Economics

How to fix financial services regulation

As I was reading of yet another spectacular mismatch between bank managers’ competence and their remuneration, and this time at JP Morgan no less, I realized there is a simple solution which really could be implemented.

Make the cost of regulation zero – or very nearly – for unlimited liability partnerships. Then let judicious self-interest, exercised by the partners themselves, do the rest.

My father was what they now call an ‘investment banker’. His firm got it wrong by expanding business into the 1970s’ slump, and when it went wrong the Official Assignee took everything he owned. That was in the days when partners had joint and several liability, which meant that all the top management of a firm were personally liable for the entire debts of their business.

Joint and several liability quickly weeded out the incompetents, the gamblers and the unlucky (my poor old Dad, I like to think). It made managers look very carefully at their colleagues’ strategies, and concentrated everyone’s efforts on controlling risks, rather than seeking bonus-building nominal profits.

The approach was discarded in 1986 after 150 years of pretty effective operation. It wasn’t perfect (what is?) but we were all very stupid to think we could do better by replacing the natural damper of direct personal liability with a combination of salaried and bonused managers, and sixty thousand pages of regulations.

I realised this morning that official regulation of financial services has become so onerous and so unsuccessful at loss prevention that joint and several liability could easily be re-introduced. All it would need would be a subsidiary arm of the regulator, set up exclusively for the regulation of investment businesses run by unlimited liability partnerships.

Lots of reputable financial professionals do not get big bonuses, because they work competently in the low-risk, low-return areas of the industry. Yet within the regulated sphere of financial services, there are so many complex rules that even these firms have to employ more compliance officers than accountants, while at the same time funding the wretchedly unfair Financial Services Compensation Scheme in the UK, or Federal Deposit Insurance Corp. in the US – which is a bit like being forced to pay for the car insurance of your drunken neighbour.

They should be given the choice of submitting to financial services, or choosing a simpler system, where they put up as collateral their house, their car, their holidays and their children’s school fees, and – within reason – are left to get on with managing their business risks as they see fit.

Making management collectively liable for their mistakes has lots of benefits.

  1. Size – Because partners all want to be able to understand their whole business it encourages smaller and less systemically dangerous organisations – ones which are not ‘too big to fail’
  2. Growth and competition – It encourages business formation, something which has ground to a halt now because of the huge cost of setting up a compliant organisation;
  3. Attention to detail – It forces revenue generators to be more critical about risks, rather than leaving it to formulae which pass the rules and get boxes ticked, but do not work in practice;
  4. Liability – It encourages senior management stability and accountability, and suppresses the job merry-go-round whereby careers advance by sweeping problems temporarily out of sight and quickly changing jobs;
  5. Rewards – It directly links remuneration to risk, as well as to performance;
  6. Clawback – It keeps all prior remuneration still in the compensation pot, to be reclaimed in the event of future investor losses.

Our experiment with rulebooks, regulators and salaried managers has been a bit of a disaster. Maybe a partial return to the old ways is not such a bad idea.

A version of this article was previously published at BullionVault.com on the 14th of May.

5 comments to How to fix financial services regulation

  • According to Mervyn King, the best capitalised bank in Britain three months prior to the collapse of Northern Rock according to the regulations then in force was . . . . Northern Rock. I.e. the regulations were a load of codswallop.

    And in 2011, the European Banking Association, plus the European Central Bank, etc did stress tests on all major European banks, and what do you know? Bankia, the hopeless Spanish bank passed with flying colours. Now it needs 20 billion and counting Euros to stave of collapse.

    Yet more codswallop.

  • Should have said: the above comment of mine was in response to the phrase in the above article: “I realised this morning that official regulation of financial services has become so onerous and so unsuccessful at loss prevention…”. I.e the statement that regulation has been “unsuccessful” is the understatement of the year.

  • Samantha

    I love this article… part real experience analysis of the past, part common sense for the present.

    In reading extensively on the Goldman Sachs pre-IPO, I absolutely agree that this is the simplest no-regulation strategy around for mananging financial service risk.

    When a GS partner nearly tanked Goldman in the ’30s, it was private market bargain hunter Floyd Odlum (Atlas America) who “bailed” them out, by buying the bad investments that he felt he could turn good. And by god, he figured out how to turn that deal to his profit.

  • Paul Marks

    The 60 thousand pages of regulations is something to remember – they did not use to exist, they now do. This is not “dereglation” – yet a massive spin operation has got people convinced that “deregulation” has occured.

    I remember Norman T. giving a talk many years ago, where he said that the changes in the City of London were one of the biggest (if not the biggest) mistakes in policy in recent years. Changes that were supported by just about everyone at the time – all about being “modern” and so on. And the old “Chingford Skinhead” was speaking at a time when the City seemed to be booming – and without any detailed knowledge of economics. His common sense told him that something was very wrong – and he was right.

    The old guild like structure may have been a case of “restrictive practices”, but the new structure which is GOVERNMENT DOMINATED is far worse.

    The regulations gave (still give) people a false sense of security.

    So they do not care that the enterprises they give their money to invest, are run by people who do NOT lose their own shirts if they fail.

    They lose their job certainly – but they do not lose their own life savings, and the inheritance for their children.

    Why do people hand over their live savings to a group of people who have no real “skin in the game”?

    Because the government tells them it has their back – that it will protect them.

    That is not a free market, it is actually FURTHER AWAY from a free market than the old system.

    As for banking (the above is really about other branches of the financial industry)…..

    The fallacies are actually spreading.

    For example “deposit insurance” is being introduced in the Channel Islands.

    A total absurdity – as one can not “insure” against a badly run business.

    What the effort will do is to give people false sense of security in handing over their money to a bank (which is actually a business – not some magical thing that creates interest by waving a fairy wand), so they will just look at the interest rates offered (not how the bank is run, who it is lending money to…. and so on).

    The taxpayers?

    Well treating banks (especially modern vast credit bubble banks) as essentially part of the state whose “depositors” may never be allowed to lose the money they have invested (sorry “deposited” – although if it were really “deposited” how could interest be paid on it? Surely a real “depositor” would have to PAY THE BANK for guarding their money in some super vault somewhere)……

    Anyway – end result of treating banks as, de facto, part of the state?

    Bankrupt taxpayers.

  • Samuel Eglington

    Put this idea together with TCC’s and Corrigan’s ideas for writing down debt and you’ve got the basis for a manifesto. Anybody fancy starting a new political party?