Regulation

Regulating Large Organisations

Introduction

There have in recent years been a number of catastrophic failures involving heavily regulated organisations, including the 2007 worldwide collapse of financial institutions, the 2010 Gulf of Mexico Oil Spill, the collapse of Enron, Bernie Madoff's Ponzi scheme, and the mis-management of the Mid-Staffordshire Hospitals. Can any general lessons be learned?

It would be a great mistake to seek to avoid all regulatory failure. Although it is clearly necessary to regulate the behaviour of organisations that are in a position to do serious damage to wider society, we must not over-regulate such organisations and so restrict their growth and innovative behaviour which is in turn so important for employment and the wider economy. It is extraordinarily hard to get this balance right. Every significant regulatory failure is followed by calls for stronger regulation, inevitably followed some time later by equally strident calls for regulators to adopt a lighter touch, and be more pragmatic. But the catastrophes listed in the first paragraph of this note were surely so dreadful that they cannot be characterised as the result of risks which were worth taking. (See Note 1 below)

This is accordingly the first in a series of notes which seek to explore these questions in some depth, and consider what might be done to avoid future catastrophes within heavily regulated sectors. In particular, should more attention be paid to the psychology of regulation:- to the behaviour of large organisations and their interaction with those who regulate them? This first note accordingly examines the behaviour of large organisations. Further notes look at ...

• the psychology of regulatory institutions, before turning to ...
• examples of the problems etc. that can arise because of that psychology, before finally considering ...
• lessons that might be learned from the above analysis and examples.

This note argues that it is a mistake to approach the regulation of large organisations as though they are merely supersized versions of individual-led smaller firms. Most senior managers do not know (and some do not want to know) what is going on outside their head offices, nor what risks (financial, environmental and other) being taken by their staff. Internal communications difficulties, compounded by the incentive to report good results, and senior executives aversion to taking responsibility for errors, mean that senior managers are often the last to learn what is going wrong. Regulators therefore need to take account of organisations' internal communications problems; the existence of herd behaviour and groupthink; and the culture and tensions that are typical of most large organisations.

Principal and Agents

It is particularly important to be aware of the principal-agent problem. This arises when a principal hires an agent to pursue its, the principal's, interests. The principal-agent problem is found in most employer/employee relationships, including in the way that shareholders and senior executives find it very difficult to ensure that middle managers, foremen etc. work effectively to maximise profits. It often seems that corporations are in practice run in the interests of the firm's executives who have grown to regard their firm's economic interests as entirely coincident with their own.

Be that as it may, it can certainly be very hard to to obtain reliable information from the intermediate levels in any hierarchy. And it is very common for middle managers to focus on the long term stability of their small part of the organisation. They will typically enter into an implicit bargain with their teams, allowing the use of material for personal ends, providing generous expense accounts, etc. so as to generate a better (non-confrontational) climate within the team - often characterised as 'high morale'. Such teams resist change - especially if it might lead to greater efficiency (working harder and/or job losses) or the introduction of tedious protocols aimed at improving quality or safety. (Rail and marine accident reports include many examples of such behaviour.) It is then quite common for such teams to begin falsifying data, including quality and safety data. And new recruits are then taught the difference between current working practices and formal instructions, which are characterised as misleading, out-of-date or impractical. It can therefore be very hard for a regulator to find out what is really happening inside a regulated entity, not least because the entity's own senior executives probably do not themselves know what is happening and, if they do, will be very reluctant to admit their partial loss of control.

The principal-agent problem also means that regulators need to take into account how the middle and lower reaches of an organisation might react to regulatory pressure. The need for change and/or improvement may be accepted by senior executives, but this does not mean that the necessary changes will be accepted or implemented at the working level. The regulatory intervention needs to be designed with this problem in mind.

See Jean Tirole's Hierarchies and Bureacracies: On the Role of Collusion in Organizations for a lengthier discussion of the Principal-Agent problem.

Herd Behaviour and Groupthink

There is a separate problem as follows. It almost goes without saying that the majority in government, in regulation, and in the financial services industry were supported in their rosy view of the 1990s financial world by the fact that all 'the great and the good' shared their optimistic analysis of corporate behaviour and of the virtues of 'light touch regulation'. This was despite the fact that there were nevertheless a good number of perceptive commentators who did their best to warn of the forthcoming catastrophe. This is a good example of a very common psychological behaviour (often called 'herd behaviour' or 'groupthink', which is essentially the unquestioning acceptance of obviously wrong answers simply because it is socially painful to disagree. For further information, you might like to read Mannie Sher's paper on the psychology of regulation, the first part of which deals with this subject.

The MacWhirr Syndrome

There is a separate though related syndrome, personified by Joseph Conrad's Captain MacWhirr who saw the signs of a devastating oncoming storm but recognised that his employers would criticise him for delaying their cargo if he sought to sail round it. "Suppose", he says, "I went swinging off my course and came in two days late, and they asked me 'where have you been?' 'Went round to dodge the bad weather,' I would say. 'It must have been dam' bad, they would say. 'Don't know,' I would have to say, 'I've dodged clear of it.'"

Modern managers who mimic MacWhirr do so, not because of social pressure, but because managers and stakeholders are very likely to criticise unforeseen delay and expense, even if the organisation achieves its objective. Executives therefore prefer to take uncertain risks rather than face certain (unjustified) criticism. Indeed, there were no doubt some senior financiers who understood that they were running their companies into serious trouble, but felt that couldn't change course - see Note 2. See also Note 3 for a brief discussion of the MacWhirr syndrome in politics.

Profits or Ethics?

In the absence of strong regulation, many organisations are not incentivised to behave in a socially responsible manner. A commercial company's primary duty is to generate profits for its shareholders. Non-profits and public sector organisations have their own primary duties, and must also operate in a way which generates income and/or reduces expenditure. In more detail:-

• Corporate' managers' primary duty is to generate profits for their shareholders, and this in law (and many would say rightly) takes precedence over the consequences for the environment, for healthy and fair competition, for customers, for employees, and for wider society if their business were to fail. Companies are now very good at filling their annual reports with information about their CSR (Corporate Social Responsibility), but it is possible that they nowadays typically exercise much less social responsibility than in previous decades. The US Business Roundtable, for instance, in 1978 listed CSR as one of the four core functions of company Boards. It had disappeared by 1990.
• Second, there is a well established business principle that the buyer is responsible for assessing the value and suitability of the thing that they are buying. ('Caveat Emptor' = Buyer Beware!) Although significantly eroded by consumer and other law, it remains the case that many companies feel under no obligation to behave ethically, even when their customers are buying complex financial and other products about which they are inevitably badly informed. This applies big time in dealing rooms. For further thoughts on this subject, see Note 4 below.
• It is also interesting to reflect on whether big business has succeeded warfare as the most exciting form of competition between human organisations. Some modern boardrooms appear to attract those who would, in previous generations, have sought to command large armies. Instead of invasions, we nowadays have corporate takeovers; instead of gold braid and military honours, we have executive salaries. The leading actors therefore remain the odd combination of hugely ambitious, sometimes inspirational, but too often also highly self-absorbed and disastrously inept. For Haig, Montgomery, Patton and MacArthur substitute Dick Fuld, Fred Goodwin, John Gutfreund, Tony Hayward, Jeffrey Skilling?
• And yet, as the FT's Lucy Kellaway points out: "Modern CEOs seem to have no [public] opinions, especially not negative ones. If they feel one coming on, they have been trained by their lawyers and PR advisers to suppress it." It is certainly difficult these days to correct the mistakes or improve the behaviour of an organisation without laying oneself open to the charge that previous behaviour was in some sense faulty and so worthy of criticism and/or claims for compensation. But senior managers are also themselves all too often concerned to appear infallible (and un-sue-able) and so organisations therefore get locked into defensive modes, from which they becomes increasingly difficult to extricate themselves - and so the problems get worse. The reputation of BP's Tony Hayward was for instance badly damaged (yet further) when he failed to answer many of the questions put to him by US Congressmen in June 2010.

Notes

Note 1. By the end of the financial crisis, the UK taxpayers' support for the banking sector totalled £850 billion, and the cost of the consequential economic recession was estimated by the Bank of England to be up to £7,400 billion (Andrew Haldane speaking in Hong Kong in March 2010).

Note 2. Citibank's Charles Prince famously told the FT that "As long as the music is playing, you've got to get up and dance. We're still dancing." This led the same paper's John Kay to conclude that "The man who held the most powerful position in the financial services industry was the prisoner of his own organisation." And Andrew Ross Sorkin, in Too Big to Fail notes that Dick Fuld "had known for years that Lehman Brothers' day of reckoning would come ... But, like everyone else on Wall Street, he couldn't pass up the opportunities."

Note 3. The MacWhirr syndrome is just as common in politics. US Congress Representative Barney Frank commented, when talking about Hank Paulson's dilemma in the middle of the Lehman crisis: "The problem in politics is this: You don't get any credit for disaster averted ... Going to the voters and saying, 'Boy, things really suck, but you know what? If it wasn't for me, they would suck even worse.' That is not a platform on which anybody has ever gotten elected in the history of the world". And others have noted that if Margaret Thatcher had acted to deter Argentina from invading the Falklands, rather than ordering a taskforce to remove the occupying forces after they had landed, she would probably have been remembered as an unsuccessful one-term Prime Minister.)

Note 4. Harry Markopolos notes that "... the [financial services] industry is based on predator-prey relationships ... If you don't know who the predator is then you are the prey." (See also Michael Lewis' Liar's Poker.) Even Warren Buffett, normally a stickler for corporate ethics, said "If you have to care who's on the other side of the trade, you shouldn't be in the business of insuring bonds" when answering his shareholders' questions about the accusation that Goldman Sachs tricked another large company into insuring sub-prime mortgage securities, despite privately believing them to be a very bad risk.

There is persistent criticism of the fees earned by fund managers:- see for instance The Times 6 November 2010: 'The ten things that Fund Managers do not want you to know about'. And only the most active savers seem to get a fair return on their savings. Which? reported in November 2010 that "Of 188 accounts offered by the five biggest banking groups for savings ... 90 pay 0.1% or less interest each year, while 141 pay 0.5% or less." (The best account paid 2.89%.)

"An employee of Zurich Advice Network received about £25,000 in commission after persuading ... a man in his late eighties who was suffering from cataracts, deafness and advancing dementia to make a series of wholly inappropriate investments ... the company denied any wrongdoing and forced the man's son to go through years of stress ... the ombudsman decided that the investments were clearly mis-sold ... you might imagine that Zurich would [then] apologise and and bend over backwards to right the wrong ... You would be wrong ... the pattern of mis-selling by Zurich suggests that the company is simply unfazed by occasional visits by the ombudsman ... there is little incentive for Zurich or any other company to rein in rogue salesman." (Andrew Ellson, The Times 31 July 2010)

For a very readable account of the origins of the financial crisis, see also Alex Brummer's The Crunch in which he notes that "[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.".

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Martin Stanley