Well, regulators do try to understand what's going on. For example, if Bank of America tried to get into this type of business, they'd have to try to figure out how proprietary trading of Thai weather futures would affect their capital requirements, no?
The bizarre thing to me (in my very short experience in the legal-financial world) is how light the penalties are for potentially screwing up an entire market (all because everyone operates under the protection of the limited liability of a corporation or an LLC). Think of Merriwether at Long Term Capital, or that trader at Amaranth who has reportedly already been hired by some other hedge fund--so what is the price of failure?

Yes, regulators do try to understand what is going on. And the courts have a long history of applying substance-over-form analysis to help regulators catch up with smart investors who think they are too smart to be caught pushing the envelope too far.

As to why some players in the capital markets get apparent second chances, consult the wisdom of P.T. Barnum.

I probably shouldn't characterize the regoes as inflexible. But I'm still not sure they're up for following wachovia's latest quant strategy. Maybe they're waiting for a big failure before they go quant.

Law school curricula have not caught up with the development of financial markets. Law schools should really have a course in the first or second year curriculum that acquaints students with the types of financial products (e.g., derivatives, letters of credit, loan syndications, securitizations) they are likely to encounter when practicing business law.

It is worth recognizing, following on the work of Joanna Sheperd and Fred Tung among others, that there are constituencies other then the Feds, particularly equity and debt providers, that have an interest in avoiding the failure of the firm.

With respect to shareholders, there is a disagreement as to how to deal with complex transactions. Stephen Schwarcz argues that the most common method of “protecting shareholders,” requiring disclosure, fails in the face of complexity. My view is that if a transaction can be described in a meaningful way to the CEO as a desirable business transaction, then this is precisely the same disclosure that should be made to shareholders, assuming the transaction is material. With respect to debt financiers, these parties are often sophisticated enough and sufficiently at risk to focus on the risks in various transactions. Finally, I wouldn’t underestimate the quality of individuals recruited by the FED. In my experience, some very bright lawyers and economists work for the FED, in part because of the recognition that the issues to be addressed are complex.

Adam - I am probably part of the problem re: educating lawyers about complex financial instruments, not part of the solution.

Mike - It's a pretty reasonable solution, though you can claim that firms like Enron were engaging in the same sort of complex transactions that Citibank does. Not clear why the risk models of one should get deference and not the other. Agreed on the quality of Fed employees, though - I'm impressed by the economists (as well as the fact that they HAVE economists who are basically doing research), and we all know them to be classy lawyers.

Mike, I like your test, but it has some issues. Often there is something you say internally about an acquisition (or other material events, like the firing of a senior executive) that in a perfect and meaningful disclosure world you would be okay with disclosing to the shareholders, but there are circumstances that militate against full transparency because of competitors, effect on employees, effects on the deal itself, etc. Indeed, my experience in dealing with SEC comments on the description of a deal has a lot to do with that: the staff wants more detail on the rationale - like what did the CEO and board really think - and it's not the shareholders but other constituencies you worry about. And usually, I think, you get to a level of materiality that is sufficient for both.

Having said that, Steve Schwarcz has a point too. My investment advisor just sent me a hedge fund prospectus, and it was a case of TMI. It took me about two minutes to jump to other heuristics.

Jeff. I don’t want to overload David’s posts, but a response to each of your excellent points. With respect to the cost to the firm of making information public, most of the time these costs are private costs but not social costs. The consequences of what are commonly referred to as interfirm externalities are an issue that I and others, such as Merritt Fox, have discussed. As for the fact that manydisclosure statements seem to provide too much information, I think this is a symptom of the problem, not a result of appropriately applied disclosure requirements. If you spent the same amount of money used to prepare public disclosure documents, but the goal was to put together as clear and understandable a presentation as possible, then you would get a very different result. Unfortunately we now have two systems. One in which management uses information to maximize performance, and a second in which lawyers, who often don’t understand all of the relevant business issues, come around afterwards and describe the situation in convoluted legalese.

I agree that law schools should offer courses that acquaint students with financial products. It should not be a one-size-fits-all course, however. Law schools should structure two courses -- one for the neophyte law student with a business degree, and the other for liberal arts majors. Otherwise, neither group profits from the instruction.

I'm not sure how private disclosure addresses systemic risk, which I assume is the primary concern of the Fed.

In over the counter transactions, derivative counterparties have an incentive to sniff out counterparty credit risk. But I'm not sure that they have sufficient incentive to account for systemic risk.

Suppose that Citibank and Hedge Fund A enter into an interest rate swap, and if Hedge Fund A fails to deliver, then Citibank can't make a payment to Fund B, and Fund B can't make a payment to Fund C, and so on and so forth. After all, if some of the costs of failure would fall on other market participants, then I don't see how Citibank and Fund A have the right incentive to force each other to disclose all of the interlocking arrangements that could impact other parties.

What am I missing? (that's not a rhetorical question - this is complicated stuff, and it's even more complicated once you think about clearinghouses and exchange regulated transactions ...)

Vic. You and David are absolutely correct. I did not mean to suggest that somehow private disclosures were a way to replace governmental oversight, but rather to suggest that there were more parties that might be involved than I read David’s original post to suggest. That post focused on the firm’s internal risk models and the regulator’s analysis; I wanted to add that in some contexts there may be other parties, for example the firm’s debt and equity holders, involved as well. Your post adds to this the suggestion that counterparties may do some types of monitoring. None of this is meant to challenge the appropriate role of government oversight.

Ah, got it. For what it's worth, my sense is that when it comes to hedge funds, we could use increased scrutiny by the Fed and might worry a little less about SEC / investor protection, since I agree that private disclosure does a lot of work re: firm-specific risk. Hedge fund registration, for example, seems sort of silly as an investor protection measure, but I wonder if it might be justified in terms of helping the Fed address systemic risk.