Monday, May 10, 2010

The False Comfort of Regulation

The US Government's typical response to man-made and natural disasters is to leap into a frenzy of creating new regulations.  The idea is that with stronger regulation, future disasters will be prevented and the nation as a whole will be made sounder.  The logic makes perfect sense - let's close loopholes, oversights, systemic problems that create pain and suffering.

Unfortunately, we need to only look at how current regulators are performing in order to understand the efficiency and efficacy of future regulations.  Let's start with Bernie Madoff - under the nose of the regulatory body designed to protect investors, the SEC, Bernie Madoff staged a $50 billion fraud.  The SEC received frequent warnings regarding the implausibility of his returns, however, Madoff was not caught until his own sons turned him in.

Regulations create codes of conduct that are supervised by a regulatory body charged with ensuring compliance.  The regulations are only as sound and as effective as the regulators themselves - regulators, moreover, are often ideology aligned with the very people they are tasked with regulating.  They are very poorly compensated relative to the businesses they regulate. Finally, they do not attract the same caliber of talent.

The myopia of regulators can be seen in dramatic fashion looking back at what they missed, however, it is not surprising that brilliant people can cheat the system in ways impossible to police or prevent.

What's the point - the point is that we should all recognize the fallibility of regulation to protect us.  There is a huge amount of legislative effort invested in creating regulations that will almost certainly fail to prevent future disaster.

We can, however, think through incentives.  The cost of moral hazard is very real - if banks, oil companies, car companies, Madoff's investors, can expect the Federal government to backstop their losses then the potential "costs" of their decisions do not factor in their calculations.  I understand that after the Exxon Valdez spill, Congress passed a law limiting future oil-spill related losses to $75m.  This paltry "cost" of a spill creates a huge lack of incentive for oil companies to prevent spills.  Similarly, large companies in the US today know that the Federal government is much more likely to bail them out than to let them fail.

Allowing companies to bear the true costs of their actions is most likely a more effective measure to prevent future pain.  We need to create incentives such that malfeasance and misfeasance is borne by the shareholders of companies responsible.

Simply passing laws does not make it so.