The House Financial Services Committee begins its Bernie Madoff inquisition this afternoon, and the Securities and Exchange Commission is sure to get its share of flack from both witnesses and committee members. Meanwhile, Sunday’s New York Times contained an epic tirade against the SEC and other blameful parties (mainly the rating agencies) by hedge fund manager David Einhorn and author/lapsed investment banker Michael Lewis.
I preferred the much shorter diagnosis that Einhorn made in a speech in 2007:
Regulators are good at cleaning up fraud after the money is gone. Government doesn’t really know what to do when it catches fraud in progress.
Or, better yet, the verdict of Allan Sloan in his excellent column in the new Fortune:
If commission enforcers get a bigger budget and are treated with respect rather than being dissed (including, I’ll bet, by some of Madoff’s victims) as an obstacle to free markets, things may improve. But don’t expect a fraud-free era to ensue.
I’m saying this not out of cynicism but because I know how regulators generally work. I’ve seen it for years, in fields ranging from department stores to oil-drilling partnerships. You’re likely to get caught if you run a few inches outside the baseline, because regulators are set up to catch that. But run so far out that you’re playing on a whole different ball field? You can get away with that if you’re enough of a financiopath, and your luck holds.
Regulators are always going to miss lots of frauds in a freewheeling, money-spinning financial system. There is simply no way around that. If you want them to catch all the fraud, you need to have laws and regulations that strictly delineate which financial behaviors are allowed and which are not. In that kind of environment it’s easy to see who is operating outside the rules (although clever people will still eventually find ways within the rules to relieve others of their money).
We had that kind of regulatory environment from the mid-1930s through the early 1970s in this country. Then it fell apart—mainly because it was too rigid to accommodate the changes in financial needs wrought by inflation and globalization. Yes, there was an ideological aspect to what subsequently occurred. But simply attributing everything to the Reagan revolution misses that the old system had begun breaking apart long before 1981 with the rise of institutional investors in the 1960s and 1970s, the advent of the money market fund in 1970, the deregulation of brokerage commissions in 1975, and so on.
The new financial landscape that resulted wasn’t a full return to the freewheeling, virtually unregulated environment of the late 19th and early 20th century. It was instead an amalgam of some heavy regulated areas and some unregulated ones. The general dividing line was that sophisticated, wealthy investors and financial institutions were deemed capable of taking care of themselves, while retail investors and borrowers were presumed to need help from regulators. But that line didn’t hold everywhere–it certainly didn’t in mortgage lending. And the Madoff case demonstrated pretty clearly that wealthy investors aren’t necessarily sophisticated.
So what do we do about it? Do we return to a system where every financial transaction must be conducted according to rules set by lawmakers and regulators? I don’t really see how that could happen–the regulatory system would either have to be global, or the U.S. would have to largely cut itself off financially from the rest of the world. I’m sure we can come up with a better mix of regulation and market freedom than we’ve got now (I’m sure we could come up with a worse one, too). But big-time frauds will still be with us.