BOSTON: The financial markets should be regulated mostly by examinations, not prosecution, which should be far more intense when prices rise, not after a crash. The Securities and Exchange Commission should devote most of its resources to on-going examinations.
The examinations first should focus on large institutions (financial or industrial), whose failure by fraud might affect investors' trust in prices and lead to a crash. Then they should target institutions whose share-prices have risen persistently signaling the "too good to be true" syndrome.
Most importantly, examinations should increase with a general and persistent rise in market prices. This is the time when fraud and violations of the law might accompany true and tested justifiable success. This is the time when "irrational exuberance," as former Federal Reserve Chairman Alan Greenspan once described market bubbles, is probably on the rise.
Continuous examinations are not new for the regulators and those being examined. They are likely to be less costly than court cases, especially against huge corporations using well-staffed law firms. Their focus should be on institutions whose failure may shake the system. Visits by regulators may produce a mild deterrent. Instead of harsh sentences and inflexible rules, examinations and suggested corrections can enhance and inculcate good habits to overcome temptations.
As a bonus, examining regulators would pick up on the latest financial innovations and developments in the markets. Had regulators understood the terms of the sub-prime mortgages, they might have been alerted to the amazing AAA rating that these mortgages received.
Examiners should learn about -- not regulate -- unregulated financial techniques, and acquire knowledge which they should share with colleagues. If regulators understand today's bubble mechanisms and identify attendant violations of the law, they can stem the trend toward empty prices before they rise and inevitably result in a painful crash.
And examinations need not mean publicity. Regulators, by law, should assure examined institutions of confidential treatment.
We have been doing just the opposite. Half of the SEC's resources are devoted to enforcement, including investigation of particular offenses. Its Office of Compliance is far smaller. In our current system, financial institutions are left virtually free of regulation during the rise of a bubble. With the inevitable crash, regulators are energized to investigate, prosecute, and come to the rescue failing institutions.
Right now there are proposals to tighten regulation in anticipation of problems, and proposals to reduce regulation and let the market solve problems. Neither is satisfactory. Addressing possible harmful activities before they actually occur may stifle innovations, harm the investors, and weaken the financial system.
Adopting a "wait and see" policy, and looking for a clear evidence to prosecute and plugging legal loopholes that were uncovered, may address problems that might not occur again soon. Such prosecutions and new regulations are acting "after the horse got out of the barn."
Like all things, the good features in the financial system can turn bad. Small bubbles offer increased liquidity, which is good. But at a break-point, bubbles can lead to devastating crashes. These are bad because markets cannot exist without trust in the prices and pricing mechanisms.
The transition from good to bad is impossible to determine. In 1996 Greenspan noted: "How do we know when irrational exuberance (bubbles) has unduly escalated asset values, which then become subject to unexpected and prolonged contractions (crashes)." Of course, we cannot. But we can examine, investigate and enforce the current law against violations, even in the good times.
Bubbles are accompanied by violations of existing law, perhaps at higher rate than in flat markets, and are likely to rise with the help of illegal "encouragement" advice and by "cooking the books." To be sure, bubbles and crashes will likely continue to occur with or without examinations. Yet, by moving from after-crash prosecution to frequent, on-going, long-term examinations, regulators' visits may minimize the devastating impact of crashes and the horrendous results and costs that the market solutions impose.
Problems may be resolved if we do nothing, or, as some people call it "markets solutions." But the cost may be so high as to undermine our entire system and our economy. It may take years to rebuild a healthy system. It would be better let the regulators watch rather than regulate.
Let regulators be the "police on the beat." Let them acquire a far better sense of trouble that may be brewing, acting only by enforcing existing laws. And let them exercise enforcement before, not after, the crash -- throughout the evolution and rise of bubbles. Perhaps then bubbles will burst early and make a "pop" rather than a nuclear explosion.
The examinations first should focus on large institutions (financial or industrial), whose failure by fraud might affect investors' trust in prices and lead to a crash. Then they should target institutions whose share-prices have risen persistently signaling the "too good to be true" syndrome.
Most importantly, examinations should increase with a general and persistent rise in market prices. This is the time when fraud and violations of the law might accompany true and tested justifiable success. This is the time when "irrational exuberance," as former Federal Reserve Chairman Alan Greenspan once described market bubbles, is probably on the rise.
Continuous examinations are not new for the regulators and those being examined. They are likely to be less costly than court cases, especially against huge corporations using well-staffed law firms. Their focus should be on institutions whose failure may shake the system. Visits by regulators may produce a mild deterrent. Instead of harsh sentences and inflexible rules, examinations and suggested corrections can enhance and inculcate good habits to overcome temptations.
As a bonus, examining regulators would pick up on the latest financial innovations and developments in the markets. Had regulators understood the terms of the sub-prime mortgages, they might have been alerted to the amazing AAA rating that these mortgages received.
Examiners should learn about -- not regulate -- unregulated financial techniques, and acquire knowledge which they should share with colleagues. If regulators understand today's bubble mechanisms and identify attendant violations of the law, they can stem the trend toward empty prices before they rise and inevitably result in a painful crash.
And examinations need not mean publicity. Regulators, by law, should assure examined institutions of confidential treatment.
We have been doing just the opposite. Half of the SEC's resources are devoted to enforcement, including investigation of particular offenses. Its Office of Compliance is far smaller. In our current system, financial institutions are left virtually free of regulation during the rise of a bubble. With the inevitable crash, regulators are energized to investigate, prosecute, and come to the rescue failing institutions.
Right now there are proposals to tighten regulation in anticipation of problems, and proposals to reduce regulation and let the market solve problems. Neither is satisfactory. Addressing possible harmful activities before they actually occur may stifle innovations, harm the investors, and weaken the financial system.
Adopting a "wait and see" policy, and looking for a clear evidence to prosecute and plugging legal loopholes that were uncovered, may address problems that might not occur again soon. Such prosecutions and new regulations are acting "after the horse got out of the barn."
Like all things, the good features in the financial system can turn bad. Small bubbles offer increased liquidity, which is good. But at a break-point, bubbles can lead to devastating crashes. These are bad because markets cannot exist without trust in the prices and pricing mechanisms.
The transition from good to bad is impossible to determine. In 1996 Greenspan noted: "How do we know when irrational exuberance (bubbles) has unduly escalated asset values, which then become subject to unexpected and prolonged contractions (crashes)." Of course, we cannot. But we can examine, investigate and enforce the current law against violations, even in the good times.
Bubbles are accompanied by violations of existing law, perhaps at higher rate than in flat markets, and are likely to rise with the help of illegal "encouragement" advice and by "cooking the books." To be sure, bubbles and crashes will likely continue to occur with or without examinations. Yet, by moving from after-crash prosecution to frequent, on-going, long-term examinations, regulators' visits may minimize the devastating impact of crashes and the horrendous results and costs that the market solutions impose.
Problems may be resolved if we do nothing, or, as some people call it "markets solutions." But the cost may be so high as to undermine our entire system and our economy. It may take years to rebuild a healthy system. It would be better let the regulators watch rather than regulate.
Let regulators be the "police on the beat." Let them acquire a far better sense of trouble that may be brewing, acting only by enforcing existing laws. And let them exercise enforcement before, not after, the crash -- throughout the evolution and rise of bubbles. Perhaps then bubbles will burst early and make a "pop" rather than a nuclear explosion.
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