Regulation, Taxation, or True Effective Enforcement?

    Regulation's efficacy and methods are not a mystery buried in some ancient tomb. It consists of little more than channeling people’s most utilitarian behaviors. Regulators can basically choose to punish, award, or charge the actors in the marketplace to reach their regulatory objectives. Rather than regulate under the assumption that every market actor will try to please the regulators by behaving obediently and with a conscience, most people choose to believe punishment and proper enforcement are more expedient.

    While I am not attempting sanctimonious irony here, human beings know what the right things are to do rather than actually doing the right things. We know enforcement mechanisms are the foundation to an effective regulatory agency, we just can’t stop promulgating lengthy rules while at the same time collectively ignoring how to make sure those rules are adhered to. And such problems are even more serious in the financial regulatory perimeter. More complicated, lengthy, and annoying regulations usually mean we are now facing a “regulatory malfunction” problem. The Dodd-Frank Act itself is at least a voluminous 800 pages (the pages vary in quantity depending on what version you choose), let alone the pages of rules that all the financial regulators in the United Stated are required to propose under this Wall Street Financial Reform Bill.

The Moral Solution to the Floating Cloud-- Restoring Trust, Honesty and Prudence in Contemporary Financial Regulation

    Financial scandals, or to put it precisely and more definitionally exact, financial crimes, are fraught in today’s global financial market. Although the line between fraud and excessive risk-taking behaviors is somehow blurred in the financial fraternity, these kinds of misconducts are transparent to the rest of the world outside of the fraternity. Are you comfortable with the recent Swiss bank trader scandal, where a rouge trader in London in the UPS AG’s investment banking division incurred $2 billion of losses that basically lead the firm’s third-quarter financial statement into the red? Or do you think it’s just for Goldman Sachs, the largest and arguably most experienced investment bank in the world, to create an CDO (known as Hudson Mezzanine funding 2006-1) in which the bank cherry-picked all the assets portfolios then sold it to investors, while at the same time making a whopping $1.35 billion profit by betting against the CDO? Simply put, performing a rouse, making money while duping their trusting, unsuspecting, clients.

    All these recent happenings above lead us to a core question: Do we still have trust, honesty, and prudence in our financial market, and if the answer is nay, how do we restore or redeem those virtues and values into our financial regulatory reform? Other than traditional prudential regulation, the global regulators pay more attention to an area in which the ethical practices have been ignored for a long time, that is, the “Market Conduct Regulation”.

Regulating the Shadow Banking System

    The core mission of Bank Regulation is, in my point of view, to mitigate the systemic risk to the extent that everyone in the world can afford the cost of another financial crisis. Maybe a bit pessimistic, however I do subscribe to the belief that we cannot stop the current financial crisis from happening. What the regulators and all the market participants can do basically is to mitigate the scale of them and foresee them as early as possible. This is no time for myopia. Clarity of vision is essential.

    The recent global financial reform efforts that were proposed by the G20 Financial Stability Board, the U.S.A Dodd-Frank Act, and the UK Independent Commission on Banking, all reveal a clear and common tendency: to regulate those financial conglomerates that operate both in the traditional banking paradigm and via non-traditional banking activities.

Too big to fail, systemic risk and the Dodd-Frank Act

    Systemic risk will easily widespread in a system where the financial industry is highly complex, interconnected and governed by several Large and Complex financial institutions (LCFIs). The cost of rescuing giant banks may be too great for the taxpayers’ purse, and the awareness of their systemic importance may encourage them to take greater risks, which is essentially the moral hazard problem.

    The Dodd-Frank Act creates the Financial Stability Oversight Council in order to manage the potential systemic system, and empower the Council with the authority to designate nonbank financial company as systemically important. Such mechanism also orders the bank holding company with assets of $50 billions automatically designated as systemically important. Bank’s activities are across the border of commercial banking and investment banking in nowadays and partly hidden behind the larger scale of derivatives transaction, in particular the C.D.S. By integrating the regulators from different agencies into a committee process can enhance their conversations as well as supplement some loopholes that failed in drawing their attention in the past. Nevertheless, through singling out the systemically important financial institutions, the government essentially create certain forms of moral hazard and which in turn dampen the “too big to fail” problem through signaling a message to the public that the government will never let those banks fail. For those designated banks, they can easily get the funding and capital with comparative low costs and thus are encouraged to take greater risks.

Regulating Credit Default Swap

    Regulation of Credit Default Swap (CDS) is probably the most contentious topic in terms of the global financial reform in the post-crash economy. Some people believed CDS is the main cause of the Global Financial Crisis, and conceived it as simply a form of speculation or, to put more explicitly, a gamble. I am not going to argue for any side but just would like to express some thoughts on the recent regulatory reforms on CDS.

    CDS indeed helped to grow and spread the systemic risk through out the financial system by promoting the securitization and the housing bubbles, escalating the interconnectedness among “too big to fail” financial institutions, and removing the transparency from the financial market. Through the CDS, banks can easily hedge and insure their risk against the default in their positions of mortgaged-backed securities (MBS) and collateralized debt obligations (CDO) that invested in MBS. Such insurance encourage the brokers and bank take greater risks through making large scale of residential loans without carefully evaluating the property owners’ credit and repaying abilities and thus failed in preventing the stimulation of the housing bubble of 2008.