Regulation of financial markets and business has been around a long, long time. One of Julius Caesar's first acts as dictator for life was to introduce a general financial overhaul for the Roman Empire, specifically limiting the practices of money lenders when a citizen was deep in debt. Despite the generous amount of time there's been to work out the kinks in all levels of regulation, something always seems to go wrong. We will look at the common pitfalls that have derailed the lofty intentions of most regulatory actions.

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The Philosophy of Regulation
While it's difficult to sum up all types of regulation, from environmental to social to financial, into one mission statement, the theme of guidance is shared by all types. The idea is to guide all the interested parties away from an undesirable action and towards the desired one. If you have a skeptical turn of mind, your first question will be "desired by whom?"

And, in a nutshell, there is one of the main problems with regulating – no matter how noble the initial purposes, the end result is always either extreme collusion or antagonistic struggle between interested parties.

The most visible interested parties are the industry heads and lobbyists that go to Washington to push their sector's agenda. Equally interested, but often overlooked, are the bureaucrats and government agencies that receive taxpayer funding in exchange for carrying out the actual process regulation. Any regulation, no matter how well-written, can be bent in practice by either of these parties. (For more on lobbying, take a look at Lobbying: K Street's Influence On Wall Street.)

Regulatory Capture and Drift
There are two ways to describe the gradual bending of regulations towards the desires of interested parties, but they amount to the same thing. Regulatory capture and regulatory drift are gradual shifts in enforcement, procedure and rules that bring the regulators and regulated closer together.

There are many ways in which this happens; the most obvious is the practice of hiring former regulators to serve as internal compliance officers and consultants at regulated firms. This encourages regulators to be more sympathetic towards the company – something that can pay off in the future with a lucrative consultant post and often immediately with perks like flights, meals and tickets – rather than the general public.

The general public, despite paying the wages of regulators, cannot exert the same pinpoint pressure – basically, the disparate concerns of the majority is easily outweighed by the immediate and intense attention of the interested minority. This lack of pressure is exacerbated by the fact that, when regulation fails, the solution is almost always to increase funding in that area of regulation.

So, although it is upsetting and perhaps unfair to some specific bureaucrats who truly do live to protect the public good, the incentive is strong for regulators to err in favor of the industry they regulate.

Regulatory Arbitrage and Moral Hazard
It goes against the grain to think that rules can actually make something more dangerous, but this often proves true when following the stated rules is further distorted by underlying incentives. To illustrate this, we'll take a look at a real world example.

Insuring a Bank
In the case of a bank we have many interested parties and warring incentives in the picture. The management of the bank should, in theory, worry about returning a profit for shareholders and providing a service to clients. However, government regulatory bodies are also involved. Their desires change with time, but one constant has been the mandate to protect consumers. Unfortunately, other mandates have included increasing homeownership, loans to underprivileged groups and so on.

While these may help a specific group, there is a very real trade-off for the population as a whole – hence a conflict with the first mandate of protecting the consumer. Furthermore, extending loans to promote homeownership among those who maybe shouldn't be granted the credit runs against returning a profit to shareholders. However, the good grace of the government coupled with an implied backing of a bank is out their pushing the government agenda becomes the more powerful mandate for banks and their regulators.

The Mortgage Crisis Case Study
These are difficult knots to untangle, but consider the mortgage crisis as a prime example. The government wanted banks to make housing a reality for more Americans. Banks already were explicitly insured for basic losses under the FDIC, but the actual managers could increase profits and thus increase their direct bonuses by lending more at higher rates. Conveniently, a public/private hybrid like Fannie Mae or Freddie Mac can accelerate this process by helping repackage loans, freeing up the banks' balance sheets and allowing for yet more supply. (Learn more in Fannie Mae, Freddie Mac And The Credit Crisis Of 2008.)

So banks issued mortgages to borrowers who were less than worthy. In the short term, this led to profits for shareholders and fit well with government mandates, and still didn't explicitly violate any regulations. In the long-term, however, this process led to one of the worst financial crises ever, hurting shareholders and taxpayers. Regulators enjoyed increased regulatory funding and many of the managers involved kept their bonuses.

One Solution of Many
In this sense, one way to align the incentives of the bank management is to convert their compensation into long-term shares in the company, making it less likely they'd sell the future for the current quarter. This would also make them more resistant to government mandates, lessening the necessity of a huge regulatory body.

Regulatory Arbitrage
The other situation in which regulation fails occurs when there is a demand for a particular transaction that the regulators want to eliminate. Throughout their history, governments all over the world have attacked futures contracts. Currency futures in particular have caused headaches because they speed up the ramifications of government policies. When countries inflate, they are usually hoping they can "get ahead" on debt payments and obligations before the effects of inflation are felt. Currency traders armed with currency futures have shortened this window of grace.

Attempts to quash currencies futures have simply led to new styles of contracts that null the regulations. For example, if a government seeks to reduce the leverage that can be used to short currencies, it can arbitrarily cap it; but then forex brokers in other countries that allow larger leverage will start opening accounts for those clients. This hurts the domestic brokers, but it can't stop the market.

Similarly, countries practicing domestic price controls on crops and goods often seek to limit internal futures trading, because a trader can open foreign contracts and then take delivery to get around some price controls. Tariffs on the delivered goods are then added and, eventually, the business seeking lower prices will just pick up and move to a country that allows it to get its inputs at a fair market price. Demand is one of the most powerful forces in economics and will not easily be denied.

Conclusion: Calling the Philosopher Kings
Plato's Republic revolved around having a group of supermen that made the right call in all situations. If you know of anyone that fits that description, the chances are that you don't know them very well. The necessity for philosopher kings/great men to be the umpire of the financial world is just not realistic. As a result, we've taken the more is more approach and added layer after layer to try and fill in the gaps. As long as there are conflicting incentives and interested parties however, regulation will continue to grow and be fraught with pitfalls and problems.

We are at the point where we either need to simplify and clarify the regulatory environment, or wait for the philosopher kings to join the public service. At least the former has a chance, no matter how slim, of actually happening. (For related reading, also take a look at Financial Regulators: Who They Are And What They Do.)

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