The passing of the financial reform legislation (H.R.4173) through the Senate has brought the national attention back to the financial regulators - and their failings. The bill creates a new consumer protection agency in the government that aims to regulate financial products like mortgages, car loans and credit cards. It also gives the Treasury Department the ability to unwind businesses once deemed "too big to fail." (For more on too big to fail, check out What is moral hazard?)
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But the major impetus for this latest incarnation of financial reform legislation was regulators' failures to catch onto serious problems on Wall Street in the last few years. Here's a look at some of the issues with the alphabet soup of financial regulation – and a few notable cases where financial regulators have failed those they're tasked with protecting.
Naturally, this isn't the first time that a major financial catastrophe has spurred the creation of a government organization to protect Main Street from Wall Street's greed. The Securities and Exchange Commission (SEC), in fact, was founded following the Crash of 1929 to ensure that the U.S. never again fell into a Great Depression. (Find out more in The SEC: A Brief History Of Regulation.)
In the years that have followed, a number of smaller financial upheavals have contributed to the creation of a spider web of federal and state regulatory agencies and self-regulatory organizations (SROs).
An Alphabet Soup of Regulation
For those unfamiliar with the financial industry's regulatory inner-workings, decrypting the myriad organizations that deal with policing banks and financial firms is no small task. While the SEC is best known for its role in making sure that companies' stock issues are well accounted for, did you know that an oil company's crude oil trading was regulated by the Commodity Futures Trading Commission (CFTC)? Or that its financials were watched over by an auditing firm? Or that the auditing firm was being watched over by the Public Company Accounting Oversight Board (PCAOB)?
On the other end of the spectrum come organizations like the Financial Industry Regulatory Authority (FINRA), which regulate the brokers who buy and sell shares on your behalf (along with the SEC).
And other groups like the FDIC, OCC, OTS and Fed contribute to the alphabet soup of regulators that's currently in place to make sure financial transactions stay on the up and up - and we haven't even mentioned the state agencies yet.
When Everyone Is Responsible...
Although these groups have made large strides in protecting retail investors and banking customers from unscrupulous businesspeople, they've been far from infallible. One of the biggest issues is the massive overlap of authority – it makes it difficult to place the blame for a screw-up on one agency when multiple regulators are holding the bag.
But when regulators fail, the effects are widely felt.
Two Famous Failings
It's hard to discuss failed financial regulation without bringing up Bernie Madoff. Madoff, the former Nasdaq Chairman who orchestrated the largest Ponzi scheme in history, was the subject of a number of SEC investigations starting in 1992, when Madoff's dealings with a certain feeder fund were put into question. The SEC cleared Madoff in 1992, despite a Wall Street Journal editorial that raised serious questions about the schemer's investment strategy.
The SEC ignored the fraud again in 1999, when financial analyst Harry Markopolos tried to bring evidence against the legitimacy of Madoff's money management business to the SEC's offices in Boston and New York. Ultimately, insurmountable redemptions forced Madoff to turn himself in in 2008. (Check out How To Avoid Falling Prey To The Next Madoff Scam.)
While Madoff's story might be the best example of regulatory shortcomings at the SEC, the D.C.-based government agency isn't the only regulator who has dropped the ball. The Enron scandal of 2001 was another example of serious failings of regulators – this time, the regulators in question were the company's auditors, Arthur Andersen and their regulators, the PCAOB. In Enron's case, Arthur Andersen had been signing off on the company's financials despite material problems because of the lucrative consulting revenues Andersen was making off of Enron. (Learn more in Wall Street History: Howard Hughes, Enron And Sin Taxes.)
In the fallout, scores of other accounting frauds were detected. Arthur Andersen and Enron both ceased operations, and the PCAOB gained power to regulate an accounting firm's ancillary business with clients. The Sarbanes-Oxley Act was another major result of the scandal.
The Regulators Continue to Evolve
Although Madoff and Enron were two of the most notorious financial scandals in recent years, for every financial regulatory failure we see in the headlines, there are likely dozens more that fly below the public's radar when they're uncovered. Still, each major financial foul contributes to the new regulations that we see on the market today.
While the true results of the financial reform legislation are yet to be seen, there's little question that additional eyes on our financial system are needed. Hopefully, we'll see our financial regulators continue to improve in 2010.
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