Paulson, Regulatory Reform, and the Maginot Line

March 31, 2008

Treasury Secretary Henry Paulson stated that

I do not believe it is fair or accurate to blame our regulatory structure for the current market turmoil. I am not suggesting that more regulation is the answer or even that more effective regulation can prevent the periods of financial market stress that seem to occur every five to 10 years.

A full copy of the Department of the Treasury's Blueprint for a Modernized Financial Regulatory Stucture can be downloaded here:

While it would be unfair to solely blame ineffective and inept regulation for our present woes, certainly a great deal of the blame must come to rest there. As I have publicly stated and written about for years, much of our present-day regulatory structure was drafted some three-quarters of a century ago-before the atomic age, before computers, before so much that is now everyday life. This is not to suggest that well-drafted laws do not often have aspects of enduring permanence. They do. However, it is important to monitor the capacity of our rules and regulations to keep step with evolving markets and new products. To that degree, Wall Street's rulebook is hopelessly outdated. It is a typewriter with carbon paper in an age of laptops.

For too long, the Congress and the SEC have tolerated the growing obsolescence of our securities markets' regulation. While Wall Street burned, its regulators fiddled. It is as if yet another ill-intentioned army saw the Maginot Line and dashed around it. The vast array of weaponry served little purpose. For all the impressive federal, state, and self-regulatory firepower, the defenders of Wall Street sat behind their defenses and were easily overwhelmed. One thing we now know for sure, that defense plan must be scrapped.

I agree with Paulson that the solution may not be more regulation. I'm not sure if the human brain can process the prodigious volume of laws, rules, and regulations that now weigh down upon compliance professionals. Moreover, each day seems to herald the birth of new, complex financial products that few understand and even fewer know how to regulate. Ultimately, Paulson may have said it best when he opined that market stresses will likely always occur and may not be preventable. That reflects the commonsense, pragmatic understanding of an industry veteran. Hopefully, such insight will permeate the new regulatory scheme.

Each year I get a flu shot. Despite that, there are times when I still get the flu. Maybe once in the past decade, but unpleasant enough when it happens. The flu vaccine does not prevent the creation of the various flu viruses, nor can it prevent them spreading from Asia to the United States. Frankly, that's not the point of the shot. The vaccine is the best-guess preparation by medical researchers as to what will likely attack us for the upcoming flu season. Sometimes they just get it wrong. Sometimes they get it right, but there's not enough vaccine to go around.

It has been rare in recent years for a flu epidemic to just start out of the blue and spread without warning. Science has become better at accumulating data and getting the information out to the media for distribution. Each year, I watch the maps to see where the flu is and how it's spreading. During the height of the flu season, you even see the mapping on television. Then the anecdotal evidence starts to pile in. My colleagues get sick. My friends get sick. My family gets sick. And then everyone starts to feel better.

Prevention is what is missing from the regulation of our markets. We never saw this subprime or credit crunch coming. Go on to the regulators' websites yourself. You just won't find anything before it hit the news in 2007. Sure, folks were warning about cheap mortgages, but not a single regulator waved the red flags, hit the panic button, and formed the bucket brigade when it mattered. That they all got to the fire when it was too late is not effective regulation. It's cheaper and better to design smoke detectors and pass laws to put them in every dwelling. By the time the fire truck is on its way, much of the damage is already done. No matter how sensitive the detector, you still need a fire department to save lives once the blaze starts. No matter how rapid that department responds, a beeping smoke detector or functioning sprinkler system will likely save more lives.

As we now move towards a brave new world on Wall Street, I can only hope that among the mainstays of our new regulatory regime will be monitoring, detection, tracking, and public dissemination of critical warnings. As Paulson suggests, there may simply be trends and recurring themes in the financial markets that must ebb and flow. I like that idea. It resonates with me. Nonetheless, we need to build a regulatory center for disease control and allocate resources as much towards detection and prevention, as we now do to fighting the illnesses of our markets.