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If you had studied finance in Europe in the early 1990s you would be aware of two raging topics in academia. First, was the how much regulation was required for efficient markets? Second, was dividends paid from profits or from cashflow?

Today, we know the answer to the second question, i.e. from cashflow, but only have a partial answer for the first question. The partial answer is that the 2008 Wall St. ‘mess’ clearly shows us that no regulation or little regulation is definitely a bad thing. That was an expensive lesson, not just for Wall Streeters, but for the investing American public, too.

In today’s New York Times editorial Starting the Regulatory Framework, the following paragraph caught my attention:

“In addition to explicit regulation of derivatives, those rules must include limits on the amount of money that financial institutions can borrow in order to boost returns — and higher requirements for the amount of capital they must hold to support their activities and cushion their losses.”

A friend of mine told me that here in the US regulation tends to be short but in Scandinavia it tends to be long. I think we miss the point when we focus on ‘explicit’ regulation or even the length of a regulation as a measure of ‘explicitness’.

I do believe that good regulation must have three properties.
1. Instill Clarity. It should be clear from the wording of the regulation what the spirit of the regulation is, even to dissenting stakeholders. Clarity discourages people from gaming the system.
2. Promote Transparency. Regulations should promote open and full disclosure of what a company is doing. For example if something is outside the books, for example off balance sheet, regulation should require that this be made visible (amount, timing, penalites, exposures, and historical trends) even if auditors, accountants and internal parties believe otherwise.  This would include trading and derivative exposures, in a manner that would facilitate public scrutiny because markets are only as efficient as the information they have available to them.
3. No Exceptions. Everyone lives by the same spirit of the regulations. This ensures that market players do not arbitrage off an unregulated segment of the market when a regulated segment would not allow them to make similar profits.

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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