"Regulation - Too Much or Too Little, or Just Dumb Regulation?"

Sydney M. Williams

Thought of the Day

“Regulation – Too Much or Too Little, or Just Dumb Regulations?”

August 11, 2011

Congress is always more interested in writing new legislation than in ensuring the enforcement of existing rules. The reason is as old as the oldest profession. Once laws have been written, lawyers are hired by affected businesses searching for loopholes, while lobbyists spend millions on those in Congress seeking exceptions. It is a symbiotic relationship, as old as the republic, which allows business to circumvent laws intended to restrict them and provides those in Congress the means to run for re-election. When a member of Congress is so unfortunate to lose his job he simply doffs the hat of a lobbyist. The game goes on.

What brings this to mind was an article in yesterday’s Wall Street Journal regarding a decision by Main Street Bank of Kingwood, Texas to exit the state banking system. The problem, according to Thomas Depping the bank’s chairman, is the tightening of the “regulatory noose.” Following the financial crisis, regulators were blamed for lax oversight. Typical of bureaucrats and frankly typical of human nature, they shut the door after the horse had left. They chose to issue new rules – more onerous than the ones they had failed to enforce. “Regulators,” the Journal quotes Paul Merski, chief economist for the trade group, Independent Community Bankers of America, “have gone one step too far and are choking off lending.”

The complaint filed by Main Street Bank is instructional. The bank concentrates in small business loans, with an average loan size of $100,000 for customers with less than a million dollars in revenues. Ninety percent of their loan portfolio is in such instruments. Charge-offs represented 1.25% of assets in this year’s second quarter versus an industry average of 1.82%. Nevertheless, the FDIC wants small business lending to be only 25% of total loans, despite this banks history and focus. That pits a perceived safety issue on the part of the FDIC against a growth decision on the part of the bank. It appears that the FDIC chose to ignore that inherent in small business loans is diversification. But an arbitrary decision, made by a bureaucrat in Washington, to cause a bank in Texas to conform to a lending model that might work in Ohio makes little sense. Regulators should be concerned with the quality of the loan portfolio, write-offs as a percent of assets and overall capital requirements.

The result will be that Main Street Bank will give up its charter and set up an operation as an independent lender. The consequences will be fewer funds available at a higher cost for the small business borrowers who had been banking at Main Street, and greater risk for the investors in the new enterprise. The FDIC’s decision seems a particularly bad case of timing. The economy has weakened materially and we may be on the cusp of another recession. Two days ago the National Small Business Association reported that 88% of small business owners anticipate a flat or recessionary economy in the coming year. They also reported that 45% of small businesses (versus 40% in December0 do not expect growth opportunities in the coming year “due to the inability to access adequate financing.”

Typically, regulators come roaring into town only when the ambulance has already departed with the patient. This tale of bad timing applies to the stock market as well. In the past, volatility such as we have been experiencing would represent investors scouring toward safety, like lemmings, piling into “risk free” assets, or changing their minds and dashing toward riskier assets. Unfortunately today it represents something far more ominous – the role of high frequency traders. These algorithmic programs are designed to capture minute mispricing in securities. With their speed and their physical location adjacent to exchanges they have been accused of front running orders. Regardless, they are chasing traditional, fundamental investors away from the field and turning what was a mechanism for raising capital for business, and a means of providing liquidity for investors, into a casino.

From what investing clients tell me, these traders provide no social or economic value other than to line their own pockets. They do have prominent defenders. Two years ago, as stocks were climbing out of the whole created during the credit crisis, Arthur Levitt, former Chairman of the S.E.C., penned an op-ed in the Wall Street Journal in which he referred to these traders as “just the next stage in the ongoing technological innovation of financial markets.” As for those who assert that “high-frequency trading has no moral or underlying economic value,” he responded: “The Securities and Exchange Commission should ignore these complaints.”

Having friends in high places has obviously served these traders well, as they now account for 75% or more of total volume. Wild swings in individual stocks, taking place in microseconds, allow these traders to make fractions of pennies, multiplied millions of times. It translates into enormous profits, which help feed our political system.

Our firm has been in business for forty-seven years executing customer orders. We trade several million shares every day. From our perspective we can see no value these people add to our clients’ returns. They add no liquidity, but they do add to volatility, chasing real investors off the field. They accentuate trends, acting as a multiplier. They love volatility. They abhor passivity. Thus far August has experienced five days (out of eight trading days) in which the Dow Jones Averages have risen or fallen more than one and a half percent. In contrast, through the end of July there had only been nine such days. This the second week in August, with its unusual volatility, looks ominously like the period from mid September to mid November 2008. On July 5 the capacity used by the Consolidated Quote System was increased to one million quotes per second, a 33% increase, permitting an increase in quote stuffing, the practice of entering and cancelling orders to slow down the prices seen by regular investors.

Our Treasury is in need of revenues, as we all know. One place to start would be to increase the capital gains tax on intraday trades. The most important reason for doing so would not be for the money collected, but for putting a “Denver Boot” on High-Frequency Trading.

We cannot live without regulation. That we all know, but it must have commonsensical characteristics and should not be based upon favoritism. …………………………………………………………………………………….

Forty-nine years ago this day I boarded a bus in Boston, debarking a few hours later at Fort Dix for basic training. In memory of that day, I will be taking my three oldest grandchildren – cousins aged nine, ten and eleven – on the ferry this afternoon to Highlands, NJ and the house we rent in Rumson for the month of August, a far more attractive place than the Pine Barrens of southeastern New Jersey. I will be back Tuesday morning.