Catching crooks will hurt investors

By Michael Coote

Friday 11th October 2002

We are not alone, it seems, in taking the view that if something goes wrong the government ought to fix it and that there ought to be a law against it.

The Economist has been reporting on the gathering tide of legislative interventionism in the US as politicians and elected attorneys-general have begun to exert themselves in response to public outrage over the egregious gouging and dishonesty that have brought the world's model sharemarket into international disrepute.

Due to multiple overlapping jurisdictions, erring companies find themselves targeted not only by the Congress, the Senate, the FBI and the SEC at federal level but also by attorneys-general at state level. An avalanche of civil lawsuits adds to the mess of litigation engulfing companies, particularly investment banks.

The latter are staring at the serious prospect of being forced to break off their analysis activities from their corporate activities in much the same way as accountancy firms are being pressured to separate auditing from consulting. Some of the biggest names in investment banking have been caught out tailoring "objective" analysis to suit capital-raising requirements of their clients, not to mention using cushy IPO share allocations as bribes to keep clients sweet.

The manic-depressive moods of the state toward the markets tend to oscillate between favouring laissez-faire and craving intervention. At this stage of the mood cycle, interventionism is on the rise.

Capitalism, always the bogeyman, is on trial, with a raft of investigations, laws and regulations on the way to try to put things right. What remains questionable is whether this burst of zeal will end up wronging rights.

It is noticeable both here and in the US that existing laws and regulations are being used to go after corporate malefactors, while new restrictions are in the pipeline.

Only where extant laws fail to capture the guilty should governments create more legislation to stop the gaps. Like angels on the head of a pin, laws should not be multiplied beyond necessity.

The rationale for more laws to control markets is that risk to investors and broader society will be reduced. However, the legitimate role of risk in capitalism should not be compromised by the desire to punish dishonesty.

Capitalism is about taking risks. Investors buy into those risks and collectively shoulder their burden to receive commensurate rewards. Over-regulation and excessive legislation can well have the effect of distracting management from creating wealth and turn it instead into a compliance committee in permanent session.

Substantial consequences follow from such a situation. In taking less risk, companies cannot expect to achieve higher returns. Investors are thereby forced to lower their risk-adjusted expectations of such companies and may look elsewhere to other countries or non-core asset classes to move back up the risk-return scale.

For retirement savers, the hurdle to financial self-sufficiency is raised. For economies, growth and diversification are inhibited. For governments, the revenue base is made more problematic, with the likelihood of over-taxing a low-return private sector. The effects of overdoing it on legislating against risk can be systemic with unintended consequences.

Ironically, while governments try to stamp out risk from capitalism, they can thereby impose more on investors due to increasing volatility in the markets. For example, governmental response to the post-Enron accounting scandal has forced corporations to make sure their books and projections are squeaky clean.

One casualty is smoothing profits and revenues. As a result, profits and revenues become volatile due to being confined to the period in which they are actually incurred, throwing share prices around wildly in response. Regardless of whether smoothing the books is malign, preventing such tricks comes at the greater cost of less stability. Far from steadying markets, accounting interventionism can unsettle them.

The Economist quotes federal deputy attorney-general Larry Thompson as saying of arraigned corporate executives: "Our strategy is straightforward. We aim to put the bad guys in prison and take away their money."

Fair enough for the bad guys but one should hope the good aspects of capitalism are not cast into the dungeon and the risk-adjusted return expectations of investors are not crushed by compliance thumbscrews.

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