Make regulation review a priority

Many commentators in recent weeks have said that one of President Obama’s first priorities must be to restore public confidence. One place that lack of confidence is most apparent is in the financial

markets. One of the first actions that the Obama administration could take to help restore investor confidence is to press Congress to hold hearings soon on the shape of financial regulation in the United States.

These hearings would have multiple purposes.

First, of course, they should be designed to identify the weaknesses in the regulatory framework that governs the operations of commercial, investment and savings banks, insurance companies, brokerage firms, investment management and advisory firms, mortgage bankers and all other lending and credit organizations.

Second, the hearings should provide guidance as to how the regulatory system can be restructured to fix structural weaknesses. These allowed the mortgage bubble to develop and grow, allowed major firms to drift toward bankruptcy by taking on excessive leverage and allowed Bernard Madoff to run an alleged $50 billion Ponzi scheme. In particular, the hearings should address how regulators can keep abreast of Wall Street’s highly mathematical financial products and tools, which no doubt will grow even more sophisticated, complex and problematic.

Third, the hearings should help to restore investor confidence by demonstrating that the government is determined to ensure that the financial markets are fair, and not simply a game weighted against the small investor.

Investor confidence has been badly shaken — of that there can be no doubt.

According to The Leuthold Group LLC, a Minneapolis-based research firm, individuals pulled $250 billion out of U.S. and foreign-oriented equity mutual funds in 2008. The firm estimated that investors added $133 billion to money market funds last year, on top of the $180 billion added in 2007.

And why would investor confidence not be shaken? Investors have experienced two significant bear markets in eight years, and in the wake of each, massive frauds have been unveiled.

After the 2001-03 bear market, scandals at Enron Corp. of Houston and WorldCom Inc. of Clinton, Miss., cost investors vast sums of money. In addition, some prominent securities analysts were found to have been touting stocks that they didn’t believe in, and mutual funds facilitated market timing by hedge funds — all of which the regulators missed until the technology bubble burst.

The bursting of the mortgage bubble also has revealed a great deal of fraud and enormous carelessness or stupidity on the part of financial institutions. Again, regulators missed these too, either through incompetence or the lack of appropriate tools.

Incompetence can be fixed by replacing the ineffective regulators. Fixing the broken tools requires congressional action.

NO BLAME GAME

Any congressional hearings must be forensic in nature, drawing on the best minds in academia to analyze where and why the failures occurred, and what shape regulations should take to avoid similar failures.

The hearings must not be allowed to degenerate into a “blame-storming” exercise seeking scapegoats. There is enough blame to go around, and plenty of time to share it later.

Such forensic hearings could pave the way for smarter, more effective regulation. The new regulatory structure must have strong tripwires to alert the regulators when financial industry practices are edging toward dangerous territory.

If Congress can hold a truly diagnostic inquiry into the failures of financial regulation and then put forward sound and reasonable new regulations, investor confidence will be restored.

Only then will investors consider investing the more than $300 billion now sitting on the sidelines.