Regulatory myopia
Fri 17 Apr 2009 by Infometrics Ltd in Government

The financial crisis wracking the world economy threatens to spawn a whole new suite of financial market regulations aimed at preventing the same thing happening again, well not anytime soon.

It’s strange that it required a crisis to highlight the shortcomings of existing regulations and market imperfections. Or is it? A recent column in The Economist1 outlined Minsky’s argument that financial markets can exacerbate an economic cycle. In the final stages of a boom banks and others essentially feed the greed that typifies the late stages of an economic cycle.

The problem seems to be that nobody, least of all politicians and their regulatory advisors, want to be labelled spoil sports by clamping down on loose lending.

In New Zealand, the finance companies were doing a great job oiling the wheels of the property market, financing new developments and helping mums and dads, Jacks and Jills buy an investment property as a way of adding another egg to their retirement nest. The economy fair hummed along producing a rich vein of tax revenue for the government to spend on revamping health services, building new roads and issuing gold cards to senior citizens. Why on earth would anyone want to blow the whistle on such an enjoyable party? And as it gathered momentum financial and property wide-boys gate crashed it.

BlueChip and BridgeCorp and a host of other slightly lower profile operators expanded rapidly sucking in small-time investors with the promise of high yields that property backed investments could apparently offer. The subsequent carnage has left many retired people with a lot less spending power. Did the regulators have a role in trying to protect these investors or is it simply a case of the greedy getting their just deserts?

One of the basic functions of financial market regulations and the regulators charged with administering them is to offer the public some protection against unscrupulous operators. One way of doing this is to ensure that businesses seeking money from the public produce a raft of documents describing their offer (trust deed, prospectus and investment statement) which are carefully vetted by lawyers, trustees and the Companies’ Office. It’s important that these documents are accurate and do not mislead the public. But because they are quite lengthy documents and often quite technical not a lot of ordinary investors read them and it appears that many financial advisors also failed to read them critically.

A recent MED report from the Registrar of Companies[2] made a number of observations about the collapse of so many finance companies. A couple that standout are that some of the failed companies were run by people who had previously been involved in financial failures. It’s not clear whether this information had to be declared to the public in any of the key offer documents. Secondly, related party lending was common and significant. Now close inspection of the documents and the accounts of the companies concerned would have shown this lending activity, but given the nature and scale of it in some cases one would have thought the regulators might have raised issues before disaster struck.

Interestingly, the MED report makes few if any observations about any regulatory shortcomings. It points the finger at trustee companies for failing to notify the Registrar of Companies of breaches or likely significant breaches of the relevant Trust Deed.

There was a plethora of other problems in the industry – weak corporate governance, second tier auditors struggling with complex company structures, and as the report states … "It is our understanding that a number of failed finance companies were in the end acting in a similar manner to ponzi schemes." This last point is extraordinary in light of Bernie Madoff’s ponzi scheme in the US and the failure of the Securities and Exchange Commission’s (SEC) to act on early warnings from a market analyst and call Mr Madoff to account.

The whole investor protection system seems incapable of doing the job intended for it.

In New Zealand it shouldn’t have taken much for our regulators to work out that many finance companies required new funds to repay maturing deposits – they were borrowing short and lending long…and wrong. Most of the finance companies were lending on property, an asset class which attracted a host of warnings from commentators as well as the Reserve Bank over several years before the meltdown began.

One of the major shortcomings in the regulatory framework seems to be the distance regulators keep from the markets they are responsible for. Their knowledge of what is happening within these markets is relatively poor and therefore it’s not difficult for them to be ignorant of looming problems. There’s a case for them to spend a little more time looking at the trees rather than gazing over the wood.

Regulations are an important part of a well functioning market and while the regulator maybe constrained in what they can do by the legislation they operate under they could do a better job at sniffing out trouble before it turns into a disaster for people trying to do the right thing by saving for their retirement.

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