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Regulation is useful, but don't rely on it

16 Jun 2010 by Jim Fickett.

Government regulation in the US is better than in most nations, and does accomplish a great deal of good. However it will not prevent crises. Everyone's investment strategy should, in fact, take further crises as given.

One reader asked for clarification of my position with regard to regulation. I do support strong regulation and, in fact, would like to see more of it. Much of the day-to-day regulation that occurs is competent and valuable – while companies' quarterly reports to the SEC are not perfect, to take one example, they are nevertheless probably the best in the world.

The main point of my earlier post on this topic was this: when regulators and politicians promise that we will “never again” have a crisis like the last one, they can be safely ignored. The feedback loops in Congress, in the regulatory agencies, and in the markets overwhelmingly support booms and busts, and always will. Do not trust that regulation will prevent further crises and, in fact, fully integrate expectation of further crises in your investment strategy.

I am by no means alone in this sentiment. In May the Financial Times wrote:

Let’s be clear. When the Senate and House versions of the US finance bill are finally mashed together, the probability of another crisis will not fall one jot from where it will always be: 100 per cent. …

The bill is littered with new authorities, agencies and councils. But the truth is that the global financial system was already scrutinised by hundreds of governments, regulators and central banks, not to mention private rating agencies, consultancies and analysts. None of them spotted trouble last time – neither will this new lot next time.

And today Bloomberg reported on on the opinions of two former regulators:

Legislation being refined by a House-Senate conference after passage by both chambers relies too heavily on regulators such as the Federal Reserve that previously failed, said Richard Breeden, who led the SEC from 1989 to 1993. Congress failed to address emerging threats, such as abuses in the municipal-bond market, that might trigger the next meltdown, said Arthur Levitt, who was SEC chairman from 1993 to 2001.

“There was massively too much leverage within the financial system,” Breeden said at a Bloomberg Link Boards & Risk Conference in Washington yesterday. “Regulators had the authority to control that and eliminate it. We can keep passing laws, but if the regulators don’t have the backbone to enforce the rules and to be realistic, then that’s a different problem.” …

“I certainly don’t think it would prevent the turmoil coming up, and I doubt very much it would have had much impact on the turmoil we have just experienced,” Levitt said at the Bloomberg conference.

The question to ask is not whether there will be another crisis, but when and where. My best guess is in a few years, in the US municipal and federal bond markets. Watch the euro zone experience carefully to learn more about how things might eventually play out here.