Regulatory balance is key for functioning markets
01 Nov 2011
By Patrick Morris
Occupy Wall Street’s protesters are calling for more regulation of banks, derivatives and executive compensation to make the system more equitable; in other words, they are calling for Wall Street to clean up its mess.
Wall Street has responded by saying that regulation is an impediment to profitability and prevents job creation. So who is right?
Actually, it is not easy to say that deregulation creates a better business environment, nor is it possible to defend regulation as a quick-and-easy fix to corruption or economic displacement. The wide range between no regulation and hyperregulation ultimately leads to a functional regulatory equilibrium—or regulibrium.
The tragic history of regulation is written in blood and suffering. The Great Baltimore Fire of 1904 changed building codes, the sinking of the Titanic changed maritime safety codes, and the Triangle Shirtwaist Factory fire changed fire codes. Both the owners of the Titanic and the Triangle Shirtwaist Factory were found innocent of wrongdoing and even received significant insurance settlements because they were in compliance with the law of the day — even though more than 1,500 people drowned when the Titanic sank and 146 people were killed when the Triangle Shirtwaist Factory burned. All died brutally and needlessly.
At the time of the global economic collapse of 2008, bankers, traders, insurance executives, money managers and regulators were for the most part in compliance with the relevant laws and regulations. This is why there have been few indictments and prosecutions, and like the Titanic and Triangle executives, they got bailed out.
Compliant though they may have been, they should have seen the collapse coming as a multitude of voices warned of impending catastrophe. Unfortunately, most people don’t want to bite the bullet of a slight decrease in profits to protect the overall health and safety of the system.
The reluctance to enact regulatory changes in the U.S. is driven increasingly by the rapid globalization of commerce and fear that our laws will inhibit us from competing in this new global landscape. However, this assumes that regulation will take away our competitive edge. Before 2008, Canadian bank executives fought vigorously to amend the 1991 Canadian Bank Act, which prevented them from participating in the types of activities that got U.S. banks in so much trouble. Now, because of that insightful regulation, Canadian banks are some of the strongest and most competitive banks in the world.
Before the recession, the argument for global commerce was, “European banks have brokerage firms, insurance, and asset management — if they have it and we don’t, we lose.” The result was good-bye, Glass-Steagall Act, and hello, Gramm-Leach-Bliley.
The unintended consequences may have led directly or indirectly to the greatest economic downfall in U.S. history since the Great Depression. The middle ground, where banks are neither all-powerful nor rendered completely impotent, is the place we should be aiming for now.
Imagination leads to innovation, but the failure of imagination can lead to disaster. Car makers were slow to introduce seat belts and air bags since they felt that they made a car appear unsafe. Now that we know that seat belts and air bags save lives, we wouldn’t consider a car without them. Financial regulation needs to be a proactive, not reactive process: We need to imagine the accident. The treasury markets and corporate bond and equity markets are heavily regulated, but they also work. They have been tested in major shocks, but they have rebounded and, most importantly, have found price stability without significant intervention after decades of substantial regulatory changes, starting in the 1930s.
So how do you fix the problem? Accept that totally unregulated, underregulated or deregulated industries can create situations leading to catastrophic failures and needless human misery. As financial services professionals, we should be proactively searching for rules and restrictions we can live with and trying to maintain a sensible outlook when it comes to the possible long-term benefits of a few impediments caused by some regulation. It is our responsibility, not because we want regulations, but because we will lose our ability to self-regulate if we don’t get it right on our own.
Just like the Wall Street protesters in Zuccotti Park, Wall Street itself needs to clean up its mess before it gets out of hand or we get driven out entirely. Let’s get to regulibrium we can live with instead of regulation that is forced upon us.
Patrick Morris is the chief executive officer of Hagin Investment Management, a quantitative hedge fund firm in New York.
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