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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1/52 isn’t the only incorrect answer, in fact it’s not even the worst answer you could give given the magician constraint — 0/52 is

Posted by Matt | Report as abusive

Or 100:1 or…

Principles-based regulation–not matter what Kydland and Prescott once said–has what I am going to start calling The Thoma Flaw (in his honor, after Mark T.’s piece on C. Romer): it sets up the presumption that things are going well.

Instead of looking for problems, you start by looking for ways to rationalise (“principles”) why something is correct. Not a good idea when the charge is gatekeeping.

Not only are they baffled by tricksters they don’t have a basic grasp of insurance contracts, some insurance broker sold them D&O insurance which supposedly covered them for misfeasance! Last week Turner, or was it Sants?, said providers of payment protection insurance had been treating customers badly by changing the terms of the policy, even my 14 year old daughter recognises that annually renewable insurance can be varied otherwise the whole thing could fall apart when millions of people lose their jobs!

Regulators suffer from myopia, they are not the solution to our probems Mr Obama, they are the cause.

As Thomas Sowell said:

“It is hard to imagine a more stupid or more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong.”

Was it the Ace of Hearts?

If the gov’t pays 10% of what Wall Street pays, you will have a hard time hiring “quality employees” regardless of how many agencies you have, even in the present environment (assuming the employees are “rational” in the classical economic sense, and assuming that Wall Street is adept at assessing “quality employees”).

Posted by Incentives | Report as abusive

Paul Wilmott must have been to some pretty rubbish magic shows. In my experience the magician quite often pretends to get the answer wrong first, only later revealing that the person holding the pack of cards has the ace of spades stuck under their seat, or behind their ear, or in their pocket. So in the absence of more context I would say that 1 in 52 is a pretty good guess.

In typical quant style, Paul Wilmott has made some incorrect assumptions to justify his stance that 1 in 52 is the wrong answer.

Posted by Stato | Report as abusive

Go on then… the tension is killing me,

was it the Ace of Spades?