Why finance can’t be fixed with better regulation

By Felix Salmon
July 23, 2012
Jim Surowiecki and John Kay both have columns today looking at the way in which regulatory structure failed to stop abuses in the financial-services industry, and wondering how we might be able to do better in future.

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Jim Surowiecki and John Kay both have columns today looking at the way in which regulatory structure failed to stop abuses in the financial-services industry, and wondering how we might be able to do better in future.

Surowiecki says that we trusted the banks when we shouldn’t have: their incentive to preserve their reputation was not nearly big enough to override their incentive to make money. He’s right about that. But his proposed solution is vague: first, he says, prosecutors should “admit that fraud is a crime and throw some people in jail”, and secondly regulators should “be aggressive not just in punishing malfeasance but in preventing it from happening”. Well, yes. This is the rhetorical equivalent of throwing your hands up in the air: if you end up proposing something which absolutely everybody will agree with, then there’s almost certainly no substance there.

Kay, by contrast, has been looking at UK equity markets in detail, and has determined that the problem lies more with market structure than with anything within the realistic control of prosecutors or regulators. Surowiecki’s proposal basically boils down to “all you prosecutors and regulators are weak, weak people, you should man up and go to war”. I don’t know how many prosecutors and regulators he’s talked to, but this does them a disservice: there are serious institutional and legal constraints here. And what’s more, we can’t try to reform financial-services regulation by assuming that we can easily find a whole new breed of regulators: we can’t.

One reason why we can’t is laid out clearly by Kay:

Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.

But this is in turn only a symptom of a broader problem, which is the way in which the consolidation and ever-increasing complexity of the financial-services industry has reduced the ability of firms to police each other and to earn each others’ trust, while at the same time increasing incentives to fraudulently game the system. Barclays’ Libor lies, for instance, started life as a way for its derivatives traders to make money: something which could never have happened when the banks reporting into the Libor system didn’t have derivatives desks.

A large part of the problem is the way in which financial tools which had a utilitarian purpose when initially designed have become primarily vehicles for financial speculation. Libor, for instance, was a way for banks to peg loan rates to their own funding costs, and thereby minimize their own risks while at the same time minimizing the amount that borrowers had to pay. Today, banks don’t fund on the interbank market any more, and Libor has become something else entirely: a number to be speculated on in the derivatives market, and, in times of crisis, an indication of how creditworthy banks are perceived to be.

Similarly, equities used to serve a capital-allocation purpose, and there was, as Kay says, a chain of trust running from investor to board to management. “Most asset managers want to do a good job – earning returns for their clients through strong, constructive relationships with the companies in which they invest,” he writes. “Most corporate executives also want to do a good job, leaving the companies they manage in a stronger competitive position.”

But that’s not the equity market we see today: “It is hard to see how trust can be sustained in an environment characterised by increasingly hyperactive trading, and it has not been.”

Kay’s conclusion is sobering spot-on: the entire financial-services industry, he says, needs to be restructured so as to create the kind of institutions which thrive on increased trust, rather than on maximized arbitrage of anything from news to interest rates to regulations.

In order for that to happen, we’re going to need to see today’s financial behemoths broken up into many small pieces — because at that point each small piece is going to have to earn the trust of the other small pieces which rely on it.

Of course, that’s not going to happen. And as a result, financial-industry scandals will continue to arrive on a semi-regular basis. When they do, they will always be accompanied by calls for stronger regulation: rules-based, or principles-based, or some combination of the two. But the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution. The real problem is deeply baked into the architecture of too-big-to-fail banks. And frankly I don’t see any realistic way of unbaking that particular loaf.

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“Most asset managers want to do a good job”. Sure, everybody in the world wants to do a good job. But asset managers don’t really care if they do or not, as they get paid (and paid well) even if they don’t do a good job, as they get paid a percentage of assets they manage, not how much those assets increase or decrease in value. The same goes for corporate executives, whose compensation often lacks correlation with their performance, and rather is more tied to their job title (which they influence via their seats on other company boards).

“..the entire financial-services industry, he says, needs to be restructured so as to create the kind of institutions which thrive on increased trust, rather than on maximized arbitrage of anything from news to interest rates to regulations.”

It’s not just the financial services industry that has this problem, it’s virtually every large publicly traded or private equity-owned corporation that believe its sole purpose is to make money. If the management believes it is obligated only to grow profits, then it will make decisions to achieve that result, without thought of customers or employees interests (or sometimes, the long term interest of shareholders – see banks circa 2003-5). Companies are founded to provide a service or product; the managers that eventually take them over are no more than mercenaries, who view their job as to squeeze as much profit out of that virtual machine. People work their way up to the top levels of the corporate world, usually employing political tactics to win promotions, for the goal of increasing their compensation. They are judged on how much money the company makes, not whether the customers are happy. The financial services industry is no more or less immune to that drug than other industry.

While the mindset of executives in the financial industry is definitely a problem, you’re giving up too easily if you say regulation cannot help. And I don’t even think we need new regulations, as we already have the infrastructure in place to protect society from the self interest if the financial industry executives. Think of the power of insurance companies. You want to put a diving board in your swimming pool? A trampoline where small children will play? Go find someone to insure you.

We have an insurance company for banks. It’s called the FDIC. Every bank that wants to take retail deposits effectively has to offer insurance provided by the FDIC. The FDIC can prevent banks from doing stupid things. They don’t need new regulations, they can just deny coverage to banks who start gambling with depositors money.

And banks themselves have power over other businesses. They can deny loans if they don’t like the way the business is operated. Well, there is bank for banks – it’s called the Federal Reserve. They loan money to banks every night. What’s to stop them from putting conditions on those overnight loans?

Posted by KenG_CA | Report as abusive

There was a recent piece arguing that “too big to fail” banks should be nationalized. And then let the smaller ones take care of themselves. Might be worth a try, if possible. (I doubt the GOP would permit).

Posted by Chris08 | Report as abusive

Too big to fail banks are only too big to fail when their failure impacts the wider economy; sever that linkage and it doesn’t matter how big they get.

So, how do they affect the wider economy? In the UK (and much of Europe) it’s because the casino is betting the salaries and risking the mortgages of ordinary folks and if a bet goes significantly wrong, those deposits and mortgages are at risk. Let them play with their own money for a change, and ‘our’ money will be safer. Then banks can get as big as they like or deserve to be, and if they fail, being big won’t be a defense. If it’s possible for them to fail, and harder for them to raise capital, maybe they’ll return to the days of needing to be trustworthy to earn our trust. If they do well, they profit; if they do badly, they fail – and are allowed to. Only then do you have true capitalism, not this Corporatist Neo-Conservative greed which is dressed up as the only alternative to ‘socialism’.

Posted by FifthDecade | Report as abusive

From Surowiecki – “LIBOR, for instance, should be revamped so that it reflects actual market rates, not self-serving guesses”. A line line like this one makes it tough to take seriously anything that Surowiecki says about the details of this issue. If he wants to make broader points about trust and regulation, fine.

The problem, however, is that the goal of obtaining LIBOR in many currencies for several maturities – and obtaining submissions from a significant number of banks for each of them – is fundamentally in tension with using actual market prices for borrowing. There’s certainly more than one way to skin the cat, and there are serious proposals for various combinations of using market rates as a check on individual submissions, expanding the panel of banks, or requiring banks to provide rates at which they would lend to particular other banks (and other ideas that I’m sure I’ve failed to mention). Someone who reads The New Yorker and doesn’t read finance-focused publications or blogs is going to be misled about how easy it is to fix this problem, however.

Posted by realist50 | Report as abusive

One straightforward way to stop all the shenanigans going on in the financial world is to stop interfering with the market, with the mechanism if risk, profit and loss.

The best method is to dramatically curtail the use of public treasury or any and all other government “insurance” for any and all institutions other than small scale consumer depository institutions. Let every one else fail and their depositors and investors reap the whirlwind. If enough billionaires get cleaned out by a bunch of fraudster “bankers” then there will be a lot less money flooding speculative, manipulative schemes. There will be many fewer Bain Capital type organizations using public money subsidies to harm the country. Just let them fail. Don’t give job reducers subsidies. If they need a subsidy, let them not do it.

This whole mess has been caused by crooked politicians using tax money to pay off their henchmen in financial institutions and then claiming to not know where the money went or who took it. It is purely and simply corruption and fraud at the highest levels of Government and the Courts.

Posted by usagadfly | Report as abusive

The problem is that you don’t need smart regulation, you need DUMB regulation.

The genius of Glass Steagal, for exampel was that was straightforward: You take customer money, you do not play the market.

It worked for over 50 years until Alan Greenspan eviscerated it, and Bill Clinton and Phil Gramm then repealed it.

We need dumber regulation that does not accomodate “market innovations”.

Posted by Matthew_Saroff | Report as abusive

Once you allow someone in a casino, and you say that you can’t possibly allow their wife and children to starve, and that the casino industry is the lifeblood of the economy, the gambler rationally believes the best course of action is to bet, bet, bet, …and bet some more. Soon gamlbers join in, and when they can’t reach the roulette table, they start betting on who at the roulette table will win.

After the gamblers go bankrupt, society than decides the gamblers MUST be GIVEN more money, because after all, their job is gambling, and their wives and children can’t starve, and oh by the way, the casino workers need jobs too! Casinos now make up 17% of the economy.

And just by coincidence (really!) when society is managing the gamblers, and 90% of campaign contributions comes from gamblers, and everyone says what a maestro government is for running an economy based on gambling, and all the winnings are due to sheer brilliance – well, the losses are something that NO ONE COULD HAVE FORSEEN.

How long before people realize that gambling makes one poorer and not richer? That someone has to pay for the bets not won???

Posted by fresnodan | Report as abusive

@fresnodan Best comment on this topic for ages! lol! And it’s so true as well…

Posted by FifthDecade | Report as abusive

@fresnodan,

REALLY well put!

Posted by OneOfTheSheep | Report as abusive

@KenG_CA,

Good points I would carry a bit further even if “off-topic”.

Would it not be equally true that “If politicians and bureaucrats believe themselves obligated only to grow government and agencies, then they will make decisions to achieve that result, without thought of the long term interests of “we, the people”? That would explain a lot of what we see today!

Posted by OneOfTheSheep | Report as abusive