Regulation
This note was last updated 21 June 2009
There have been quite a number of major regulatory failures in recent years including:
But this note concentrates on the 2007 worldwide collapse of financial institutions which was facilitated by a massive failure of the regulatory systems that were supposed to stop this happening. This note (still in early draft form) will consider and analyse what happened, with special reference to the UK.
It is early days, of course, but the following appear to be the principal failures - not just of regulation.
There are of course plenty who argue that it was not that " ... the institutions did not appreciate [what they were doing] ..." but that, to quote Alex Brummer in "The Crunch": "[One particular] episode, with its blatant exaggerations and deceptions, sums up the complete folly of the sub-prime bonanza in America. Bear Sterns, like so many financial firms, had lost its moral compass." There were certainly plenty of warnings that the various business models were unsustainable. Regulators and investors therefore either thought that the warnings were emanating from those who did not understand financial markets or they hoped to have departed the scene before the wheels fell off the bandwagon.
There were indeed plenty of indicators to back up the warnings that something odd was going on. All large financial institutions earned big profits year after year. And they paid some 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. 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 retail customers receiving unfair treatment - high penalty charges, surreptitious reductions in interest rates, and so on.
Above all, again to quote Alex Brummer: "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?"
And national governments, standing behind the institutions, the investors and the regulators, appear to have been oblivious to the growing danger, and to the scale of the danger, again despite all the warnings. They were more concerned to promote the virtues of "light-touch" regulation, especially as a way of attracting financial institutions to invest in their countries. They even failed to act on their 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.
There seem to be five possible types of change:
Early thinking is inevitably being driven by by government ministers and officials, and by the regulators themselves, including by the incoming Chairman of the FSA. To no-one's surprise, they conclude that they or their predecessors were pretty competent, but underpaid, not allowed to regulate large parts of the financial services industry, and taken by surprise by unprecedented turmoil. They conclude, therefore, that pretty much the same people - including regulators recruited from the industry itself - should carry on working broadly as before. But attempts should be made ('1' above) to strengthen the regulators by recruiting even more senior bankers etc. There should also be improved cross-border regulatory co-ordination. And 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 ('2' above).
But some informed commentators are beginning to wonder whether we might not need a totally new approach, perhaps policed by totally different people. Maybe ('3' above) 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. Indeed, it is interesting that Ofgem announced on 23 March 2009 that they were minded to provide that energy suppliers must:
And maybe ('4' above) we need fewer city experts in the FSA, not more. 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.
Surely, too, governments and parliaments are going to have to put much more effort into overseeing regulatory structures and practices ('5' above). The buck must, after all, stop with our elected representatives. Follow this link to access a further discussion of this topic.
Martin Stanley
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