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The Regulatory Bug

By: Briar Foster
September 2010

In the past two years, the fastest growing industry globally has been regulation. It started with the U.S. financial sector, which had been ineptly regulated as well as under-regulated. Insurance giant AIG should never have been permitted to issue more than $500 billion of credit default contracts. The credit rating agencies never should have been allowed to give triple A ratings to packages containing sub-prime (toxic) mortgages. Bernie Madoff's multi-billion dollar portfolio of fictitious assets should have been verified by asking for corroborating statements from the agencies which were supposedly holding these assets.

In response to these and hundreds of other failures to protect the public interest, U.S. lawmakers created more than 1,000 pages of new financial regulations. It will take time for the financial service companies to figure out how these new rules affect them. It will take even more time to recruit and train the thousands of additional regulators required by the act. It will take decades for the courts to assess the full meaning and legal implications of the regulations as written.

Set Rules

Recently, the Securities and Exchange Commission announced it was going to set rules for the rating agencies that give triple A ratings to undeserving assets. Were there no rules in place before?

The Regulatory BugFinancial regulation was a lead topic at the June G-8 and G-20 meetings in Toronto, ON. Weeks earlier, Federal Finance Minister Jim Flaherty announced intentions to create a national securities regulator to replace the 13 separate regulatory bodies. The idea has been relentlessly pushed by members of the investment industry for at least 50 years. Flaherty's announcement met with strong opposition, especially from Quebec and Alberta, both provinces having expressed the importance of their physical proximity to local industries. It is also true that financial industry supervision is a solid money-maker for provincial governments with an active investment community.

In Great Britain, the Bank of England has taken over regulation of the banks from a quasi self-regulatory body (SRO). The EU has made efforts to impose more stringent capital requirements on banks in member countries and to get member countries to agree to meet deficit targets by 2013. There will also be new regulations to standardize the financial reporting of EU members.

More recently, the regulation bug has spread beyond the financial sector. The U.S. is setting new rules for off-shore drilling for hydrocarbons, especially pertaining to 'deep' drilling. Apparently, the Minerals Management Service, a government department, has a history of doing everything it could to accommodate the petroleum companies. Like a very weak SRP, it did not enforce the rules if companies complained of 'inconvenience.' Sadly, in response to industry protests, it shelved the implementation of a new set of regulations that likely would have at least mitigated the BP spill.

Not A Panacea

Unfortunately, new regulations are not a panacea. Some have argued that we do not need new rules, only capable, honest, and intelligent people to enforce the rules we already have. A cynic might respond, it is easier to write new regulations.

From the private sector point of view, the immediate problem with new regulations is uncertainty about the substance of the rules and even more uncertainty as to how they will be applied. A second concern is the added cost. Invariably, there is an inflationary impact of new regulations. It is axiomatic among the legal profession that any new regulatory legislation provides additional work for lawyers, just as new tax laws provide additional work for accountants.

Sometimes new regulations produce 'regulatory capture.' This occurs when large institutions such as major banks, investment houses, and law firms provide staff for the regulatory agency (infiltrate is too strong a word). When the staff member returns to the private sector, their contacts at the agency will be useful in getting preferential treatment, even bending policy. The steady stream of Goldman Sachs personnel to and from Washington is an example of (unintended?) regulatory capture.

Finally, new regulations all too frequently suffer 'unintended consequences.' Having set out to solve one set of problems, new ones are created inadvertently. The classic example of legislative unintended consequences is the U.S. Volstead Act of 1928, bringing in Prohibition. This was the making of the Canadian distillery and brewing business.

Will there be unintended consequences to the new pieces of regulations? Probably, but it is too early to foresee exactly what they will be. Certainly, Wall Street's role as 'the financial capital of the world' will be diminished. In fact, over the past three years, the financial centre of the United States has moved to Washington, DC. If offshore 'deep' drilling is curtailed, perhaps natural gas will see greater use and oil sands producers will feel more secure (much to the anguish of environmentalists).

Usually Overrated

The truth is, the importance of regulations is usually overrated compared to how the regulations are administered. New regulations, however, have a cleansing affect, making some people feel they are making a fresh start. Usually, there is optimism in making a fresh start. In recent months, there has been a shortage of optimism.

Briar Foster is chairman, CEO, and founder of Foster & Associates.

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