In the last 14 years we have seen several financial scandals in the United States. Each case essentially stands on its own without a line to connect the dots to other events. However, mistakes are repeated often when you look at these types of scandals.
But are U.S. regulators putting the systems and tools in place to bring an end to these scnadals, or are the new rules simply tactical patchwork?
The Enron scandal decimated $60 billion of market value and after two or three years with little path breaking innovation, U.S. economic world dominance declines. There is a dearth of economic growth drivers and the the Iraq war doesn't even spur the economy. The world's biggest economy changes to buying and selling property and a massive financial system is built around it to transact securitized mortgages and other creative financial instruments. As we all know, the huge debt bubble burst, crippling the economy, hurting common citizens and all but freezing the financial markets for period of time.
Following the 2008 crisis, to quell the impending disaster in the global financial system, governments printed more money, took equity in banks, loaned money for bad or illiquid collateral to prevent the overall system from freezing. many of these decisions led to sovereign debt crisis in Europe, as certain European countries are now considered risky investments. In aftermath the crisis, Dodd-Frank -- a dramatic collection of regulatory changes -- is passed.
So, what can be inferred from the above issues?
Credibility: Organization credibility can't be judged based on articles in the media (Enron won many awards like 'most innovative company' but teetered on the brink for a while without questions being raised).
Risky Business: Bad behavior is easily forgotten or overlooked over time (e.g. Enron had a history of dubious transactions).
Easy Grades: Rating agencies and analyst reports on corporates, economy, etc. can be as wrong as any layman investor analysis.
Gambler's Heaven: Excess speculative profit making either in Wall Street or outside (people buying and selling houses) needs regulation and smarter taxation which would deter this behavior.
Self Regulation? Unregulated markets and unstable big banks pose a big danger to the larger economy.
Balancing Act: It's a hard balancing act for regulators to sound rationale to speculators (needed in any market to provide liquidity) and investors
Crash Cycles: Over spending is a malaise whether its private or public and needs monitoring. Market crashes and recessions are cyclic. As the world economy gets integrated it's getting harder to understand and control the local economy. It's quite evident that effective regulation is a sine-qua-non in the financial industry.
Some key regulations include:
Break Up The Banks: Banks and Investment Banks need to be separated. In banks when loans are the only liability federally insuring public deposits is costly at times. When liabilities include derivative trades it becomes a nightmare.
Transparency: All trading institutions need full disclosure and regulation. We can't have Investment Banks being regulated and hedge funds escaping it. Hedge funds have typically claimed secrecy and confidentially. In other industries, secrets enter the public domain through IP, copyrights, etc. Why is finance less keen to take this route? Consistent regulation is required to prevent one type of trading companies to get higher returns with less responsibility or cost.
Risk: Reputational risk hasn't impacted finance companies. So punitive measures need to be thought differently. Fines have to be a factor of the annual profits of the banks to make it a deterrent.
Tax Implications: Income, irrespective of the source (like capital gains) should incur standard income-tax rates. Dividend and long term capital gains shouldn't be different from other income tax despite many arguments against it. This will bring in more discipline into this system and make it similar to other sectors. Currently the view of finance is "shortcut to make lot of money".
Leaders Wanted: Countries like US, UK, Germany should lead efforts in defining market discipline guidelines globally. Violating countries should incur sanctions similar to a country breaking the NPT (Nuclear non-proliferation treaty). Not having this will only transfer bad practices elsewhere.
Accountability: Rating agencies should be more accountable to their reports and data and should be exposed to more public scrutiny. Any breaches should be severely penalized.
We need to understand that regulation and socially useful financial innovation are mutually exclusive. In the recent past though government regulation seems to be catching up fast in many areas stated above, it shouldn't get shrouded in complexity or get diluted because of implementation challenges or lobbying by vested interests. The financial markets weave through the lives of common people in several ways. More governance and brute force rationality in market rules will it make it a "richer" experience for all.
About The Author: Senthil Radhakrishnan has 16 years of experience in Investment Banking IT, including experience covering various instruments such as Equities, Listed Derivatives and Rates in Middle/Back-office and in Enterprise Risk. He is currently VP for Capital Market Solutions Practice at Virtusa Consulting Private Ltd.