Running Around with Their Hair on Fire - Why Regulators Have Got it So Wrong So Far
September 8, 2009

Whatever happened to the principle of caveat emptor? In the rush to react to systemic failures that came to light after Lehman and Madoff, the regulatory establishment is encouraging the view that investors need to be protected from their own reckless behaviour. Earlier this year, for example, a French court ordered Société Générale, as depositary bank, to compensate a French asset management firm that had lost money through its prime brokerage relationship with Lehman Brothers. The message seemed very clear: even if the depositary bank is entirely blameless, it will end up footing the bill for its clients' poor decisions. The judgement brings to mind Willie Sutton's famous response when asked why he robbed banks: "Because that's where the money is."

Regulators are struggling to understand their role in the new world order. It is hardly surprising that they are confused: a clear dividing line between regulation and politics no longer exists, so that politicians interfere in the regulatory process (Lord Myners springs to mind) whilst regulators increasingly look and sound like politicians (Ben Bernanke holding a televised ‘town hall' meeting in Kansas City). The result is that political necessities now supersede prudent supervision: the entirely unnecessary, ineffective and counterproductive bans on short-selling are one obvious example.

Nowhere is this state of confusion more obvious than in the regulatory reaction to hedge funds. In 2007, many regulators – including the Fed, the U.S. Treasury, the UK's FSA and the European Commission – agreed that further hedge fund regulation was unnecessary. Charlie McCreevy, Europe's Internal Market Commissioner, said in February 2007: "In Europe, we are continually reviewing the situation. We have a well-developed set of checks and balances in place to address the possible impacts of hedge fund/private equity businesses on the overall financial system. I don't see any case for complementing them by a set of EU legislation specific to hedge funds."

How times have changed. Despite the absence of any evidence that hedge funds were the cause of the credit crisis, the European Commission seems determined to punish them through an ill-considered and probably unworkable set of measures that will almost certainly result in a flight of capital and jobs to friendlier locations. Once again, the political imperative has taken precedence: hedge funds are a soft target and getting tough with them plays well with voters.

Being second-guessed by politicians is not the only challenge for regulators. For a start, they do not appear to understand the difference between systemic and market risk. Regulators seem to think that, post-Lehman, all risk is bad and must be managed or, better still, eliminated. By meddling with market risk – which is, after all, where the real money is made – regulators threaten to distort global capital markets. That is not their role. Once the regulator is satisfied that the market has established good risk management and mitigation procedures that will work in the event of counterparty default or other market-related failures, it should step back. The market is the first, and often best, defence against systemic meltdown. Regulators need to learn to trust it.

Additionally, national regulatory organisations are not only working in a vacuum, but are frequently undermining each other. When Treasury Secretary Geithner recently called in all the senior financial market regulators in the US to tell them off for their lack of co-operation and the use of blocking and stalling tactics, it was an indication of how distant the prospect of global co-ordination has become. When the US cannot line up its own regulators, what chance is there for a cross-border deal that will stop investment firms from playing regulatory arbitrage? Hong Kong, Dubai and Macao might be the new centres of alternative investment if the regulators continue to concentrate on turf wars rather than problem-solving.

Ultimately, politicians and regulators need to make a decision about their attitude to the realities of global capital markets. The dynamics are simple: some people lose money, whilst others gain. That happens every day, and it doesn't mean there is anything intrinsically wrong with the model. That message needs to be made much more forcefully to both regulators and politicians, none of whom appear to be very good at listening. They would do well to remember the warning of Walter Wriston, the former head of Citicorp. "Capital will go where it is wanted, and it will stay where it is well treated," he said. Poor regulation will inevitably lead to a flight of capital, and talent, to centres where it receives better treatment.





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Whatever happened to the principle of caveat emptor? In the rush to react to systemic failures that came to light after Lehman and Madoff, the regulatory establishment is encouraging the view that investors need to be protected from their own reckless behaviour. Earlier this year, for example, a French court ordered Société Générale, as depositary bank, to compensate a French asset management firm that had lost money through its prime brokerage relationship with Lehman Brothers. The message seemed very clear: even if the depositary bank is entirely blameless, it will end up footing the bill for its clients' poor decisions. The judgement brings to mind Willie Sutton's famous response when asked why he robbed banks: "Because that's where the money is."

Regulators are struggling to understand their role in the new world order. It is hardly surprising that they are confused: a clear dividing line between regulation and politics no longer exists, so that politicians interfere in the regulatory process (Lord Myners springs to mind) whilst regulators increasingly look and sound like politicians (Ben Bernanke holding a televised ‘town hall' meeting in Kansas City). The result is that political necessities now supersede prudent supervision: the entirely unnecessary, ineffective and counterproductive bans on short-selling are one obvious example.

Nowhere is this state of confusion more obvious than in the regulatory reaction to hedge funds. In 2007, many regulators – including the Fed, the U.S. Treasury, the UK's FSA and the European Commission – agreed that further hedge fund regulation was unnecessary. Charlie McCreevy, Europe's Internal Market Commissioner, said in February 2007: "In Europe, we are continually reviewing the situation. We have a well-developed set of checks and balances in place to address the possible impacts of hedge fund/private equity businesses on the overall financial system. I don't see any case for complementing them by a set of EU legislation specific to hedge funds."

How times have changed. Despite the absence of any evidence that hedge funds were the cause of the credit crisis, the European Commission seems determined to punish them through an ill-considered and probably unworkable set of measures that will almost certainly result in a flight of capital and jobs to friendlier locations. Once again, the political imperative has taken precedence: hedge funds are a soft target and getting tough with them plays well with voters.

Being second-guessed by politicians is not the only challenge for regulators. For a start, they do not appear to understand the difference between systemic and market risk. Regulators seem to think that, post-Lehman, all risk is bad and must be managed or, better still, eliminated. By meddling with market risk – which is, after all, where the real money is made – regulators threaten to distort global capital markets. That is not their role. Once the regulator is satisfied that the market has established good risk management and mitigation procedures that will work in the event of counterparty default or other market-related failures, it should step back. The market is the first, and often best, defence against systemic meltdown. Regulators need to learn to trust it.

Additionally, national regulatory organisations are not only working in a vacuum, but are frequently undermining each other. When Treasury Secretary Geithner recently called in all the senior financial market regulators in the US to tell them off for their lack of co-operation and the use of blocking and stalling tactics, it was an indication of how distant the prospect of global co-ordination has become. When the US cannot line up its own regulators, what chance is there for a cross-border deal that will stop investment firms from playing regulatory arbitrage? Hong Kong, Dubai and Macao might be the new centres of alternative investment if the regulators continue to concentrate on turf wars rather than problem-solving.

Ultimately, politicians and regulators need to make a decision about their attitude to the realities of global capital markets. The dynamics are simple: some people lose money, whilst others gain. That happens every day, and it doesn't mean there is anything intrinsically wrong with the model. That message needs to be made much more forcefully to both regulators and politicians, none of whom appear to be very good at listening. They would do well to remember the warning of Walter Wriston, the former head of Citicorp. "Capital will go where it is wanted, and it will stay where it is well treated," he said. Poor regulation will inevitably lead to a flight of capital, and talent, to centres where it receives better treatment.