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.
I am interested to see where you are going with this, but I do have a few issues.
Separation can be good. Having independent auditors review your operations keeps you on your toes. Madoff’s auditors were a captured small shop, not independent and not separate. Having a separate custodian so assets can be segregated and identifiable is good. Madoff did not have a separate custodian.
It looks like Madoff preyed on the separation of responsibilities in the SEC. Was he a hedge fund, an investment advisor or a broker-dealer? Each had a separate role in the SEC and each seems to have the other was looking at Madoff.
Compliance has gotten a bad reputation. Check the box is not effective. However, there is a growing movement to take a more holistic approach to compliance by matching it up with risk management and governance. More to come.
Transparancy is good. But you are right to point out that reporting lots and lots of information can obscure the underlying problems. Enron did this alot. It looks like Madoff did as well. Madoff was not transparent in his operations. From the stories I have heard, Madoff would not let anyone into his operations and would not let anyone know how his investing strategy worked. I think people confuse disclosing information as transparency. It is not transparency if businesses are only making selective disclosure.
Doug, thanks for contributing to the dialogue.
Separation can indeed by good, and the examples you pick are powerful ones to that point.
At the same time, it’s not clear to me that divorcing auditing from consulting, a la Sarbanes Oxley, did us a service. It greatly constricted the world experiences of auditors, thus rendering more vulnerable to being blindsided.
Glass Steagall is an interesting case; one can argue it served us very well for years, and that its repeal led to our current economic downfalls. I’m not as sure about that one, but we may be too close to it to have an historical perspective as yet. What do you think?
Sounds like we’re in violent agreement about the dangers of separation of responsibilities within the SEC, and any movement in the holistic direction you mention sounds right to me too.
I could not agree more with you that disclosure doesn’t equal transparency. It’s a distinction we all need to remember in all arenas of business.
I have not looked closely at the effects of separating the accounting from the consulting. I agree with the concept. Having a firm act as a consultant on separating up a financial structure and then having another branch of the same firm act as an auditor of that structure on its face has some inherent conflicts.
As for the downfall of Wall Street, I am not sure that the separation of financial institutions contributed to the implosion or not. The damage was so widespread it is hard to tell.
Personally, I focus much of the blame on the rating agencies. They were clearly wrong about their ratings on billions (trillions?) of dollars of mortgage-backed securities. The AAA rating bestowed by the rating agenceis turned a pool of mortgages into gold, when in reality they were toxic.