How to Make U.S. Financial Regulation Work Again

Financial services must regain their historic role of creating wealth for entrepreneurs, investors, and society. Good regulation benefits all

By Eric K. Clemons

This is the second of two parts

Given the breadth and depth of the current financial crisis and the public anger in London and elsewhere about its consequences, it is clear that profound changes need to be made to our regulatory system. Some of the calls for regulatory change are insightful and on-point; others call into question the entire nature of free markets.

Adam Smith taught us that the invisible hand of the market,—each of us acting in our own self-interest—produces social benefits beyond those any of us intend or seek. Likewise we have known for centuries that free markets work only with rules. We cannot sell addictive soft drinks, toxic toys, or dangerous consumer goods. We cannot poison rivers or dump mining slag in our neighbors' yards. And we cannot dump toxic derivatives into the economy.

Here I will describe a few critical changes that can be made to our regulatory framework. They should preserve free markets without creating new problems by simply limiting the opportunities for current abuses to continue.

What should regulation do?

First and foremost, it must restore the true role of financial services: the creation of wealth for entrepreneurs, investors, and above all, for society. It is quite all right if some financiers earn money as well. John Pierpont Morgan was as much a producer as were John D. Rockefeller and Andrew Carnegie. Warren Buffett and the best venture capitalists and early-round investors are producers as much as Bill Gates and Sergei Brin are.

But financial services should not exist principally to reward financial services personnel. The new structure of the securities industry, with banks not only acting as securities firms but owning them, precludes a return to Glass-Steagall, but something is required to protect the industry and our economy. A few regulatory changes would make it impossible for financial services executives to reward themselves without actually creating wealth by advancing capitalism.

1. Focus financial services on expanding the economy, not the house, and on rewarding entrepreneurs and investors, not the house. Unfortunately, this is not going to be achieved in a few simple steps, such as capping compensation of financial services executive. Nor should it. It will be done by changing how the house produces and realizes its own profits. Many house privileges such as reduced trading fees encourage activities like arbitrage, which are little more than front-running the market. More important, compensation of executives cannot be based on mark-to-market paper profits, or, worse yet, mark-to-model paper profits, but can be paid out only when a position is finally liquidated and its value rendered clear.

2. Provide incentives for appropriate risk-reward trade-offs. There was indeed self-policing in such old British partnership firms as Smith Brothers, whose mistakes could be lethal to the firm, with bankruptcy devastating to individual partners. At its simplest, this would require return to performance-based compensation, not mandatory end-of-year bonuses. It would require due diligence by investment advisors, and criminalization of any failure to perform due diligence. Bernie Madoff's business model in the 1980s and early '90s involved paying for order flow, giving brokers pennies so he could steal dimes from their investors by bypassing the floor of the New York Stock Exchange and capturing the spread on all trades. The business model a decade later seems to have changed only in scale—paying feeder-fund executives tens of millions of dollars in order to steal billions from their investors. The feeder-fund executives who took funds from Madoff are already being investigated for civil fraud abuses in Massachusetts and Connecticut and may be found financially liable and forced to make restitutions. In the future, similar firms should themselves be treated as co-conspirators and if found guilty, their executives should serve jail time with the principals themselves. Changes in civil and criminal liability would profoundly alter the risk-reward trade-offs of feeder-fund managers and accountants.