Sub-Prime Boomerang: The Danger of Over-Regulation

Over the last two days, the Bush Administration and U.S. Secretary of the Treasury Henry Paulson have outlined their proposals to overhaul the financial regulatory structure of the U.S. Ordinarily, this is the kind of topic that puts people to sleep. But thanks to the Sarbanes-Oxley laws passed after the last financial scandal, techies know that financial regulation can be a very dangerous thing.

Was there a need to reform our accounting and governance laws after the the blow-ups and fraud at Enron/WorldCom? Of course there was. Was the regulatory response appropriate? Not really. Whether it was unintended consequences or just plain ignorance, Sarbanes-Oxley has made it much more expensive and difficult for small companies to raise money in U.S. capital markets. See Henry Blodget’s rant on this topic–it’s spot-on.

Now, we are faced with another similar situation. Is there a need to overhaul our financial regulatory regime? Of course there is. But lawmakers should move more deliberately and carefully this time around. For one, the financial system is already self-correcting its problems. Second, remember that this crisis exploded in one of the most regulated parts of the economy-the banking sector. Third, the U.S. is facing increasing competition in this new multipolar world. Our financial markets have been a source of strength and competitive advantage the last 60 years. We can’t afford to screw this up.

Any reform should be guided by two principles. One, better oversight of the home lending market. Since the basis of this latest scandal was poor lending standards to home-owners, which are leading to record foreclosures, policy makers should focus their efforts om improving oversight of this sector. As a purchaser of two homes, I know that mortgage brokers are some of the most unscrupulous people who often screw over customers and provide them with inaccurrate or incomplete information.

Second, the government should focus on improving transparency in financial markets. As my colleague Mike Mandel wrote yesterday, “the most striking thing about the current problems is just how much money the banks and the investment banks have lost. They apparently had no idea of how risky their own exposure was. The supposedly smart guys were simply stupid.

For me, the main lesson from this debacle is that both banks and investment banks must be required to fully report what securities they are holding, both directly and indirectly. No more off-the-book special purpose vehicles, no more hiding derivatives under the table. If a bank or an investment bank is holding a security, they have to publish the amount and the basic characteristics.”

This is a great suggestion–and one that dovetails with the mission of the Securities and Exchange Commission. One of the smartest aspects of our securities laws is their focus on transparency through the required filing of regular financial reports. Lawmakers can not legislate away greed or a recession, nor should they try. But they can and should force commercial and investment banks to disclose all of the investments they make in a clear and concise manner. That way, investors and consumers and regulators can make their own informed decisions on how they want to deal with these assets.

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