Regulatory reform and risk management

Every news cycle seems to offer a new financial story line that drives us a little crazy for a day. The rating agency Standard & Poor’s gives a thumbs-down verdict on government debt and a touch of market-selling hysteria ensues. Fed chief Ben Bernanke gives a news conference and the conventional wisdom suddenly shifts like a galloping herd of animals on the African plain.
Unfortunately, we hear very little about global and meaningful regulatory reform, which is disappointing. Part of this phenomenon is understandable. Like dealing with the proverbial mad uncle in the attic, there seems to be a self-imposed societal and media gag order to ignore the obvious. It is a tedious process that can’t compete with the sizzle and attention of a royal wedding. After surviving the financial collapse of 2008 and its aftermath, the economy has begun a slow climb upwards and people feel slightly more optimistic. But few doubt that post-collapse anxiety still remains.I am not alone in believing that we are still vulnerable to “fat tail” quakes today – a low probability, but highly impactful event such as 9/11 or the 2008 meltdown – as we were just a few years ago. The rules creation process stemming from the new Dodd-Frank legislation of last year has barely begun.From my research in the past year, lobbyists may influence rulemaking far more than our founding fathers intended or congressional lawmakers fully understand. It will not be
easy to get it right, but if we fail to learn anything from recent history, we shouldn’t expect a future crisis to be any less critical or devastating.The report by the Financial Crisis Inquiry Commission provided an in-depth perspective into what we understand about the excessive risk taking, misaligned incentives and the institutional herd mentality that took place at many levels – from investment banks to ratings agencies to regulators asleep at the wheel.Transparency is keyThe subprime crisis that ended up crippling the global financial system was avoidable. So much effort went into this report, but it begs a very human question – how much will we either use or learn from it?Not a lot, perhaps. The partisanship on the commission was strong enough to require not just one, but two dissenting opinions by four members of the 10-member commission. The effort extended by the well-intentioned bipartisan commission appears to be wasted. I think it wise for all of us to remember these closing thoughts from the majority report: “The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again … It falls to us to make different choices if we want different results.”If the public believes that the passage of Dodd-Frank takes care of all that ailed us, they may be making a serious miscalculation. The reality is that the process takes time: It took a few years from 1999 before we saw the full impact of repealing the Glass-Steagall Act firewalls that had been in place since the Great Depression.The new framework envisions 247 new financial regulatory rules coming from the work of over 60 new study groups. Political contamination could undermine doing the right thing to protect the public and a truly global risk management structure is just in its infancy.What does regulatory reform have to do with risk management? The key to a healthy market and reasoned risk management is transparency. The less transparency we have, the more likelihood that a bull market might return based on some sort of Alice in Wonderland mentality.What do the Asian crisis of 1998, the Internet bust of 2001, and the financial meltdown of 2008 all have in common? They were the products of wild psychological swings based as much on fantasy and faith as any type of rational financial approach. The challenges arising from a lack of transparency is that it can infect the entire system – even sound investors who kept their distance from the subprime Ponzi scheme were hurt.Investors should and will demand transparency and not presume that a regulator, often in a politically sensitive position, is their advocate.A recent book, “How Markets Fail,” by John Cassidy captures this essential historical lesson – a free market system can be wonderfully efficient in producing goods, services, innovation and wealth, but financial markets are remarkably unstable far too often for coincidence.What is the common denominator? Human beings, wonderfully creative and capable of superb self-delusion, can act with perfectly rational intentions that contribute to collective folly.”The fault, dear Brutus, is not in our stars,” said Cassius in William Shakespeare’s Julius Caesar. “But in ourselves, that we are underlings.”Tom Sedoric is managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth.