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How to Make U.S. Financial Regulation Work Again

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.

3. Restore transparency. Businesses acquired by private equity firms do not need to report in precisely the same way as publicly traded firms. But the compensation of fund managers and the source of their payments (retained earnings or additional capitalization) need to be clear to all investors. The role of market to model in assessing compensation must be clear—and possibly be restricted by regulation. The positions of nonbank financial institutions and their exposure in unregulated nontraditional financial instruments needs to be made more transparent as well.

4. Apply more complex capital adequacy requirements, especially to nontraditional financial institutions and shadow banks and nontraditional financial instruments. This is the most technical, most complex, and probably least controversial reform. It is essential in an era of increasing interconnectivity among financial firms broadly construed, when the largest nonbanking financial institutions can jeopardize the global economy's stability. Securities firms can determine capital adequacy on their net positions; a firm that is long $5 billion in U.S. Treasuries in one office and short $4 billion in another needs merely to provide capital for its net $1 billion exposure. It is not entirely clear what this form of netting means with interest rate swaps. A firm that holds several billion in debt that it is responsible for paying, as well as comparable billions in debt for which it is receiving payment, may look secure. But if anything jeopardizes its ability to make payments, even temporarily, the downstream repercussions for institutions, banks, and others may be catastrophic. Regulators have not yet figured out what this regulatory regime should be.

What should regulation not do?

There are several mistakes to avoid in our next round of financial regulation.

1. It should not interfere with the true function of finance, which is to provide funding for industry and to reward investment.

2. It should not interfere with financial innovation, which has been essential to the growth of industry and social wealth. Although much maligned today, securitization of mortgages and credit card debt has been essential to fostering increased competition in consumer lending and increased long term liquidity for real estate development. Even the despised swaps serve a valuable purpose in allowing institutions to tailor payment schedules to their needs.

3. It should not sow the seeds of the next financial disaster by driving derivatives and innovative instruments further out of the banking system—and out of the secondary shadow banking system—turning them into entirely unregulated and completely opaque instruments created and traded by unregulated financial entities.

4. It should not so restrict the earnings of officers of currently endangered banks that they are willing to let their institutions go under rather than accept the funds needed to save them.

What do we need to worry about?

We need to worry about the migration of trading to institutions with even less regulation. We need to worry about the migration of investors to even less regulated institutions—much as they did when Sarbanes-Oxley was introduced—in hopes of earning higher profits. We need to worry about well-intentioned but vengeful regulation that solves our current problems but creates conditions that inevitably contribute to the next crisis.

As we did in responding to the market crash of 1987, we need to coordinate regulatory response. When I worked with regulators in both Washington and London, we needed to make sure that regulatory change was first, sufficient to protect investors and to prevent abuse and second, not so strict as to drive institutions and investors to less-regulated markets. Sufficient regulation provides a competitive advantage. Too little regulation can destroy investor confidence, especially during our current meltdown, while too much regulation inspires competition in lax execution to lure institutions fleeing what they perceive to be regulatory excesses.

What do we not>/em> need to worry about?

We do not need to worry about the loss of institutional house traders, arbitrageurs, and other "producers" to rival banks or even other nations. There is no shortage of talent. If every top business school student who previously went to Wall Street were replaced by the student just behind him or her on the firm's hiring list, the financial industry would be little changed. And if some of these top students had taken jobs outside the financial sector—and more broadly, across the entire U.S. economy—we all would be far better off today.

Most important, we do not need to worry about the end of capitalism or of free markets. Even with periodic crises and disasters, no other system has done more over time to allow the creation of wealth and improve the human condition.

Clemons is a professor of operations and information management at the Wharton School of the University of Pennsylvania.

Clemons is a professor of operations and information management at the Wharton School of the University of Pennsylvania.

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