First, Fire the Regulators
In the aftermath of the stock market crash of 1987, reformers moved to remake America's regulatory structure. Some experts proposed tinkering with the oversight agencies, merging the Securities and Exchange Commission with the Commodity Futures Trading Commission, for instance. Others recommended regulating derivatives, which were in their infancy. George Soros, not yet the bte noire of right-wingers, took to the editorial page of the Wall Street Journal to warn that nobody was thinking big enough: "The longer markets function without supervision explicitly aimed at maintaining stability, the greater the danger of an accident like October 19, 1987."
Anyone remember the landmark 1987 Securities Act? It never materialized. And did anything happen in 1998, after Long-Term Capital Management nearly went under and a similar dance took place? Many of the same players strutted on the same stage, and Soros again predicted that without sweeping international regulatory reform, we risked "the breakdown of the gigantic circulatory system which goes under the name of global capitalism." Again, no '98 Securities Act-perhaps not surprising, given that what followed was a market recovery that we now know was a massive equity bubble.
In our current financial mess, hardly a day goes by without another hearing on the failures of the U.S. regulatory system or speech on regulatory affairs. In November, Henry Waxman, chairman of the House Committee on Oversight and Government Reform, hauled five of the most influential hedge fund managers before the committee and extracted pronouncements from each of them-some less full-throated than others-that the markets, including hedge funds, needed more regulation. Once again, there was George Soros, as right as ever, leading the Regulatory Light Brigade.
This time, the calamity in the markets is more devastating than any of the previous crises since the Great Depression. Luckily, it's looking like history won't repeat itself. One of the enduring legacies of this economic collapse will be that the government finally had to embark on a wholesale financial rethinking. Right now, finding a way to end the crisis and reinvigorate the economy is the most pressing issue. But in a few months, after the Obama administration settles in-assuming we aren't all eating cat food under a bridge-we are going to have the debate we need about how to rebuild the regulatory system.
The pressure to put off this debate will be enormous. The financial industry is bound to resist. But Wall Street is at its weakest point in decades; the new administration has to strike while the public temper is at its hottest.
"Investors have lost confidence in everything: the regulators, the system, the oversight of Congress, the fairness of our markets," says Arthur Levitt, a former S.E.C. chairman. "How do you restore that?"
One hopeful sign is that President Obama has given the matter significant thought. In a campaign speech in March, he talked about regulating the derivatives markets and raising the capital standards for banks. If that speech becomes the template for reform, it's a promising start. It's also promising that Gary Gensler was named co-head of Obama's search team for a new S.E.C. leader. Gensler has been a prescient critic of excesses at Fannie Mae and Freddie Mac (which were not remotely the cause of the crisis but were inarguably pockets of systemic risk).
First, regulators need to change their ninnyish attitudes. They have gone about their jobs in the past decade like hall monitors at the prom, deeply afraid of being ostracized. They need to bring some mettle to their roles. The challenge is to remake the system so that it's up to the task of preventing, or at least minimizing, the next global meltdown. Alter the structure all you want, but unless you have the right regulatory attitude, it'll be for naught.
This is not a moment to think small. First, we raze the S.E.C. and the C.F.T.C., along with most, if not all, of the federal banking and state insurance regulatory structure. We should strip the Federal Reserve of its responsibility for regulating banks; it's enough to oversee the economy. And just as everyone was trying to express how bumbling and irrelevant the S.E.C.'s enforcement approach has been, the agency provided perfect examples.
In mid-November, headlines blared that the S.E.C. had charged Mark Cuban, the billionaire owner of the Dallas Mavericks and a frequent blogger, with insider trading. Did he gain secret knowledge of the failure of A.I.G. and sell his stake? Had he done something untoward with regard to Lehman Brothers? No. Four and a half years ago, Cuban sold stock in a company called Mamma?.com based on inside information, according to the S.E.C., and thereby avoided $750,000 in losses. Today, Copernic, Mamma?.com's successor, sports a market value of less than $3 million. Cuban may well be guilty. But who cares? It's as if Homeland Security had a ceremony in 2008 to announce that it had erected a gold-plated bollard at ground zero. And come December, it became clear that the S.E.C. had shockingly botched multiple chances to upend confessed Ponzi schemer Bernie Madoff.
Before the economic crisis became acute, Treasury Secretary Hank Paulson put forward his plan to remake the regulatory system. Like most of Paulson's initiatives, it was inadequately explained and poorly sold. And the motivation was exactly wrong, born of a fear of regulation that looks ridiculous today. It died on arrival, as it should have.
But surprisingly enough, given the dubious way it began, a Paulson-like framework is a good place to start. It was influenced by what is known in regulatory circles as the Twin Peaks approach, used in Australia and the Netherlands. The idea is to create two financial regulators that are given separate responsibilities not based on financial firms' lines of business. Currently, we have separate regulators for securities, futures, banks, and insurance. That antediluvian division of labor needs to be scrapped. Under a Twin Peaks structure, one agency would focus on the safety and soundness of financial institutions: the strength of their balance sheets, whom they trade with, and how strong their risk controls are. An agency with this structure would remedy one of the glaring limitations of the S.E.C.-that it has too many lawyers and too few market experts.
The second peak will be more familiar. It would focus on business conduct and investor protection, otherwise known as lying, cheating, inadequate disclosure, and manipulation. This would encompass much of what the S.E.C. is currently supposed to be doing. It would go after big targets and not monkey around with dinky companies and small-time insider-trading issues.
The Twin Peaks model has good-cop, bad-cop appeal. The safety-and-soundness regulator can work with firms to make sure they are solid or else the enforcer will come in. And we should consider a third peak as well: one with responsibility for surveying systemic risk. It would monitor the safety and soundness of the entire financial system, rather than assess it on a company-by-company basis.
One debate-sometimes drawn as a Europe-vs.-U.S. argument-is about whether we should reorder regulation based on broad "principles" rather than strict "rules." This is a red herring, despite the energy expended on it. Rules come from principles, after all. Whatever we have, it needs to be enforced.
In remaking the regulatory architecture, we will need to update the regulatory mandate to deal with 21st-century financial products. Accounting rules should be tightened to prevent anything from being moved off the balance sheet unless there is a true sale of the assets. No entity or instrument should be untouched by some form of regulation.
Regulators need to monitor positions taken by banks, other financial institutions, and major investors, including hedge funds. To its credit, the S.E.C. did attempt in recent years a modest hedge fund registration requirement. The courts struck it down. Congress will have to expand the regulatory mandate to include private investment partnerships, or at least those of a certain size.
Clearly, the regulators will need new powers. We must install higher capital requirements for all financial institutions. Given the disastrous incompetence of the rating agencies, Congress will have to undertake the enormous task of decoupling our regulatory framework from its dependence on ratings. Right now, ratings are written into the fabric of thousands of laws and regulations. Instead, market prices should be used.
There is wide consensus, as there should be, that derivatives will be brought under the umbrella. In the 1990s, the definitive fight was over the regulation of derivatives. Brooksley Born, then the head of the C.F.T.C., pushed to regulate them. Alan Greenspan, Robert Rubin, and Lawrence Summers fought her. She was right. It's encouraging that people like former S.E.C. commissioner Levitt, who sided with the crowd that argued that regulation would plunge the market into legal chaos, are now having second thoughts. Let's hope the same is true for Summers, who is now in Obama's inner circle. "I have regrets that I didn't use that as an opportunity to say, 'Wait a second, maybe it will create uncertainty, but what about going forward? And what about mandating a clearinghouse?'?" Levitt says. "I could have and should have, and I regret not doing it."
Other problems are thornier. Can we do something about outrageous compensation for executives and Wall Street? Can we prevent institutions from becoming too big to fail or, worse, too interconnected to fail? Right now, unfortunately, regulators are encouraging mergers, giving us a land of one-eyed institutions buying blind ones. They have to be followed by a complete re-thinking of our capital requirements. Stronger capital requirements might help with excessive bonuses too. They will make financial firms more stable, less profitable, and therefore more parsimonious with their own employees in order to leave more for shareholders.
But a revitalized regulatory sector won't be enough. We need more dissidents. We need to make the world a safer place for short-sellers to criticize companies. Regulators should publicly praise short-sellers, rather than periodically ban their activities. Critics and whistleblowers, no matter how self-motivated, should be regularly consulted about suspicious companies, not dismissed as cranks once they expose wrongdoing.
And then we need to bring back plaintiffs' lawyers. In the past decade and a half, Republicans not only weakened regulation but also led an attack on these lawyers. Corporate America hated them-and why not? They seem like parasites, ready to pounce on every corporate mistake. But they are vital to keeping capital markets functioning because they keep boardrooms scared. Frank Partnoy, a University of San Diego law professor and prescient critic of the fragile financial markets, says that "it's crucial that standards not stand alone and they be enforced with real teeth. We need public enforcement and private litigation."
The current catastrophe presents us with an opportunity. But the Obama administration and a Barney Frank-led congressional effort have to be aggressive and ambitious. Reforms can always be scaled back if they overshoot the mark. But the reform-minded cannot enter the debate in a defensive crouch. As new chief of staff Rahm Emanuel says, Don't let a crisis go to waste.VisitÃÂ Portfolio.comÃÂ for the latest business news and opinion, executive profiles and careers.ÃÂ Portfolio.com© 2007 Condé Nast Inc. All rights reserved.
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