The New World of Regulation by Investigation

It’s a big day in the world of regulatory investigations into sophisticated financial institutions: First we learned that the SEC is investigating SAC Capital to see whether it engaged in insider trading, and then the Manhattan district attorney let it be known that he’s sending subpoenas out to Goldman Sachs (GS) in the wake of the Levin report.

The markets aren’t clear on how they’re expected to react to these kind of events. On the one hand, if you were running a major financial institution, discovering that you were being investigated by the SEC or any kind of attorney general would be likely to make you very cross. Think a tax audit, only so much worse — with the possibility not only of civil prosecution at the end of it, but even of criminal prosecution.

On the other hand, we’re living in a post-Dodd-Frank world now, where regulators can, should, and will be much more aggressive about policing the companies they’re regulating. Given that we live in a political democracy, it only stands to reason that the juiciest targets of such investigations are going to be the SACs and Goldmans of this world — the places that make unconscionable amounts of money doing things that nobody really understands.

It’s going to take a while for everybody to adjust to this new world — investors have no way of knowing what proportion of these investigations are likely to end in prosecutions or large settlements, while the financial companies themselves have no idea, really, how to behave in a world of regulation-by-investigation.

Over the medium term, we’re going to enter a dynamic equilibrium, where there’s a more or less constant number of investigations on the go at any given time, and a much lower number of prosecutions. But right now no one knows where either of those numbers are going to level out, and so there’s going to be a jittery adjustment process on the way to the new status quo.

And part of that adjustment process, of course, is going to take the form of House Republicans trying to defang as many regulatory provisions of Dodd-Frank as they can. They should beware: If they succeed, that might just result in more investigations from the likes of Cyrus Vance — people over whom Congress has essentially zero control.