Should Mary Schapiro save the SEC or shut it down?

Mary Schapiro, reported to be the President-elect's choice to run the Securities and Exchange Commission, is—by several miles—the most qualified person for the job. She's served a previous six-year stint on the SEC (she was first appointed by Ronald Reagan), including a period as acting chairman. She's been chairman of the Commodity Futures Trading Commission. She's currently CEO of the Financial Industry Regulatory Authority, the self-regulatory body for Nasdaq and the New York Stock Exchange. The woman has forgotten more about running a securities-regulation outfit than anyone else in the country can ever hope to know.

But the events of this year—the Bernard Madoff debacle being just the latest and perhaps the most shocking of them—would seem to raise the question of whether securities regulation as practiced over the past few decades is really worth anything at all. This can't just be blamed on George Bush and the weak series of SEC chairmen he appointed. Yeah, Arthur Levitt was better than Chris Cox, and he tried to use his SEC chairmanship as a bully pulpit to rail against some of the excesses of the late 1990s. But the bread-and-butter work of the SEC hasn't changed all that much. It was and is mostly busy work. Look through the enforcement actions of the past year and they're generally either penny ante lawsuits against minor manipulators or cases of closing the barn door long after the horses (and their billions of dollars) have escaped. Look through the 1999 list and it isn't all that different—although it is longer.

The first explanation for this lack of regulatory success is that regulators are never going to catch every financial shenanigan before it blows up. They don't get paid enough, there aren't enough of them, and—as Gillian Tett put it in at FT column last spring—they're as wary as anyone on Wall Street or in the City of "challenging the dominant financial creed." Bad stuff is going to happen from time to time, especially after a long period of benign financial conditions that rewarded the Pollyannas and punished the skeptics in the private sector. No amount of regulatory reform can prevent that.

But there's a second problem with financial regulation that has to do with the structure of the SEC and the rest of this country's financial regulatory agencies. Each tries to manage an impossible balancing act between looking out for consumers/investors and promoting the health of the particular financial sector it regulates. This seems to have been a crucial factor in the SEC's failure to uncover Madoff's fraud, despite repeated tips. Madoff was a pillar of the brokerage community, a man the SEC looked to for advice on how to regulate markets. Who were the people at the SEC to believe when whistleblowers questioned the numbers generated by Madoff's money-management side business—their friend or some cranky outsider?

There's really no solution to the first problem, other than doing away with all financial regulation in the hope that this would make investors and creditors more vigilant. That probably wouldn't work, and definitely ain't gonna happen. But the second, structural problem with the SEC and its brethren in Washington is fixable. If there were one agency charged with looking out for the interests of investors and consumers of financial products, and a different agency (or agencies) responsible for the health of financial institutions,  the bureaucratic incentives would seem to dictate a much more aggressive pro-consumer approach than we've seen so far. And the funny thing is, this division of labor was a centerpiece of the Blueprint for a Modernized Financial Regulatory Structure that Hank Paulson unveiled in March.

So the really important question for Mary Schapiro may not be How are you going to fix the SEC? but How are you going to shut it down and replace it with something better?

Update The wording change in the first paragraph (in bold) is in response to commenter barracho, who writes, "i can name at least three people who have forgotten more about securities--and commodities futures and options--regulation than mary schapiro will ever learn." I can't vouch for that, but neither can I vouch for my original statement. What is undeniable is that she's spent the last 14 years running major regulatory agencies and self-regulation operations, and I don't know of anybody who can come close to topping that.

Update 2 University of Illinois law professor Larry Ribstein makes a similar diagnosis but prescribes the opposite cure:

The SEC should either get out of the fraud protection business and serve warning to investors that the market is their best protection, or get serious about fraud protection and not waste time on the other stuff.

I'd vote for the former. I doubt that any government agency will ever do as good a job as a vibrant market whose participants are alert to the potential for fraud rather than lulled into a false sense of complacency. Moreover, more aggressive enforcement involves the risk of error or worse (politically motivated decisions, Blagojevichism).