Sunday, May 13, 2012

Regulators! Mount Up!

As the news of JP Morgan Chase's recent multi-billion dollar loss on derivatives transactions breaks, many people are asking the all too common question: where were the regulators?

I can understand the impulse to ask this question.  The downfall of Lehman Brothers in 2008 significantly harmed the American economy and marked the beginning of a tough economic period from which we have yet to emerge.  Government oversight theoretically could prevent future events of this sort from wreaking havoc with the American economy.

Unfortunately, I think the proposition of government providing appropriate oversight of major financial institutions is far fetched.  The main reason why is that the government is simply not competent to provide such oversight.

Finance is an incredibly complex business.  Successful executives at major financial firms make tens of millions of dollars in annual income.  This attracts elite level talent to the industry, both interms of IQ and drive.  I'd note that typical investment bankers out of MBA school work 60-80 hours every week and the top Ivy League MBA graduates tend to flock to investment banks. On the other hand, government workers are frankly not as intelligent or hard working.  That's not an insult, it is demonstratable fact.   

Even if government regulators were as talented as the management of the finance industry, they simply don't have the resources to develop the complete understanding of the transactions that take place at individual corporate levels.  A company like JP Morgan Chase is just one of the thousands of companies that the Securities Exchange Commission is tasked with regulating.  Companies like JPM/Chase have thousands of employees dedicated to their various tasks and they can work those employees for ridiculous hours.  Regulators simply don't have the manpower to keep up.  Because they are outsiders, they don't have the context to understand the activities that these firms undertake.

So what is the answer?  Laws like Sarbanes-Oxley and Dodd-Frank have been unable to prevent events like we saw last week at JPM/Chase.  I'd suggest that one role for government is to prevent financial institutions from getting too big to fail.  That's a fine line to walk and I don't endorse that solution lightly.  However, in an environment where Federal Government's the response to the failure of a large financial institutions is to initiate a near-trillion dollar loan program, I submit that we simply cannot afford to allow institutions to be "too big to fail."  Other than limiting size and scope of such institutions, any regulation designed to prevent events like we saw last week is folly.