Too Big to Fail: Closing the Barn Door to Late

Without exception, each of the regulators with responsibility for monitoring financial markets has spoken in favor of strong enforcement of financial regulation and policing market players. Unfortunately, little has actually changed in the past year since the collapse of Lehman Brothers and it appears that whatever regulatory regime gets passed by Congress will be a watered down version.

The debate of "Too Big to Fail" feels a little like closing and locking the barn door after the cows have escaped. Too little to late! The current debate surrounding the principle of Too Big to Fail has been interesting. Without taking sides, I find it interesting that much of what has occurred could have been prevented with simple enforcement of existing regulation. See posting by the FTC (http://www.justice.gov/atr/public/speeches/245711.htm).

Lax enforcement suggests that the regulatory markets; like politics, has become influenced by campaign finance. The conflicts of interest may be too great and may require new thinking altogether! To tackle this issue head on one could envision the creation of an independent oversight board that is funded through industry fees and enforcement revenues and staffed by professionals with multi-disciplinary expertise in financial services. This board would not be funded by Congress but would be accountable through legislative oversight committees. The members of the board would serve as the "Risk Regulator" and would provide market data on trends in emerging risks in banking, finance, and industry in general. The mandate of the board could include ensuring that regulators are sufficiently engaged in oversight, mitigate gaps in regulatory oversight, and draft policy recommendations to improve systemic risks.

One important service that this board could provide is an "early warning" on products that are high risk or not in the best interest of the public. The "early warning" reports should be available to investors and the public in general. The transparency of public disclosure of high risk behavior would serve to curtail or "chill" excessive risk taking for fear of "making the list" of bad actors. In the future, market participants would promote their risk management expertise by exclusion of their presence in the report. This strikes me as more effective than tying risk management to compensation given the challenges in calibrating compensation to risk taking.

There, no doubt, will be many variations on this theme. However, the reality is that the financial markets' ability to innovate new and potentially risky products exceeds regulators ability to keep pace. An independent Risk Regulator would be able to set a strategic agenda without the influence of industry or congressional mood shifts.

Too Big To Fail assumes "failure" is inevitable. Failure does and will happen however American taxpayers should not be expected to assume this risk. We should focus on getting back to the Prudent Man Rule of investing and overseeing one of our most important means to securing our future, the financial and economic markets.