Regulatory myopia

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

It’s strange that it required a crisis to highlight theshortcomings of existing regulations and market imperfections. Or is it? Arecent column in The Economist[1] outlined Minsky’s argument that financial markets can exacerbate an economiccycle. In the final stages of a boom banks and others essentially feed thegreed that typifies the late stages of an economic cycle.

The problem seems to be that nobody, least of allpoliticians and their regulatory advisors, want to be labelled spoil sports byclamping down on loose lending.

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

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

One of the basic functions of financial market regulationsand the regulators charged with administering them is to offer the public someprotection against unscrupulous operators. One way of doing this is to ensurethat businesses seeking money from the public produce a raft of documentsdescribing their offer (trust deed, prospectus and investment statement) whichare carefully vetted by lawyers, trustees and the Companies’ Office. It’simportant that these documents are accurate and do not mislead the public. But becausethey are quite lengthy documents and often quite technical not a lot ofordinary investors read them and it appears that many financial advisors also failedto 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 peoplewho had previously been involved in financial failures. It’s not clear whetherthis information had to be declared to the public in any of the key offerdocuments. Secondly, related party lending was common and significant. Nowclose inspection of the documents and the accounts of the companies concernedwould have shown this lending activity, but given the nature and scale of it insome cases one would have thought the regulators might have raised issuesbefore disaster struck.

Interestingly, the MED report makes few if any observationsabout any regulatory shortcomings. It points the finger at trustee companies forfailing to notify the Registrar of Companies of breaches or likely significantbreaches of the relevant Trust Deed.

There was a plethora of other problems in the industry –weak corporate governance, second tier auditors struggling with complex companystructures, and as the report states … "It is our understanding that a numberof failed finance companies were in the end acting in a similar manner to ponzischemes." This last point is extraordinary in light of Bernie Madoff’s ponzischeme 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 ofdoing the job intended for it.

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

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

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


[1] The Economist 4 April 2009, p71; "Minsky’s Momment

[2] 2007/08 Financial Review (Appendix B) – Ministry of EconomicDevelopment

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