Does Financial Regulation Protect Investors?

Financial laws are driven by psychological bias.

Posted Sep 05, 2008

After reading several of these posts, you may think that investors need more regulations created to protect them from themselves. It is true that cleverly designed policies, rules, and laws can help investors. Unfortunately, these are few and far between. Why? Because the political process is just as impacted by psychological biases as individual investors.

Consider that the stock market climbed 200% between 1925 and 1928. In this euphoria by investors, lawmakers passed a law in 1927 that allowed commercial banking activities and investment banking activities to combine. Then came the 1929 stock market crash. By 1933, the market was down 90%! So the government passed a law separating commercial and investment banks (1933 Banking Act). In the big bull market run of the 1990s the market was up 125% between 1996 and 1999. So, the government allowed the commercial and investment activities to combine again in 1999 (1999 Financial Services Modernization Act).

In fact every major law to protect investors comes after a major decline in the stock market (like Sarbanes-Oxley in 2002 and Insider Trading in 1988). The emotions and biases that are involved are scapegoating, xenophobia, fairness, and negative social mood. That is, Congress changes the laws after the damage has been done! Every major law loosening the protections comes during or at the end of a bull market. Key elements are overconfidence and positive social mood. So Congress loosens the laws when things appear to be going great-just in time for investor excesses to kick in and lead us to another collapse.

These days, the financial sector is hurting the economy. Resulting from the mortgage debacle and the real estate decline, some commercial banks have failed. One investment bank was bailed out (Bear Stearns) and others are weak. I guess that if the market goes down further and more people lose a lot of money, we should expect Congress to leap into action. You know, tighten up those laws after it is too late.


See David Hirshleifer, 2008, "Psychological Bias as a Driver of Financial Regulation," European Financial Management, forthcoming, and John Nofsinger and Ken Kim, 2003, Infectious Greed, Prentice Hall: Chapter 14, Regaining Investor Confidence.