Regulatory confusion

Our American correspondent discusses the future of Wall Street regulation, and whether there's an oath of hypocrisy taken by those looking for change

My memory is getting shorter and shorter these days, but not as short as some financial observers that I read.

Take the Financial Times Lex column, for example, which recently said that when the credit crisis eases, Wall Street will be hamstrung by “regulatory vice.” The column went on, “bankers will not be allowed to place the big bets that generated the unprecedented returns of recent years. Investors in for the long haul must be prepared for a humbler future.”

It’s true that the hot topic for U.S. regulators is to stamp out the investment practices that caused the credit crisis and restore public faith in the American banking system. Some regulators are threatening and/or pursuing litigation, including New York attorney general Andrew Cuomo who has threatened to sue Merrill Lynch for an allegedly inadequate plan to buy back auction rate securities from investors.

The U.S. Federal Reserve Board also plans to work with Congress and other state regulators to implement a system-wide focus of financial regulation and supervision. Even U.S. presidential candidates Barack Obama and John McCain have touched on this subject and promised every American more financial stability when one or the other is sworn into office in January.

Bankers are very clever people, however, and it’s very unlikely that a few regulators will stop a few clever U.S. entrepreneurs from structuring a new financial instrument to make lots of money. It’s bound to happen –perhaps even happening now -- and when it does, no one, not even regulators, will bat an eye until something goes wrong.

Wall Street and, indeed, the City of London, is lined with many millionaires  who have built their fortunes on regulatory loopholes and there will be many more. Okay, so structuring securities using sub-prime U.S. housing mortgages might not have been a good idea in the long run. But it looked good on paper and on balance sheets for a very long time and regulators did not blink until it all went wrong.

In fact, the credit crisis loomed its head in America about six years after Enron went into bankruptcy in late 2001 as a result of allegedly fraudulent inflation of its revenues in part using various financial instruments. Enron had been named by Fortune magazine as “America’s Most Innovative Company” for six consecutive years and was under the radar of regulators apparently during that time.

As a result of Enron’s demise, various new regulations such as the Sarbanes-Oxley Act have been implemented and enforced, but they didn’t stop the credit crisis from arriving. It’s doubtful whether new legislation or regulations resulting from the credit crisis will do much to allay the next financial disaster.

I’m afraid that, at the moment, when I think of U.S. regulators, I think of horses bolting. But it’s difficult to be ahead of the innovative financial game when you’re trying to put out existing fires, especially when some of those fires may cost trillions of dollars. It’s difficult to see at the moment which trades will cause new problems.

Of course, if regulations are properly implemented and enforced, then there shouldn’t be any more troubles ahead. Now pigs and flying come to mind.