Sunday, March 27, 2011

Regulating Shoe Bombers & Financial Institutions

Flying has become more tedious and time consuming since passengers to remove their shoes as part of airport security. As most people are aware, this policy was put into place after Richard Reid, an amateur terrorist tried to set off a shoe bomb in an airplane. This highlights some fundamental problems with government regulation that are applicable to financial regulations. While the goals of terrorists are almost always irrational, their methods are not. When planning attacks, they take existing security measures into account, which means that the chances that they will utilize are shoe bombs are slim to none. Aspiring terrorist will now seek other means to terrorize air travellers or they will seek softer targets like sports stadiums and museums. And while intelligence operatives may be swift and effective, bureaucrats never move and change as fast as the individuals and organizations that they seek to regulate. By the time they have planned and implemented a new regulation, such as airport shoe checks, that regulation has already become outdated. And hence its only achievement will be to make air travel slower and more costly for airlines and travellers alike.

On a deeper level this represents the distinctly American obsession of seeking to eliminate uncertainty and risk by continuously expanding laws and regulation. In some instances these endeavors are successful, but a great many social and economic phenomena are by their nature in a constant state of flux and are beyond the control of static rules and regulations. In these cases, our focus should be on covert enforcement based on sound intelligence gathering. In other words, rather than burden all travellers with ineffective, security pantomimes, we should focus our monitoring and disrupting terrorist networks. And we must focus limited attention and resources on individuals who statistically pose a greater risk. This does not mean we should harass all Muslims; frisking an Elderly, Iranian Woman, just because she wears a hijab would be a waste of resources, because on three counts (age, national origin & gender) she does not pose a statistical risk. However, young men, like Richard Reid who attended radical mosques and madrases in London and Lahore fit the profile to a tee.

How do these principles apply to financial institutions? Take the real estate crash; by the time regulators made the mortgage market more "safe & secure," fraudulent or reckless investors had moved on to "softer targets." Crooks and excessive risk takers know that utilizing mortgages to realize illicit, high return gains is equivalent to a terrorist using a shoe bomb after the Richard Reid incident. In both cases, regulators are focusing their attention on preventing a specific set of behaviors. Knowing this, terrorists and financial criminals will seek new means or entirely new targets, leaving a rattled public to bear the costs of new regulations. While they may be warranted, such regulations will not protect the public from the next bomb or financial bubble. And if anything, in response to the financial meltdown, most banks are now erring on the side of caution, to the detriment of the general economy.

Numerous commentators cited the Bernie Madoff scandal as proof positive that we desperately needed more regulation of financial institutions. But, a closer look at the Madoff story shows that the problem was not a lack of laws, but failure to enforce existing laws. According to Wikipedia:

"Concerns about Madoff's business surfaced as early as 1999, when financial analyst Harry Markopolos informed the U.S. Securities and Exchange Commission (SEC) that he believed it was legally and mathematically impossible to achieve the gains Madoff claimed to deliver. According to Markopolos, he knew within five minutes that Madoff's numbers didn't add up, and it took four hours of failed attempts to replicate them to conclude Madoff was a fraud.[81] He was ignored by the Boston SEC in 2000 and 2001, as well as by Meaghan Cheung at the New York SEC in 2005 and 2007 when he presented further evidence. He has since published a book, No One Would Listen, about the frustrating efforts he and his team made over a ten-year period to alert the government, the industry, and the press about the Madoff fraud."

Rather than subject travellers and financial consumers, to new and more onerous laws, there are three things that government can do to protect the public from criminals and terrorists, be they corporate or Islamic in nature:

1) Profile: a business, such as Madoff's that consistently produced unsustainable rates of growth, over extended periods of times warranted a serious federal probe. To those who looked, the red flags abounded, much like they did with the shoe bomber.

2) More Responsive Investigators: If the SEC had responded to Mr. Markopolos's concerns in 1999, the Madoff scandal could have been avoided and investors may have exercised greater caution. We can assume that a combination of institutional sloth and a cosy relationship with investors contributed to the SEC's ineffectiveness. The same can be said of British Intelligence; why did they not better monitor Richard Reid and the other alienated young men who attended the Finsbury Mosque and later radical madrases in Pakistan?

3) Punishment: Corporate fraud and white collar crimes should be treated as harsh, if not harsher than less destructive street crime. The same should be done for any individual or organizations preaching violence in the name of Islam.

Of course we must always strive to put wise regulations into practice, to minimize risk and protect the public. But, we must avoid illusions that we can maintain safety and security by imposing undue burdens on the general public. Our efforts must be focused on intelligence gathering and targeted enforcement and avoid needlessly multiplying the number of regulations and bureaucracies that govern American life.

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