June 26, 2010

Overhauling The Financial Services Industry – Really?

We're almost there... US House and Senate lawmakers agreed on the terms of the biggest overhaul of US financial regulation since the 1930s. The Wall Street Journal reported on the major provisions of the proposed bill on Friday.  How the new regulations will play out in practice is anyone's guess at the moment.  It is also questionable whether more regulation and bigger regulators will do a better job at preventing fraud, bubbles & busts and whether the consumer will actually be better off after all new rules are set in place.

There are many reasons to have a healthy dose of skepticism when it comes to regulators and regulatory reform.  And being skeptical about regulators is not unique to the US.  Other countries have raised equally strong calls for financial services reforms.  Just last week, the new Chancellor of the Exchequer, George Osborne, abolished the Financial Services Authority (the UK's main financial services regulator) and gave more regulatory powers to the Bank of England. 

Yet, it was just in1997 when the FSA was created by Gordon Brown, which was supposed to be the regulator par excellence then as well.  Prior to that, it was the financial services "Big Bang of 1986" which led to the creation of the Securities and Futures Authority (SFA) promising equally strong and consumer oriented regulatory reform.  Having personally dealt with regulators right before and after the creation of the FSA, I can tell you that more often than not, regulatory reform simply meant different tick boxes, slightly different terminology and just a lot more paperwork.  In typical British demeanor, some of my colleagues then said:  All they did was shuffle around the letters from SFA to FSA; everything else was business as usual except for the #$&% load of additional paper work...

Historically, regulators have always been running behind the curve.  To make the case in point with a simple example, let's look at the FDIC, the Federal Deposit Insurance Corporation.  As part of the financial service overhaul bill, the FDIC deposit insurance would be permanently increased to $250,000, retroactive to January 1, 2008 – BRAVO!

Created in 1933 as part of the Glass-Steagall Act, the FDIC guarantees deposits in checking and savings accounts of its member banks.  The initial insurance coverage was $2,500 in 1934 but that amount was subsequently raised numerous times throughout the decades. Using inflation as a gauge, we examined how the deposit insurance has kept up with the general rise in prices over the years.  As the chart below shows, the first few decades generally kept pace with inflation.


However, there were periods starting in the mid 70’s and from thereon for almost 3 decades until 2008 when the official FDIC coverage was nowhere near in line with inflation. The most recent adjustment of the deposit insurance to $250,000 did nothing to give more credibility towards banks, it simply brought things on level terms with the perception of the required safety amount in 1980.  In essence, the financial regulator has been running a couple of decades behind the curve.  Unrealistically low coverage does not exactly spur consumer confidence in banks and two additional questions come to mind...

  • Could the severity of the recent financial crisis have been reduced if coverage limits had been adjusted earlier?
  • What if the recent financial crisis was not as severe - would the FDIC still get away with the laughable $100,000 coverage limit?

Going back to the main point of this article, more regulation in itself does nothing to improve investor confidence nor would it protect consumers any better. It doesn’t even do the environment any good - think about all the trees that could be saved with less paper work (yes some regulators still require those paper filings).  As I pointed out on a number of occasions, most recently in a general criticism towards a new Super Regulator:

I believe the concept of regulation has to be smart, efficient and it must focus on some key components i.e. protecting the general public and investment community from too much risk and from fraud.  To improve the efficiency of financial regulation, another fundamental change has to take place. Instead of recruiting accountants and lawyers, both of whom are often clueless about the financial instruments they’re supposed to oversee (they only need to understand trading and risk from reading a book), regulators should find ways to attract real talent, real brokers, traders and market practitioners who can feel and smell when something isn’t kosher.

Until that happens, I’m afraid it will be business as usual - just another acronym for yet another government agency and definitely more paperwork...

Good luck and good investing! 

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