Our Regulatory Futures: Beyond the Cover of a TARP

So now the deal has been done. Bailout 2.0 (more formally known as TARP or the Troubled Asset Rescue Plan) has passed its last Congressional hurdle and now the machinery of US government can soon begin to implement the plan to defrost the credit markets. This political compromise may have preempted a deeper and more formidable financial crisis but it remains unclear whether this plan will stop the US and global economy from descending into deep recession or, as the most pessimistic bears fear, a depression. Most people, including the Plan’s authors and supporters, realize that the bailout is limited in what it can do. It will, hopefully, provide a bottom to the markets for toxic assets, allow banks to get bad assets off their books, free up credit markets, instill confidence in the financial systems for investors, consumers and banks, and lead to healthier and more fluid capital markets.

But there are other problems that lie in waiting and whose magnitude is not yet known. It is yet uncertain whether this facility for purchasing assets will be timely enough or whether the damage is so deep that it will take much longer, and cost more, for market stability to return. It is also uncertain how long it will take for banks to stop hoarding money and start lending again to consumers and other banks. The LIBOR determines the rate at which banks lend money to each other and that rate remains persistently and precariously high. The financial contagion continues to spread around the globe with Fortis being the newest casualty and the first continental European bank to succumb to nationalization. Large governments such as the state of California have formally warned the Treasury of their cash flow problems that will require a large injection of cash by the end of October. And many economic indicators such as jobless reports indicate that the US economy is under significant duress.

Though there are many problems that lie in waiting, one of the biggest problems is how the US and other governments will respond to the argument that current financial problems were created due to the lack of adequate regulation which, as the argument goes, requires the firm hand of more rules, regulation and supervision. There is no question that certain parts of the financial system have not been properly controlled and that the lack of regulation has exacerbated the current financial crisis. The sad and surprising truth, however, is that very little is known about where the real problems and causes of the current mess lie: too little regulation, too much regulation of some financial players and too little regulation of others, excessive risk appetites that were not tempered by good risk modeling and calculation, business’ cultural predisposition to leverage and encourage risk-taking in the pursuit of personal and corporate reward? The list of causes of this financial meltdown is long and is intertwined in the often mysterious and subterranean underworld of international finance.

Since the problems are so complex and intertwined, there is a clear and present danger for governments if they respond prematurely to the crisis, and with the wrong tools. Increased regulation may be a useful tool. However, it is no secret that the chemists who work in the meth labs of finance have been ingenious in devising ways to circumvent regulations and rules, no matter how well drafted. Regulation, particularly quickly devised and politically motivated regulation, also has often unintended consequences. Some cite the Sarbanes Oxley legislation (SOX) as a warning and example of how hasty and politicized legislation may fall far from its objective and create such unintended consequences. Many have criticized SOX for creating a box-ticking exercise for corporations that has not really improved corporate governance, transparency or meaningfully decreased the likelihood of corporate misconduct that the legislation was created to prevent. Others have also claimed that the legislation resulted in businesses locating and listing in non-US jurisdictions where they are not subject to Sarbanes Oxley; an unintended consequence that may have harmed the American economy.

And this is one of the big problems that may lie ahead in how politicians, regulators, consumers and voters react to this financial problem. Politicians and regulators should be very careful to avoid creating a game of regulatory arbitrage that may not only harm their own economies in the US and Europe, but that may do even greater harm to the global financial system and global capital markets as a whole. A number of countries and their fledgling financial markets are already salivating at the opportunity to assume a greater role in international finance now that US investment banks have vanished and the US financial systems is in disarray. Markets and marketeers in China, Russia, India and the Middle East would love to entice even more capital to their banks and markets. And if the US and Europe respond to the present crisis by creating clumsy and onerous regulatory restrictions on financial institutions and financial instruments, then those activities may merely move elsewhere where such rules and limits do not exist or interfere. That is a game of regulatory arbitrage that could easily further jeopardize the stability and sustainability of global finance and capital markets.

Of course financial institutions seldom benefit from a chaotic and unregulated wild West of financial markets. They too benefit from rules that limit the opportunity for fraudulent practice, abuse, government interference and corruption. The challenge is to create an intelligent, sophisticated and flexible regulatory framework guided by meaningful principles rather than just creating rules. Whatever governments and regulators decide to do to control financial institutions, hedge funds, derivatives and securitization- and the numerous other possible contributors to the financial system’s ailments- it is important that the pendulum of regulation not swing too far to counterbalance the perceived consequences of under-regulation and deregulation. It is also important that adequate time is taken to understand what actually happened and where the real problems lie. And it is equally crucial that whatever solution a government chooses to pursue, that government should realize that it cannot solve the problems alone. Capital is very liquid and moves around the world and across borders at whim. The problems that lie ahead are global problems that require global solutions: coordination, cooperation and harmonization of important financial practices. If governments, politicians and regulators become too mired in regulation as a panacea and too confident in the global reach of their own national regulation, then the regulatory arbitrageurs and meth lab chemists of finance will descend again. And this will not be good for the future and sustainability of global financial markets and our collective hope for our economic health and prosperity.

By Robert Adamson
October 3, 2008