Great Depression and subsequently refined over the years. Why was such an astronomical financial impropritey not fully investigated?

Paul Moore, former head of regulatory risk at HBOS, raised alarm bells on the lax risk management in his bank. Had the Financial Services Authority (FSA) pursued the matter, British taxpayers could be spared billions of pounds in bailout money. Well, no action was taken and Moore’s reward was an unceremonious dismissal. In fact, he is not alone, many analysts, managers, directors, auditors experience the same fate for being whistle blowers.

While regulators cannot force CEOs of financial institutions to rein in their reckless strategy (it is a free market after all, and people have the right to make their own decisions), the FSA and the SEC could have warned about the dangers. Shareholders, creditors, and depositors will then make their own decisions if they prefer to visit casinos themselves or let the banks gamble with their money.

Another conflict of interest comes from the need to recruit the best talents who have an intimate knowledge of the industry. This usually means regulatory agencies are staffed by former high-ranking employees of Wall Street. While industry ties (revolving door policy) are unavoidable, having CEOs or directors of investment banks wearing regulatory hats means there is nobody in the position to see, not to mention, stop the impending train wreck.

Sir James Crosby, as CEO of HBOS, was also on the board of the FSA which resulted in the head of a financial institution overseeing the regulator. Crosby can either stifle his bank or bend the rules backwards to facilitate the orgy. From the financial mess that was to become of HBOS, it is clear which choice Crosby made. How did such a conflict of interest goes unnoticed for so long?

In order to reduce risk of regulatory negligence or deliberate cover-ups, taxpayers who have an especially big stake in any bailout, have a right to expect regulatory bodies to be fully transparent with their tip-offs and outcome of investigations.

The public also needs information on industry connections of top management (both present and future), in order to ensure rigorous regulation will not be compromised. This clear policy on conflict of interest should be well publicized so that taxpayers can assess if the regulators have their best interest at heart.

Although now is not the time to talk about performance pay or bonuses, regulators should enjoy huge incentives, much like the fat cats on Wall Street. Else, they will not be motivated to take on financial institutions which can employ the best lawyers. Without regulators exercising the new powers that Congress will soon endow them with, we are back to square one.

This financial crisis has shown that light-touch principles-based regulation with an emphasis on banks’ internal risk controls cannot work. Even Alan Greenspan, the most prominent proponent of the free market where profit-maximising self-interest limit risk-taking, has also expressed regret that a mistake was made.

The momentum is there for some serious financial regulation and America must show its leadership and resolve, without which we should just brace ourselves for another devastating bubble.

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