Bankruptcy

Principles aren't always enough; rules are needed too.

By Ethan Cohen-Cole

In my last posting, I discussed the tradeoffs of regulation on the consumer side, and the extent to which disclosure would be sufficient to resolve consumer protection issues.

Here, I pose a simple problem to illustrate why principles based regulation would be inadequate.

To illustrate why, I cut and paste the abstract from Ed Kane?s (Professor at Boston College) paper ?Unmet Duties in Managing Financial Safety Nets?

He writes: ?Authorities and financiers violated common-law duties of loyalty, competence, and care they owe taxpayers indicates a massive incentive breakdown in industry and government.?

?First, procedures adopted at private firms and federal agencies for supervising securitization activity at commercial banks, investment banks, and government-sponsored enterprises inappropriately shortcut due diligence by outsourcing the monitoring and policing of the safety-net consequences of potential defects in the securitization process to private parties. Second, when the adverse consequences of this imprudent arrangement emerged, officials falsely claimed that the difficulties that short-funded, highly leveraged firms were facing in rolling over debt reflected a shortage of market liquidity rather than a shortage of economic capital at key firms. Among knowledgeable parties, this raised severe doubts about the integrity and competence of the officials in charge of rescuing the industry. Finally, the panicky way that the Treasury and President recharacterized the nature and extent of the industry?s accumulated losses in September 2008 created an extreme urgency that subsequent delays in implementation revealed to have been dangerously exaggerated?

Why do we believe that any new, reformulated or reconstituted regulatory agency would act differently on consumer products issue if we have not first put in place explicit limitations, rules, etc.?

A principles based approach is only as effective as the individuals that are the regulators in place at the time. We all have hope for Professor Warren?s ability to rise above the regulatory history; however, it?s far from clear that we can find anyone to follow her. 

Full post as published by Credit Slips on November 18, 2010 (boomark / email).