Regulating: A Losing Game

Out of the frying pan and into the fire.  Last month Russell Wasendorf, Sr. attempted to commit suicide via asphyxiation by using a hose to funnel the exhaust from his Chevy into the car. A Good Samaritan thwarted his attempt and saved his life.  He is currently in jail awaiting trail where he will be charged with stealing around $200 million dollars from his own clients for the past twenty years.

Within the financial world $200 million is not a particularly large amount of money.  A scandal of this magnitude, although terrible, would not normally ring many alarms, but following the Madoff Ponzi scheme and the collapse of MF Global, it has done so, and with good reason.  This outright theft, along with the more recent LIBOR fixing scandal, has, to a certain extent, confirmed the public fear that the financial industry cannot always be trusted to keep investors’ money safe. This fear is helping to fuel the current economic downturn as investors continue to lose faith and withdraw money from financial markets.  Although this doubt in the system is certainly justified and is clearly an important issue, these recent scandals also beg a more fundamental question:  Can regulators be trusted to regulate?

It is almost laughable how simply Wasendorf was able to fool U.S. regulators as he stole hundreds of millions of dollars through his futures firm Peregrine Financial Group.  The ultimate authority for regulating firms such as Peregrine resides with the U.S. Commodity Futures Trading Commission (CFTC), which, because of its limited resources, delegates most of the oversight, such as regular auditing, to the National Futures Association (NFA).  The NFA, an internal self-regulatory organization, had audited Peregrine three times since 2010 and failed to pick up on the fraud.  Even more shocking is the fact that Wasendorf was able to frustrate the NFA’s attempts to verify Peregrine’s bank statements simply by sending them forgeries.  Instead of picking up the phone or contacting the bank electronically, the NFA relied on written mail to reach Peregrine’s bank.  The only problem was that Wasendorf had provided his own P.O. box as the bank’s address.  Receiving these letters himself, Wasendorf was easily able to falsify records.  He wrote, “Using a combination of Photoshop, Excel, scanners, and both laser and ink jet printers I was able to make very convincing forgeries of nearly every document that came from the Bank.”  When the NFA finally gained enough sense to contact the bank for electronic records, they stumbled upon nearly twenty years of fraud.

Although it is clear that regulators at the CFTC and NFA cannot be blamed for this scandal, it is rather astounding just how incompetent they were at detecting it.  When this failure is seen in aggregate with the several other scandals around the financial world, doubts quickly begin to arise about nearly all regulators’ abilities to provide oversight.  They are clearly struggling to do their jobs effectively.  Blame, however, should not fall solely on their shoulders, for they are playing at a natural disadvantage, which can be seen if we consider the massive disparity in resources between the financial services industry and those organizations that regulate them.  The CFTC for example, which is one of the largest regulatory agencies in the United States, employs roughly 700 people and has a budget of about $200 million.  Goldman Sachs, on the other hand—a single bank that participates in the futures trading regulated by the CFTC—employs about 47 times as many people and has about 22 times as much spending money, with 33,000 workers and $ 4.4 billion in net income for 2011.  With this absurd discrepancy of resources in mind, it should come as no shock that regulators struggle to keep up with financial firms’ attempts to skirt regulations (both legally and illegally).

The problem is exacerbated by the fact that there is no clear solution.   Adding more resources does not seem to be a possible remedy, because of the government’s limited funds.  The U.S. cannot afford to simply throw money at this problem. Attempts to find and incentivize better regulators also run into problems because of the nature of the job.  In addition to being understaffed, regulators are also underpaid compared to those working in the financial sector. Considering this, it is not surprising that the financial industry attracts a much larger array of talented people who can do their work at a much higher level.  Even when people are at their jobs on these opposite sides of the industry, their incentives are vastly different.  A banker who exploits some sort of regulatory loophole or flat-out breaks the law stands to make millions of dollars, while a regulator who manages to do his or her work exceptionally well and stops the banker merely gets a “job well done.”

It seems obvious that regulators are struggling to do their job and provide the policing that the financial industry needs, even if it is not entirely their fault.  Although this may not be the main problem behind financial scandals, it is certainly present and fueling the flames of fraud.  If we wish to change the industry that has caused so much grief though its greed, changing the organizations that are meant to prevent this fraud may be a good place to start.