Regulating The Cobblestones On Wall St.

There is nothing wrong with regulatory agencies and regulations for that matter.  It is what keeps four-year-olds from becoming airline pilots and orangutans from being airline mechanics. The theory behind regulation is simple. It is based on the fact that people are not intelligent enough to take care of themselves or too dishonest to take care of others.

Treasury Secretary Geithner has told Congress that he would like to regulate Wall St. right down to the foundations of all of its buildings. That includes hedge funds, private equity firms, and traders of exotic financial instruments which may include credit default swaps and financial derivatives. Investment advisors like Mr. Madoff would also be watched more carefully by the government. In the Secretary’s own words, “What we need is better, smarter, tougher regulation, because we’ve seen the costs of these weaknesses and gaps are catastrophic to the system as a whole.”

The reasons in favor of Geithner’s proposals are too numerous to mention. Among them, and perhaps at the top of the list, is that proper regulation would have prevented all of the events which caused the credit crisis, and, perhaps in turn, the recession. It is impossible to say whether that is true, but it sounds true, which is even better.

There are two major arguments against the level of regulation that the Administration would like. The first is that regulations do not prevent people from acting rashly or dishonestly. Rogue traders can still lose hundreds of millions of dollars on an investment bank trading floor with a PC and access to their firm’s capital. Inside trading and naked shorting of stocks happen all the time, although both are illegal. Fighting regulation because some people refuse to be regulated turns out to be indefensible because the alternative is chaos.

The other argument against excess regulation is that if the capital markets are prevented from efficiently trading and creating capital, then they do not really exist as capital markets any more. With the economy in such tough shape discouraging traders from creating liquid markets or the credit default swaps market from efficiently insuring risk may do more to hurt a system that is trying to build new capital more than it helps it.

If the reasonable goal is to build liquidity without substantially increasing government regulation and the number of government people needed to monitor that regulation, the alternative is simply to enforce the rules that already exist.

Lost in the argument about why there was not risk management in place when a bank like Citigroup moved to the brink of collapse was the fact that Citigroup had a committee of its board of directors charged with monitoring the risks taken by the bank. Citi also had an army of risk managers who probably reported to an executive who also ran a part of the company that was taking risks. Of course, it is fair to assume that the bank also had a chief financial officer who had an excellent idea of what Citi had on its balance sheet and in operations that it owned which had their own balance sheets.

It is clear that the Citigroup board did not come close to performing its fiduciary responsibility related to risk and that the risk management staff within the company never understood the exotic mortgage-backed paper that the firm was holding. Or, worse, the risk managers may have known what was happening and were afraid to risk their jobs by blowing the whistle.

It is not too much to ask whether enforcing the rules on the books accomplishes 90% of what creating vast new systems of regulation would accomplish. And, it is not too much to say that boards and executives who turn their backs on protecting the interests of their depositors, shareholders, customers, and employees will be keelhauled. This applies as much to hedge funds which have customers and shareholders of their own as it does to the Bank of America (BAC) which is, under the banking laws already in place, is regulated to within an inch of its life.

It will take years to create new regulations and build and staff new regulatory agencies. In the meantime, the current crisis will have passed. In Geithner’s mind he is doing something for future generations which might face a financial crisis if it were not for his proactive efforts now. But, the whole process of re-regulating the financial system will never be much better than the diligence of the people who run the companies which are regulated.

Douglas A. McIntyre