After weeks of intense negotiation and commercial lobbying, there is a palpable sense of conclusion in Washington, D.C. The process of regulatory reform is nearing completion with the Senate having wrapped its work late last month. Next step is to fully “bake” regulatory reform proposals in a conference committee of House and Senate Members to hammer out differences in their respective versions. Regulatory reform has gone from being a possibility to a probability in a few short weeks. Never mind that it took two years to get there.
[IMGCAP(1)]The end result is shaping up to be decidedly underwhelming from an investor/taxpayer protection standpoint. After regulatory reform was labeled a “war on Wall Street” in some circles, you might have expected real fireworks, especially given the depth and aftermath of the once-in-a-century financial crisis. More importantly, the potential consequences of getting regulatory reform wrong and repeating our mistakes of the past 24 months are serious indeed. Unfortunately the “war” has proposed only limited reforms, and there are some measures that even roll back existing investor protections. Let’s examine the progress.
First off, we have the odd circumstance of the Financial Crisis Inquiry Commission continuing to examine what happened in the crisis. This is going on at the same time as corrective reforms are being enacted, raising questions about the sequencing. The important gaps in market and financial regulation, the adequacy of systemic risk oversight and reforms to the derivatives area are clearly identified. Yet we have failed to advance any truly meaningful regulatory or systemic changes. Even widely acknowledged defects of importance (such as fiduciary responsibilities of financial service providers) have been deferred for “study” rather than addressed head-on.
The House and Senate reconciliation is poised to deliver a model political solution to our financial problems. By design, most constituent voices are heard, but few other than moneyed commercial interests are ingrained. To hear it from them, regulatory reforms are anti-jobs, anti-competition and simply knee-jerk reactions to populist strains of “Main Street vs. Wall Street.” Guess who is listening? Any bold progressive reform has given way to incremental changes that might acknowledge perils, but fail to fill gaps or offer only marginally improved regulatory oversight of our financial system. The further we get from the depths of 2008, the further we have gotten from demonstrable reform.
Perhaps this is all that we should expect from the political process. As confounded as we are by “reforms” that explicitly weaken investor protections (such as the House provision to exempt small companies from having auditors weigh in on corporate risk controls as required by the Sarbanes-Oxley law), perhaps our list of investor priorities is too long and undeserved. Never mind the Troubled Asset Relief Program — we investors and taxpayers fail to appreciate the entire political landscape.
Unfortunately, the realities of misaligned incentives, regulatory gaps and systemic risks remain. There is simply no substitute for the authority of law and regulation to address some of these issues, both here at home and globally. Moreover, looking beyond the watering-down of reforms being experienced here in the U.S., we wonder what will happen to attempts to synchronize rules in all of the major global financial markets.
We know from our experience of the past years that unbridled market forces exist and they expand to exploit any weakness or gaps in existing rules. It works pretty well when the actual losers in that game suffer the negative consequences rather than permitting all losses to be converted to public liabilities. We must admit, as an industry there is little room for weak and incremental change here, if we are serious about avoiding a repeat. What else can be done?
First, it is time for us all to be far more discerning consumers, identifying the practices of capital markets participants that are contrary to our interests individually and collectively. We should reward the firms that affirm our interests with our business. The bottom line of investment performance is necessary but no longer the sole consideration: Consideration of risks must also compel our buying decisions, as depositors, investors and traders. Secondly, for our financial industry firms, this means transforming ethics and ethical conduct from high-minded slogans to financial processes and products that reflect client interests.
In the end, regulation serves as an important boundary to accepted practices in our capital markets, and getting the boundary markers correct is critical. Most importantly, as markets change, these boundaries must also change and keep pace. For our industry, there will always be incentives to work at the edges of the regulatory framework. We are masters at seizing competitive advantages by pushing hard against the boundaries. Unfortunately, it is the dominant approach at too many firms in this industry. Just as the conference committee will hopefully keep some of these issues in mind as it wraps up its work, our industry is well advised to work with the same creativity and intensity on re-engineering our ethical core. The war that really does exist is the one on our own credibility.
Kurt Schacht is managing director of Standards and Financial Market Integrity division at the CFA Institute, a global nonprofit organization for investment professionals. Bob Dannhauser is director of advocacy outreach for the CFA Institute.