More than 20 years ago, at the Brandenburg Gate in West Germany, President Reagan gave an historic speech, in which he called upon Soviet General Secretary Mikhail Gorbachev to “tear down this wall.” Two years later, the Berlin Wall in fact came tumbling down, and the City of Berlin was reunited, permitting Western technology and freedom to transform the lives of both East and West Berliners.
The United States’ fragmented, compartmentalized, bifurcated, and dichotomized regulation of financial services does not pose quite the same threat to freedom and national unity that the Berlin Wall posed, but President Reagan’s notion of tearing down walls could certainly provide apt lessons for those seeking to rationalize our system of financial regulation. And, lest anyone misperceive the importance of the issue, it’s useful to bear in mind that the individual freedoms we enjoy are very much a product of our economic well-being.
In the United States, we have at least fifty regulators for insurance companies, at least 54 regulators for commercial banks, at least 55 regulators for investment banks, and at least 52 regulators for our commodities markets. We have federal regulatory bodies, self-regulatory bodies, private-sector regulatory bodies, multiple state regulatory bodies, local regulatory bodies, and now global regulatory bodies, each struggling to define its role and justify its existence, often at the cost of duplicative or conflicting regulatory approaches. Added to this is the existence of private litigants, whose cases can often have more far-reaching regulatory consequences than the acts of regulators and prosecutors.
It is possible—but unlikely—that this silo approach made sense in the world in which it developed. But whether or not it ever made sense, it is painfully anachronistic in a world in which financial products are fungible, transactions are electronic, and the impact of financial activities is global, not local. In the same spirit embodied in President Reagan’s exhortation at the Berlin Wall, we must tear down the artificial and counterproductive barriers that define the current U.S. financial services regulatory structure so that the U.S. can participate fully, and maintain its premier position, in the world’s capital and financial markets.
The foundations for financial services regulation in the United States were laid nearly 150 years ago. In 1863, Congress enacted the National Currency Act (later the National Bank Act), to create and regulate a system of national banks. Of course, it did nothing to displace the existing regulatory system of state commercial banks. In 1871, the National Association of Insurance Commissioners was formed to coordinate regulation of interstate insurers by the individual states’ insurance commissions. In 1945, after the Supreme Court ruled that insurance was, in fact, interstate commerce and was therefore subject to federal regulation Congress in effect nullified the Supreme Court’s decision holding the business of insurance subject to federal regulation. It did so by adopting the McCarran-Ferguson Act, which leaves regulatory authority over insurance with the states.
Beyond the realm of insurance, in the early 1930s, Congress utilized the notion of independent regulatory agencies to establish the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, and in 1974 it established the Commodity Futures Trading Corporation. In the case of the SEC, Congress explicitly recognized that the regulatory powers and remedies provided were in addition to, not in substitution for, existing common law and state regulatory provisions and remedies. Each of these regulatory initiatives, and its related agency, was aimed at a particular product or a particular segment of the financial services industry. And each was adopted long before the current global focus on financial transactions.
At the time, the services and products provided by the insurance industry were quite distinct from the services and products offered by investment bankers and broker-dealers. And these, in turn, bore little resemblance to services and products available from commercial banks. Indeed, at the time, Congress had adopted the Glass-Steagall Act, mandating the separation of commercial from investment banking, and had deterred commercial banks from engaging directly in the business of insurance. Unfortunately, this regulatory regime provided no flexibility for developing financial products or the changing nature of financial transactions. By the 1970s, with the advent of money market mutual funds, and their related checking accounts, the rationale underlying the separation of financial services no longer was viable.
It stands to reason, therefore, that the regulatory structure created to deal with the financial services world of the 1930s and 1940s is ill suited to address the continuing transformation and consolidation of the financial services industry. Whatever viability the system might have had was, in any event, completely eradicated with the passage of the Gramm-Leach-Bliley Act in 1999. That statute permitted the consolidation of various financial services and repealed the Glass-Steagall Act. Unfortunately, it expressly kept in place the existing regulatory patchwork of agencies and state regulatory bodies. Indeed, in some cases, the SEC and the CFTC were given joint authority to regulate certain products.
Currently, commercial banks, investment banks, insurance companies, and broker-dealers around the globe offer functionally equivalent products and services. The names of these products and services may differ and, in the United States at least, they are regulated differently by different regulators, but they are all designed to accomplish a common goal—allowing investors to balance consumption with asset accumulation.
The present, multiple, regulatory approach to financial services in the United States stifles innovation, discourages risk taking, promotes inefficiency, encourages regulatory arbitrage and, ultimately, provides ample incentive for domestic firms going offshore. U.S. financial services firms have developed in a mirror image to the regulatory structure—with a different business group for the products under the purview of each regulator. The organizational infrastructure necessary to support these multiple groups results in inflated overhead, redundancy, and internal inefficiency.
A better approach is to design a new regulatory structure that’s optimal for today and provides flexibility to grow and evolve with the unforeseen.
If this weren’t bad enough, these effects are magnified by the need to answer to multiple regulators in the ordinary course of approval and oversight, as well as in the course of regulatory investigations and enforcement activities. The same ground must be covered and recovered as various regulatory bodies compete to see who can impose the “best” regulations, identify the “worst” offense, or justify the most severe sanctions. And, once there are multiple regulators, with multiple agendas and multiple rulebooks, the environment is ripe for regulatory arbitrage, which occurs in one of two ways: Either regulated entities, knowing that different regulators have different rules, seek out the regulatory regime most favorable, or regulators adopt rules with a particular eye to aiding, or inhibiting, the entities they regulate. No matter which way the phenomenon originates, the results are almost always less than satisfactory. On the one hand, it’s impossible to achieve optimal regulation in the face of multiple regulators and, on the other hand, industry participants are encouraged to develop products that will pass regulatory muster, rather than those that are most innovative and economically valuable.
One of the greatest, and most immediate, dangers posed by duplicative regulatory bodies and, therefore the greatest and most immediate threat to the position of the United States in world financial markets, is geographic disintermediation. It’s economically rational and, therefore, predictable that market participants eventually will decide that it’s easier, more remunerative, more efficient, and less troublesome to opt out of U.S. regulation and subject themselves instead to the jurisdiction of a different regulator, such as the United Kingdom’s Financial Services Authority. To the extent this is occurring and continues to occur, it can only result in lost opportunities for U.S. businesses and investors, and in lost jobs for the U.S. economy.
The solution to this problem requires a “greenfields” approach. Rather than attempting to evaluate “what went wrong” and attempt to “fix” the existing balkanized regulatory system, a better approach is to design a new regulatory structure that’s optimal for today and provides sufficient flexibility to grow and evolve with the unforeseen. The only valid reason to examine how we got where we are is to avoid winding up in the same place. In order to move forward, we must look forward, not backward. Starting over means doing a thoughtful and thorough analysis to identify current best practices, both domestically and internationally, and then determining what should be done to further improve upon these existing practices.
Such a process will, admittedly, be difficult to carry out in the United States. Too often, partisan and pluralistic politics stand in the way of clear thinking and rational processes. The U.S. steel and auto industries would have benefited from this type of analysis, but shortsightedness and parochialism prevented it from occurring. It would be a shame if the U.S. financial services industry were to experience the same fate as has befallen other former giants of the American economy.
Successful revision of the U.S. financial service regulatory process will require several bold steps. It is, however, possible to construct a model that would provide substantial benefits to U.S. consumers and investors that would improve significantly on the existing system.
Sunlight may be the best of disinfectants, but sunset has advantages, too. We should begin “sunsetting” existing regulatory institutions. The length of the sunset period may be a long period of time—say five or ten years—but it’s probably necessary for success that existing regulatory bodies be scheduled to disappear as separate entities. Imposing sunset provisions at the outset will firmly focus decision makers on the reform issue, provide incentives to keep them focused, and overcome inertia. Without firm deadlines, it’s too easy to do nothing and let problems spiral out of control, to be dealt with, if at all, on someone else’s watch.
All politics may be local, but financial services are national and international. The restructuring of financial services regulation ultimately must be a federal matter. State enforcement of existing fraud protections can be beneficial to consumers and investors, if coordinated with federal regulators, but state agencies, attorneys general, and legislatures should withdraw from activities that impact the regulatory process. State regulation of national and international industries and markets adds uncertainty, complicates the regulatory process, and contributes little, if anything.
Misery loves company. A joint private-public congress should be convened, under the auspices of the Treasury Department, to design a new regulatory structure for the financial services industry, with the goal of efficient, liquid, and transparent providers of financial services and products, with an appropriate balance between efficiency and consumer/investor protection. Treasury Secretary Henry M. Paulson, Jr., has already initiated this kind of thoughtful review of the current regulatory process, and the regulatory congress suggested here would build upon those efforts. The product of this congress would be a blueprint for a new regulatory regime.
There’s a need for layered regulation. The genius of the federal securities laws back in 1934 was the recognition that, while government could define what was unlawful, only industry could and should define what may be lawful but is unethical or unfair. Accordingly, any new regulatory paradigm should provide appropriate, but non-duplicative, roles for government and industry self-regulators.
There’s a definite need for inclusiveness. All professions and industries ancillary to the financial services industry should be included in the regulatory construct. This isn’t a call for additional regulation, but rather a recognition of the fact that any regulatory regime must eliminate the possibility of cracks that allow some players to escape any regulation while their competitors are heavily regulated.
Any system should acknowledge and account for regulatory convergence. The United States is no longer the only economic regulator on the world scene. We need to recognize that alternative systems of regulation exist and can be every bit as effective as our own, and borrow liberally from them when it makes sense to do so.
The regulatory approach should be long on principles and short on rules. The existing approach of detailed and prescriptive rules has not been effective. In general, the more detailed rules are, the easier it is for people to figure out ways to avoid them. While not every rule can be principles based, most surely can. It’s important for regulators to be able to make this decision pragmatically.
Prudential regulation should be the guiding principle. While most people do, and should, support effective and zealous enforcement of the law, it’s surprising how often some fail to recall that, by the time enforcement actions are brought, the damage has already been done. It’s far better to encourage people to comply with the law in the first place, rather than merely utilizing regulatory authority primarily to punish those who got it wrong. This means that government must encourage those who are regulated to ask questions and vet proposed activities in advance of their implementation, rather than playing “gotcha” by prosecuting those who bring their questions and concerns to the government’s attention.
Avoid “piling on.” Having multiple layers of regulation always raises the concern that the same misconduct may be punished multiple times. That’s certainly the current situation. The principle of “one violation, one enforcement proceeding” would go a long way toward encouraging respect for enforcement efforts, reducing the cost and burden of regulation, and yet not sacrificing the public interest.
Private litigation needs to be rationalized. Over 40 years ago, the Supreme Court correctly recognized that private litigation can be a “necessary supplement” to the government’s own enforcement activities. But, much has changed since the early days of private litigation. The law in private securities civil actions is largely judge-made, an approach the Supreme Court has more recently rejected. If Congress wants private litigation, it should rationalize the process by creating express remedies, defining when, where, and how such litigation can ensue, capping liabilities, and giving the federal government the ability to prevent private litigation from being used abusively.
Federal and private sector regulators should be organized functionally, and operate pragmatically. At present, either multiple governmental and private bodies compete for jurisdiction over perceived abuses, or conduct that requires regulatory oversight falls through the cracks because jurisdiction is poorly defined. The goal should be to encourage regulators to protect investors, depositors, and consumers, promote competition, and facilitate the development of new products. The fact that some government officials mull new products or transactions for years before allowing approval, out of a fear of “giving away the store,” hurts the very people government is mandated to protect. Functional organization will lead to divisions designed to promote consumer protection, capital adequacy, and market regulation, rather than product-by-product organization—insurance, banking, equities—or geography. Similarities between products are more important than the nominal differences between them.
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Ronald Reagan’s advice two decades ago—to “tear down this wall”—is good advice for financial services regulation today. If we persist in providing different regulators for various aspects of what is a single marketplace, we’re destined to surrender our leading position in the world’s capital markets and make our own financial services providers less competitive, as other countries offer more attractive, yet equally effective, regulatory regimes. That would be a terrible result, and one that no one seriously could contend should be our objective.
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