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Why Regulation Won't Fix Finance

Tuesday, 24 Jul 2012 | 4:26 PM ET
The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
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The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.

The Libor scandal has given rise to a new era of handwringing about our failure to fix finance with better regulation.

James Surowiecki laments that the Libor lies show that banks have undermined the “basic level of trust” markets need to operate well. He thinks that a good response would be for regulators to become “intrusive and overbearing”—basically, to man up and start acting like NYPD beat patrols doing stop-and-frisks on anyone who looks “suspicious.”

Felix Salmon agrees with Surowiecki about the state of things, but doesn’t think tougher regulation is likely to do much. Nothing short of breaking up the banks will do—even though that’s not likely to happen either.

And as a result, financial-industry scandals will continue to arrive on a semi-regular basis. When they do, they will always be accompanied by calls for stronger regulation: rules-based, or principles-based, or some combination of the two. But the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution. The real problem is deeply baked into the architecture of too-big-to-fail banks. And frankly I don’t see any realistic way of unbaking that particular loaf.

It’s rare and refreshing to encounter this level of clear-headedness following scandalous financial revelations. Salmon here sounds like H.L. Mencken writing about the world view of that magazine’s editors in the inaugural issue of American Mercury.

“The Editors have heard no Voice from the burning bush. They will not cry up and offer for sale any sovereign balm, whether political, economic or aesthetic, for all the sorrows of the world. The fact is, indeed, that they doubt any such sovereign balm exists, or that it will ever exist hereafter. The world, as they see it, is down with at least a score of diseases, all of them chronic and incurable…”

My only point of departure with Felix is that he doesn’t look clearly enough at how we baked the loaf of too-big-to-fail. The truth is, as I’ve explained through a long series of posts here at NetNet, is that this loaf was leavened with well-intended government regulations from the get-go.

In the early 1960s, the Kennedy administration reversed a decade-long trend away from activist regulation in the financial sector. Kennedy upset the balance at the SEC, which was mostly staffed by professional regulators with legal expertise in securities laws, by appointing a Columbia law professor named William Cary and three of his allies to the Commission.

Cary’s SEC conducted something it called the Special Study of the Securities Markets. One of its findings was that understaffing and underfunding of the SEC had led to lax enforcement that was also inefficiently slow.

Here’s how the site SEC Historical describes the findings:

In 1963, the SEC conducted its Special Study of the Securities Markets. The study concluded that, from 1959 to 1962, "activity in new issues took place in a climate of general optimism and speculative interest" but as a result of agency understaffing, the SEC extended the average review of registration statements from twenty-two days in 1955 to fifty-five days in 1961.

Cary’s ideas about market regulation did make it into law in the form of the Frear-Fulbright Act of 1964. Among other things, the budget of the SEC was dramatically increased and new rules were put in place to encourage companies to list themselves on the New York Stock Exchange by imposing burdensome disclosure and reporting requirements on non-listed companies. (These are the same rules that—decades later—forced Facebook to go public.)

We now have a far better understanding of the limits of disclosure. In particular, a paper published by a trio of scholars in 2011 demonstrated that the additional disclosure requirements provided almost no additional value to investors. The main beneficiary was the New York Stock Exchange, because so many previously unlisted companies listed on the big board. The other beneficiaries were the brokerage houses who were members of the NYSE.

But the new disclosure requirements were costly. They were a severe blow to brokerages specializing in over-the-counter markets. Many folded or merged with exchange-based brokers.

The newly-staffed SEC was processing new listings faster and companies were pouring into the exchanges from the OTC market. Volume on the NYSE increased 33 percent from 1966 to 1967. Meanwhile, NYSE brokers saw their oligopolistic hold on securities markets grow even stronger—resulting in falling efficiency at the very time when trading and listing was rapidly growing.

The 'Paperwork Crisis'

The result should have been predictable but almost no one saw it coming: a calamity known as the “Paperwork Crisis” that nearly brought down Wall Street. Even today, the details of this crisis are little known and the causes even less understood. It is presented in most histories as something like a natural disaster for finance, a tsunami of stock trading that just overwhelmed the brokers.

From my earlier description of the Paperwork Crisis:

The brokerages failed to make customer trades, errors became rampant, fraud and outright theft of securities flourished. They took losses because their inability to execute trades left them in short positions on stocks.

In reaction to this, the NYSE and other exchanges agreed with the SEC to curtail trading hours. During one period, the NYSE would shut down every Wednesday to allow member firms to get their books in order.

The NASD urged its members to cut back on their business. The SEC gave similar orders to firms it considered the most troubled.

Not surprisingly—with firms cutting back on their business, trading hours constrained, capital losses from poorly executed trades—trading volume dropped off badly. By 1969, Wall Street was in a deep slump. Over 160 member firms of the NYSE went out of business.

As a result of this regulation-triggered crisis, Congress acted to pass another set of financial regulations: the Securities Investor Protection Act (or SIPA).

[SIPA] created something like FDIC protection for the customers of securities firms. In the minds of lawmakers, this raised the concern that brokers—no longer fearing a “run on the bank” by customers—would behave recklessly. So, following the banking model, SIPA authorized the SEC to impose capital adequacy requirements to ensure against that “moral hazard.”

The capital rules the SEC set up required firms to maintain specified levels of net liquid assets as a ratio of obligations to customers and creditors. Initially, many firms merged with each other in response to the rules and found that they were able to meet the capital requirements as partnerships.

But the market boom of the 1980s resulted in enormous growth of many Wall Street firms. The strongest capitalized firms or those with the least SIPA-exposed businesses, such as Goldman Sachs, held out the longest.

In other words, the size and complexity of our financial institutions did not arise as some sort of natural outcome of market processes. It was driven by a series of financial reforms that began under the Kennedy administration.

This shouldn’t be surprising. Rules aimed at consolidating enforcement and regulation tend to result in organizational consolidation among the regulated.

This, in the end, is why we’re unlikely to ever fix finance through regulation. Every time we’ve tried, we just make things worse.

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