The Three Sides of Financial Regulation: Rules, Guidelines and Saving Face

Thursday, March 4, 2010

When a product or service goes bad, there are three natural reactions: To punish those responsible, to help those harmed and to ensure it doesn’t happen again. I want to address the third item, which typically involves congress and government agencies ramping up protection for users.

During such periods, we need to keep our expectations realistic and our reactions separate from our investment decisions.

Rules and Guidelines

The government typically relies on two main types of protection, each a form of regulation. The first is the establishment of clear rules – defined boundaries in which product/service providers must operate. The second is the establishment of guidelines, with an agency to administer them.

The first – rules – can be the easiest to enforce and the least problematic to providers. If all providers must abide by the rules, then there is a level playing field on which they all operate (e.g., minimum auto mileage requirements). However, there can be other effects that must be considered, such as:

  1. Substitute products/services. For example, coal mining rules can raise coal prices, making other energy sources more competitive.
  2. Foreign production. For example, US minimum wage rules can make foreign producers, not bound by the rules, more competitive.

The second – guidelines – is where the challenges are. Here, the reliance is on an agency to ensure providers are adhering to the guidelines. Food safety is a good example of the difficulties. The sheer volume prevents anything like 100% inspections. Add to this the widespread production facilities, handlers, distributors, retail stores and restaurants and the job of ensuring food safety becomes extremely complex. Finally, throw in all the foreign food production and that job becomes mind-boggling.

Financial Industry and Saving Face

Now, let’s talk about the financial industry. The realization has been that the capitalist backbone of the US requires a sound, smooth and (especially) trustworthy financial system. No one entity (even the US government) or industry (e.g., banking) must be allowed to gain at the expense of others.

Over the years, there have been a number of man-made financial problems. From those difficulties, there has been a powerful, positive reaction: to strengthen the system to prevent and/or withstand any future recurrence. Effective regulations and competent agencies were the result.

That process was effective until the 1990s. It’s not obvious why things changed, but it is clear that a reversal began then. A number of regulations were weakened or eliminated.

This means congress has a new challenge. In addition to establishing new protections, it must examine those previously overturned regulations that could have helped. This is a problem because reestablishing an abandoned regulation is an admission of having made a mistake by dropping it in the first place.

The SEC’s proposed new short-sale rule is a good example. It is clearly a poor substitute for the previous 1938 uptick rule that the SEC dropped in 2007. Their rationale for preferring this new rule is that it is less difficult to administer. That reason is incorrect and lacks common sense, plus the new rule misses the goal – it allows short-sellers to drive a stock down 10% before the new rule kicks in. But, with Wall Street firms affected by the rule nodding “yes,” it will likely carry, allowing the SEC to say it has taken action with a new, “modern” rule to protect investors.

The Senate Banking Committee has the same problem. How it all turns out remains to be seen, but we will likely not see a return of the effective banking provisions in the 1933 Banking (Glass-Stegall) Act. Yanked in 1999, it probably would have prevented many of the recent bank shenanigans and “mistakes.”

Don’t Let This Situation Adversely Affect Your Investing

So, what do we do as investors? Being frustrated – even disgusted – is okay. But, we don’t want to cut off our noses to spite our faces. We can remain enthusiastic investors by focusing on sound investments. The US capitalist system remains strong, and its powerful incentives will continue to produce growth and profits from well-conceived products/services provided by soundly run companies.

As always, we must be careful with our money and investments. Past events and current actions simply confirm that Government and industry reassurances can never substitute for sound analysis and common sense. Perhaps it can help to remember that, in spite of a lack of regulations and agencies in the decades preceding the Great Depression, the stock and bond markets (and the banking system) still operated effectively. Investors and savers earned good returns, so long as they avoided excesses – just like now.

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