My First O&M Guest Post
Peter Klein and his colleagues at the excellent blog Organizations and Markets have graciously invited me to guest blog, and cross-post here. Here’s the O&M link, and here’s the piece:
On the Border*
This is my inaugural post as guest blogger here at O&M. I am grateful for the opportunity.
In his very gracious introduction, Peter Klein noted that my research is at the border of finance and industrial organization. Quite true (and indeed, “borderer” is a good description of me overall.)
That border is very, very busy today. Indeed, so much is happening there that it is difficult to keep up. In the aftermath of the financial crisis, Congress and regulators are beavering away on laws and regulations that will completely reshape the organization and regulation of financial markets, and especially of the area of particular interest to me–derivatives.
I anticipate that many of my O&M blog posts will explore these issues, but I’ll start with something very topical. Senator Chris Dodd just yesterday heaved up a 1136 page proposed financial regulation bill, and one proposal that is attracting considerable attention is his plan to consolidate banking regulators. Dodd is not alone in thinking along these lines. Even before the financial crisis, there were myriad proposals to consolidate various regulators, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission. These have only gained in popularity in light of the crisis.
In the modern financial markets, firms are big and complex, and operate in many markets (defined geographically, or by product). It is difficult to fit a big financial firm into any box. A Goldman Sachs deals in the securities markets and the derivatives markets. So it doesn’t fit comfortably in a securities box, or a derivatives box, so in the current system for regulatory purposes the firm is split into pieces, some of which are put into the securities box and others into the derivatives box (and there are many other boxes too for a big firm like Goldman).
This leads to potential for conflicting regulations, jurisdictional disputes, regulatory arbitrage, and other problems. So, the Dodd proposal–and most of the other consolidation proposals–advocate creating really big boxes, and in the extreme, one big box that regulates everything a financial firm does.
The problems of the seen are well known (though arguably exaggerated). What concerns me are the largely unexamined problems of the as yet unseen big box alternative.
Economic theory can shed some light on these problems. Specifically, any government agency multitasks. The CFTC, for instance, regulates the financial health of futures brokerages and polices market manipulation. The more expansive the agency, the more tasks it will perform. Thus, regulatory consolidation exacerbates multi-tasking problems.
Moreover, any agency has multiple principals, including Congress and the White House. Moreover, even within Congress there are multiple different constituencies that view themselves as principals. The more expansive the regulatory agency, the more principals it will have; more Congressmen will perceive an interest in the activities of the agency because it will regulate a larger array of firms operating in more districts.
Agency theory tells us that multi-tasking agents working for multiple principals face serious incentive problems, and that given this, it is the interest of the principal(s) to subject the agent to very low powered incentives. Indeed, assigning the agents more tasks and subordinating the agent to more principals generally requires (in a second best arrangement) a reduction in incentive power. Weaker incentives, in fact, than those that regulators currently face.
Thus, Congress will find it in its interest to subject an uberagency that regulates everything that breathes (financially speaking) to very low powered incentives. This translates into an agency that is highly bureaucratic, sluggish, unresponsive, (fill in additional pejoratives here).
Regulators hardly covered themselves with glory in the lead up to the crisis. Does anyone really believe that a single, even less incentivized super regulator is likely to do any better? Has anyone who matters even asked the question?
* With apologies to the Eagles. And Taco Bell.
What amazes me about all the dithering about financial markets reform is that there is absolutely zero talk about holding individuals in regulatory positions accountable, absolutely zero talk about changing the culture within various regulatory bodies and absolutely zero talk about replacing senior regulatory officials with individuals more suited to lead us into the “new” regulatory regieme.
I have a fair amount of experience with the inepitude of those at the SEC and at FINRA. I contrast the cultures of those two organizations with that of teh FAA. MAdoff and Stanford were both epic regulatory failures. Had such epic failures occurred in the aviation world, teh FAA would have ensured teh pilots of the crashed aircraft would not be allowed to fly until after a thorough review of teh facts. FAA officials would have send out an investigatory team to find out what happened, why it happened and then (if necessary) rules, policies and procedures would have been issued to the industry to ensure what happened would never happen again.
Just last month two pilots overshot their intended airport and, as a result, they lost their careers. Lets contrast this with the regulatory response to the Allen Stanford affair. Stanford has been accused of running a massive ponzi scheme, using his U.S. regulated broker/ dealer to sell the majority of the securities at issue. Additionally, his U.S. regulated broker/ dealer stands accused of fraud. To date not a single individual has been sanctioned by FINRA in any way, shape or form. The “pilots” of the firm, the senior management, have effectvely been allowed to simply walk away from the crash and while still drunk on hubris, arrogance, greed or whatever, have been allowed to walk across the street, get into another plane and resume business as usual. No licenses have been suspended, no regulators have been called to account for failing to enforce current rules or regulations, no investigation has been initiated and no report has been issued to the industry. In fact, the Chief Compliance Officer (a man of HIGHLY questionable judgment and former lifer within FINRA itself) of not one, but TWO of the firms named in the SEC complaint is not only still in the industry, he is actually consulting with other firms, teaching other compliance officers the “tricks” he learned that lead to the SEC having to seize the firms he oversaw and force them from existence.
Rearranging the same incompetent regulators on an organizational chart will not change the failed culture of the financial regulators. Until Congress wants to start admitting we need substantive change within the regulators, changing the organization names on their business cards will simply offer more of the same systemic incompetence.
Comment by Charles — November 11, 2009 @ 6:00 pm
By the way, I hope you ignore the typos. I was doing three things at once, but had to get my two cents in. regime, inepititude, the, Madoff, effectively. Insert where appropriate. 🙂
Comment by Charles — November 11, 2009 @ 6:08 pm
Hey, folks, Charles may not be able to type (just kidding you, Charles, but speed kills–as does multi-tasking), but he definitely knows whereof he speaks. Definitely. So it’s worth heeding what he has to say.
I really would like to hear the counter to my argument that FINRA and the SEC should adopt some (if not most) of the elements of the culture of the FAA. If the SEC has to come in and effectively shut down a company for malfeasance, how could the licenses of the principals of the firm not be suspended pending an investigation? Yes, the suspension would stay on the record of the individuals for the rest of their careers, but is that a bad thing?
Before we begin to draft new regulations, shouldn’t we have a discussion about how to more effectively enforce the current regulations and to ensure any new regulations will be enforced? New regulations that are not going to be enforced or will be enforced in an uneven manner will serve no productive purpose. In my mind, self regulation hasn’t failed. What has failed are the regulatory organizations responsible for overseeing the self regulatory structure. An uberagency will not serve the interests of the country unless the principals of that agency are directly accountable. Before we change the regulatory structure of the marketplace, we need to change the culture of the regulatory agencies.
Comment by Charles — November 12, 2009 @ 12:18 pm
The SEC may be finally doing something proactive. Just read SEC requested a copy of STOCK SHOCK–new movie about market manipulation and naked short selling of Sirius XM stock (among others). Amazon has the movie on DVD.
Comment by MTF — November 13, 2009 @ 1:02 pm