To appear in 2003 Wall Street Journal's "Classroom Edition" and also

Prentice Hall classroom textbook.

Should the government do more to regulate financial markets?

Yes.

Financial markets work best when investors are fully informed and the markets are free of fraud and manipulation.

They also work better when there isn’t a breakdown of management control at companies, or the threat of failure of one financial institution leading to the failure of others and in turn a possible collapse in the market. These are not problems that can be solved by individuals’ self-interests working things out in the marketplace. Instead this is where the government is needed to make markets more stable and improve the way they work.

In an unregulated market, investors will not have enough information to guide their investments, which should not be based on rumor and hearsay. Companies have incentives not to share information, such as bad news about themselves or information about others that is not already known in the marketplace. That’s why regulators require companies to fully disclose information. That way, the entire market is better informed. This results in a greater willingness of firms or individuals to invest. Better rules are needed now to improve disclosure, especially in financial transactions such as “derivatives,” which are complex financial contracts whose values are “derived” from the price of something else such as a commodity or security.

Fraud and the manipulation of market prices rob investors of a fair return on their money and this discourages investment and harms the entire economy. But possible gains from cheating apparently have become more of an incentive to many than the loss of a good reputation, so destructive activities continue. A large share of financial markets are not covered by anti-fraud and anti-manipulation prohibitions. Strict rules against fraud and manipulation are needed that apply to all financial transactions, even those that occur outside the formal securities exchanges.

Another reason regulations are important is because risks taken by one brokerage firm can harm not only that firm but other companies as well. When a business fails it harms not only its employees, clients, vendors and creditors but also the firms that lent money to the creditors, clients and vendors. Yet this potential loss to others does not restrain firms from taking greater risks.

In order to limit harm to others, better regulations are needed. We need new investment rules for the managers of pension funds and insurance companies because of a new class of high risk securities and derivatives . The government also needs to set standards so that adequate collateral is used to back up financial transactions. Lastly, the government needs to encourage, if not require, that clearing houses be used to make sure trades are completed in full.

U.S. financial markets did not become world class until after prudential regulations made them honest and more stable. Today they are suffering from a lack of trust in confidence – not over-regulation.

Randall Dodd

Director, Financial Policy Forum

Washington, D.C.