Luigi Zingales of Chicago Univ has written an excellent paper on future of financial regulation. Abstract:
The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. For this reason, I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management.
He highlights financial system has gone through a sea change from being individually owned to institutions owned. What has also happened is that large number of people now depend on financial markets for their retirement purposes. So earlier you had to pass laws/regulation to save people from frauds etc, we still need regulations to save people from such dramatic collapses in financial markets.
The massive increase in the use of financial markets for retirement purposes has made the financial markets much more important for ordinary people. In 1975, the value of privately-held pension assets represented only 18% of the GDP and 70% was represented by defined benefit plans, which did not directly expose workers to financial market risk; today, pension assets represent 60% of the GDP, 70% of which is in defined contribution plans and thus exposed to financial market risk. As a result, the efficiency of individual investment choices and the costs they bear is not just an issue of fairness, but a primary public finance consideration. Without wise investments, the vast majority of Americans will not have enough to support themselves in retirement.
He proposes 3 measures:
First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board. This reform will make it worthwhile for directors to develop a reputation of acting in the interest of shareholders and hence to make corporate managers accountable. However, to minimize the risk that institutional investors pursue a self-interested agenda, institutional investors should be themselves independent. To achieve this goal, I propose a new Glass-Steagall Act, which instead of separating commercial and investment banking will separate mutual fund management from investment and commercial banking.
The second goal should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all the expenses that will be charged to their investment, including the amount paid in trading commissions, itemized as commissions paid for trading and those paid for services. Similarly, at the time of the purchase, brokers should disclose the fee they receive on the different products they sell, including the “soft dollar” they receive in the form of higher trading costs. The same strict standards should apply to both brokerage accounts and money management accounts.
The third goal should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration from the former to the latter suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private one. In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. On the private market front, there are compelling reasons to mandate a delayed disclosure provision in which hedge funds, private equity funds, and even companies private equity funds invest in report information and performance with a 1 to 2 year delay.
So, in first he talks about a new Glass SteagalL Act which seperates MFs from Commercial and I-Banking. I think there is a need to seperate all investment management options (MF, hedge funds, private equity etc) from C-Banking and I-Banking. What is also happening is that most of these C-Banks/I-Banks also own (partially or fully) quite a few of these investment vehicles.
Second is basically a nudge which nudges the MF/brokers etc to disclose all about the expenses charged by them to the investors. Thaler/Sunstein had also proposed something similar in this WSJ article using internet. Zingales also adds:
A more delicate topic is whether to take a more paternalistic view toward investors who seem to behave in an uninformed or irrational way. At the very least, there is a strong case to apply some version of the “libertarian paternalism” à la Thaler and Sustein (2003), by introducing default options that favor low-cost indexed funds. For example, it could be required that every 401(k) plan contains at least one low-cost index fund, which should be the default option for investors, unless they specify otherwise.
India’s pension authority has already taken lessons from the same.
The third proposal is a follow-up to the first proposal. It is only when we know enough about private financial market participants can we know whether they are independent or not. This has been raised many a times but nothing has really been done. The Private financial market activity has only exploded without any regulation.
A very interesting and readable paper with loads of interesting stuff (a Luigi Zingales paper always is).