More ND20 FinReg Reactions: Bill Black and Henry Liu
The key things to look for in judging the seriousness and effectiveness of any reform effort are whether it addresses the primary drivers of our recurrent, intensifying crises. Those are:
1. Compensation: Executive and professional — control frauds use these to (a) create the “Gresham’s dynamic” that allows them to suborn “controls”, officers and employees and turn them into fraud allies, and (b) to convert firm assets to their personal benefit while minimizing the risk of prosecution.
2. Accounting: Capital and liquidity ratios are meaningless without good accounting. We have weakened the real capital requirements because the industry used its contributions and its economist allies to convince Congress to extort FASB to gimmick the accounting rules so that banks need not recognize losses on bad assets prior to their sale. Until this action is reversed everything done on capital/liquidity is a sham.
3. Ending the regulatory black holes that were deliberately created: You can’t leave any holes. Control frauds are dynamic. If you fix five of seven holes they will exploit the other two and your five successes will be hollow.
4. Regulators: By far the largest problem was with the anti-regulators that Bush appointed for the explicit reason that they opposed regulation. Desupervision was a far greater problem than deregulation. As long as the anti-regulatory Rubin wing of the Democratic Party governs economic and regulatory policy we will fail. So watch for whether Rubin, Summers, Geithner, and the anti-regulatory Bush leftovers running the Fed, OCC, and OTS remain in power. When they hire Mike Patriarca to be their top regulator you’ll know that they actually want to succeed. Track how many criminal referrals of CEOs the regulatory agencies make.
5. Control fraud: While the Supreme Court decision on corporations being persons for First Amendment purposes is obscene, it has at all times been within Congress’ power to restrict conflicts of interest. When the financial services committees bar their members from receiving any political contributions from the financial services industry and its shills (and bar anyone that took money from the industry from joining the committee) we’ll know that serious reform has arrived.
So, proverbial bottom line: the Senate bill did, in fact, get stronger. And that tells us something very positive about what the Members’ constituents are supporting, because the organized “special interest” effort to weaken the bill was intense. The fact that the strengthened bill is zero for six on dealing with the problems driving these crises shows that the original bill was so weak in all of its fundamentals that even with the marginal improvements it will not address successfully the reasons why we are suffering recurrent, intensifying crises.
Generally speaking, while regulatory reform is obviously needed in financial markets, one should recognize the limits of reform as always being a rearview mirror endeavor. That is the difference between reform and revolution. The former is an attempt to restore a broken past while the latter is an attempt to construct a utopian future.
Based on information available so far, regulatory reform seems to have been ensnared by obscure technical details — the systemic consequence of which have not been fully established — and headline-grabbing red herrings that divert attention from fundamental issues. Financial innovations are adopted in the market generally because they serve a particular positive function. Yet a sharp knife can cut many ways; in the hands of a surgeon it will be a useful instrument, while in the hands of criminals or even innocent children it can be a dangerous weapon. Therein lies the dilemma of financial regulation, a problem faced also by regulation on scientific research.
There is logic in not placing unrealistic hope in regulation as a regime of forbiddance. Rather, the application of the concept of fail-safe may be more useful than the nebulous quest to eliminate the too-big-to-fail syndrome. Fail-safe incorporates systemic features which in the event of failure respond in ways that will cause no harm or at least a minimum of harm or danger to other elements in the system. Fail-safe components in a system allow, but do not cause or invite, improper systemic behavior without a system-wide contagion of penalties. It seems that the current regulatory reform effort has been focused more on the concept of fail secure — by seeking to prevent improper systemic behavior through the impediment of proper systemic behavior.
In a market system, incentive-driven good behavior is preferable to criminalization of bad behavior. Given the ingenuity of market participant creativity, one can expect that an incentive-driven fail-safe regime can be developed for financial markets. History has shown that fail-safe regimes have been devised to successfully manage nuclear arms control during the Cold War to prevent a nuclear war.