New Rules, Same as the Old Rules

Today’s Financial Times wrote: 

In spite of advances in science and statistical methods and ever-growing accounting regulation, we continue to be plagued by corporate governance problems.  This is in part due to focus on managers and boards of directors and our belief that their actions can be controlled.  But people’s responses to controls are often influenced, often in unintentional and unpredictable ways, by the actions of others, such as a accountants, lawyers, investment analysts and even policymakers and government regulators.

. . . When things go wrong, it is never thought to be the result of the unpredictable or unintentional nature of corporate governance controls or programmes.

Instead, new problems are seemingly uncovered justifying further accounting controls or standards.  These new controls or standards seldom solve existing problems but often compound them. 

In short, what Mr. Stein is saying is that people don’t react as you want them to when you create new rules and things often get worse, not better.  That sounds quite trite and obvious, but it’s worth noting when we applaud legislators and regulators who propose and execute such laws and regulations, while at the same time creating safety nets when the rules fail.

Tim Geithner, U.S. Treasury Secretary, was on the Sunday morning talks shows yesterday suggesting this very thing . . . that this time the rules will work.  I could feel my eyes rolling in my skull.

I have closely watched the evolution of changes in the accounting and finance regulation arenas for the past 25 years and studied it going back for over 100 years.  As the FT article suggests, no matter what’s changed in terms of the rules, the behaviors we don’t like always seem to return.

In 1972, the SEC’s rules led to the average corporate annual report to be 19 pages long . . . today they are hundreds of pages long, including a dozen of the first pages which list all of the risks associated with investing in the company.  In 2000, federal banking regulations were 12,000 pages.  By 2008, they were 18,000 pages. 

And yet, those rules didn’t provide the information or guidance to avoid the debacle almost no one saw coming.

Further, many of the same tactics used by Enron between 1997 and 2002 were used by Citigroup, Goldman, Bear Stearns, Lehman and others in trying to hide risk.  They found loopholes in the rules to do what they wanted to do anyway, which explains why there’ve been so few arrests during this collapse–it was all legal.  And while the corporate risk managers spent their time complying with and evading the new rules, and therefore focused on the short-term implications of their actions, these financial institutions didn’t spend enough time asking whether the risks were worth it in the long-run.  We know now that they weren’t worth it for just about everyone.  The folks who made out the most were the managers and the mid-level credit holders.  The former could escape with their pay and their reputations mostly in tact, given the bailouts, and the latter could escape with their return of capital, again, because of the bailouts.

In short, we incentivized managers to focus only on what was legal and to ignore real risks.  We incentivized the most critical group, the debtholders, to seek short-run returns and largely ignore risks, as well.

How likely is it that our new, new set of rules, which do nothing meaningful to alter the risk-reward calculus, will fare any better?

How have we lost sight of the fact that the market economy, which punishes each of these groups through lost reputation and lost investment if  they take bad risks, is the best way . . . rather than more futile rules and safety nets when the rules fail to operate as intended?

Advertisement