Regulation is reactive and thus has inherent flaws.
    Could you imagine what shopping would be like if retailers were subject to the same regulations as financial service providers?
    Before you browse the shelves, you need to fill out an application to assess the suitability of products for your lifestyle. When you finally enter the store, you barely catch a glimpse of the products which that lie behind lengthy documents describing the risks associated with buying the product.
    Even the price tag is undecipherable because the retailer must disclose how much profit they are making per sale, what sort of relationship they have with the distributor, wholesaler and manufacturer; any concessions they have received for product placement; and any conflicts of interest that could be inferred from the manager's, employees', friends' or relatives' owning of the product.
    What sort of hours or services would this hypothetical store provide? The store itself is operated by an independent director-someone who has no stake in the long-term success of the store and so has no personal incentive to make optimal investment, strategic or operating decisions.
    Laughable? Yet this is the regulatory environment that financial service providers must operate in.
    Financial services are clearly different from consumer goods. Though Americans spend more than they save, any given product is a small fraction of our wealth; whereas, our savings and financial investments represent our wealth which is to provide for our families, our communities, our churches, our government and our heirs.
    A financial product is not just something that is sold; rather, it is a relationship that is fostered. Consumer goods are, by definition, things that are consumed. Durable goods are more like investments. We tend to derive some utility from these goods over an extended period of time. It is with durable goods that consumers tend to contemplate their purchase with more care since they will have to live with their decision for a longer time period. So, to avoid buyer's regret, consumers need to be informed more about their durable goods purchase than their consumer goods purchase. It is the same with financial products and services; clients need to be educated about the product or service because it is not a commodity they are buying-it is a relationship they are entering into.
    There is also a significant difference between financial products and retail products as far as the asymmetry of information between buyers and sellers. Financial services representatives are usually much better informed about the services they provide than their clients, and this puts the client in a vulnerable position. The relationship itself is incredibly fragile as the client assumes their financial services representative is in an advantaged position, so they are particularly sensitive to any insinuation of impropriety. The client fears their future will become the victim if they are taken advantage of.
    This is where financial services representatives must be responsible: not only to their clients, but also to their colleagues. Just as bank panics were caused by one bank having a crisis, which made depositors at all banks question the liquidity of their own bank, so too does scandal in one part of the financial services industry deteriorate the reputations' of everyone in the industry.
    Financial representatives and advisors have fragile relationships with their clients that take time to strengthen. The problem with reputations is that they can be destroyed or marred so quickly and, often times, just by the insinuation of impropriety. In theory, over time all businesses have an incentive to build investor confidence, but in the short run, each individual has an incentive to exploit the good reputation of others.
    Unfortunately, we always live in the short run. This myopia could lead to regulatory backlash that could be costly to society as a whole: As less research is trusted, so research is rewarded less, which leads to poorer quality research, which means it is trusted even less, and we enter into a downward spiral of ignorance.
    Regulators, employers and trade organizations have to confront the issue of how to make doing good profitable. People are self-interested, and this causes a myriad of problems if people bite and devour each other for their own gain. Regulators deal with this issue by making it costly to violate a rule, which would make it less likely that someone would engage in the activity that the rule is designed to prevent. To increase the expected cost of violating a rule, regulators can increase the penalty for breaking the rule, they can increase the probability of being caught, or they can do both.
    What has happened recently suggests regulators have found a way to increase the perceived probability of being caught along with increasing the cost of violating the rules. When it is well publicized that someone has been brought to justice, all people become aware of the costs of doing wrong. In psychological terms, publicly prosecuting violators creates consciousness, and imposes a social cost on malefactors. This is one reason why traffic police keep their lights flashing when they pull you over (that and it protects them from getting hit by any gawkers).
    Employers confront this issue-of making doing good profitable-by creating compensation systems that are incentive-compatible: employees behave in their best interest and unwittingly behave in the best interest of the employer. Obviously this system does not work perfectly (hence the prevalence of cubicles in the work place, which make it easier to monitor the behavior of employees). It can be argued that this is precisely what some have done in the directed brokerage scandals: fund companies have rewarded sales representatives for superior performance. The difference between quid pro quo in the workplace and in the financial services industry is that in financial services, this behavior is explicitly illegal.
    Industries as a whole can adopt similar strategies as societies have for directing individual behavior to coalesce with group goals: adopt shunning and celebration rituals. Social ostracization can make it socially costly to deviate from the ethical norms of the group; whereas, celebrating ethical behavior serves as a nonpecuniary reward.
    The Securities and Exchange Commission has delegated some of its regulatory oversight duties to the National Association of Securities Dealers and other private, self-regulating bodies. This is an efficient way of regulating an industry when all is going well, but it rarely is effective when there is a wave of public outcry against particular industry practices. There has been a lot of coverage lately about soft dollar commissions and conflict-of-interest scandals (especially involving mutual fund sales which have been alleged to violate "anti-reciprocal" rules), so there is bound to be a lot of public outcry against this apparent malfeasance.
    The history of regulation has been one of reaction and not pre-emption. Most laws and new regulations come about due to past abuses with the hope of preventing further abuses. In response to anti-competitive practices of business, we get antitrust laws. In response to bank failures and fraud, we get new regulations on banking. In response to questionable selling practices, we may get new regulations on our profession.
    One of the clearest dangers to the financial services profession is when people cross borders; especially now, when brokers are behaving as advisors. Provided that the advice given is "incidental" to the service that is being offered, the law permits such advising, but how do you define "incidental?" By pushing the definition and testing its limits, the industry risks the government imposing a stark definition. It is entirely foreseeable that just as there is an implied warranty of merchantability in the market for goods, financial assets that are sold by brokers could be afforded the same warranty. Worse, when a merchant knows the particular purpose of a buyer, and the buyer relies on the skill and judgment of the merchant, the merchant gives an implied warranty of fitness for a particular purpose. Imagine what would happen if the same protection was given to clients who call their broker telling the broker exactly what their investment objective is: If the broker advises the client into a particular instrument, the client follows the advice of the broker and the goal is not met, then the broker could be held liable for any loss.
    It is up to the registered representative, the registered investment advisor, and other financial service professionals to behave preemptively to assure that there are no scandals for regulators to respond to. In short, doing what is good is more than just doing what is legal. 

Brian J. Jacobsen, Ph.D., is an assistant professor at Wisconsin Lutheran College and chief economist at Capital Market Consultants.