Banking reform breeds false sense of security

As Barack Obama's administration turns its attention to financial-market regulation from health care, investors would do well to remember the last time the government gave us "the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt" as then-president George W. Bush said in 2002.

The Sarbanes-Oxley Act of 2002, passed after a series of accounting fraud scandals including Enron and WorldCom, was hailed as a great investor-protection achievement. It failed, though, to prevent accounting gimmicks that contributed to the largest bankruptcy in US history six years later: Lehman Brothers at $639 billion (Dh2.347 trillion) was more than triple the Enron and WorldCom collapses combined.

History suggests that regulators are fighting a losing battle. Regulations create incentives for people to circumvent the very rules being imposed while creating a false sense of security, its own special form of moral hazard. The public believes it must be safe if the government has sanctioned the product or activity.

Remember, the Securities and Exchange Commission provides an aura of validation for rating companies by allowing financial firms to use their endorsements for regulatory purposes. When Moody's and Standard & Poor's assigned AAA ratings to securities created from subprime mortgages, investors took it as the equivalent of an SEC seal of approval.

Moreover, the moral hazard created by the government-engineered takeover of Bear Stearns by JPMorgan Chase in March 2008 helped set the stage for the failure six months later of the $62.5 billion Reserve Primary money-market fund, which held Lehman debt.

Federal help

The SEC's suit against the fund's parent, Reserve Management, cites e-mail from its chief investment officer showing he "believed Lehman would, if necessary, be assisted by the federal government".

History also shows that Wall Street has been adept at getting around the rules and regulations imposed upon corporate behaviour and financial instruments, and there is little reason to believe it will be different this time.

For example, Bill Clinton's administration in 1993 tried to rein in executive pay by limiting to $1 million the tax deductibility of their cash compensation. Corporations simply offered stock options to skirt the restriction.

Enron hid debt and losses with off-balance sheet transactions. Lehman used them to hide assets to make it appear less leveraged, according to Anton Valukas, the examiner for Lehman's bankruptcy. Greece used currency swaps to hide some of its debt to gain entry to the European Union.

Missing it all

Some of Senate Banking Committee Chairman Christopher Dodd's remarks on his financial overhaul bill suggest lawmakers may not even grasp the essence of the crisis. "This legislation will bring transparency and accountability to exotic instruments like hedge funds and derivatives that have for far too long lurked in the shadows of our economy," Dodd said. The problem is that neither the instruments nor hedge funds were catalysts for the financial crisis; regulated banks and securities firms were. The crisis and subsequent recession killed off 2,300 hedge funds in 2008 and 2009, according to Chicago-based Hedge Fund Research. The only people who suffered were investors in these lightly regulated investment pools.

Besides, the major impulses to financial innovations have come from regulations and taxes, according to the late Merton Miller, winner of the 1990 Nobel Prize in economics. Government regulations are to blame for currency swaps in the first place.