Saturday, October 11, 2008

Need For More Regulation?

We need more regulation, that's been the current mantra heard across the country. But what has been overlooked is that we had regulation and already had regulators who failed us. Warren Buffet explains a fundamental problem with regulation and regulators, we can't assume that they will do their jobs and actually regulate the industries they're supposed to!

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get
them on the Internet, every year. And, in fact, they reported to Sarbanes and
Oxley every year. And they went—wrote 100 page reports, and they said,
`We’ve looked at these people and their standards are fine and their directors
are fine and everything was fine.’ And then all of a sudden you had two of the
greatest accounting misstatements in history. You had all kinds of management
malfeasance, and it all came out. And, of course, the classic thing was that
after it all came out, OFHEO wrote a 350—340 page report examining what went
wrong, and they blamed the management, they blamed the directors, they blamed
the audit committee. They didn’t have a word in there about themselves, and
they’re the ones that 200 people were going to work every day with just two
companies to think about. It just shows the problems of regulation.

QUICK: That sounds like an argument against regulation, though. Is that what
you’re saying?

Mr. BUFFETT: It’s an argument explaining—it’s an argument that managing
complex financial institutions where the management wants to deceive you can
be very, very difficult.

I don't necessarily disagree that we need changes to the regulatory system. The question is in what manner and in what way? As with everything, the details are critical. But it is wrong for us to believe that there was no regulation and no oversight whatsoever and that's what caused the financial crisis. Regulators must be capable and have knowledge of the industry they regulate. They must understand the complex financial instruments in use and be smart enough to recognize a problem ahead of time. That's a lot to ask of a government employee. Especially if that employee is part of a no-name regulator like OFHEO, if you had any talent, why would you work for OFHEO instead of Treasury or a Wall Street firm?

It's failures like OFHEO's that make me question the effectiveness of government and government programs. I know the intent of programs and regulation, but no one seems to look at if the intent can be reasonably carried out, or make adjustments for government incompetence. A government plan or program is usually taken at face value, with very little consideration of the fact that government doesn't do many things perfectly, and is prone to screw up.

There should be regulation that sets up a clearinghouse for derivative instruments. There also needs to be a law that gives shareholders the power to veto any management compensation plan. Basel I has to be changed so that financial institutions have to keep more reserves and cannot leverage as much as they have been. Accounting rules should be reformed to make institutions show SIVs (Structured Investment Vehicles) on their balance sheets if they are obligated to fund them. Regulators like OFHEO and the SEC should be merged into a larger regulator such as Treasury or the FED. Those are large reforms, and I think they comprise most of what we need. But in the end, we still will have to depend on regulators to do their jobs, the financial sector, and the world at large are just too fast moving and changing for hard rules to work. We need good judgment and talent, something government agencies don't always have. But the more important the agency, the more likely we are to have talented people with good judgment working there. Paulson and Bernanke are two such examples, Rice another. Still, no amount of regulation and no government system has been able to prevent financial crises from occurring now and then. We've had financial crises in the past and will have them again in the future. There are some things that are just unavoidable.

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