Over the last decade or so, there haven’t been many dull moments for those watching the merry-go-round of financial market crises/scandals and subsequent legislative and regulatory actions.  One of those turns of the carousel (now largely complete), the Global Research Analyst Settlement, is the subject of this continuing series of postings.the research puzzle | This is the eighth in a series on “the settlement.”  This link will take you to an index of the postings on the topic that will include all of the postings as they are written. Five regulatory bodies settled with twelve investment banks for an advertised price tag of $1.5 billion, although implementation costs at the banks were not included in that figure, so the real cost was greater.

Rather than focus on too many details of the settlement or enumerate the other events of note during this period (which featured low returns in addition to all of the messes), a look at the regulatory process itself is in order.

Of course, there are those who always argue for less regulation, and those views increasingly held sway during the final twenty years of the last century.  Like a lot of things, in the short term it seemed wonderful and in the long term more the case of, “What were we thinking?”  Even a hard-core believer like Alan Greenspan was forced to ask himself the question.  I can dream of a world where little or no regulation makes sense, it’s just not this one.

And some believe that self-regulation works.  I’ll go with the words of Satyajit Das, who wrote, “The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.”naked capitalism | The line comes from a guest post by Das on the linked blog.

To discuss what should be regulated and by whom is beyond the scope of this review — there are sites that deal with those questions on a regular basis, and which do so more effectively than I can.  I do, however, think that a different approach to regulation is needed.  What we have now is behavioral regulation, akin to behavioral finance, where actions are anchored by the events of the immediate past.

The settlement looked backward rather than forward, and its provisions addressed the specific issues that triggered it.  That is the very nature of the regulatory model; it fights the last war.  (Those battling are not just regulators, per se.  Looking backward and reacting to well-known problems is natural for the political classes in the legislative and executive branches as well.)  For example, in the independent research portion of the settlement, the parties agreed to an approach that ignored emerging trends in the research business, perpetuated a narrow view of what research is, and did not anticipate some key implementation issues.

Many of the overlooked considerations came to light during meetings of the consultants charged with implementing the independent research portion of the settlement and the representatives of the regulatory bodies.  The group of consultants included individuals with significant experience in various parts of the investment industry.  It was clear in a short while that the group was good at seeing the problems from new angles and coming up with solutions.  Unfortunately, outside of certain implementation issues, the die was cast before we got involved.

There were better times to have included a group of experts of that type in the regulatory process.  For one, had such a group been involved in structuring that portion of the settlement, it would have looked different, to the benefit of the clients of the settling firms.  The firms and the regulators did not consider a sufficiently broad range of issues — or the needs of different types of investors — when arriving at terms.

Even more important would be to have that type of multidisciplinary expertise integrated into the day-to-day process of regulation itself.  Some argue that the investment industry always will win the arms race because of the money it generates and the talent it can afford, and there is truth in that.  But a change in approach by regulatory bodies would make a significant difference.  Certainly they exist to enforce the regulations on the books, but they must know the industry inside and out, be aware of the state of the investment art, and anticipate where the industry is going, not just where it has been.

In the great rethinking after the biggest of the crises, there have been signs of progress on this front, but amid the confusion over the grand regulatory scheme of things, they are small steps.  Giant steps are needed.

As for me, I’ll complete this series by tying up some loose ends in the next posting.