After years of tracking, report writing, report filing, documentation, and general paper churning, the Age of Re-regulation is nigh for the financial sector. The current Great Recession has forced the visible hand of government to act. Blame must be laid, and so politicians promise more rules and restrictions, as if the industry had been operating in a vacuum.
Regulation did not go away for eight years, but was partly subsumed by the wish that markets would naturally regulate themselves. Regulators looked but mostly did not touch. A majority of economists and policy makers now appear convinced that the market is not some extraterrestrial force only alterable by its own devices.
What should and can be done?
The Group of 30, a nonprofit organization of scholars, central bankers, and financial sector executives led by former Federal Reserve Chairman Paul A. Volcker, emerged in January with a "program for reform" it hopes will help steer the world financial markets toward responsibility and clarity. The document is being shared with global public and private leaders. Volcker, who chairs the Obama administration's Economic Recovery Advisory Board, delivered the report to the Oval Office.
The core recommendations could stand on their own as a 'four commandments' for the global financial sector. First, repair the holes in regulation and supervision, and monitor "all systemically significant financial institutions, regardless of type," the G30 urges. Second, quality is key - provide regulators and central banks with the resources they need, and raise the bar for "national and international policy coordination." Third, toughen governance, risk, capital, and liquidity standards. These rules must "guard against procyclicial events" and help maintain "prudent business practices." The fourth recommendation could be considered the essence of any regulatory reform plan: add transparency to the markets and build an infrastructure strong enough to protect against failures "of even large institutions."
These are good first steps for writing a new body of regulations, but what about regulation itself? Now policy makers are viewed as either nagging nannies or neglectful babysitters. The regulatory structure going forward should look more like a fire department, with firehouses devoted to securities, mortgages, retail banking, etc., all reporting to a central command under a shared organizational structure and budget.
The firehouses must be well-staffed with regulators trained in the structures and hazards of the sectors they safeguard. And the regulators must be compensated at the same rate as their business-side counterparts, alleviating the revolving door problem. Make sure the budget always matches regulatory needs - how can firefighters contain the flames without the proper equipment?
"You have to make sure you have the appropriate number of regulators to do the job," says John Schneider, managing director at Navigant. "Agencies must be scalable in relation to the business they regulate. Even though mutual funds grew from 1,000 in the 1990s to 9,000 today, regulatory staffing levels did not meet that growth," Schneider points out. The present budgetary process is also out of kilter. "You'll get your budget based on last year's numbers, not actual needs," he says. "The cost-benefit spend of government regulatory oversight has been inadequate."
Still, the promises of politicians playing to the angry mob must be contained. "Do we think we can ever fool-proof the market," asks Schneider. "No. You always have some degree of bad behavior. The goal is to police out enough of the noise to prevent systemic risk."
As for the rules, keep them as simple and broad as possible - that makes regulation easier to enforce and harder to evade. And some rules don't require a major rewrite. "There was a failure to enforce the spirit of the rules that already existed on soundness," notes David Levy, chairman of the Jerome Levy Forecasting Center. "Yes, there are some holes, but lax enforcement has been the main culprit. The biggest danger is the propensity to try to protect ourselves from the problems of the past."
For those concerned about the restrictive nature of regulation, these words from Adam Smith in "The Wealth of Nations" might provide some comfort: "But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed."