Why regulation often does not work

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.


  1. Alfred T Mahan
    December 16, 2008

    Couldn’t agree more. Complicating regulations only makes it easier to conceal the truth and/or find loopholes.

    I also think we might consider revisiting anti-trust law. At present, these are designed to protect consumers from abuse of market position through pricing. Maybe there’s an argument for restricting the size of commercial entities for public risk reasons? As taxpayers, we are constantly hearing that the banks or the US auto industry are ‘too big to fail’. It seems to me that, for society as a whole, the efficiency benefits of scale are now outweighed by the risks of too many eggs in one basket in a number of sectors, and we should think about breaking up the largest players or otherwise limiting their market share.

    I accept that this wouldn’t necessarily solve a problem where everyone in a particular industry acts like a lemming, but it might well give us advance warning or limit the damage.

  2. Lola
    December 16, 2008

    Mr R, I run a financial services business. Where do I sign up for your regulatory system?

    PS. Have you seen that the FSA is recruiting another 260 bods to do more of the bad things they are doing badly and failing at?

  3. Rare Breed
    December 16, 2008

    JR has already alluded to the counter cyclical reserve ratio that SHOULD have been operating over the last 10 years (rather than the pro-cyclical shambles we have been enjoying).

    Obviously the reserve requirement should go up but since this ratio IS THE CAUSE OF INFLATION, then once you win the argument for a higher reserve requirement you win the argument for a 100% reserve requirement. As the reserve requirement is increased, so the severity of the fluctuations in the supply of money is decreased. Always remember that a state has the option of printing money as the demand for it increases without debasing its value. Some would argue that since it is the people that created the demand for the money and therefore the growth of the economy, it is them rather than the banks who should benefit from the creation of money.

    The current system based on debt leaves governments powerless to act effectively in a recession in a system where large fluctuations are built in, not created by poor management of the economy.

    As long as the fractional reserve system is continued there will continue to be overheating through the oversupply of credit/debt.

    Capitalism would work better (and I am a capitalist) under a 100% reserve requirement as it would help to control the economic growth and allow the people to have greater control over their own property.

    However, you can only increase the reserve requirement in growth times as to restrict the supply of money at the present time would prevent the supply of credit and worsen the recession. This is exactly what Gordon has done by increasing the captial reserve requirement in a downturn – something about stable doors and horses bolting…

  4. Obnoxio The Clown
    December 16, 2008

    “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.”

    Hear, hear!

  5. adam
    December 16, 2008

    surely a Ponzi scheme is 101 in Regulation. The FCC or whoever cant spot one operating for ten years plus, then claim there needs to be more regulation to do so.
    Typical public sector, failure = need more of the same.

    who regulates the regulators

    1. StevenL
      December 17, 2008

      I don’t know much about financial services regulation, however, in terms of general business regulation (food hygiene, health and safety at work, consumer protection that sort of thing) apparently both the government and business want more of the box ticking approach.

      Look up ‘retail enforcement pilot’ in google. Put simply, the idea is that local authority inspectors go around businesses with handheld computers asking lots (and at last count I think it was over 100) tick-box questions about regulation. The idea is to reduce the number of regulators visiting businesses, by, for example, getting an Environmental Health Officer to go around ticking boxes for Trading Standards and the Fire Service.

      All the data from the box ticking is supposed to then be processed, perhaps triggering other regulatory events, depending of course on which boxes the regulator ticked upon the visit.

      The politicans think it is a good idea, the civil servants think it is a good idea and so do the CBI! Personally I think it is a really stupid idea, but it seems to be one of these ‘consensus’ things we were blogging about the other day regarding Afghanistan.

      You quite reasonably asked ‘who regulates the regulators’?

      Good question adam, and I answer you as a regulator, we are regulated by people with little experience of the real world who seem to make a good living for themselves talking in soundbites and writing in jargon.

  6. Neil Craig
    December 16, 2008

    It is the same principle which applies in strengthening the laws against anybody owning guns as an alternative to executing those who actually use them to kill. We live in a society where government prefers to extend its power over all of us rather than take the unpalatable moral decision to come down hard on wrongdoers. By contrast China recently executed a con man who stole $400 million by running a ponzi scheme (it involved buying & selling ants but the principle is the same).

  7. Pete Chown
    December 16, 2008

    I think you’ve hit on something important here. By attempting to check up on everyone, the government actually checks up on no one. For example, I am honest, so when I go to open a bank account I show them a real gas bill. But gas bills don’t have any anti-forgery features, because they aren’t meant to be proof of ID; they are just pieces of paper that ask for money. I could produce a realistic looking fake gas bill in a few hours. The bank staff probably wouldn’t look too closely at it anyway, because they see so many of them.

    The result is, as you say, box-ticking regulation that causes more inconvenience to ordinary people than to criminals.

    (Identity cards will just move the problem around. Instead of the bank being shown fake documents, they will be shown to the passport office. The passport office has the same problem as the bank: a few fraudsters hidden among millions of honest people.)

  8. rugfish
    December 16, 2008

    That’s a VERY good understanding of what’s required Mr Redwood, which just about hits it on the button.

    Currently, there are more European “MiFid” directives than the all the laws enshrined within the entire British legal system, both statutory and common, since 1066 when we were first invaded by the first set of Europeans !

    I note these MiFid directives prevent direct marketing of financial products, stop jobs, create costs and paperwork to businesses, along with transfers of much of their operations to places like India.

    So the FSA and its lunatic compulsive bureaucratic controls, which is akin to England being under occupation by aliens, has to be dismantled and people who KNOW what they are doing put back to where they are in order to restore sanity, more profit for business, more jobs, less cumbersome and understandable protection for consumers and avoid the dictatorship of MiFid directives from well meaning bureaucrats which don’t have the first foggiest idea of what they are doing when it comes to running a business, policing or advising face to face customers in their homes who can’t grasp the mentality of bureaucrats but would rather have plain old common or garden, good honest ‘advice’ from someone who understands they are real people and not people to put in ‘tick boxes’.

  9. ManicBeancounter
    December 16, 2008

    Allied to the box-ticking mentality if the US is the use of detailed rules, rather than general principles.

    This is very closely tied to the world of accountancy. the fiasco of Enron was due to people finding creating ways to keep items off the balance sheet. The creativity circumvented thespecific rules that were in place. In the UK (and Europe), Enron would have broken the general principles about subsiduaries.
    The advantage of general principles is that they can allow for situations yet unkown. In the complex world of finance, this can increase the effective control, whilst reducing the complexity and compliance. It enables the regulator stay ahead of the game, whilst reducing the burden on businesses.

    I was on a course a few years back on accountancy rules. The tutor gave an illustrative example that helps illuminate the idea.
    Imagine having a teenage daughter going for a night out. You could give her a long list of rules about what not to do. Alternatively you could say “You should do nothing that you would not be prepared to tell your parents about the next day”

  10. mikestallard
    December 16, 2008

    I am just reading about Young Stalin. Under the Tsarist Police, (Stolypin) Bolshevism was all but eliminated by 1912. The way they operated was by getting secret Policemen into the organisation. To the end of the regime, the handful of Bolsheviks who remained were paranoid about this and yet they let the real Okhrana secret agents get away with it!
    Are our financial services so much worse that the Tsarist Police in 1912?
    You are so right in what you say. Horse sense and simplicity! That is why I am bothered about the FSA and all those Parliamentary Committees. Wouldn’t the professional Bank of England/ the Police Fraud Squad be much better placed to sniff trouble out?
    Box ticking simply protects the burgeoning army of bureaucrats which is about to bring my little country to its knees, (they, natch, will survive on good pensions).

  11. Sava Zxivanovich
    December 17, 2008

    Regulation should be simple:
    1) Licence to use investors money should insure investment against agent’s wealth. Agents should behave in the same way entrepreneurs do – invest their own money when they ask for investments, in their case insure customers’ investments.

    2) No wealth – no licence.

    3) Ratings company should provide insurance for instruments they do ratings for. As a minimum 5% of the whole investment should be enough for them to avoid costly mistakes (for investors).

  12. Tommy Cockles
    December 17, 2008

    Please could you tell me how many people were brought to justice when your party was in charge of regulating the Financial System?

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