When regulators are weighing whether they need to legislate good behaviour or if they can rely on the financial services industry’s enlightened self-interest to ensure investor protection, they should remember the “muppets.” Not the adorable Jim Henson TV puppets, but the derisive term that some senior executives at Goldman Sachs Group Inc. use for their clients, according to departed executive, Greg Smith.

Smith famously resigned from the firm last month in a public letter lamenting the deterioration of Goldman’s culture, telling tales of managing directors who refer to their clients as “muppets” and focus only on making as much money as possible from them. Smith warns this approach will ultimately drive clients away, and lead to the end of the firm.

Ultimately, firms that take advantage of their clients cannot survive. But they can operate that way for an extended period. While it may not be a sustainable strategy, it certainly can be a lucrative short-term one.

Which is why regulators must be the ones to ensure that clients’ interests come first. It is not enough to try to guide firms gently with vague regulations designed to encourage good behaviour. Only hard and fast rules that require firms to put clients first, accompanied by enforcement to ensure that those rules are followed, can promise that.

While industry initiatives aimed at improving the treatment of clients – such as the Investment Industry Regulatory Organization of Canada’s new client relationship model rules – are worthy, they aren’t going to change the world. For years, regulators have been unveiling new initiatives in the hope that they will foment a culture of compliance throughout the industry so people will do the right thing and investors will be protected. But those results never seem to follow.

If regulators are serious about investor protection, they need to legislate it. It’s that simple. Whether that means banning certain compensation structures, outlawing abusive products or imposing fiduciary duties, these are the sorts of steps that regulators must be willing to take. After all, if the self-proclaimed smartest firm on Wall Street views its clients as mere muppets, what hope is there for the rest of us?

© 2012 Investment Executive. All rights reserved.