Pell Center

The Pell Center for International Relations and Public Policy at Salve Regina is a multidisciplinary research center focused at the intersection of politics, policies and ideas.

Government Regulation of the Financial Industry. A Struggle to Create Effective Reform.

The general sentiment in the country is that the financial crisis of 2008 signaled a need for more regulation in business, particularly in the finance industry. No one questions that we need reform, but it must be effective reform with accountability.  The questions are what type of government regulation will actually keep consumers and investors safe, without creating a huge productivity drain on the economy, and who will be accountable to make sure that it is effective.

We already spend billions of taxpayer dollars on financial regulation. In fact, that number has increased from $725 million in 1980 to $2.07 billion in 2007 (in 2000 dollars, and prior to the 2008 financial crisis).  In addition, there are billions more in aggregate compliance costs across financial institutions. The cost of compliance is so extensive, it is actually a competitive advantage if an organization can comply in a cost effective way.  Particularly in this economic climate, we need to ensure that taxpayer money is spent in a way that produces real results, namely measurable reduction in risk.

The government, usually reacting to a crisis in consumer confidence, has put forth several pieces of legislation to monitor and control financial institutions. We will look at some attempts below.

In response to the Great Depression, the government introduced the Banking Act of 1933. The entire law is often referred to as the Glass–Steagall Act. The Glass–Steagall Act limited commercial bank securities activities and affiliations between commercial banks and securities firms.  It essentially meant that banks and securities firms could only offer certain financial instruments, and therefore, the banking and securities businesses would be separate.  In the 1990s, financial institutions lobbied hard to appeal Glass–Steagall. They were successful in influencing public opinion to the point that commentators were arguing that Glass-Steagall was unnecessary, and even harmful to financial institutions.  In 1999, the affiliation restrictions in the Glass–Steagall Act were repealed through the Gramm-Leach-Bliley Act of 1999 (GLBA), and signed by President Clinton.

In a piece written for Forbes, Mr. Watkins and Dr. Brook talk about government intervention. They state that “Regulatory evangelists including Nobel Prize economist Joseph Stiglitz and recent senatorial candidate Elizabeth Warren, not to mention the Occupy Wall Street protesters, have named the overthrow of Glass-Steagall as public enemy number one.” Recently, President Obama stated that “there is not evidence that having Glass-Steagall in place would somehow change the dynamic.” But maybe, the evidence could be that there was no financial meltdown while it was in place.  Less than 10 years after GLBA, there was such commingling of financial instruments, no one could identify toxic assets or even estimate the magnitude of the problem.

In 2002, Sarbanes-Oxley (SOX) was enacted in response to the high-profile Enron and WorldCom financial scandals. The act is administered by the Securities and Exchange Commission (SEC). The intent was to protect shareholders and the general public from accounting errors and fraudulent practices. Section 802(a) made it meaningful. For the first time, there would be signoff at all levels of financial organizations, big and small, and real consequences for the heads of those institutions: “Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies… shall be fined under this title, imprisoned not more than 20 years, or both.”

Hank Paulson, Secretary of the Treasury from 2006 to 2009, released a “Blueprint for a Modernized Financial Regulatory Structure,” in March 2008, prior to the financial crisis. Paulson cited the need to overhaul the financial regulatory system.  He had extensive financial risk management experience; he had run Goldman Sachs for almost 20 years.  “We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to more effectively deal with inevitable market disruptions and one that will better protect investors and consumers,” said Secretary Paulson in remarks at the Treasury Department. The proposals called for the creation of several new regulatory agencies and to expand the Federal Reserve’s responsibilities. It would streamline the regulatory plan for depository institutions, securities firms, hedge funds, mortgage originators, and the insurance industry. It would introduce major changes that would take years to establish, but it is still unclear that this proposal would prevent another collapse. Measurable success criteria with accountability needs to be a part of any meaningful reform, because “if you can’t measure it, you can’t manage it”.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 into law.  It is a comprehensive reform of the U.S. financial regulatory framework that reaches far beyond Wall Street. Dodd-Frank set out to keep a check on the banks and prevent another “too big to fail” situation. The law created a new Federal Insurance Office (FIO) that would detect insurance companies that created too much risk. It also would introduce the Office of Credit Rating to regulate credit ratings agencies such as Moody’s and Standard & Poor’s.  However, it does not address major contributors to the 2008 crisis. It does nothing to fix Fannie Mae and Freddie Mac, and or end their taxpayer-funded bailouts. The cost of Dodd-Frank is staggering. It is estimated that businesses will have to spend more than 24 million hours each year to comply with the red tape from the first 224 rules. How will we know if it is effective, and if it isn’t, who will be accountable for 24 million additional hours of lost productivity?

It is critical that the public have faith in the regulators. Time Magazine reported on Sept. 3, 2009, that “The SEC internal-investigation report … points a clear finger of blame at the agency, stating that SEC investigators missed multiple opportunities to discover Bernard Madoff’s criminal activities.” Even worse, the OIG report states that “the SEC’s futile investigations of Madoff were ultimately used by Madoff as a means of reassuring clients that his operations were clean, and these had the effect of encouraging additional individuals and entities to invest with him.”

Yet, this past Wednesday April 10th, the 2nd District Court found that the SEC could not be sued for negligence by victims of the Madoff pozi scheme. “The SEC’s “regrettable inaction” was protected by a law that shields federal agencies from any liability in use of discretionary powers. The eight plaintiffs lost $50 million in the Madoff ponzi scheme. Their attorney, Howard Kleinehendler said that “He found it unconscionable that taxpayers pay money for the upkeep of an agency, but can’t hold it accountable for blatant negligence.”

Suing the regulators may not be the answer, but in the same way that SOX created accountability in the financial enterprise, we need to know that there is accountability in the taxpayer-funded financial regulatory system to ensure that it is effective.


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