Regulatory Policy 2.0 : The Real Meaning of Madoff

[First of a two-part Blog Post]

Madoff has been a late-night TV comedy staple for some time now. While his victims surely don’t appreciate the humor, most of use have relegated him to cafeteria conversation, alongside Lindsay Lohan and the Oscars.

That would be a big mistake.

L’affaire Madoff will dramatically affect our approach to regulation. And in this case, our first instincts—can you say, ‘Sarbanes-Oxley 2.0’—would be the worst. We need Regulatory Philosophy 2.0. Here’s why, and how.

The Latest on Madoff. The headlines this past weekend screamed one thing: Madoff Bought No Stocks for 13 Years. ‘Look how brazen he was, how could the SEC miss that, no way his sons weren’t in on it all along, etc.’

It was no surprise to readers of this blog.

On January 17, I wrote, in a blogpost titled Madoff—Investment Fund or Virtual Reality Game

It’s beginning to look like Bernie Madoff’s business model had less in common with a hedge fund or investment management firm than it did with an online virtual reality game. Sort of a Sim City for investors. The money sent in was real: everything thereafter was from Oz…
…[It] was bupkus. Virtual reality money. Sim City money. Monopoly Money. In the real world, it didn’t exist except in Bernie’s bank account and a computer program.

This was not a case of sophisticated hedge fund managers in Greenwich or rogue currency traders in Hong Kong. The SEC was not out-gunned, outsmarted, or out-manned. This was not a Danny Ocean operation.

This was as simple as a Nigerian inheritance email spam scam. Gimme your bank account number and I’ll send you money. A garden variety mugging. Like a good magician, Madoff got us to look one way, while he swapped card decks.

Overnight, this recasts the regulatory task facing the SEC. We can no longer rely on traditional regulatory philosophy: we must get personal, human, and trust-based.

Regulatory Philosophy 1.0. Regulation (and not just in the financial industry) has become driven by three models—separation, compliance, and transparency. None of them stopped Madoff—in fact, they enabled him.

Separation. Think building walls—to legally and physically separate potential co-conspirators. Think traditional anti-trust laws. Think separating accountancies and consultancies. It is a heavy-handed, expensive, and sub-optimal way to regulate.

Madoff used this to his benefit—claiming his brokerage and investment management businesses were separate because, ‘after all, they had to be.’ Therefore FINRA could claim “it wasn’t my job.” Madoff knew FINRA would make that claim; in fact, he depended on it.

Compliance. This approach turns legislation into a blizzard of administrative processes, which must be complied with. Think check-boxes, filed copies, no-later-than dates, renewal requirements. All monitored and tracked in the latest systems. This approach is less heavy-handed, but equally oppressive—and mind-numbing to boot.

Madoff used this also to his benefit. You want forms? I’ve got forms. But the data was itself bogus.

Transparency. Lawyers, financiers, mortgage brokers and credit card operators love transparency-as-panacea. Coupled with a convenient belief in efficient market theory, this enables people to blame those who didn’t read the small print (Rick Santelli, are you listening?).

Madoff used this to his benefit too—blitzing investors with day-trader-like “records” of trades (bogus). We have come to measure “transparency” by the pounds of documents “disclosed,” rather than by their truth or import.

If we focus only on outrage at Madoff and at government bureaucrats, our politicians will do what they’ve always done: legislate more structural boundaries, design more and more checkbox procedures, and require publication of more minutiae. And thus we’ll enable Madoff 2.0–even faster this time.

Regulation 2.0.  There is a better way.

It is based on a simple fact–people are human. People are good and bad, trusting and non-trusting, sometimes all at the same time. Systems don’t commit fraud, people do. In this case, one Bernard Madoff.

Yet our existing regulatory processes are entirely non-human. Walls, processes and transparency are mechanical things. Devised by people, they can be broken by people. And being inhuman–we don’t trust them.

Our existing Philosophy of Regulation does not engender trust. To trust our institutions, we have to return to a simple principle: trust is inherently human. We have taken the human part of trust out of regulation, and we’re paying the price.

Tomorrow’s BlogPost: Why we need to build regulatory policy more around personal trust.

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