Does Regulation Prevent Financial Fraud?

Predictably, the Bernie Madoff financial scandal has prompted calls for stricter regulation of the investment industry, just as the collapse of the Manhattan Capital hedge fund led to calls, by the Securities and Exchange Commission and others, for new anti-fraud regulations in 2004. If those regulations reduced fraud significantly, they would seem to be a reasonable solution to a real problem, but at least two assumptions underlying the SEC’s proposal in 2004 were dead wrong, according to financial journalist Chidem Kurdas, writing in the lead article of the Winter 2009 issue of The Independent Review.

First, government regulators already possessed the ability to detect fraud at Manhattan Capital. Hence, the extra benefit of the SEC’s proposal was unclear. (Was the SEC engaging in a bureaucratic cover-up or trying to justify a larger budget?) Second, securities regulations themselves can increase the likelihood that an investment will turn sour: by lulling investors into thinking their funds are more secure than they really are, regulations reduce the incentive to closely monitor one’s investment.

Wishful thinking can undermine the diligence of investors and regulators alike, but there’s often a big difference in the consequences of their respective mistakes, Kurdas argues. When investors fail, everyone tends to learn from their mistakes; but when regulators fail, new regulations are proposed, and investors are not given stronger incentives to learn.

“The conventional response of boosting government watchdogs magnifies the impact of their mistakes while reducing both the watchdogs’ and the public’s incentive to learn,” writes Kurdas. “It creates a vicious spiral of more regulation, regulatory failure, and even more regulation.”

You can follow Kurdas’s insights on mutual funds and hedge funds, respectively, at MutualFundSmarts.com and HedgeFundSmarts.com.