TCS Daily

The Proper Attitude Toward Financial Regulation

By Arnold Kling - August 10, 2005 12:00 AM

Editors note: this is the last in a series of essays on financial markets and the economy.


6. Financial Regulation


-- Matt Ridley, Genome, p. 263


Frequently, we open a newspaper to find an article reporting on researchers who have found a gene that increases one's susceptibility to a particular disease. Matt Ridley wants to remind us that genetic variation has a purpose. Often, a gene that increases susceptibility to one type of disease helps to reduce susceptibility to another. Genetic variation is a response to the diseases that exist in the environment.


Similarly, people need to keep in mind that every financial instrument has a purpose. To paraphrase Ridley, financial instruments are not there to cause risk. Financial instruments are a response to risk that exists in the economic environment. In terms of our Food Court metaphor, the projects to develop new recipes are inherently risky. Financial instruments can be used to redistribute these risks, so that the benefits of innovation can be enjoyed with the least adverse effect on personal risk postures.


By the same token, financial arrangements are not there to cause managers to take advantage of shareholders. On the contrary, the goal of private sector arrangements is to reduce this form of moral hazard.


Unfortunately, it seems to me that most financial regulation is predicated on "folk finance," the misguided intuitive beliefs that have been disproven by modern financial economics. Folk finance looks at risk as a property of individual transactions, securities, or institutions, rather than as something that arises in the underlying economy and is best dealt with in a portfolio context. Folk finance imagines that government regulators can do a better job than private contracts at aligning the incentives of managers with shareholders.


Often, the goal of financial regulation is to keep certain types of securities away from particular individuals or institutions. This is based on the "folk finance" view that risk resides in securities, as opposed to portfolios.


In a previous essay, I mentioned economist Robert Shiller's idea of creating a futures market in indexes of local home prices. That way, buyers of homes could hedge against the risk that they are buying into a bubble. However, most individuals would face stiff regulatory hurdles for setting up accounts to trade in such futures contracts. From the government's perspective, it is just fine for you to buy a really expensive house "on margin" (that is, using money borrowed in the mortgage market), but you would face strict scrutiny if you tried to scale back your risk by using a futures market!


Until very recently, banks and other financial institutions faced much tighter restrictions on the use of "derivatives" (options and futures contracts on Treasury securities, foreign currencies, etc.) to hedge risk than on having large unhedged exposures to interest rate movements. Even now, the use of derivatives is considered suspect, although bank regulators have gotten wiser about looking at overall portfolio risk exposure.


When an individual or institution is discouraged from using derivatives, the effect is to deter someone from hedging a risk. As a result, a regulation that supposedly is intended to reduce risk-taking can have the effect of forcing someone to retain exposure rather than spread the risk.


One tenet of "folk finance" is that the stock market is more risky than Social Security. This is probably false.


If the economy performs well, then neither the stock market nor Social Security should be at risk. In this case, by strong economic performance I mean steady productivity growth of 2 percent per year or more. Good productivity growth would be reflected in solid dividends and capital gains on stock portfolios. Higher productivity also would increase the revenue base for taxes, ensuring that the government can meet its Social Security obligations without crippling the economy with high tax rates.


If productivity growth is weak, then the stock market will not do well. By the same token, however, the tax base needed to pay future Social Security benefits will not be there. Social Security, which will require higher taxes in even the "standard" scenario projected by the actuaries, will be in dire trouble if growth falls short of the "standard" forecast.


Anyone under the age of 50 who is counting on Social Security is taking a "long" position in the U.S. economy, whether they are in the stock market or not. In addition, they are incurring demographic risk, which is the risk that the ratio of workers to retirees will continue to fall. Finally, they are taking political risk, in that they are counting on Congress to hold down spending on other programs so that future taxes are sufficient to cover Social Security benefits.


According to modern finance theory, the way for financial markets to improve risk allocation is to allow individuals to shed unnecessary risk and instead to choose between risk and expected return by varying their exposure to the market portfolio. The evolution of private financial markets serves this end. Social Security exposes consumers to the unnecessary risks of demographics and political uncertainty. Financial regulation often serves to constrain market participants from transferring away specific risks.


Regulating Moral Hazard


When the Enron scandal broke, politicians treated other corporations as if they were guilty of similar deceptions. The result was Sarbanes-Oxley, legislation which has caused much of corporate America to put productivity-enhancing investment on the back burner while instead trying to play CYA (Cover Your Assets) to meet Sox's standards.


In my opinion, one quantity that the accountants will never be able to estimate with accuracy is the cost of Sarbanes-Oxley itself. You cannot simply measure the number of staff-hours devoted to compliance. In my experience, senior management time is one of the most important scarce resources at a corporation. The only way for a significant cross-divisional initiative to be successful in a large organization is if top management pays close attention. Given their other responsibilities, executives will not have time for more than two or three major initiatives in any given year. Sarbanes-Oxley compliance probably took up one of these critical slots at most American corporations for at least one or two years after the law was enacted.


As the Enron example illustrates, moral hazard is a real problem. In general, managers will seek to extract large bonuses from good company performance while trying to insulate themselves from the down side when the company falters. There is no such thing as a perfect contract between shareholders and managers.


On balance, the relationship between pay and performance probably has gotten closer in the past thirty years. Note that I said "closer," not "close." My sense is that prior to the corporate takeover battles of the 1980's, corporate executives were under-invested in their own companies, and executive turnover rates were too low. The result was that many executives were in it for the perks, not for maximizing shareholder value. As bad as things are today, they were worse back then. My sense is that today corporate managements tend to be more focused and less lazy than they were in the 1970's.


I believe that the market can and will develop better executive contracting arrangements, by a process of trial and error. The job of government is to enable private individuals to enforce the contracts under which they choose to operate.


Politicians who claim to favor corporate reform are instead saying that they do not trust private contracts to be able to regulate moral hazard. They believe that the right contracts have to be imposed on the private sector by government.


Sarbanes-Oxley re-wrote the contract between shareholders and managers, in order to address the perception that there were dozens of other Enrons out there. In the event, it turned out that the harvest of earnings restatements was far below the bumper crop that was expected. In retrospect, it does not appear that Enron was sufficiently generic to justify rewriting the corporate contract. Moreover, it is hard to see government's rewrite as producing results that are better than what would have been achieved with free-market evolution.


Protecting Weak Investors


Another rationale for financial regulation is protecting weak investors. Investors may suffer from irrationality, ignorance, or lack of access to information.


Concerning this rationale for regulation, I am sympathetic to the principle but suspicious of the practice. That is, I believe that there are many investors who are unsophisticated, and there are plenty of financial industry participants who find a profitable market niche in selling to the gullible. However, not every regulation promulgated in the name of protecting the weak actually serves that purpose.


Fundamentally, I believe that there are two types of wrong committed by people selling and giving advice on financial products. A level-one offense is committed by people who know better. A level-two offense is committed by people who do not know better.


If I deliberately give you bad advice, then that is a level-one offense. For example, suppose that I know that as a client you would be better off investing in index funds than in high-turnover mutual funds or individual stocks. Then, if I do not advise you to invest in index funds, I am committing the crime of someone who knows better. Basically, if I advise you to do something that I would not do myself under similar circumstances, then I might be presumed guilty of this crime.


There are many brokers and financial advisers who genuinely believe that specific stocks and mutual funds make better investments than index funds. These brokers and financial advisers are almost certainly wrong, but they are guilty only of a level-two offense. They are over-estimating their own knowledge, but they are not deliberately trying to make their clients worse off.


I am not a lawyer, but it seems to me that we could simplify financial regulation by making level-one offenses a crime and trying to use disclosure to deal with level-two offenses. I would try to define the level-one offense generically, and in the process get rid of a lot of specific rules concerning licensing, conflict-of-interest, fraud, and so on. All of those issues could be subsumed under the category of a level-one offense. We should make it clear that anyone who knowingly advises a client to make poor choices can be sent to prison.


Level-two offenses are much more common and more difficult to address. However, they do not make me as angry.


To address level-two offenses, I would require disclosure. People selling or giving advice on financial products should be required to disclose their training and track records. The disclosure system would have to be designed in such a way as to not favor people who have a track record of lucky gambles. For now, things like risk-ratings and multi-year performance ratings of mutual funds are a reasonable approach for warning people off of short-term jackpot-winners.


I believe that if you send to prison those who deliberately deceive clients, then with disclosure the rest will sort themselves out. We may observe that both the supply and demand for bad investment advice are huge, but it is my hope that this phenomenon will ultimately correct itself. Certainly, financial regulation as it exists today can hardly be said to have solved the problem.




Private financial markets are not there to cause risk. There is no need for politicians to presume that their services are needed in order to control private-sector risk-taking.


Private financial contracts are not there to cause moral hazard. Private contracts evolve in an attempt, given the state of technology, to find the most efficient resolution of the conflict of interest between managers and shareholders. Legislative rewriting of such contracts does not advance the public interest.


It is legitimate to want to protect gullible investors. People who deliberately give advice in bad faith ought to face prison. People who give advice in good faith should have their backgrounds and track records disclosed. One may hope that disclosure will ultimately reduce the extent of bad advice given unknowingly.


The capital markets certainly fall short of the perfect system envisioned by Fischer Black, as described in previous essays. However, they are slowly evolving for the better, and this process could be enhanced with more circumspect regulation.


Arnold Kling is the author of Learning Economics.


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