The super-SEC

The WSJ writes today of a key item on Barney Frank's wish list -- a "systemic risk regulator," which Frank likens in scope and importance to the creation of the SEC.

I understand that right now nobody wants to hear stuff about markets correcting themselves, or about the costs of broad new financial regulation like SOX.

So I'll just focus on some other points that somebody might care about:  it won't work, and it might make things worse.

For starters, we already have the SEC.  Admittedly the SEC didn't regulate many of the new financial products that caused some troubles (that was another Congressional decision, eight years ago).  But some of those products were designed to skirt existing regulation.  Does anybody think that Congress will be able to outwit the collective genius of the financial markets?  Worse, this regulatory arbitrage might bring new and unpredictable risks.

Perhaps the law will be designed well and tightly enough that it manages to block most of the risks we know about now.  The problem is that the broader and tighter the law is, the more it might inhibit beneficial financial innovation.

More generally, the biggest problem we have seen in the recent meltdown is not with the instruments themselves, but how they were used.  At the heart of the now collapsing inverted pyramid of financial products was the notion that real estate prices would keep rising.  When they started south, default rates rose and mortgage-backed securities fell.  This is what started the collapse of securities values and the liquidity crunch that accompanied it. Remember that business people made the decisions to bet their companies on the dubious proposition of ever-rising real estate.  And that there was apparently nobody around to check these awful decisions.

This was a failure of governance.  How do we solve that?  Well, we supposedly already had the solution:  SOX.  Sarbanes-Oxley was to expose material weaknesses such as portfolios built on toxic securities.  Indeed, to some extent it did -- PW found in 2007 the material weakness in AIG's credit default swaps.  But clearly SOX did very little to stop the very sort of excessive risk that it had been passed only six years ago to deal with.

I have suggested, e.g., here, that the alternative governance models underlying private equity and hedge funds may be a way to deal with these governance problems. Yet I would not be surprised if misguided regulators see these firms as the problem rather than part of the solution. 

The worst case scenario is that we'll end up with more of the "good corporate governance" practices that did nothing to stop this crisis, yet with less of the market corrective provided by uncorporations.  Setting us up for the panic of 2015, or earlier. 

Comments

[Ed]

Larry,

What are your thoughts on merging the CFTC and the SEC (as is being bandied-about a bit)?

On the one hand, and perhaps like the creation of the Dept. of Homeland Security (only in minature), the merging of these two separate agencies with previously distinct mandates, disparate statutory and regulatory schemes, and widely divergent cultures would seem to be unlikely to yield bureaucratic efficiencies. On the other hand, the British FSA model certainly seems 'cleaner' than our system, and merging the CFTC and SEC would be one step towards a more comprehensive system of commodities and securities regulation. (So maybe it'd be a net positive long-term.)