Will the Meltdown Lead to Sox 2.0?

The Find: One legal scholar reminds us that Sarbanes-Oxley was supposed to prevent market crashes like the currently unfolding disaster from happening and ponders whether the present turmoil will bring about a destructive Sox II.
The Source: The Ideoblog of University of Illinois professor of law Larry E. Ribstein, via Marginal Revolution.

The Takeaway: As Congress is battling about the proposed $700 billion bailout this week, some cooler heads in academia are looking further into the future, and they're a little concerned about the new regulation they see materializing out there on the horizon. While few would argue against the claim that the unfettered capital markets managed to get themselves (and the economy at large) in a whole lot of trouble, Ribstein asserts that doesn't mean that more regulation is necessarily the answer. Instead, he reminds us that the government's first stab at preventing bubbles and crashes, Sox, "utterly failed" while imposing huge costs. He breaks it down like this:

The big problem we face now is finding out how much assets are worth. Only markets can do that. Surely the government hasn't a clue. Some say that it's evil over-complex derivatives that got us into this fix. Well, if the problem is over-complexity, we might ask why the market would produce more complexity than it needs.

What does Ribstein blame for this complexity? Regulation. And what would more regulation likely result in? More complexity. He notes his suspicion that "regulation of the derivatives markets will lead to still more complexity by inducing the markets to work around the additional regulation."

Forcing more disclosure of information would be counter-productive, according to Ribstein, as "the market is already buried under a mountain of disclosure. Clearly ordinary investors can't sort through this, and the sophisticates probably don't need it." Instead of placing the blame on lax disclosure regulations, Ribstein points the finger at the incentives that led managers to buy derivatives with values "based on patently unrealistic assumptions about real estate prices," i.e. junk.

So what's the solution? "Better managerial incentives and more information," says Ribstein who goes on to warn that "by regulating short-selling and hedge funds, we might get less of both." For a more in-depth and technical discussion of the issues and the proposed solutions, check out the complete post.

The Question: Play regulator for a minute: what new rules do we need?

(Image of the making of more socks by Breibeest, CC 2.0)

Jessica Stillman

Jessica lives in London where she works as a freelance writer with interests in green business and tech, management, and marketing.

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