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Ever since the obama administration put forth its proposal for regulatory reform in June, a flood of alternatives have been promulgated — most recently, the 1,135-page draft legislation from Connecticut Senator Christopher Dodd. All of these proposals are flawed, however, because they focus only on what will be regulated and who will do the regulating. They fail to address the fact that the regulatory process itself needs to be reformed, without which any legislative change has no hope of achieving its objectives.
In the 35 years I’ve spent running businesses regulated by the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Department of Labor and various state banking authorities, I have seen several regulatory reforms, and in each case the sequence of events has been the same. First, a calamity occurs (such as the collapse of Enron Corp. or Lehman Brothers Holdings) that causes a public outcry for reform. Then regulatory agencies use the event as an excuse to request greater regulatory power. Last, Congress grants the request, the problem is declared “solved,” and the financial services industry is more closely regulated than before.
This is not to suggest that regulation is useless or unneeded. If that were true, financial firms would long ago have moved to some third-world country where regulation is nonexistent. Still, for regulation to be effective, the process needs to be reformed in the following four ways.
Regulators must understand an industry before being given the power to regulate it. Regulators often argue that the way they can best learn about an industry is by actually regulating it, and that the longer they are in power, the more effective they will be. Maybe so, but just as surgeons are required to attend medical school before being allowed to operate, regulators should have to show sufficient knowledge of their industry before they are allowed to oversee it. A recent example of a regulator doing unintended damage was provided by the SEC when it thought it had the authority to regulate hedge funds by forcing them to register but exempted the managers of funds with a minimum two-year lockup. This inspired many managers to initiate longer lockups, hurting investors by costing them liquidity.
Regulators need to consider everyone who could be affected by their actions. Participants in any industry can be divided into two constituencies: the visible and the invisible. For example, the Federal Reserve Board’s visible constituency is the banking industry. Banks want to entice homeowners into variable-rate mortgages with low initial payments but which require long-term predictions about future housing prices and interest rates. The Fed’s invisible constituency, the homeowners, are not economists and are clearly unequal to this task. Every regulatory agency needs to find a way to solicit useful comments from representatives of both constituencies.
Regulators need an enforcement program that encourages compliance. During her confirmation hearing before the U.S. Senate, SEC chairman Mary Schapiro hinted at one possible solution that would help regulators catch willful offenders. In explaining why two of her previous employers — the Financial Industry Regulatory Authority and the National Association of Securities Dealers — had been unable to catch Ponzi schemer Bernard Madoff, Schapiro pointed out that neither agency had received any tips from whistle-blowers. For whistle-blowers to be an effective deterrent, there needs to be a well-publicized tip hotline staffed by an agency’s “best and brightest,” who will keep the identity of a whistle-blower secret. If the identity is revealed, the whistle-blower must be compensated for damages. And if the tip results in a conviction, the whistle-blower must be paid a substantial reward.
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