financial regulation, the invisible hand, and the only real answer to corporate accountability

Ben Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, recently gave a speech at the New York University Law School.

His basic message is we can't count on market forces to help control risk in the financial sector, whether you're talking about commercial banks or hedge funds. Ideally, creditors and investors would want to protect their investments, so therefore would exert a lot of pressure on organizations to take prudent risks and capitalize appropriately. However, I know that my bank won't go out of business, because it's FDIC insured (and Uncle Sam won't let a big bank fail), so why should I monitor them closely?

Bernanke doesn't carry this argument forward, but modern financial instruments, such as mutual funds, index funds, etc., offer not just a diversified portfolio, but also make it so I as a personal investor don't have a vested interest in the controls of any one organization. As my fortunes rise and fall not based on one particular organization in my portfolio, but how my asset manager has allocated my resources, I have less interest any one organization (except, perhaps, Charles Schwab). While creditors and depositors may have been activists in an earlier time, when they were fewer and had relatively more money, that incentive, and relative power, has disappeared.

So if my creditors and depositors no longer have a reason to monitor my actions, there is no economic penalty for undercapitalization or taking inappropriate risks. Wow, so if there's no downside, why wouldn't I take excessive risks, hoping for an excessive reward?

With this situation, many turn to regulation. But you also can't count on regulation to drive accountability. Bernanke goes on to say that government regulation exacerbates the issue, as creditors believe that government oversight means they don't have to monitor banks.

He proposes that risk is best addressed by a hybrid approach between regulation and market forces. For example, having regulation that requires minimum capital requirements, or the transparency requirements which are the driver for Basel II.

Regulation is such a weak instrument, however, as it's only effective when an organization buys into the reason for the legal requirements. However, organizations don't even achieve their OWN strategic objectives, because they always end up distracted by the budget. When the budget is the key factor in regulatory compliance, you end up hearing, "What's the minimum we have to do to pass the audit?" That approach only brings bureaucracy, inefficient processes, and heightened expenses when the next regulation comes along and the process has to be patched once again. Few organizations can keep their eye on the ball, thinking, how does this help our transparency or reduce our risk?

Ultimately, organizations are filled with people who don't want to do any more work than they have to. A combination of selfish capitalism and a maze of regulations can create the appearance of financial stability and reduced fraud, but it's foolish to believe that they can actually create a positive financial environment. Of course, he needs to pretend that we have sufficient controls, to avoid a loss of confidence in the markets. So it will last until the next profound case of investor fraud. Then we'll all talk about a few bad apples.....

Risk is only controlled within the organization. The company needs to have a positive intent, and create a culture of transparency and ethical behavior. Auditors talk about how difficult it is to test entity level controls such as "tone at the top." But nothing influences the direction and actions of a company like its leadership. The only truly lasting effect of any regulation is greater involvement by corporate boards -- more accountability by senior leadership. When the markets are primarily focused on short term gains, who is going to preserve the integrity of the institution? It has to be the board.