Annals of regulatory incompetence, FSA edition

By Felix Salmon
June 26, 2009

Remember Paul Wilmott’s question to an audience of quants?

You are in the audience at a small, intimate theatre, watching a magic show. The magician hands a pack of cards to a random member of the audience, asks him to check that it’s an ordinary pack, and would he please give it a shuffle. The magician turns to another member of the audience and asks her to name a card at random. “Ace of Hearts,” she says. The magician covers his eyes, reaches out to the pack of cards, and after some fumbling around he pulls out a card. The question to you is what is the probability of the card being the Ace of Hearts?

As Wilmott says, there is no correct answer to this question, but there is an incorrect answer, which is one in 52. Magicians are in control of what’s going on, and there’s no way that any magician would leave this kind of thing entirely to chance.

Wilmott just talked about this to an audience of about 100 people: 97 actuaries, and 3 employees of the FSA, the UK’s top financial regulator. All but one of the actuaries understood pretty quickly why the 1-in-52 answer was wrong. But two of the three FSA employees remained adamant that 1-in-52 was the right answer, even given the magic-show context:

One of them explained his reasoning. I cannot remember the details, it was quite lengthy, but the essence was that “The answer should have been one in 52 except that the magician was tricking us and so really we should ignore this factor…” (I apologise if I have got this wrong, but from the reaction of the audience I don’t think I have!)

Now forgive me but isn’t the FSA supposed to be operating in the real world in which things are just not about pure mathematics? A world in which risk managers hide risk, moral hazard is rife and magicians do, er, magic. Isn’t that sort of the entire point? If it was all about the maths then we wouldn’t have the FSA, we’d use someone like the EdExcel examiners to give banks marks out of a hundred at the end of term.

The FSA, famously, is a principles-based regulator — the kind of entity which is meant to be able to look at the totality of what’s going on rather than at unhelpfully narrow questions. But a principles-based regulator is only as good at its employees, and if the FSA’s employees are going to be so rule-bound as to insist that 1-in-52 is the only correct answer to Wilmott’s question (as opposed to the only incorrect answer to Wilmott’s question), then you haven’t really achieved anything at all.

As ever, the important thing, when it comes to regulators, is that they’re smart and powerful and unlikely to be snowed by bankers who make orders of magnitude more money than the people regulating them. Such regulators can and do exist — but there aren’t very many of them. And if you set up a system with lots of regulators — the Fed, the National Bank Supervisor, the FDIC, the SEC, the CFTC, the FHFA, Treasury, etc etc — you pretty much guarantee that you won’t be able to staff them all with quality employees. Which is one reason why the Obama administration’s regulatory-reform proposals don’t go nearly far enough.

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