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How should we think about President Obama’s newly proposed financial regulations? I suggest that to do so,investors have to ask a basic question which is this: what is a regulation?

To answer that question, I’d like to reflect on the wisdom of one of my law professors. In his class on tort law, Judge Guido Calabressi would teach his admiring students (including this admiring student) a fundamental point on the true nature of law. Law is merely something that assigns liability for certain behavior to one party or another. The Judge would point out that in one sense, it doesn’t matter which party bears liability, given that parties are free to “contract around” the liability. For example, Judge Calabressi would posit a law that assigned strict liability to car drivers for accidents involving pedestrians. Car drivers could (and do) contract around such liability by purchasing auto insurance, shifting the cost of the liability to an insurance company for a fee. Alternatively, Judge Calabressi imagined, you could structure the law so as to assign strict liability to pedestrians for accidents involving automobiles. In that scenario, pedestrians could contract around the liability by purchasing catastrophic health insurance policies, and policies that would pay car drivers for the dents in their cars caused by running into pedestrians. So in terms of risk allocation, the net effect of how either law allocates risk is identical, because it can always be shifted (at a cost) to an insurance company. So what, students were left to wonder, is the point (if any) of even having a law at all if law doesn’t actually matter?!
Two things follow from Judge Calabressi’s philosophy of law. First, it is clear that having a law, verses having no law, amounts to the same thing: either scenario equates to an allocation of risk. The second thing that follows is something his Honor would present at the following class. He would point out that there is, in fact, a profound consequence of assigning risk to one party or the next, which is that by assigning liability among parties, laws create incentives which, in turn, ultimately influence behavior. If I am a driver in a strict driver-liability state, I might have an incentive to drive with squishy-soft bumpers on my car, if doing so would bring down my insurance costs. Alternatively, if I am a pedestrian in a strict pedestrian-liability state, I might have an incentive to wear armor-plated underwear whenever I cross the street – particularly if doing so might spare me some pain and agony, and lower my insurance costs to boot. The task of the legislature, then, is simply to make a judgment as to which behavior is more worth encouraging: getting people to drive with squishy bumpers, or getting people to wear armor plated underpants.
Squishy bumpers and armor plated underpants are the pure essence of what law is.
With that in mind, let’s now return to the question investors should be asking in light of President Obama’s proposed rules. We now see that like all law, a regulation is something that shifts the risk of liability. The next question is this: how?
Under the previous administration, the risk of financial improvidence on the part of banks was born largely by investors who owned shares of banks. In retrospect, it is clear these entities were subject to little oversight and were virtually free to engage in any sort of risk-taking endeavors their managers saw fit. It was up to investors to judge whether this behavior on the part of their companies would produce profits or lead to losses, assuming the investors could even access the requisite information to make that call. Judge Calabressi’s philosophy might be that a law (or lack thereof, which amounts to the same thing) that assigns risk to investors (as opposed to some other party) is irrelevant in one regard: investors can contract around that risk by owning put options on their bank stock, by owning enough shares to enable them to control the board of directors of the bank, or other means. But on another level, assigning risk to investors must influence investor behavior. How? Perhaps by making investors less eager to pay a high multiple for their banking shares. Indeed, during much of the boom years from 2002 through 2007, the share prices for many banks reflected lower price earnings ratios than the overall equities market.
Under the newly proposed rules, risk has been shifted to some degree from investors to, in effect, the public. Regulatory agencies, rather than private investors, will now have the duty to scrutinize bank practices, and a responsibility to oversee behavior amounts to nothing more than an obligation to bear the risk of such behavior. Or more precisely, an obligation to bear the downside risk of such behavior. Here lies the important part of the analysis. The point of regulation is not to reward the regulated entity for “good” behavior – and in that sense, the regulator bears no risk with respect to good behavior on the part of the regulated entity. The point of regulation is to ferret out and punish, and thereby hopefully prevent, “bad” behavior on the part of the regulated entity. Simply put, regulation is nothing more than shifting the downside risk of “bad” behavior to the government. It should be clear that regulation is, in effect, nothing more than a free call option awarded to the party that, prior to the regulation, bore the downside risk of “bad” behavior.
I believe we can recast the question we started with at the beginning of this article. When investors assess President Obama’s newly proposed regulations, they should be asking how the government’s grant of a free call option to investors effect investor behavior? What multiple of earnings would an investor pay for a company’s shares, if the stock came (at least to some extent) with a free call option?
The answer to that question is less complicated than the actual proposed rules themselves.
Disclosures: the author owns shares of J.P. Morgan and Goldman Sachs.
Source: Why President Obama's Proposed Regulations Subsidize Bank Investment