The efficacy of economic regulation relates to why it was written. In the aftermath of scandal, policy and law are intrinsically reactive and extreme. Though rare, such regulation poses downside risk in an open economy. In America, by no means can business exercise total free will, but markets are allowed to mature of their own accord. Government and courts ought to facilitate efficient markets rather than intervene unless there are compelling competitive grounds, and not all regulation is bad. Setting recognized, predictable standards for regulation and legal protection attracts capital.
Perhaps an advantage to the Bretton Woods agreement was that the country backing the reserve currency owed it to the world to maintain impeccable credentials for probity. If dodgy practices occurred, then the knock-on effects on the world economy would have been large. Any sharp rise in U.S. interest rates or capital flight might have triggered economic collapses in countries who borrowed from the World Bank. I am not advocating a formal return to this system, but it left a legacy: the dollar remains in the eyes of many the global standard even if its status is de facto and not de jure. Yet, recent regulation has provided rather short term benefit.
Sarbanes-Oxley did much to restore faith in public markets after scandals. However, its corollary effect sparked a boom in private equity investment as companies sought private finance rather than complying with onerous filing protocols. Private equity deals relied greatly on leverage facilitated by cheap credit. By cutting interest rates, the fed eased the pain of recession brought on from the puncture of the dot-com bubble. In addition to the cyclical shifts in corporate organization, equity research changed also as investment banks began shifting away from in-house analysts after the Quattrone fiasco at CSFB. Luckily, the presidential election has distracted lawmakers somewhat from proffering a knee-jerk, slapdash bill in the aftermath of the end of the recent housing bubble, which ironically sprung from the monetary easing used to stave off any deep effects from the previous bubble. This time, legislation would affect ratings agencies breaching ethical rules of advising firms whose equity and debt they rated on what firms could do to receive a desirable rating, and thus receive favorable terms form their creditors.
Despite great uncertainty over the extent of the credit crunch, bank exposure to sub-prime mortgage-backed securities, and what role did ratings agencies play, three truths emerge.
One, ratings agencies cannot compromise objectivity in the same ways auditors cannot. Independent risk assessment is as important as accurate account statement – the two are inexorably linked to efficient results. If accounts are dodgy, than the price signals to the market will be based on a falsehood. Hence, the market would be inefficient.
Second, because the severity of mortgage market is yet unknown, the distraction of a federal election is a good thing. Instead of hasty, incompletely thought out bills, and pressure on an ill-prepared Congress to act, the SEC,, Treasury department, Justice Department anti-trust division, and bank regulators can do their parts in sorting through the scale of the mess first, and only then prosecuting any crimes which may have been committed.
Third, though financial markets have become more competitive since the repeal of arcane laws such as Glass-Steagall, it is false to conclude that efficiency is feasible absent regulation. Rather, correcting for this market failure lies in stricter rules separating ratings agencies and their clients, an explicit, accepted method of pricing securities based on mathematical models, and, most importantly, funding regulatory agencies to enforce the rules and monitor market activity for irregularities.
“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation,” according to the SEC website. Knowing how and what type of securities are being issued certainly falls under these auspices. Fifty years ago, stout regulatory mechanisms attracted investors to American stocks and bonds because of high levels of market predictability. Recent volatility strengthens the case for addressing these structural failings which limit the competitive advantage of sound institutions.
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