The Real Problem Isn’t Regulation

The tragicomic events of the past few months—the London Whale (what are we up to now, $6 billion), Barclays-Libor, HSBC laundering money have prompted renewed interest in better, stronger regulation of the financial sector. Not that it’s going to go anywhere: it’s an election year, the Republicans have a blocking majority in the House and a blocking minority in the Senate, and they are only going to gain Senate seats in November.

But we’ve been here before. Remember the financial crisis? The Obama administration’s response, codified in the Dodd-Frank Act, could be summed up as “better, stronger regulation”—instead of substantive changes to the industry itself. This misses the basic problem with our regulatory structure, as described by John Kay:

“Regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.

“Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.”

The only thing I would disagree with is the characterization of U.S. regulators as “crudely corrupt.” Yes, many Congressmen are “in thrall to Wall Street money,” but when it comes to the staff at the regulatory agencies I think the picture is more complex and closer to the “intellectual capture” that Kay describes in Europe. (This is something we discussed briefly in 13 Bankers and that I cover in more depth in my contribution to Preventing Capture.)

Kay’s proposal is to replace today’s intricate rules, which only provide employment for loophole-seeking lawyers, with broad fiduciary duty standards. Then, for example, the ABACUS case wouldn’t have hinged on whether the fact that John Paulson was betting against the CDO was material and should have been disclosed, but on whether Goldman was acting in the best interests of its buy-side clients. In practice, the effect would be to make it easier for clients to sue their financial institutions—which might be a good thing, given how toothless the regulators have been over the past few decades.

Felix Salmon, however, builds on Kay to argue that what we really need is a financial services market where reputations matter and firms have an incentive to maintain them. That’s clearly not the world we live in today: Goldman gets a reputation for screwing its customers, but they don’t lose any business because those customers (a) figure it’s just a cost of doing business and (b) don’t have any meaningfully different choices. And to get there, Salmon continues, “we’re going to need to see today’s financial behemoths broken up into many small pieces.”

Better regulation would be great at the margin. So would more highly-paid, highly-motivated regulators. But as Salmon says, “the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution.”