News Release: Faculty Experts, Finance and Economics

May 15,  2009

Will Over-Regulation Hamstring U.S. Competitive Advantage?

News Article ImageWilliam W. Buzbee, professor of law and director of the Environmental and Natural Resources Law Program

From Knowledge@Emory

For decades, American presidents from both sides of the political aisle have steadily relaxed regulations governing areas from pollution to finance.

But as the U.S. faces its worst economy since the Great Depression—and with a new president who champions a stepped-up role for government—President Obama’s administration appears poised to move aggressively on a number of fronts: from reigning in the finance segment—including the formerly nearly ungoverned hedge fund market, to embracing new strategies to cut emissions.

A bigger dose of regulation may indeed be in order, say faculty from Emory University and its Goizueta Business School. But they also caution that heavy-handed oversight could pose fresh threats to financial institutions and to other struggling industries.

A new direction for regulation

”From Ronald Reagan onward, the general movement was in the direction of less government regulation,” observes William W. Buzbee, a professor of law at Emory’s School of Law and director of the institution’s Environmental and Natural Resources Law Program. “We will see more regulation under President Obama, but it took a long time for the economy to weaken, and it will take a long time to develop and implement the tighter rules.”

Financial institutions in particular will have to get used to the idea of more oversight, according to Buzbee.

“Many banks went over the edge when it came to overly liberal mortgage lending and exotic mortgage-linked securities, while hedge funds gambled too much on derivatives and other investment instruments,” he says. “The collapse of many companies has increased the momentum to reign in excesses.”

U.S. Treasury Secretary Timothy Geithner struck a similar note in his late-March written testimony to the House Financial Services Committee.

“The crisis of the past 18 months has exposed critical gaps and weaknesses in our regulatory system,” said Geithner. “As risks built up, internal risk management systems, rating agencies and regulators simply did not understand or address critical behaviors until they had already resulted in catastrophic losses. This crisis has made clear that certain large, interconnected firms and markets need to be under a more consistent, and more conservative regulatory regime.”

During his first few months in office, much of Obama’s attention has been focused on economic challenges. But during the presidential campaign, Obama also addressed environmental, healthcare and other issues. Buzbee thinks those issues will not stay sidelined very long.

“The recession has slowed the momentum for legislation targeting climate change,” he says. “Also, to make people pay for greenhouse gas emissions and encourage use of alternative energy sources could raise prices in the short-term, so those efforts too are on a slower track right now. But Obama is not likely to drop them from his agenda.”

In fact, says Buzbee, although industry lobbyists have already mounted a strong push against increased environmental and financial regulation, Obama is likely to get strong public support for some of the changes.

“The recent national recall of peanut products due to salmonella contamination concerns has a lot of people worried,” explains Buzbee. “So the support is there for expanded federal Food and Drug Administration activity. Also, the high number of Americans without health insurance—and the heavy costs to business under our current system—is likely to generate support for new legislation on that front.”

How far does Obama’s mandate go?

Obama may have a clear mandate for change, particularly when it comes to the financial industry, but will he go too far and make U.S. institutions less competitive?

“There is some concern that the administration is using the bank bailout as an excuse to dictate too much to the industry,” according to Narasimhan Jegadeesh, a chaired professor of finance at Emory University’s Goizueta Business School. “The salary restrictions and the prohibitions on hiring H-1B visa holders [both imposed on banks that received Troubled Asset Relief Program, or TARP funds], make some banks jump through very strict hoops and could end up damaging their ability to compete in a difficult market.”

Jegadeesh is quick to point out, however, that he’s not condemning any additional regulation. Instead, it’s a matter of degrees.

“Some enhanced oversight would not hurt,” he says. “For example, perhaps there should be restrictions on insured assets—like accounts that are covered by the Federal Deposit Insurance Corp—that prevent banks from investing them in risky securities.”

Hedge funds may also be subject to more rules—or at least more transparency, according to Treasury Secretary Geithner.

In the wake of the Bernard Madoff pyramid scheme, “it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage,” noted Geithner.

“Hedge fund investments are usually limited to wealthy people who should be sophisticated enough to take care of themselves,” says Jegadeesh. “But it would not hurt to require more disclosure, particularly about risk exposures. It’s still too early to determine how far the Obama administration will take regulation, but there is a general concern that restrictions in general can tie industries’ hands and weaken their competitive advantage.”

One concern is that the government may impose heavy regulation on the “low hanging fruit,” or easily visible targets like hedge funds, according to Kevin M. Crowley, an adjunct lecturer of finance at Goizueta.

“Some activity, like credit swaps, collateralized debt obligations and other derivatives that are not very transparent and that were traded with minimal regulations, probably should be subject to greater regulation,” he says. “But plans to increase taxes on money funds’ offshore profits may go too far, and could hinder the investment activity of U.S.-based funds.”

Unintended consequences and moral hazard

In fact, some “heavy handed” government regulation is already resulting in unintended consequences, says Klaas Baks, an assistant professor of finance at Goizueta and director of the  Emory Center for Alternative Investments.

“The bonus and salary restrictions placed on banks that accepted TARP money represented a fairly crude measure,” he says. “Performance-based bonuses tend to align employees’ incentives with the interests of shareholders and incidentally, with the government, too. Even if the bonuses during Wall Street’s heyday were not perfectly structured to achieve this alignment, killing these bonuses altogether eliminates the link between the parties.”

Additionally, in the long run, says Baks, “people will follow the best economic opportunities,” so the banking segment is likely to lose valuable talent.

Part of the problem with the Obama administration’s efforts is that “you can’t simply regulate away losses,” says Tarun Chordia, a chaired professor of finance at Goizueta. “The optimal level of loan losses in a bank’s portfolio is not zero.”

Chordia says he can understand the concern among the president’s advisers, but adds that research indicates too much regulation can also hurt the economy.

In addition, Chordia worries about politicizing agencies that are supposed to exercise independent judgment.

“The Federal Reserve is getting more involved in market functions [like directly lending money to Wall St. firms and purchasing some mortgage-backed securities] than it ever did before,” he says. “So far the Fed has retained its independence, but will it stay that way? Its deep involvement with markets could leave it more susceptible to political pressure.”

There is better way, according to Goizueta’s Crowley.

“In a healthy free market, capital should flow to the strongest institutions and best management teams,” he says. “When the government interferes with the free market, this process is distorted. Sick companies and weak management teams are supported, and healthy competitors and strong, prudent managers are denied growth capital.”

Some observers, for example, have argued that the federal government should have saved former Wall Street powerhouse Lehman Brothers Inc. from liquidation. But that would be the wrong move, Crowley argues.

“According to this view, we could have avoided much of the market turmoil if Lehman had been protected,” he says. “In my view, this is not clear. We really do not know what the market reaction would have been if another sick company were propped up. And any potential short-term benefit of protecting insolvent banks would be offset in the long run by a financial system that lacks the necessary market disciplines of both risk and reward. Moral hazard would increase, and institutions would continue to take out-sized risks expecting that the government would shelter them from pain.”

In general, “a heavy regulatory hand could crimp the market, causing financial distortions and creating moral hazards,” he says. “Perhaps the best approach is simply to let people pay dearly for their own sins."


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