More Financial Regulations, More Financial Failures

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Back in 2000 and 2001, the first stage of the Internet era ran aground in an ugly way. From Webvan to to eToys, investors saw their stakes in these once high-flyers reduced to nothing.

What’s important is that the dying companies were allowed to fail. Internet firms had no real regulatory oversight to speak of, nor does Silicon Valley to this day, so when problems arose, investors and employees had to respectively accept their losses and move on. Their losses were their own.

This is notable considering the global response to the financial problems in our midst. Politicians and the regulators they oversee, seemingly unconcerned by how unequal they were to those they regulated this past decade, see the failure of all manner of financial firms as reason to enhance, not reduce regulations.

Indeed, among the major decisions made at last week’s G20 confab in London concerned financial oversight, and the desire among G20 leaders to create a global regulatory framework. Simply put, when government regulators fail, unlike businesses they can keep trying, albeit on the dime of the taxpayer.

The move toward global regulation is not insignificant. Much like moves afoot to achieve worldwide tax harmonization that would effectively trap corporations and individuals in tax sameness, global financial regulations will retard the process whereby individual countries serve as laboratories for regulatory concepts. If financial regulation is harmonized, bad rules will be imposed on everyone.

Some might say this is a good thing, that finance companies ensnared in a global web of regulations will not be able to operate outside of them, and major failures will be reduced. It’s a nice thought, but once again this kind of thinking presumes that someone taking a relatively paltry government paycheck might be able to outsmart the more enterprising minds in the private sector. Good luck.

Instead, regulations and regulators at first blush play right into the hands of the Bernie Madoffs of the world. Once they know the rules they must get around, not to mention the regulators they need to please, their jobs are easy. Indeed, it’s far easier to trick someone with no skin in the game than it is to trick a customer. Regulators allow customers to be lax in their oversight, and that’s why con artists always thrive when the role of the state is large.

Much the same applies to big banks seeking to operate in an above-board way. Not only do regulations serve the interests of big institutions for suppressing new entrants, they also create opportunities for sharp minds within banks to figure out legal ways around the rules put in place. They get paid to do just that. Think about it: banks are presently regulated by no less than the Federal Reserve, the Comptroller of the Currency and the FDIC on the federal level, and they also face myriad regulators on the state and local level. Despite this seemingly impressive oversight, banks once again were able to overextend themselves in ways that supposedly have us experiencing the “worst financial crisis since the Great Depression.”

The above should be remembered in light of G20 talk suggesting that hedge funds are next when it comes to massive oversight. If regulators can’t control the relatively prosaic world of banking, is it remotely credible to assume that truly bright hedge fund managers will somehow meet their match in Bonn, Paris or Washington? Not very likely.

Sadly, however, more financial regulations will have a deleterious impact on the very taxpayers they were meant to protect. Indeed, once a firm or sector is regulated, the regulatory bodies overseeing them are frequently on the hook for failures. This is why the failure of S&Ls in the ‘80s and ‘90s, and banks/investment banks this decade have proven so costly. Compare this to the aforementioned decline of Internet companies earlier this decade, and the reality that taxpayers weren’t forced to cough up a dime.

Treasury secretary Geithner feels he can solve the problem of bank failure and its broader impact by corralling the “too big to fail” banks into some form of “super-regulatory” system. The obvious problem here is that sharp minds will once again game the Geithners of the world in seeking to figure out who’s important, and who isn’t. It shouldn’t be hard to figure out, and once the mystery is solved, the supposed “key” financial institutions benefitting from their governmental patrons will possess an unfair competitive advantage not gained through skill, but thanks to being too large. For the federal government to crown one or many corporations with the tag “too big to fail” is for that same government to author future financial crises caused by the firms it deems essential to our financial health.

What’s not been discussed enough is how much better off we would all be if regulators here and around the world were to recognize their limitations, and let those with actual money at stake regulate those they’ve invested with. If so, it’s fair to assume that investors would be far more aggressive when it comes to making sure those they’ve entrusted their money with are operating in ways that don’t risk the capital they’ve committed. Put another way, who might regulate a big bank more effectively: a smart money manager with hundreds of millions invested in said bank’s future, or an over-degreed SEC newby possessing little to no financial experience with no money on the line?

Beyond that, the surest way to reduce the number of financial failures would paradoxically be for our federal minders to make plain that bailouts from the government are not a future option. If so, it would be well known that faulty decisions would be met with bankruptcy, and this reality alone would insure that banks, heavily regulated by their investors, would be far more prudent when it comes to deploying the capital they’ve been entrusted with.

Absent that, more in the way of regulations to fix past problems misses the point, and it insures more financial failures in the future. The financial system doesn’t suffer from too little regulation, but it does suffer from investors over-reliant on governments to do their work for them combined with a bailout culture that says government won’t countenance failure. On the other hand, if governments get out of the way, we’ll achieve the very best kind of regulatory situation whereby those with money at stake will oversee those they’ve entrusted it with.

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