Regulatory Failure

Regulation

What Lessons Might Be Learned?

This is the fourth in a series of notes which consider the behaviour of large organisations and their interaction with those who regulate them. This note looks at how we might aim to counteract the behaviour which is discussed and analysed in the first two notes in the series. Other notes look at ...

the behaviour of large organisations, and
the behaviour or regulatory institutions, before finally considering ...
examples of the problems caused the lessons that might be learned from the above analysis and examples.

Following recent regulatory catastrophes, there may be five ways in which regulation of key industries might be reformed and/or made more effective:

Regulators could become more sceptical and/or tougher and/or less forgiving
There could be a very different approach to the regulation of larger institutions
There could be more emphasis on ex ante as distinct from ex post regulation
The regulation could be carried out by quite different people
Governments and parliaments could exercise much more effective oversight of regulators, and regulated industries

Should regulators become more sceptical and/or tougher and/or less forgiving?

See Note 1, below, for early responses to the financial crisis. But it was hardly surprising that the FSA then began to make a lot of noise about its new tough approach to the financial services industry, whilst politicians in parallel began made a lot of noise about the need to cut bankers' bonuses. The FT reported on 30 December 2010 that Fines levied against companies and individuals by the UK markets watchdog nearly tripled this year as the regulator further stepped up its enforcement operations in the wake of the financial crisis. ... the regulator ... also banned 60 people from working in the financial sector, raided high-profile City institutions and won its first overseas extradition request. In addition, it launched its first cross-border insider dealing case in conjunction with US authorities. "These are not just random cases. The industry is not popular and the regulator has to take and be seen to be taking action," said Jonathan Herbst, partner at Norton Rose. But the scale of this activity remained tiny in comparison to the profits made by, and the numbers employed by, the industry (see Note 2) and it was far from clear that the threat of this ex post activity had any significant deterrent effect. Nor was there any sign that other regulators were becoming more aggressive in their approach to other industries.

There were fewer signs that the FSA or other regulators had learned the need to employ staff who have the guts and determination to find out exactly what is going on in their sector, to understand the larger trends, and to act when they become concerned, whatever the howls of outrage from vested or complacent interests. It had been very depressing to hear Alan Greenspan admit, after the financial crisis, that he "didn't understand what they were doing or how they actually got the types of returns ... that they did". And it was equally depressing that David Einhorn was able to say, of the SEC, that "The SEC has been very tough ... on [less-powerful entities]. But when it comes to large corporations and institutionalized Wall Street, the SEC uses kid gloves, imposes meaningless non-deterring fines, and emphasises relatively unimportant things like record keeping rather than the substance of important things ...".

More general lessons, from what we have learned about the psychology of large organisations are that:

politicians and regulators need to discount very heavily the assurances given by Boards and senior managers unless they are backed up by hard independent evidence. Conversely, they need to give significant weight to evidence from junior staff, customers and whistleblowers ,and
politicians and regulators need to be on constant guard against uncritically accepting an industry or institutional viewpoint. This is of course much easier said than done but the best defence against complacency is to take critics seriously, however annoying or self-serving their messages.

Should there be a very different approach to the regulation of larger institutions?

It is interesting that some informed commentators (including Cranfield's Professor David Parker) are beginning to wonder whether we might not need a totally new approach, perhaps policed by totally different people. Maybe company directors should be put under a duty to operate in a different way? Many senior business people have in the past thought it perfectly proper to "pull the wool over the eyes" of regulators (and to avoid taxes, and exploit their less savvy customers) and so on. There was a game to be played and, if the regulators did not have the wit and experience to ask the right questions, or spot misleading or incomplete answers, then that was their problem. Maybe there is something to be said for requiring directors - and their advisers - to ensure that their businesses operate in good faith, so to speak? One solution may therefore lie in company law. Another might be to strengthen the existing codes of banking practice etc.

It was therefore interesting that Ofgem announced on 23 March 2009 that they were minded to provide that energy suppliers must:

not sell a customer a product or service that they do not fully understand or that is inappropriate for their needs and circumstances,
not change anything about a customer's product or service without clearly explaining why,
not prevent a customer from switching product or supplier without good reason, and ...
not offer products that are unnecessarily complex or confusing, but must ...
make it easy for customers to contact their supplier, and ...
act promptly and courteously to put things right when the supplier makes a mistake.

There was a somewhat related development in March 2010 when the FSA announced that it would in future intervene in order to stop risky products being sold to the public, rather than merely require the industry to pay compensation after things had gone wrong. This change of style (which stopped short of requiring products to be vetted before they went on sale) did not immediately apply to the regulation of financial institutions themselves (as distinct from their retail products) but it showed that the regulator was at long last willing to consider taking firm action. It remains to be seen whether these good intentions will in practice be implemented on behalf of the public.

And Lord (Adair) Turner, Chairman of the Financial Services Authority, writing in the FT on 7 December 2010, raised the possibility that senior bankers might be required to operate in a more risk-averse way than their counterparts in other industries:

"[RBS Executives were] doing what executives and boards in other sectors of the economy do: sometimes getting judgments right and sometimes wrong. But banking is not like other sectors. The fact that many banks made decisions in the same way as other companies was itself a key driver of the crisis, a big problem, but not one that regulators had adequately identified. In some other sectors we want bold risk-taking, which might sometimes result in failure, shareholder loss or even the danger of bankruptcy. But banking is different. Failure in banking, or even the threat of failure offset by public intervention, carries huge economic costs quite different from non-banks. In banking, higher return for higher risks is also sometimes achieved not by socially valuable product innovation, but by leveraging up and taking liquidity risks, increasing the danger that society must clean up the mess.

The question is should we reflect these fundamental differences in a more explicit recognition that the attitude of bank boards and executives towards risk-return trade-offs should be different from other sectors, and should we create incentives to adopt this different attitude? It would, for instance, be possible to set a rule that no board member or senior executive of a failing bank will be allowed to perform a similar function at a bank unless they can positively demonstrate to the regulator that they warned against and sought to reduce the risk-taking that led to failure. Such automatic rules would recognise that while the financial crisis entailed some instances of professional incompetence, recklessness and fraud, the more general problem was that some executives and boards made risk-return trade-offs that might have been appropriate in non-banks, but were hugely harmful to society when made by banks.

Investigations focused on whether individual executives breached rules have a role and the FSA has successfully brought some enforcement cases relating to breaches revealed by the banking crisis. But achieving a general shift in attitudes to risk and return may require that bank directors and executives are made subject to quite different incentives than those that are appropriate in other sectors of the economy.

Comment: It is interesting to consider the consequences of substituting the names of other highly regulated industries for the references to the financial services industry in Lord Turner's proposal.

Martin Wolff addressed this issue, writing in the FT in January 2012:

The core institution of contemporary capitalism is the limited liability corporation. It is a brilliant social invention. But it has inherent failings, the most important of which are that companies are not effectively owned. That makes them vulnerable to looting. Incentives allegedly provided to align the interests of top employees with those of shareholders, such as share options, create incentives to manipulate corporate earnings, at the expense of the long-term health of the company. Shareholder control is too often an illusion and shareholder value maximisation a snare, or worse. What is the answer? Unfortunately, no simple remedy exists. The corporation is the best institution we know of for running large, complex and dynamic businesses. It is surely important to ensure that taxation and regulation do not obstruct other forms of ownership, including partnerships and mutuals. It is vital to encourage the creation of genuinely independent, diverse and well-informed boards. It is sensible to ensure that pay packages are transparent and any incentives for destructive forms of remuneration are removed. But except in banks, where the public interest demands intervention in the incentives of management, governments should not intervene directly.

Should there be more emphasis on ex ante as distinct from ex post regulation?

The next question is whether regulators should intervene in advance ("ex ante) to prohibit what they perceive as excessively risky or undesirable behaviour, or whether it is better to ensure that companies and their managers are suitably punished, after the event (ex post) if things go badly wrong. In economic regulation, this is the debate that divides the Chicago and Harvard Schools of economists: follow this link for more discussion. In traffic regulation, it is the debate between those who favour speed cameras and those who would punish only those who speed and cause injury to others. This question is essentially one of psychology.

Recent regulatory failures seem to point to the need for ex ante intervention rather than ex post punishment. Alan Greenspan famously put too much faith in the self-correcting power of free markets (see Note 2 below). It certainly seem clear that senior executives will seldom confront groupthink even if consider the consequences for themselves if they were to go along with faulty decision making. Indeed, the consequences are seldom cause for serious concern. Although they know they may eventually lose their jobs, they also know that they would then receive very generous compensation for loss of office to add to all the millions they have saved whilst in that office. And they are almost never held legally responsible for even the most dramatic misjudgements. This is particularly the case in the USA where 50% of public companies are incorporated in Delaware - the second smallest state but a notable 'corporate haven' with very CEO-friendly 'business judgement rules'. Even Delaware's own Senator Ted Kaufman noted somewhat desparingly in September 2010 that "We have seen very little in the way of senior ... level prosecutions of the people ... who brought this country to the brink of financial ruin."

Much the same point can be made following the Gulf of Mexico oilspill. The New Scientist (July 2010) reported that conservationist Sylvia Earle had pleaded for stiffer penalties for oil companies - after the 1989 Exxon Valdez disaster - to prevent anything similar happening again. Sadly, it would have made much more sense if she had argued for stronger 'ex ante' regulatory activity, for neither the fear of penalties nor the fear of other financial damage seems to have affected the behaviour of BP and its contractors.

Should regulation could be carried out by quite different people?

Maybe, too, we need fewer city experts in financial and other regulation, not more experts? It is after all very hard for anyone, steeped in any background, to seriously and energetically challenge their ex-colleagues who are very likely to be their friends and their future colleagues and bosses. And it is very difficult to discard 'group-think'. If everyone - absolutely everyone - is behaving in a certain way, how can a member of that circle possible challenge it? And how do they withstand the contemptuous suggestion that they must be a little too stupid, or inexperienced, to understand why everything is just fine. It takes a very brave regulator to press for an explanation that they can understand when faced by a very senior person, or renowned expert, who is baffling them with complex and incomprehensible explanations. There are many circumstances in which outsiders ask better questions, and see things more clearly, than supposed experts.

Another way of improving the FSA's gene pool might be to aim to raise its status, and the status of other regulators. (This is not the same as paying them more. Indeed, high salaries may be counterproductive.) The culture of regulation seems to be more ingrained, and less resented, in the American psyche; bright US lawyers and economists see working for a US regulator as a key career stepping stone; and, though far from perfect, US regulators are generally more willing to 'kick doors down' than their UK counterparts.

Should governments and parliaments exercise much more effective oversight of regulators, and regulated industries?

Surely, too, governments and parliaments are going to have to put much more effort into overseeing regulatory structures and practices. The buck must, after all, stop with our elected representatives. Follow this link to access a further discussion of this topic.

Notes

Note 1. The general conclusion of the political and regulatory establishment, following the financial crisis, was that they or their predecessors had been pretty competent, but underpaid and not allowed to regulate large parts of the financial services industry, and so taken by surprise by unprecedented turmoil. They concluded, therefore, that pretty much the same people - including regulators recruited from the industry itself - should carry on working broadly as before - albeit in different configurations. But attempts should be made to strengthen the regulators by recruiting even more senior bankers etc. Perhaps the regulators' role should be expanded so as to provide much more effective regulation of the previously unregulated 'shadow' parts of the financial services industry? There should certainly be improved cross-border regulatory co-ordination. And maybe banks should split into their 'more risky' and 'less risky' parts? (The discussion of changes to the detail of banking regulation such as increases in capital adequacy ratios are outside the scope of this website, but follow this link to read about the debate about the structure of the industry and ways of increasing the effectiveness of competition within the industry including the deliberations of the Independent Commission on Banking.)

Lord (Adair) Turner, the incoming Chairman of the FSA, who gave a very interesting interview to Prospect Magazine in August 2009, saying that:

... There clearly are bits of the financial system, and particularly the bits that relate to fixed income securities, trading, derivatives, hedging, but possibly also aspects of the asset management industry and equity trading, which have grown beyond a socially reasonable size ... It is hard is to distinguish between valuable financial innovation and non-valuable. Clearly, not all innovation should be treated in the same category as the innovation of either a new pharmaceutical drug or a new retail format. I think that some of it is socially useless activity. On the other hand, I don't know whether that means the world would have been better off without any credit default swaps, or simply some credit default swaps. I just think it's difficult to work out where one can draw the line with this. And that leads me away from the idea that regulators should be saying: product X bad, product Y good, and more towards a set of mechanisms such as high capital requirements which create hurdles for new products, but do not stop those that are of obvious value."

The media inevitably jumped on the phrase "socially useless" but it is hard not to agree with the way it was used when read within the context of the surrounding sentence.

Note 2. Joseph Stiglitz, writing in the FT in August 2010, said "Alan Greenspan ... express[ed] surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking."

This page was last updated February 2011

Martin Stanley

Click here to return to the home page.
Follow this link to browse the separate How to be a Civil Servant website.
And please help me keep this Regulation website up to date. Please send me an email if you have interesting new information, or if any of the links stop working. Thank you.