Thursday, July 10, 2008

Risks And Follies of More Financial Regulations

It seems that our financial gurus in Washington, D.C. have finally put their brain on autopilot and left their mouths on auto “rant.” I know Hank Paulson has been doing this for a while, with his well-worn rant of "We want a strong dollar. A strong dollar is in our nation's interest.” (For those interested, there is a drinking game devised by Paul Kedrosky, based on Paulson’s strong dollar rant. Click here for the rules.)

And now, with Ben Bernanke, one of the few voices of reason in the government, calling for a consolidated oversight of investment banks, there doesn’t seem to be anyone in Washington, D.C. who is willing to face the facts that trying to heal a ailing economy with more regulatory duct tapes and rhetorical rants.

According to Bloomberg, Ben said: “Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks,” in his testimony to the House Financial Services Committee today. “He also asked for a procedure to liquidate failing investment banks and for Fed powers over payments systems.”

Mr. Bernanke, such a single federal regulatory body exists: The SEC. Perhaps, we should let the SEC do what it was founded to do: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

A Quick Romp Through Recent History Of Knee-jerk Regulatory Actions

1 – The Great Depression
Congress created the SEC in response to the Great Depression. SEC, with the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, had the responsibility to restore investor confidence in the capital markets by providing more reliable market information and clear rules of honest dealing.

I doubt that SEC is fulfilling its mandated mission if financial crises continue to occur with such regularity.

2 – S&L Crisis of 1980’s
The Savings & Loans crisis in the 1980’s led to the government adding another layer of regulation through the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). All this regulation did was to shutter existing agencies, create new ones, and shuffle existing government staffers from the old agencies to the new agencies. Change the nameplates, slap on a new cost of regulatory whitewash and everything is now supposed to be better and improved.

One of the interesting regulations that came out of this was the new capital reserve requirement that banks had to meet to ensure that they can weather the financial downturns. (FYI, this requirement was rescinded in 1990; so much for regulations.)

3 – Dot Com crash
With the blow up of Enron and other similar high-flying companies, the Congress rushed and passed the now infamous Sarbanes-Oxley Act of 2002 (SOX). Infamous in that it added such a deep layer of needless complexity, large public companies are still, to this day, trying to comply with its requirements. In a nutshell, SOX made it a criminal offense to falsify or sign falsified financial reports and held the CEO accountable. Also, it created a quasi-governmental agency, Public Company Accounting Oversight Board (PCAOB), and charged it to define the audit process and procedures.

My question on this is what really is the difference between PACOB and Financial Accounting Standards Board (FASB)? Private versus public?

What’s Changed?
Astute readers would note that another financial meltdown happened, even after all the regulatory laws and governing bodies that have been created to prevent such an event. So what has changed? Much like the rest of human development, when one side comes up with a rule, someone else will come up with a way to circumvent it. This escalation is almost instinctive. On the positive, it drives innovation, leads to new discoveries, and growth of human civilization. On the negative, it drives those bound by greed or other selfish desires to find ways to gain at the cost of others’ suffering; a zero sum game.

Ergo, the same is playing itself out in the financial market. A similar meltdown will happen. It won’t happen in the same way. However, when it does happen – a matter of when and not if – it will look similar to the past meltdowns.

Mathematics calls this The Chaos Theory. For those investors who seek to understand why and what a near catastrophic financial meltdown is happening, look at the work done in weather prediction. It is similar to that of the financial market.

Getting Back On Point And Conclusion
So what does all these historical and mathematical diversions have to do with the main point? Simple.

A direct message to Mr. Bernanke: We haven’t learned from our past mistakes and, judging from the messages being sent out from Washington, D.C., it appears that we will very likely see a similar situation in the near future, regardless of how many more additional regulations and oversights you propose to add to the already motley mix.

Ed Kim
Practical Risk Manager

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