Bumper Crop

Re-Regulation
By Miriam Hill

It’s a huge, unenviable task: Overhaul financial regulations so that investors and the economy don’t fall into a black hole again. But don’t institute such tight restraints that they straightjacket growth. And while you’re at it, make sure the system catches the next Bernard Madoff before he runs away with $50 billion.

The economic crisis has given President Obama a rare opportunity to build a new regulatory system that can quickly gauge the systemic risk that left investors afraid to open their 401(k) statements, according to Penn law professors and a graduate who is now a prominent regulatory lawyer.

Alan Beller, L’76“I would tell them to do something, but I would tell them not to rush into it,” said Alan Beller, L’76, a former director of the Corporation Finance division at the Securities and Exchange Commission and now a lawyer at Cleary Gottlieb. “You only have this opportunity at most once in a generation.”

Crises create the political will needed to tear down old systems and build new ones, Cary Coglianese, Penn Law professor and director of the Penn Program on Regulationsaid Cary Coglianese, a Penn Law professor, associate dean, and director of the Penn Program on Regulation. “When someone gets a heart attack and goes into the emergency room, and the doctor says it’s time to lose that excess weight, that motivates people,” Coglianese said. The push for less regulation that began under President Ronald Reagan no longer holds sway, he said. “I think the era of free-market ascendancy is coming to a close. At least in the near future, arguments about the virtues of completely unfettered markets are politically dead in the water.”

But what should this new system look like?

Penn Law Professor Jill Fisch is an expert on securities regulation.Penn Law Professor Jill Fisch, an expert on securities regulation, said the new administration should examine the current crisis before proposing solutions. “The first order of business for the Obama administration is to understand the problem a lot better,” said the co-director of the Institute for Law and Economics. Financial experts still must figure out how Bear Stearns collapsed so quickly or how Madoff perpetuated his scam for so long, despite repeated questions about his methods. She believes regulators will need to stay in closer contact with industry and have access to more frequent updates on the state of the financial markets to head off such problems.

“You’ve really got to think about a different process for keeping the regulators in touch,” Fisch said. “They don’t recognize the speed at which the market changes, and so they’re always reacting after the fact.” She thinks agencies such as the Securities and Exchange Commission should hire more people with industry experience so that regulators have first-hand knowledge of complex products and markets.

Charles Mooney, an associate dean and professor at Penn Law, agreed that regulators need more relevant information. He said data about the financial condition of institutions is frequently outdated and not very useful. He wants to see something closer to the kind of information doctors get when they monitor patients in intensive care units.

Fisch thinks data on a host of topics could illuminate policy. Some examples: What kinds of losses did mutual funds experience during the stock-market collapse? What kinds of pressure did they feel to sell stocks to meet redemption demands? How big is the hedge fund industry? How have retirees fared in this bear market, and what does that suggest about the need for investor protection going forward?

The new regulatory system will have to keep close tabs not only on individual institutions but on the system as a whole. Failure to understand the connections between financial companies contributed to the rapid unraveling of markets last fall. Some instruments, such as credit default swaps, were so complicated that investors didn’t always know all the parties to a transaction.

As a result, former Federal Reserve Chairman and Obama adviser Paul Volcker and others have suggested creating a “super regulator,” an agency responsible for the health of the entire financial system. A super regulator, which the Obama administration could base at the Federal Reserve or in an entirely new agency, would weigh risk in the financial system.

Beller said this super regulator might simply oversee all banks deemed “too big to fail.” Some experts have said the federal government should have let some big institutions fail in order to discourage excessive risk-taking, but Beller said the idea that the government needs to intervene to prevent systemwide collapse is prevailing. “The idea that we’ll allow failures and just suffer the consequences and the system will not be significantly disrupted is not a realistic way of proceeding,” he said.

High on the agenda are new regulations that will dictate restrictions on some activities at big banks. Mooney said regulators must keep a better eye on liquidity at individual institutions and in the overall system. Liquidity refers to the ability to buy or sell an asset and convert it to cash without significantly reducing its price. “The whole market depended on liquidity and when there was no liquidity, the market stopped,” Mooney said.

Maintaining liquidity will require banks to hold on to much higher amounts of capital to cushion against losses and provide assurance to investors, Mooney said. Higher capital requirements will increase the cost of doing business and dampen profits, so expect vigorous debate on the new rules.

Hedge funds also are the target of proposals for new regulations. These unregulated investment vehicles threatened the stability of the financial markets, because no one other than the manager has the right to information about them. Michael Wachter, an expert on corporate law at Penn, said hedge funds likely will have to periodically disclose their investments so that regulators and investors can understand the size and type of their positions. But Wachter said new regulations should stop short of forbidding what hedge funds can invest in. Such restrictions inhibit entrepreneurialism and rarely work, he said. Hedge fund managers for years have howled that such disclosure will make it too easy for others to copy them and destroy their profits, but Wachter and others said those arguments have lost weight in this meltdown.

Credit rating agencies have been faulted for failing to review with rigor the quality of bundled home loans. Mooney said they may encounter new rules. Fisch added that the Obama team may revise the role of self-regulatory bodies such as the Financial Industry Regulatory Authority, or FINRA, which oversees investment firms. At a minimum, she said, investors should be able to find details of cases filed against brokers and financial advisers. Currently, those cases are arbitrated, and few details are available to the public.

Derivative products, such as credit default swaps, also are likely to be regulated in the new system, Beller said, because their willy-nilly growth led to huge losses at many companies. Wachter said one solution being considered is a rule saying that companies can only buy derivativetype insurance on products they own. Derivatives are financial products whose value is based on an underlying security. A credit default swap, for example, is a bet that a creditor will or will not pay off a debt. In the last few years, investment firms bought such swaps despite knowing little about the underlying credits or about the financial health of the companies that were, in effect, providing insurance on those credits. In theory, requiring investors in derivatives to own the underlying products would make those markets function more like insurance markets and less like the casinos they had become.

Disgraced Wall Street financier Bernard Madoff arrives at U.S. federal court in New York on March 12, 2009 to plead guilty to all 11 counts of fraud. Madoff could face a prison term of up to 150 years at a sentencing later this year, according to prosecutors. Prosecutors have said they are also seeking to recover the $177 billion that Madoff is alleged to have stolen.Of course, this market has revealed that even investments touted as simple and safe weren’t what they appeared. The downturn has exposed allegations of widespread frauds by Bernard Madoff, the Stanford Group and others, raising the question of whether new regulations could protect investors from such losses. Wachter and others said disclosure requirements could help, because money managers such as Madoff could no longer hide behind a veil of secrecy.

“It was sort of a ‘trust me’ phenomenon,” Wachter said.

He expects the Obama administration will end up experimenting with various reforms before hitting on the ones that work, much as President Roosevelt did as he struggled with overhauling the failed financial system of the 1920s.

“I don’t think we can expect regulators to be omniscient,” Wachter said. “We would like to think they could, but it’s like thinking there is a big mommy or daddy out there who will save us.”

Miriam Hill is a staff writer at The Philadelphia Inquirer.