Monday, November 2, 2009

The Upcoming Banking/Financial Regulation

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.

There are three topics that seem to be missing in every discussion about new regulation or re-regulation.

First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?

The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.

Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.

I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.

Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!

Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”:

Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.

Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?

Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.

Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.

The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.

We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.

My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.

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