The problem with regulators

John Kay explains a fundamental problem:

The search for a cadre of people employed on public-sector salaries to second guess executive decisions is a dream that could not survive even the briefest acquaintance with those who actually perform day-to-day supervisory tasks in regulatory agencies. They tick boxes because that is what they can do, and regulatory structures that are likely to be successful are structures that can be implemented by box tickers.

He also has this gem:

Perhaps the most fundamental confusion in the evolution of financial services regulation is the equation of financial stability with the survival of established institutions. If I had a million pounds for every time I have heard a possible reform opposed because “it wouldn’t have prevented Northern Rock or Lehman Brothers going bust”, I might now have enough money to bail out a bank.

The objective of reform is not to prevent Northern Rock or Lehman going bust. It is highly desirable that organisations such as Northern Rock or Lehman should go bust.

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10 Responses to The problem with regulators

  1. johanna

    Spot on.

    In a previous life I had considerable contact with the regulation of telecommunications, which was jointly done by the (now) ACMA, a special division of the ACCC and the Communications Department. For a start, you can imagine what a shemozzle of conflicting decisions that caused.

    But the real game was the “game”, because every time one of these agencies came up with a proposal, the industry (principally Telstra) was invited to comment on the likely impact. Implicit was the assumption that preserving the industry as close as possible to the status quo was a high priority.

    No prizes for guessing who outsmarted whom almost every time, and often managed to make a profit on the back of it. Telstra in particular has a very deep pool of expertise in regulatory technicalities – and it’s been worth every penny they spent on it, which was quite a lot.

    The deal they cut over the NBN ran rings around the government, and not for the first time by a long shot.

    Consumers are very low in the pecking order of regulatory priorities, in complete contrast to the rhetoric.

  2. Bruce

    From Mr Kay’s essay:

    Lehman was run (badly) for the benefit of its senior employees rather than customers or shareholders.

    That is the problem. The concept of a limited liability company has been subverted by the corporate class. Otherwise I’d say (and I’m a bank shareholder), fine, wipe out the shareholders and sell the business to the highest bidder, or liquidate the assets.

    But the regulators’ approach has been not to hold the management class to account but to ‘bail-in’ the innocent depositors. Which has not yet caused cataclysmic bank runs, but on the recent policy of the EU this will happen in the future. Mattress futures are a ‘buy’.

    I also strongly disagree with his comment “It is hard enough to find people capable of running financial conglomerates”. It is dead easy to find such people. But to find honest people? That is hard. As for competency, the lowest desk trader could probably do as well as the Dimon’s of the world, since the financial engineering to rort and arbitrage the body of regulations may be transiently profitable, but come downturn it is a disaster. J.P. Morgan may get away with only paying a $5 billion fine. If they’re lucky. Add up a few more of these and suddenly the financial innovation looks like a bad bet gone badly wrong.

    The simplest reform which would vastly improve banking governance is to require personal penalties on the management for failures, be they accidental or mendacious. Without recourse to employment contracts or insurance. A personal risk of emasculation focuses hearts and minds remarkably well. Excessive risk taking would disappear instantly.

  3. Balatro

    Reading this I am reminded of a recent post by ( I think)- Sinclair about Milton Friedman’s thoughts on the four ways to spend money. This is about an extension of those precepts. When you have regulators spending other peoples money in an attempt to outflank those folk who are hell bent on making money for personal benefit there is only one outcome – regulatory failure. Bruce is right. Skin in the game for management is a start. But it is not the total answer. Murder has been unlawful for a long time, but we are still locking up murderers.
    Complexity adds confusion and allows special pleading, so regulations need to simplified, not made more complex. Howard’s mantra about the GST – no exemptions, no exceptions – had the benefit of clarity and low cost to apply.
    Simple regulations rigorously applied with personal assets at risk for breaches will go a long way in curbing boardroom enthusiasm for innovative accounting.
    I don’t know of any cases of prosecution for the instigators of the GFC. Certainly none in the USA. In fact, Obama talked tough but actually handed over millions in chapter 11 bailouts and watched the perpetrators pay themselves a ‘bonus’ the following year. It would have been more salutatory if he liquidated the personal assets of the partners and handed it over to the receivers.

  4. I am the Walrus, koo koo k'choo

    The objective of reform is not to prevent Northern Rock or Lehman going bust. It is highly desirable that organisations such as Northern Rock or Lehman should go bust.

    Um, well, yes and no.

    And I realise I take my life into my hands disagreeing with John Kay.

    But it depends on what you mean by ‘bust’.

    You want them to be able to fail, in the sense that poor decisions by management are met with the consequences of a falling share price attracting a takeover and new, hopefully more competent management to manage the assets, which is what happened here with Bankwest. That’s what the ‘market for corporate control’ is all about.

    You don’t want them to go ‘bust’ by blowing their creditors’ investments to smithereens, creating widespread uncertainty among those creditors, and threatening the entire financial system, which is what happened with Lehman.

    Although it must be said that the main reason why the fallout from Lehman was so bad was that the regulators let it fail, rather than finding a home for it, and thus created immense uncertainty for creditors linked to every corner of the financial system.

  5. M Ryutin

    I always found this report/paper of the Dallas Federal Reserve, in 2011, extremely important. And advice clearly wasted on the Obama administration – and a concept relatively un-noted in Australia it seems to me…
    “Choosing the Road to Prosperity – Why We Must End Too Big to Fail—Now”
    ‘The too-big-to-fail institutions that amplified and prolonged the recent financial crisis remain a hindrance to

    http://www.dallasfed.org/assets/documents/fed/annual/2011/ar11.pdf

    by Harvey Rosenblum (“head of the Dallas Fed’s Research Department,a highly regarded Federal Reserve veteran of 40 years and the former president of the National Association for Business Economics)”.

  6. johanna

    Further to my post above re why governments are utterly out of their depth when playing with the big boys, I just came across this gem:

    “Telstra is suing national broadband network builder NBN Co in the NSW Supreme Court over the timing of its payments to rent Telstra’s pits and ducts for $11.2 billion.

    The $11.2 billion deal, which took more than two years to negotiate, gives NBN Co rental access to the huge network of underground pits and ducts that contain Telstra’s phone network. NBN Co is set to use them to house fibre optic cabling and connect homes to the high-speed fibre network.

    It is understood that while Telstra believes the payments should have been indexed to 2011 when the two companies agreed on a deal, The Australian Financial Review is reporting. But NBN Co believes they should be linked to 2012 when Telstra shareholders ratified the contract.

    If the court finds the case in favour of Telstra, it could mean it could get over $100 million.
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    Telstra spokeswoman Nicole McKechnie confirmed the legal proceedings and said the impact of the decision would be significant but not material from a market perspective.

    “We have commenced legal proceedings with NBN Co over when CPI adjustments should start to apply under the NBN Definitive Agreements,” she said. “We have one take on the contract and NBN Co has another.

    A spokesman for NBN Co declined to comment and said the company would rely on the court’s decision.”

    Read more: http://www.smh.com.au/business/the-economy/telstra-suing-nbn-co-over-deal-20131030-2wfkg.html#ixzz2jC0HRvs5

    Yep, big T is getting $11.3 BILLION from NBN (that would be us) for “renting” their pits to NBN. Money goes straight to the bottom line. Now a smartie in the legal department has noticed an opportunity to hoover up another lazy $100m – and if I had to bet, it wouldn’t be on the NBN.

    Governments are simply incapable of taking these players on and outsmarting them, but they will never admit it. The more tangled the regulatory regime is, the worse it gets.

  7. JohnA

    I am the Walrus, koo koo k’choo #1051705, posted on October 30, 2013 at 6:53 pm:

    You don’t want them to go ‘bust’ by blowing their creditors’ investments to smithereens, creating widespread uncertainty among those creditors, and threatening the entire financial system, which is what happened with Lehman.

    The simplest regulation is to ensure that the minimum reserve ratio (required liquid funds to liabilities) is expressed as 100% of liabilities capable of being redeemed within the next month, regardless of expectations about depositor behaviour drawn from past history. Then risking the entire financial system becomes nigh impossible. Risks are contained to the banking enterprise itself.

    The core of our banking problem is fractional reserve banking, whereas original principles of banking ensured that call deposits were always 100% available to be redeemed. [The Evil Princes of Martin Place, Chris Leithner] Once we entered the fairyland realm of fractional reserves, runs on bank deposits would almost guarantee a failure, or result in inflation. The world chose inflation, and the GFC was “solved” (HA!) by re-inflating.

    Similarly, the core of our insurance problem is re-insurance into one place. As I understand it, AIG became the final bearer of risk, by consolidating into its empire most previously competing insurers, when the original principle of insurance was to share and spread risk. “Too big to fail” is actually an indictment of the insurance industry’s failure to adhere to original principles.

  8. I am the Walrus, koo koo k'choo

    JohnA, AIG also severely underpriced the risks that it was insuring! Pretty much the cardinal sin of the underwriting business.

    Don’t know about the idea of 100% liquidity for deposits. Banking is essentially the mangement of risk. Society has made a collective decision that the benefits of fractional reserve outweigh the risks. I don’t have an opinion either way as I haven’t studied it.

    However I am worried that we are going the way of Japan and the US – ie, inflating asset prices with immense amounts of debt, which will then lead to a long (say, at least one whole generation’s working life) secular stagnation. The recent rise in home prices in Sydney is terrifying, when seen in this light.

    However, the central bank and Treasury don’t see a problem. So – all systems go! Set the controls for the heart of the sun!

  9. Andrew

    Remind me again how letting LEH fail was a good thing? For $50bn, they could have done another Bears. By all means, let it “fail.” Lose stockholders money, blow up the prefs, stop servicing the sub (who becomes the controlling class, swapping non-paying debt for warrants. Surely that would have sent an adequate signal? Or is there a view that mgt would say “Hey, I lost my job, wiped out a lifetime’s worth of stock grants, boned the sub debt, got a conservator appointed – but hey, the senior bondholders are intact so I’ll happily spin the roulette wheel again?”

    Trivial cost of bailing out the seniors compared to the omnishambles we got instead. And then 3 months later the GFC ended anyhow after a mere $2tr thrown at it in the short term.

  10. I am the Walrus, koo koo k'choo

    Andrew – well said, I agree 100%.

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