Finance is a world filled with conflicting incentives and asymmetric information. What makes the financial system so opaque is the fact that it is driven by raw emotion. Investors make long-term bets; traders make very short-term bets in order to help investors make their bets; and bankers make things to bet on. In the end, everyone weighs their fear of risk against their expected reward to make their best possible bet. Finance is a group of gamblers who get frightened, get greedy, use backdoor connections, and are willing to cut throats to get ahead. You may be fighting the urge to ask: Why are we letting a bunch of scared, greedy people gamble away trillions of dollars’ worth of currencies, fixed income, and stocks?! So do we need to regulate them? No. Here’s why:
1) Financiers are smarter than regulators. Over the past few decades, Ivy League grads have dominated the financial system. Hardly anyone outside of an Ivy League institution is even considered for jobs at bulge bracket firms like Goldman Sachs, Citi, and Morgan Stanley. Sure, jobs like trading may be a meritocracy. But, it’s a meritocracy among an elite, preselected group. The highly intelligent are filtered through the mass of peons and harvested by the financial industry. After all, they offer the big bucks, so they can be very selective with their applicants. If an Ivy League degree isn’t selective enough, the accepted pool is filtered through competition. Analysts compete tooth and nail to get ahead. After two rounds of filtration, the best of the best of the best get to the top of the best banks. This implies something very crucial to policy-making: the best of the best of the best are not working for the government.
Government regulators are not smarter than bankers, who can get around just about any regulation policymakers construct. Look at the 1980s. The government bans insider trading in equities, so what do financiers do? They start insider trading with junk bonds – a totally legal maneuver at the time. It all began with Michael Milken at Drexel Burnham. This Wharton School grad managed to popularize junk bonds – an odd type of bond which behaves just like a stock but is not subjected to the same regulation. It didn’t take long for everyone else to catch up. Brilliant. Thought Basel II would solve problems? No, bankers found very creative ways (credit-default swaps and structured debt) to securitize and remove risk from their balance sheets, dodging the regulation. The most recent Volker Rule is just as ineffective. Did regulators really think banks would sit idly by as the government banned proprietary trading?
2) This regulation has simply made U.S. banks less competitive relative to foreign banks and increased banking costs. Just recently, Deutsche Bank announced that it is changing the legal status of its U.S. subsidiary from bank-holding, an action its U.S. competitors are legally unable to mimic. Switching status exempts Deutsche Bank from the Volcker Rule and some Dodd-Frank requirements. Sure U.S. banks can’t dodge regulation simply by changing status, but what’s stopping them from spinning off their proprietary trading desks? They will still keep the desks open, but at a higher cost since they will have to go through the trouble of raising additional cash to sustain these affiliates. Actually, regulators faced this same issue when Blanche Lincoln moved to bar FDIC insured banks from trading derivatives. So in the end, we are left with disadvantaged banks facing higher costs. Will banks find ways around these regulations? They’ve done it before, and they probably will again. The catch is that getting around this regulation is costly, not more costly than compliance, but still costly.
3) Regulators themselves end up contributing to the very financial opacity they despise. A crash occurs; the government blames it on Wall Street (whether or not it’s justified is irrelevant) and consequently pumps out regulation to stop banks from working with financial instruments the government does not understand. They often say that these instruments are too volatile and they plague balance sheets with excess risk. The regulation is passed and bankers simply find more complex instruments in order to get around these regulations. Another crash happens, more regulation is passed, and bankers create even more complex instruments. The cycle needs to stop. You can’t blame bankers for wanting to make money, but you can blame regulators for the consequences of their regulations.
4) Have we forgotten about the revolving door? Any thought of regulation should be ruled out immediately once we recognize the existence of a revolving door. In the Senate Finance Committee, there are 116 members who have been through the revolving door. In the House Financial Services Committee, there are 58. And guess who’s included in the list of 2011-2012 Top Political Contributors List? Goldman Sachs is reported to have donated over $3 million in total to both parties. JP Morgan Chase has donated just under $1.5 million. Bain Capital has donated $2.7 million. Morgan Stanley donated $1.2 million and Cititgroup has donated $1.1 million. Not only are financiers in regulating positions, but they are also among the largest financial contributors to both political parties. On the whole, they’ve done a pretty good job at steering regulation. Between 2000 and 2006, of the only 5% of the bills aimed at tightening financial regulation have passed. During the same period, 16% of bills aimed at loosening financial regulation have passed. (Data found here and here). Apparently, they weren’t so successful with Dodd-Frank. The underlying conflict of interest is evident. So how can we trust regulation coming from a system overrun by the people who are to be regulated? I don’t believe we can. The tightening regulation, as discussed previously, is bad for the industry (increasing costs and putting U.S. banks at a disadvantage), and the loosening regulation is riddled with conflicting interests.
As stated in the beginning, the financial industry is driven by emotions. Trust, fear, greed, pride, joy, and sadness make the markets go round. The government cannot regulate emotion. Nor can it regulate the highly driven bankers on Wall Street. The only thing regulation, like the Volker Rule, will do is put U.S. banks at a disadvantage, impose a higher cost on these banks, and give them incentive to develop even more complex instruments. Furthermore, the very system which develops this regulation is biased. How can we trust politicians to regulate bankers if they are bedfellows?