At the recent meeting of G-20 finance ministers in London it seems "more regulation" was on everyone's lips as the way to avoid a repeat of the current financial mess. The only difference between the U.S. and most of the other countries was "how much?"
The Europeans are hung up on bringing hedge funds under much tighter regulation. Why is this so? At first glance, it is hard to understand: no huge "too big to fail" fund had to be bailed out by any government - although a lot have simply folded up and returned a few cents on the dollar to their original investors. It is true that hedge fund managers became very nervous when their "prime brokers" such as Bear Stearns and Lehman Brothers started looking sickly. These funds started pulling out their money and securities - or buying credit default swaps to protect themselves if their broker went bust. Were they wrong to behave in this manner?
The standard European politician's complaint is that hedge funds are secretive and disruptive, especially for the managements of old-line, sleepy corporations. That would help explain the push for regulation - along with the fact that they pose a long-run competitive threat to already over-regulated traditional financial institutions.
Who's the Biggest Problem? The fact is that it was the most regulated institutions in the U.S. that have caused us the most problems: investment banks and money market funds overseen by the SEC plus commercial banks and bank-holding companies overseen by the FDIC, the Comptroller of the Currency and the Federal Reserve.
With respect to the rating agencies (who made a major contribution to the 'perfect storm' of the current financial mess), the SEC has plenty to answer for. They required money market funds to structure their portfolios around S&P and Moody's credit ratings as a substitute for the funds' own due diligence. And anyone who studied the models used by credit agency analysts to rate complex mortgage securities had to take a dim view of their robustness (i.e. using less than 10 years loss experience). All this, plus the well-known weakness in the agencies' current business model, where issuers, not investors, pay for the rating.
While the new SEC Chairwoman has talked obliquely about moving the agencies towards an "investor pays" model, the major government initiative at the moment seems to be to impose regulation and its attendant costs on the only honest canary in the credit rating coal mine - the unregulated credit default swap market.
And then there's the shadowy links between Bernie Madoff and the SEC staff, and the failures to follow up on credible suspicions of a long-standing Ponzi scheme.
AIG's Regulator: Asleep at the Switch. Only just coming to light - and lost in the uproar over AIG bonuses - is the failure of Federal government oversight of AIG's disastrous bets on derivatives. In an extraordinary "mea culpa" in recent Congressional testimony, the Acting Director of the Office of Thrift Supervision has conceded that his agency (which had authority to examine all parts of AIG due to its ownership of a federal savings bank) fell down on the job despite "continuous, consolidated supervision of the AIG group."
You would think that thoughtful politicians and public officials would understand that it wasn't too little regulation that contributed to the financial mess, but a combination of clueless regulation, perverse incentives (e.g. for rating agencies and financial firms' compensation arrangements) and an inability by the federal government to effectively address the "too big to fail" issue that are the central regulatory issues. Addressing these subjects effectively is where real leadership in Congress and at the agencies is needed - and sorely lacking.
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