Regulation
This is the third in a series of notes which consider the behaviour of large organisations and their interaction with those who regulate them. This note lists some examples of the behaviour (italicised) which is discussed and analysed in the first two notes in the series. Other notes look at ...
A number of factors interacted to cause the financial crisis of the early 21st Century. In particular, there was clear evidence of herd behaviour, groupthink and the MacWhirr syndrome, as well as classic principal-agent problems. It was fairly obvious at the time, and subsequently it became crystal clear, that the individual financial institutions - and in particular their Boards - did not appreciate or did not care about the riskiness of sub-prime lending (mainly in the US); nor the riskiness of mortgages which represented a high proportion of asset value and/or of loans which were based on "self-certified" and hence exaggerated borrower income (both in the UK); nor the riskiness of certain commercial lending made by certain aggressive lenders; nor the dangers posed by off-balance sheet borrowing (as particularly evidenced by Enron and Lehman Bros - see the Valukas report's reference to "actionable balance sheet manipulation"); nor the riskiness of relying on wholesale markets, instead of retail deposits, for their funding; nor the dangerous short-term incentives that were built into bonus structures; nor the fact that the apparently clever spreading of risk via CDOs did not in fact reduce the total risk undertaken by the financial institutions when taken together. Above all, as Alex Brummer said in in The Crunch:- "There was a central paradox at the heart of the mortgage boom. How as it possible to make money by lending large sums to people who had not a hope in hell of paying it back?"
The interesting thing about the incipient financial crisis was that there were plenty of hard indicators which backed up the critics' warnings that something odd was going on. It was pretty obvious that senior appointments in major banks were made on the basis of 'who you knew' rather than through any objective process. (Four of Lehman's ten outside directors were over 74 years old.) Investment banks were leveraged to an unprecedented degree. (Lehman Brothers were leveraged at 30.7 to 1.) All large financial institutions earned very big profits year after year. And investment banks paid fantastically high salaries and bonuses, not just for genuine stars but for people who could never have earned anything like the same income in any other walk of life (see Note below). It was far from clear why these profits and incomes were not competed away over time. Equally worrying, the media was full of stories of institutions unethical behaviour:- retail customers receiving unfair treatment - high penalty charges, surreptitious reductions in interest rates, and so on. And then there was the the fantastic growth in the unregulated shadow banking systems.
The standard riposte to the above comments is that - if the problems were so very obvious - why didn't more investors start selling their shareholdings and taking other steps to shied themselves from the coming storm? The answer, I suggest, is that both regulators and their governments were to some extent caught up in the herd behaviour, but were in particular the victims of the MacWhirr syndrome. National governments, standing behind the institutions, the investors and the regulators, certainly appeared oblivious to the growing danger, and to the scale of the danger, despite all the warnings. But they were also very keen to promote the virtues of 'light-touch' regulation, especially as a way of supporting an industry which appeared to be generating large profits, large tax revenues, and significant employment. No government or national regulator dared step out of line for fear of deterring financial institutions from investing in their countries. The UK government even failed to act on its own HM Treasury/FSA/Bank of England November 2006 'war game' which showed that the UK government's investor compensation scheme was inadequate and could too easily cause panic, as happened on 14-17 September 2007 when there was a run on Northern Rock.
But incompetence or complacency surely played a part as well. It is not much of a defence to note that government and regulators did not appear to be aware that the credit rating agencies themselves did not understand the risks associated with the financial instruments (SIVs (structured investment vehicles), SPVs (special purpose vehicles) and the rest that they were rating, and/or were conflicted because they were being paid by those designing ever-more-complicated instruments rather than those buying them. And financial regulators (the Bank of England and the FSA in the UK) also did not know or did not understand what risks the institutions were taking with the financial instruments or off-balance sheet vehicles, nor did they seem at all concerned that financial deregulation, on both sides of the Atlantic and in Japan, allowed even the regulated banks to lend to a much wider (and riskier) range of borrowers, and failed to recognise the 'moral hazard' associated with such lending - that is that the risk-taking borrower wins if his risk pays off, but the bank (and the state behind it) loses if it all goes catastrophically wrong. Finally, both regulators and investors did not seem to appreciate that the hedge funds' models were bound to lead to eventual large losses, perhaps after many apparently good years.
Similarly, it became clear that BP's Board and their US regulators were not aware of the risks being taken by BP's staff and contractors managing the Deepwater Horizon drilling activity, a classic example of the principal agent problem in action. Indeed, the root cause of the disaster may have lain with the difference between BP's culture and that of Amoco, the American oil company which it had bought some years previously. BP preferred to delegate considerable responsibility to its operational managers, but expected them to behave responsibly and to be held accountable for their decisions. Amoco had a much more centralised and controlling management style. There are strengths and weaknesses in both approaches, but add the two together and the result might have been ex-Amoco teams whose behaviour was no longer closely monitored, and which had a good deal of freedom which they did not have the experience to handle. It is therefore interesting, though hardly surprising, that BP's board announced in late 2010 that it would would tighten its oversight of the company's day-to-day operations.
Whether or not the above theory is true, the Head of the Presidential investigation into the disaster announced in November 2010 that they had identified "a culture of complacency" on the Deepwater Horizon rig, though he did not believe that this was driven by over-enthusiasm for cost-cutting. This is consistent with what we know of the consequences of principal-agent interaction within a large organisation. And the US National Academy of Sciences had previously said that BP had demonstrated inability to learn from past near misses and "insufficient consideration of risk".
It is also worth noting that the Academy also made serious criticisms of the "education, training and personnel of [regulatory] personnel involved in the oversight ... of deepwater exploration operations" and expressed concern about the failure of any one of "the multiplicity of regulatory agencies and classification societies" to develop "an overall perspective of the exploratory operation" and their individual failure to understand the duties of the other bodies.
There was a particularly shocking failure of corporate ethics when several very senior GlaxoSmithKline executives ignored a whistleblower's complaints in 2003 about contamination and mixed drug types and doses being put in the same bottles in GSK's Puerto Rico plant, probably because they feared the impact on US Food and Drink Administration approval of new products. GSK were seven years later fined $750m, of which the whistleblower received $96m. But I would not be surprised if GSK privately believe that they would do the same again in the same circumstances. The company made a pre-tax profit of £2.25 billion in the three months to December 31 2009, so the fine was hardly catastrophic, almost all the (very highly paid) executives remain in post, and neither the company nor its executives appear to have suffered significant reputational damage.
More than 2,800 people in the City of London were paid more than £1m in 2009, according to the Financial Services Authority. Total City bonuses paid in 2007 were around £10 billion, just less than the total of c.£11 billion given to charities each year by all 60 million UK residents.
This page was last updated February 2011
Martin Stanley
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