Tuesday, February 26, 2013

Building the Better Mousetrap: Two Views on Regulation and Innovation


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

[M]ore than anywhere else in the world, the United States remains a place where a visionary can risk everything on a dream or an idea and have a fair chance of fighting for it.  And he or she can do so in an environment where the investors who underwrite that dream are protected. -SEC Chairman, Elisse Walter

 


How do you build a financial regulatory system that constrains risk-taking but still allows financial institutions and others to take innovative chances?  This question is at the very heart of financial regulatory reform world wide. No regulator wants to pull the reins so tight that financial innovators will take their creativity elsewhere.  But at the same time, investors deserve some protection in return for their finance, and taxpayers should no longer be expected to bail out the risk takers.  The financial crisis revealed a regulatory regime that was improperly focused, mismatched with what financial institutions were doing outside traditional banking, and unable to keep pace with technological and other innovation. It demonstrated that regulators had placed too much confidence in the capacity of firms to measure and manage their risks. Post-crisis, regulators found themselves faced with the choice of regulating in a highly prescriptive New Deal manner or a more prudential and flexible manner.  Their goal: "to maximize stability and to minimize risk, to enhance capital requirements, to minimize moral hazard and to increase scrutiny by regulators who collectively can see across sectors, grasp their interrelated operations and diagnose problems that have the potential to grow and spread."  All this, while at the same time being nimble enough to permit, yet understand, monitor, and react to new innovations.  


What does this mean? From the perspective of SEC Chair Elisse Walter, it means "strong investor protections and prudential regulation of systemically important financial institutions. But as we work to limit systemic risk, we don’t want to discourage all risk-taking." In the US, at least, Ms. Walter suggests a framework focused on investor protection, transparency, and level playing fields.  

 

 

 

  • Regulation that is focused on detecting and preventing fraud – as we are now doing with proprietary algorithms that detect irregularities in hedge fund filings and single out some for closer scrutiny, and a state-of-the-art nationwide tips system and a whistleblower program  that combine to give us an unprecedented ability to process information that comes to us from outside. 
  • A regulatory system that is capable of detecting and deterring market manipulation – as we do when we break up the largest insider trading ring ever unveiled or swiftly freeze the proceeds of potentially illegal trading in overseas accounts. 
  • Regulation focused on assuring that companies make available the information investors need for educated decision-making – as we did in reviewing offering documents for significant IPOs last year, focusing on issues including appropriate use of non-GAAP measures and disclosure of dual-class voting structures.
  • And regulation that supports investor confidence in the architecture and technology of the exchanges and other large players in the markets – a commitment that we demonstrated by approving strict market access rules, more effective circuit breakers and more sophisticated limit-up, limit-down strategies. And a commitment that we will continue to demonstrate by moving forward on a regulation that will mandate minimum system compliance and integrity – including appropriate testing and reporting.


From the perspective of Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, international coordination is the key to regulating, while not stifling innovation and appropriate risk taking.  He warns that the more regulations remain in flux, however, the more uncertain the business environment. Tarullo says it is critical that national authorities find "equilibrium at which firms can get on with the business of planning their strategies in a clearer regulatory environment, and regulators can begin to take stock of the cumulative effects and effectiveness of the changes that have taken place in that environment."

Mr. Tarullo sees synergies to be had from international cooperation. Rather than competing regulatory regimes, he envisions international efforts building on experience derived from national practice in one or more jurisdictions. By combining the ideas like Chairman Walters' and experiences of many nations, consistent (yet not necessarily identical) regulation that addresses the vulnerabilities in the financial system may emerge globally.  At the same time, this ongoing international cooperation will have a better chance of keeping up with innovation and what financial institutions are actually doing in real time.  
  
Regulators all over the globe are working to thread the needle between preventing the next financial crisis while avoiding throttling the engines of financial growth.  They are well aware that the decisions they make can affect not just the entities they are charged to regulate, but countless investors and the very future of global finance.  

 

 

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