Financial businesses are different from most other types of business. They entail sending your money to someone else to look after, on the promise they will give it back to you at a later dtae, preferably with some improvement in its value.
Because of this I have always favoured two types of regulation for financial businesses. The first applies to deposit takers. They should be required to meet overall standards of capital and cash reserves. The Economic Policy review I helped produce in 2007 demanded stronger requirements in these important areas, as we could see the banking sector was grossly over extended under the then current regulation, which could make it difficult for people to retrieve their deposits from some banks if many wanted to at the same time.
The second type of regulation should apply to all financial businesses. It should be a policing system designed to find the thieves amidst the large financial community, and take early action to prevent them trading or to wind them up rapidly where theft or fraud is occurring.
Instead, what we have witnessed is a a big growth in the regulation of the many honest businesses, in the strange belief that if you put in enough complicated rules to “prevent” some past way of carrying out a fraud, you will prevent fraud. This is never likely to work, because of course if someone is going to commit theft, breaking a few Regulators rules and lying to the Regulator is just a subsidiary part of the task in order to steal all the money.Fraudsters will break regulators’ rules as well as pocketing the cash.
I am not surprised that a large fraud may have taken place in the US. They like the UK have box ticking regulators who create ever more rules in substitute for being detectives seeking out the mercifully small number of bad apples in the financial barrel. The danger of the US system is the regulators concentrate on a wide range of honest businesses who fall foul of the increasingly complex rules owing to human error, disagreements about what the rules mean, and through misreading the complexity of all the process issues the regulator seeks to control. At the same time invetsment managers can be losing their clients billions legally, and a handful can be stealing billions of their clients money without the regulator being able to see it.
When I was the UK’s non banking financial Regulator, in the days when that role resided in the DTI, I drew up a list of things regulators should look for to try to detect crooked businssses. I told them to concentrate on that, as I was quite sure the public, like me, primarily wanted their regulators to find the Maxwells before they had taken too much money from clients or pension funds, and stop them.
Included in my list of warning signs worthy of investigation were: returns that are too good to be true;promised returns out of line with the asset returns they said they were buying; frequent changes of year end and auditor; complex company structures;lack of independent people on the Board and at the top of organisations;lack of independent custodian arrangements; market rumours.
I favoued using the invetsigatory powers, in private, when our suspicions were aroused. A public investigation, or worse still a press briefing before enough evidence had been amassed ran the risk of breaking a perfectly good business if it had good reaons for the warning sign.
In the hue and cry that will follow the Madoff case there will doubtless be the demand for yet more process regulation to “stop” someone else doing what it is alleged he did. Instead the cry should go up for a detection based approach to regulation, instead of yet more box ticking for the largely compliant and the wholly honest. People should rememnber that it is only the honest who do the box ticking honestly. Crooks can tick boxes too, and can make up the things to put in them. It’s just the same with money laundering. Money launderers doubtless have passports and gas bills. Making sure every financial business has all its clients passport and gas bill copies does not mean the end of money laundering.