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Good Regulation, bad regulation

Posted by Graeme in Business & Investment,Market failure at 8:23 am on Thursday, 21 June 2007

If the continual tightening of regulation in the financial sector good or bad? It depends.

It appears that subjecting Wall Street investment research to legal pressure to be more independent has made things better. The effect has been that sell side analysts are now reasonably willing to make sell recommendations.

I am not certain that this has been entirely due to the legal pressure. Pressure on analysts have changed with the rise of hedge funds giving them an import group of clients who love sells, providing some balance to the traditional pressure from their own investment banking departments to be relentlessly positive about clients, potential clients (everyone who was not already a client).

However, given when the change occurred, I am pretty convinced that the change can be attributed to agreements forced on the major investment banks by the then New York attorney general Eliot Spitzer.

Economist Kash Mansori blogs that this is a case of market failure in financial markets, the show-piece of free market capitalism.

A less successful piece of legislation has been the US’s Sarbanes-Oxley legislation. No one doubts that it has been a very expensive way of protecting investors and the public from another Enron. It has also become apparent that it has been causing New York to lose business to London.

A recent piece of academic research has provided evidence for the loss of business to London. Even worse it has suggested that it has lead to American companies increasing hoarding of cash (rather then investing it or returning it to investors), and reducing both capex and R & D expenditure.

This is a very damaging set of unintended consequences, even by the standards of panic legislation. Will the next politician who thinks “we must do something”, just stop and think a little before acting? I know the answer, its “no”.

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