As a child, I found "The Emperor's New Clothes" to be a funny story about a foolish sovereign, but truth be told, I didn't understand it. This is, in part, the point—for had I been able to, the story, in which a naive child's exclamation cuts through layers of pretense, wouldn't exist at all.
What I now understand is that the story isn't about the clothes. It's about the fact that emperors—not to mention kings, czars, and officials of all varieties—don't like being told they're wrong, which is how they become vain enough in the first place to rely on swindling tailors (i.e. experts) requesting ever more gold thread to complete their work.
The Great American Experiment has been successful for as long as it has precisely because the founding fathers avoided reliance upon a single monarch, having seen what the monarchy had wrought in England. Yet the dynamics of groupthink can yield almost the exact same result as imperial vanity, such that many distinguished individuals insist on parading around naked because they have managed to convince each other that doing so is, in fact, normal. This is the strange society in which we live.
Financial regulation, rather than fashionable robes, is the topic of considerable debate these days, and with good cause. The world is reeling from one crisis after another, whether of capital, currency or confidence.
Effective regulations that were once concise, a few pages of text at most, have been replaced with ineffective regulations that span thousands upon thousands of pages of incomprehensible legalspeak. Many of these pages have been written by the very entities who are supposed to be regulated—one of many alarming problems with the current state of financial regulation. Yet one common theme, buried among the volumes that comprise the federal and state laws and regulations that comprise the financial regulatory regime, underlies all of the madness, appearing in law after law, clause after clause.
Bigger is better.
It is shocking in its obvious wrong-headedness, and yet there it is, the answer to so many of our problems. The implicit assumption, written into law time and again, that entities with more money are inherently more trustworthy, is wrong. It's not just wrong, it's patently absurd.
There are approximately forty-seven state money transmission laws in the United States that govern how non-bank entities operate. There are also forty-seven different sets of minimum capital requirements, bonds, and fees nominally designed to keep consumers safe (which suggests that if the minimum requirement theory is valid, no two regulators can agree just how valid). These requirements do nothing to protect us.
In the past year, JP Morgan Chase lost nine billion dollars (which it originally claimed was two) due to risky trading. MF Global misappropriated about a billion and half. Peregrine did the same with over two hundred million. Bernie Madoff had plenty of cash. These entities were regulated by the FDIC, the Federal Reserve, the Office of the Comptroller of the Currency, the Department of the Treasury, the Commodity Futures Trading Commission, and fifty different state banking departments. JP Morgan alone is worth trillions of dollars. So if these massive conglomerates could not be trusted to keep money safe, does that mean that the minimum capital requirements were simply too low? Should one need a hundred trillion dollars on the books to operate a bank safely?
No, I think not. By this line of reasoning, eventually it would take more money than exists in all the world to run a responsible financial institution. Rather, to ensure fund safety, financial regulators should rely on something else other than a minimum capital requirement, which after all, is a one-dimensional metric that has absolutely no correlation with trustworthiness.
We live in an era where technology makes it possible to track account balances in real time, automatically, at little to no additional cost with no manual intervention. Yet our regulators wait until after a failure has occurred to compile partial account histories piece by piece from printouts obtained through legal discovery, if they even can. We also have plenty of information on individual trustworthiness in the court system—information that goes out the window so long as you're rich. Just look at Mark Zuckerberg, who has been sued more times for alleged character flaws and breaches of trust than most regulators can count. Yet Facebook has been approved to hold onto client funds as a money transmitter in record time in several states.
Until we acknowledge that capital requirements simply do not work as a means to protect consumers—and in fact, stifle innovation by keeping out new entrants—we will continue to see failure after failure after failure of the financial institutions that we rely upon. The institutions will blame the regulators, and the regulators will blame the institutions.
They're both at fault. The institutions wrote these regulations, and the regulators are still parading them in front of the public. Too bad for us that they're not wearing any clothes.