Getting It Right: Making the Most of an Opportunity to Update Market RegulationPublished: January 21, 2009 in Knowledge@Wharton
As the global economic crisis continues, politicians and investors are escalating calls for new regulatory scrutiny of financial markets. After decades of a cat-and-mouse game between the industry and regulators, Wharton faculty say it is clear a dramatic overhaul of the United States' Depression-era regulatory system is needed. At the same time, they warn that meaningful reform will be enormously complex and require long and careful consideration, not a quick fix to appease voters looking to place blame for the meltdown.
Any new regulation, they say, must balance the need to provide transparency and protections for investors while also allowing financial markets to continue to innovate and generate the capital required for economic growth.
"This financial crisis is so serious, and clearly the mechanisms have broken down [to the extent] that we're really going to have to get more serious about regulation," says Wharton finance professor Richard Marston. "We can't allow another crisis like this to occur.... We have to protect an industry that is among our most important." He notes that while regulation enacted in response to the financial collapse leading into the Great Depression was largely successful, markets and institutions have since evolved and demand new approaches. Reform will likely include regulation of financial instruments, such as hedge funds, that have until now been free of government oversight, he adds.
According to Marston, one possible model is a consolidated system, in which monetary policymakers and regulators are closely aligned, similar to that of the United Kingdom. "We'll have to start from scratch again and think about how we regulate finance and allow it to thrive, and not take undue risk which society as a whole has to pay for," he says. "It's a balancing act. Everything is on the table."
Shutting the 'Barn Door'
Wharton management professor Sidney Winter warns that Congress, in an attempt to "shut the barn door," could enact regulations that create more problems than they solve. The nation could easily adopt financial regulation that would make markets more orderly, but those changes could also lead to economic stagnation. "I'm in favor of doing something ... in a carefully considered way," he says, adding that any reform would more likely have an impact over the long term, rather than "put out the fires that are now burning."
Wharton finance professor Marshall Blume says there are many examples of how financial markets and regulators have been engaged in a dance -- with markets leading and regulators one step behind. Today's fragmented regulatory environment often allows shrewd industry players to choose an oversight venue where officials are more likely to approach their role with a narrow focus that prevents them from considering larger trends shaping the financial world.
For example, he says the development of swaps and futures contracts effectively allows financial firms to turn securities, which ordinarily would be regulated by the Securities and Exchange Commission (SEC), into commodities overseen by the Commodity Futures Trading Commission (CFTC). The separate missions of those regulators made sense when securities were stocks and bonds and commodities were pork bellies and wheat. "But modern finance learned how to package a security under the guise of a commodity and choose its regulators, which means that neither actually controls what is going on," explains Blume. Similarly, Blume notes, broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA) independent of the SEC. "Again ... all sorts of mischief can take place."
Meanwhile, Blume says the original mission of the SEC is no longer in line with the realities of the market. When it was created in 1934, the SEC was designed to protect individual investors. Now, the market is dominated by large institutional investors, but the SEC's structure remains geared toward the individual. The Madoff scandal, according to Blume, indicates that the SEC has been ineffective in regulating registered investment advisers, but it has also missed institutional problems. He cites the mutual fund market-timing case uncovered in 2003 by the New York State Attorney General's Office under Elliott Spitzer. "The information was available to the market regulators and they never put two and two together."
In addition, Blume explains, financial regulation remains fragmented because separate committees in Congress control different regulatory bodies, and no committee is likely to give up power easily.
Now, he says, there is deep concern about risk across the economy as a whole, or systemic risk, raising questions about the role of the Federal Reserve and monetary authorities around the world who are pumping liquidity into the system to ease the crisis. "We have centralized oversight of systemic risk; however, I don't believe the Fed has the tools necessary to do an adequate job there." He adds that as more investment firms become banks, the Federal Deposit Insurance Corp. (FDIC) may usurp some of the role of the SEC and other regulators.
"The SEC is probably good at knowing if a filing is right or not, but its track record of finding big problems is not great," says Blume. "There has to be some consolidation, but it will take a great deal of thought on how to do that. Politically, I think it will be very difficult to consolidate because there are jobs at stake and power in Congressional committees at stake."
Winter suggests a three-tiered approach to regulatory reform. The first tier would aim at issues that clearly should have been addressed even before the financial crisis reached its current proportions. For example, he points to deceitful practices in the mortgage industry that put people in homes they could not afford, leading to the subprime meltdown. Another area to consider is incentive structures that might redirect the system away from extreme risk-taking, such as requiring originators of a mortgage to retain a piece of the loan to ensure the agreement is viable.
The second tier would address issues in ways that seem like a major departure from current practices, but have strong cases. Winter's favorite example is executive pay. He finds it difficult to understand why executives are allowed to take away huge performance bonuses based on a single year's results when it is so easy for them to take actions that enhance their performance one year, but may harm shareholders for years into the future. He suggests escrow provisions on bonuses might solve this problem. At the moment, however, executive compensation is viewed as a corporate governance issue. "It's not clear that we ought to expect a solution to come from the current players in the corporate governance domain or whether we need to push in a regulatory fashion at some point to address these problems."
Winter's third tier would address the more fundamental question of balancing the benefits of innovation against the risk of creating new products with little or no corresponding regulatory structure. "Great enthusiasm during the boom years was expressed for financial innovation and letting the players in these markets do what they could to figure out new, intriguing angles for making money," he says. "In retrospect, it appears a lot of the effort was not in the public's interest."
In recent years, Winter notes, the balance between regulation and innovation has shifted toward innovation, which he calls "overrated." For example, he argues, the financial industry has focused too much on getting information faster in order to exploit that advantage on the trading floor. "There are clear reasons why individual traders want to be able to move fast, but whether there is a public interest in knowing something an hour earlier or a day earlier is not apparent. As far as I'm concerned, we need to move away from all the celebration of speed and innovation and think more about the social stakes involved."
Any framework for new forms of financial regulation will need to address the role of the Federal Reserve, whose primary mission has been to manage the economy -- and the trade-off between inflation and unemployment -- with monetary policy. However, Winter argues, sticking solely to that mission may leave out important considerations that can lead to asset bubbles and harsh consequences for the economy when bubbles burst.
"My view is there isn't any obvious lever that would directly affect these asset values besides the interest rate lever, but that doesn't mean the Fed can't have an opinion [that's] not necessarily an official opinion," according to Winter. He imagines a system that includes research and discussion of conditions in asset markets as part of the Fed Open Market Committee meetings, without the Fed taking direct policy action to raise or lower rates in response.
Former Federal Reserve chairman Alan Greenspan attempted to offer such an opinion when he used the term "irrational exuberance" to describe a run up in equity markets. Greenspan's comments turned out to be premature and set off an uproar over whether he had overstepped the Fed's bounds. "He felt burned," says Winter. More recently, when housing prices began to soar, Greenspan held his tongue. "Now the criticism is on the other side," Winter points out.
Marston says that although financial professionals often go back and forth between jobs in regulatory agencies and industry, the revolving door is not a serious problem. In many areas of society, individuals frequently move between government and the private sector, he notes. While it is important to avoid obvious conflicts of interest, Marston argues it will take people with experience in both sectors to develop new regulations that might avert future crises. "We don't want bureaucrats making all the decisions," he says. "We want well-informed people, some of whom have recently worked in the industry."
Wharton finance professor Franklin Allen argues that while regulatory reform may be helpful, the current global economic crisis was not caused by faulty regulation. He says a long period of low interest rates, combined with global financial imbalances between countries, were the larger causes of today's problems.
"We wouldn't have [this situation] if there were not a bubble in the stock market and then in property. It's the collapse of the bubble that caused these problems, which have been exacerbated by problems in the financial system and regulation," he says. "It's not clear that even if the current regulations worked, we would have been able to stop what happened."
Governments, he adds, should take responsibility for the low interest rates that exacerbated imbalances and the leverage that allowed unsustainable asset price increases and global imbalances to continue too long. "One view is that by trying to patch it up, they will make matters worse. People stopped saving in the United States for a long time because they thought stock and property prices would keep going up, and now we have all these problems."
According to Marston, as the federal government pours money into the financial system to revive the economy, taxpayers will become angry about using government resources to prop up the private sector. Regulatory reform may become a vent for that anger. "I think this is a great opportunity for us to rethink regulation and have political support for doing it better this time."
The severity of the current crisis and the immediate focus on the banking industry may give reformers some breathing room to take a careful approach to new regulations, he says. "The authorities are so concerned about not causing any further meltdown that the Obama administration has the luxury of time to think about how they would go about setting up a better system."
President Franklin Roosevelt and his advisors created the current regulatory infrastructure in piecemeal fashion, Marston says. In the wake of the current crisis, the administration and legislators must start over with a comprehensive approach. "And," he adds, "they better get it right."