Wall Street Needs New Regulations

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First, regulators need to change their ninnyish attitudes. They have gone about their jobs in the past decade like hall monitors at the prom, deeply afraid of being ostracized. They need to bring some mettle to their roles. The challenge is to remake the system so that it’s up to the task of preventing, or at least minimizing, the next global meltdown. Alter the structure all you want, but unless you have the right regulatory attitude, it’ll be for naught.

This is not a moment to think small. First, we raze the S.E.C. and the C.F.T.C., along with most, if not all, of the federal banking and state insurance regulatory structure. We should strip the Federal Reserve of its responsibility for regulating banks; it’s enough to oversee the economy. And just as everyone was trying to express how bumbling and irrelevant the S.E.C.’s enforcement approach has been, the agency provided perfect examples.

In mid-November, headlines blared that the S.E.C. had charged Mark Cuban, the billionaire owner of the Dallas Mavericks and a frequent blogger, with insider trading. Did he gain secret knowledge of the failure of A.I.G. and sell his stake? Had he done something untoward with regard to Lehman Brothers? No. Four and a half years ago, Cuban sold stock in a company called Mamma​.com based on inside information, according to the S.E.C., and thereby avoided $750,000 in losses. Today, Copernic, Mamma​.com’s successor, sports a market value of less than $3 million. Cuban may well be guilty. But who cares? It’s as if Homeland Security had a ceremony in 2008 to announce that it had erected a gold-plated bollard at ground zero. And come December, it became clear that the S.E.C. had shockingly botched multiple chances to upend confessed Ponzi schemer Bernie Madoff.

Before the economic crisis became acute, Treasury Secretary Hank Paulson put forward his plan to remake the regulatory system. Like most of Paulson’s initiatives, it was inadequately explained and poorly sold. And the motivation was exactly wrong, born of a fear of regulation that looks ridiculous today. It died on arrival, as it should have.

But surprisingly enough, given the dubious way it began, a Paulson-like framework is a good place to start. It was influenced by what is known in regulatory circles as the Twin Peaks approach, used in Australia and the Netherlands. The idea is to create two financial regulators that are given separate responsibilities not based on financial firms’ lines of business. Currently, we have separate regulators for securities, futures, banks, and insurance. That antediluvian division of labor needs to be scrapped. Under a Twin Peaks structure, one agency would focus on the safety and soundness of financial institutions: the strength of their balance sheets, whom they trade with, and how strong their risk controls are. An agency with this structure would remedy one of the glaring limitations of the S.E.C.—that it has too many lawyers and too few market experts.

The second peak will be more familiar. It would focus on business conduct and investor protection, otherwise known as lying, cheating, inadequate disclosure, and manipulation. This would encompass much of what the S.E.C. is currently supposed to be doing. It would go after big targets and not monkey around with dinky companies and small-time ­insider-trading issues.

The Twin Peaks model has good-cop, bad-cop appeal. The safety-and-soundness regulator can work with firms to make sure they are solid or else the enforcer will come in. And we should consider a third peak as well: one with responsibility for surveying systemic risk. It would monitor the safety and soundness of the entire financial system, rather than assess it on a company-by-company basis.

One debate—sometimes drawn as a Europe-vs.-U.S. argument—is about whether we should reorder regulation based on broad “principles” rather than strict “rules.” This is a red herring, despite the energy expended on it. Rules come from principles, after all. Whatever we have, it needs to be enforced.

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