Many analysts blame insufficient government oversight for the present financial crisis and demand additional regulation in order to prevent future crises.

Their belief in the powers of regulation is religious in nature. Evidence suggests that regulation fails at its stated purpose of protecting the innocent from the rapacious. At best, regulation lulls the innocent into a false sense of security and causes them to feel relieved of the duty of due diligence.

Regulation, then, is a false god. It makes people feel better but does them no good. To the extent they depend on this false god and support it with the fruits of their labor, they are harmed by their belief.

Consider the Madoff case. If the allegations [PDF, 11 pages] against Mr. Madoff are true, he operated a massive fraud for many years (and thus spanning multiple accounting periods and audits) in the face of multiple regulators possessed of unlimited powers to detect and prosecute the fraud. These regulators failed to act even when warned of the potential fraud by a Certified Fraud Examiner:

“Madoff Securities is the world’s largest Ponzi Scheme,” Mr. [Harry] Markopolos, wrote in a letter to the U.S. Securities and Exchange Commission in 1999.

The regulatory failure is even more remarkable and inexplicable when one considers that this alleged fraud was effected through accounts at a brokerage firm under common ownership and control with Mr. Madoff’s advisory business, over which he exercised discretion. Anyone with an iota of experience in managing a brokerage or investment advisory firm knows that this arrangement incorporates multiple red flags that would invite heightened regulatory scrutiny.

Not every missed or ignored the red flags raised by Madoff’s business operation. Private enterprise Aksia LLC warned clients to stay away from Madoff on the basis of due diligence alone. Private enterprise Societe General nixed a deal because of red flags flying from the Madoff business and private investor Doug Kass spared a client exposure to the Madoff debacle because Madoff’s stated returns did not compute.

Madoff was himself a regulator, whether as chairman of Nasdaq or governor for the New York region of the NASD (now FINRA). This raises the specter that cronyism explains, at least in part, the failure of authorities to protect the public.

The Madoff website proclaims in bold color the firm’s membership in FINRA and SIPC. Investors took comfort in those credentials, such as they are, at their peril. To the extent investors relied on regulators rather than their own due diligence, they lost.

While the alleged, Madoff fraud may prove to be a $50 billion or larger instance of criminal incompetence by regulators, it pales in comparison with their failures to properly supervise the so-called bulge bracket on Wall Street. Whether at Lehman or Goldman, AIG or Bear Stearns, Citi or Merrill, at no point in time did regulators lack the power or the means to question or constrain the risks these firms were taking. The idea that credit default swaps are “unregulated” is a lie advanced and promoted by the disciples of regulation. No aspect of any bank or brokerage firm is beyond the reach of regulators. The American people are now on the hook for trillions of dollars in losses because too many of them worshiped at the alter of regulation.

Fraud, theft, and trespass are crimes by common law, each of an economic nature. They constitute sufficient boundaries for the operation of financial firms – no further “regulation” is necessary and all further regulation is harmful. Substantially everyone is touched by and must interact with financial firms – a body of potential victims too massive for third-party protection. People must look out for themselves. Private enterprise provides the only reasonable, reliable third-party means of investor protection, whether through due-diligence services or insurance arrangements.

After the Madoff case, no one has any excuse for believing in the efficacy of regulation.

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