the importance of trust

I have had several conversations in the last week with my fellow, non-retired, financial professionals about the impending regulatory environment. In each case they are fearful that too much regulation will be put into place. They all feel that it is inevitable that the regulators will overstep their bounds and put in place regulations that will make our economy less competitive.

I totally disagree with this assessment, if not with the concern. Why?

Well first of all, yes it is possible to put in place too much regulation. Regulation that will impede economic growth. However, this is a question of details, not of the principle itself.

As I said in my last post it is crucial that long-term investors have faith that the financial markets are on a sound footing before they are prepared to invest in them. This makes so much sense that it sounds obvious, yes?

I don’t think that most people have any idea about how fragile all financial markets are. And for that matter, the economy itself. The fragility lies in the absolute dependence on TRUST. Trust that the regulatory framework is a good balance between safe and laissez–faire. Trust that the businesses reporting their results are honest. Trust that your fellow investor is honest. Trust that your broker is honest and represents you well. Trust that investment bankers know what the heck they are doing. Etc. Etc. Etc. Etc. Underlying all capitalism is trust. Don’t believe me? Look at economies where there is rampant, immovable, ne impossible to shake, mistrust. Corruption abounds in South America and Russia where no trust exists that you are going to get a fair deal, be protected by your government, or treated well by the other party in a transaction. The assumption is that it is underhanded. The reason why America’s capital markets became the largest and most trusted in the world was due to a solid regulatory environment. Not in spite of it!

The soundness of our financial markets is a GIGANTIC economic competitive advantage for us. Why? Because businesses here can raise money quickly to fund great business ideas. And because investors trust that everything is fair and square, they willingly provide their capital. In other words, investors here never used to spend much time thinking about the structural issues that are the obsession of market participants in other countries. Instead, investors here spend their time trying to figure out if a specific investment is worthy of their hard-earned money.

Unfortunately, trust is a very, very fragile thing, isn’t it? Don’t believe me? What would hurt more, your spouse or girlfriend of many, many faithful years cheating on you, or knowing that the person you’ve been out with once has decided to see someone else? The fact is that trust is earned and over long periods of time. The result is that with the people and things we trust we begin to incrementally let our guards down. We do this because our mental calculus is that it is wasted effort to worry about people and things that have earned our trust. So what happens when our trust is shaken or broken completely?

The fact is that it takes a long time for trust to be re-established, doesn’t it. Remember when you were a kid and you betrayed your parents’ trust in you? What did you have to do? Did you continue doing things in the same way? No, obviously not. Did you make changes to your behavior to re-earn their trust? Yes, absolutely. Did you go out of your way to restore your parents’ confidence in you? Yes, very likely. In other words, you over-compensated. But what happened was that trust was restored more quickly, yes? Your contriteness was the essential key to the restoration of your personal power with your parents, yes?

OK, so that is why this notion of, “I’m afraid that we will over-regulate” is a crazy one. Why? Because the details of the regulations are NOT, absolutely NOT, the important thing. What is important is the restoration of trust and as quickly as possible.

This was part of the genius of the financial regulations put in place after the Great Depression. The dictates were not very specific. Instead, legislators created a new framework for regulation and then let the new regulatory bodies (e.g. the SEC) create regulations over time. I believe that is the sole concern we should have with regard to this process of re-regulation and new regulations being put into place.

Smiles!

Jason