Avoiding bubbles: SEC has it backwards

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: The financial markets should be regulated mostly by examinations, not prosecution, which should be far more intense when prices rise, not after a crash. The Securities and Exchange Commission should devote most of its resources to on-going examinations.

The examinations first should focus on large institutions (financial or industrial), whose failure by fraud might affect investors' trust in prices and lead to a crash. Then they should target institutions whose share-prices have risen persistently, signalling the "too good to be true” syndrome. Most importantly, examinations should increase with a general and persistent rise in market prices. This is the time when fraud and violations of the law might accompany true and tested justifiable success. This is the time when “irrational exuberance,” as former Federal Reserve chairman Alan Greenspan once described market bubbles, is probably on the rise.

Continuous examinations are not new for the regulators and those being examined. They are likely to be less costly than court cases, especially against huge corporations using well-staffed law firms. Their focus should be on institutions whose failure may shake the system. Visits by regulators may produce a mild deterrent. Instead of harsh sentences and inflexible rules, examinations and suggested corrections can enhance and inculcate good habits to overcome temptations. As a bonus, examining regulators would pick up on the latest financial innovations and developments in the markets. Had regulators understood the terms of the subprime mortgages, they might have been alerted to the amazing AAA rating that these mortgages received.

Examiners should learn about - not regulate - unregulated financial techniques, and acquire knowledge, which they should share with colleagues. If regulators understand today's bubble mechanisms and identify attendant violations of the law, they can stem the trend toward empty prices before they rise and inevitably result in a painful crash. And examinations need not mean publicity. Regulators, by law, should assure examined institutions of confidential treatment.

We have been doing just the opposite. Half of the SEC's resources are devoted to enforcement, including investigation of particular offenses. Its Office of Compliance is far smaller.

In our current system, financial institutions are left virtually free of regulation during the rise of a bubble. With the inevitable crash, regulators are energised to investigate, prosecute, and come to the rescue failing institutions.