Does regulation cause financial scandals?
Reliance on regulation instead of reputation is what”™s behind the past decade”™s litany of financial scandals, according to Jonathan Macey, a Yale Law School professor.
Before government regulation was used to protect customers, clients demanded a clean corporate reputation before they would invest any money with a company, Macey writes in his latest book, “The Death of Corporate Reputation.”
But with corporate scandal after scandal, customers have become jaded to the point that they have little regard for a company”™s reputation. Instead, Macey writes, they depend on the government to protect them and entrust their money to individual investment managers, not companies.
To learn more about Macey”™s theory, the Business Journal went straight to the source.
Business Journal: What is the reason for the recent string of financial scandals?
Macey: “Financial scandals occur when companies want to disguise their performance. This happens when these companies (including banks and hedge funds, as well as manufacturing firms and all other companies) perform poorly and want to hide their losses or when they want people to think that they have performed better than they actually have.
“The scandals at Enron, WorldCom, Tyco and other frauds involved accounting shenanigans designed to inflate performance. The Bernie Madoff fraud also involved efforts to inflate performance. The financial problems that brought down banks like Washington Mutual, Lehman Brothers and Bear Stearns were not scandals because they involved poor performance rather than illegal activity. These firms lost money and failed. This sometimes happens in capitalist systems.”
Why don”™t you think more regulation would solve the problems that have occurred?
“We have more financial regulation than any country in the world. The financial industry has endured wave after wave of financial regulation over the past 80 years. The regulation has not helped reduce or prevent fraud. In fact, if anything, the regulation has been counter-productive. Sarbanes-Oxley was designed to improve financial reporting and accountability, yet it did nothing to improve the financial reporting and accountability of the banking industry, as we saw in 2007 and 2008.
“Similarly, Dodd-Frank was supposed to eliminate systemic risk and prevent the massive bailouts that occur when the government follows a ”˜too big to fail”™ policy for big financial institutions. Dodd-Frank is a spectacular failure on both counts. We need less regulation, more straightforward regulation and less reliance on government regulation and on government bailouts in particular. All that regulation does is give investors a false sense of security. Investors should fend for themselves by not doing business with people or firms that they do not trust. If you don”™t trust your broker or other financial advisor, then stay out of the market or risk losing everything you invest.”
What”™s the impact on companies whose actions have damaged their reputations?
“In a competitive industry having a tarnished reputation is fatal. In an uncompetitive industry ”” like the ones in which the credit rating agencies, major accounting firms and bulge bracket investment banks operate ”” reputation does not matter. Firms in these industries have rotten reputations, yet they continue to thrive.”
How can financial companies restore clients”™ trust?
“To the extent that hedge funds and other financial service companies want to raise funds from institutions and people without Wall Street connections, they need to offer concrete promises, perhaps in the form of a bill of rights for investors or other concrete communications that inform investors what they do and do not have the right to expect from these companies. Also, the compensation schemes of financial companies must align the interests of professionals more with the interests of their clients rather than with the interests of the companies themselves.”
What”™s the main takeaway here?
“Forget about institutional reputation. It”™s a thing of the past. What matters now is what clients, customers and counterparties think about the particular professionals on the other end of the telephone or Internet connection.”