The regulation puzzle

If nothing else, the financial travails of the past couple of years have demonstrated the central necessity of effective regulation – that is, regulation that encourages integrity in business. Nowhere is this more important than in financial services!


If nothing else, the financial travails of the past couple of years have demonstrated the central necessity of effective regulation – that is, regulation that encourages integrity in business. Nowhere is this more important than in financial services!

The world’s governments have reacted fast to this message, without a doubt. Both in the US and in Europe, new regulations followed hard on the heels of massive bank rescues. All in all, what started as the fall out from imprudent bankers’ and mortgage lenders’ bad practices managed to depress the world economy to a devastating extent.

It could be argued that even the European debt crisis is a result of this. The debt crisis is at its worst in Greece, though Ireland and now Portugal are suffering as well; the national finances in Greece were shaky, admittedly, but it could be argued that the problems with credit and the costs of rescuing the international financial industry are what finally pushed it over the edge.

The cost has been enormous. Europe has come together to protect its own, a good thing. This does mean, however, that the costs are that much more widely spread and the potential damage even wider. More than ever before, it has become clear that no country is an island (even little ones like Malta, a real, physical island which has contributed its fair share to the rescue pot).

So what has the response been? New regulation – needed, beyond a doubt. It became clear that deregulation had gone too far. Worse, it had left space for a very dangerous misalignment of incentives masquerading (ironically) as a reduction in risk. As Joseph Steiglitz (in Freefall) and others have pointed out, some of the multilayered securitization of mis-sold mortgages actually managed to amplify risk.

Clearly, this needed to be put right. I have only a vague idea of the way the US went about this, but in Europe the drive was relentless. The first thing the EU did was propose, discuss, agree and put into place a new, multi-level regulatory structure. First, a layer of three pan-European bodies which oversee and coordinate the actions of the national regulators. Second, a top layer that watches out for emerging systemic risk.

This approach is definitely a step in the right direction. As financial services become more internationalized, more complex and more intertwined, the risk that emerging problems may get lost in the cracks between different national regulators becomes ever larger. This new structure addresses that.

The EU has taken action in other areas as well. Revised capital requirement rules for banks (under Basle III) are one; the new Alternative Investment Fund Managers (AIFM) Directive is another. On the face of it, there is nothing to disagree with in this. Looking at the detail, you may begin to have misgivings.

I will not go into the day-to-day issues of specific national interests, though there could be a lot of intriguing stories there. No, what I do begin to worry about is the general picture that emerges. Start by asking yourself: what is it we need from regulation? Foremost, quite clearly, is the protection of clients from unethical practices by financial services providers. This means we need regulation to encourage integrity, to incentivize ethical behaviour if you will.

Note this is the opposite of what happened in the years up to 2008. The gut reaction has been to reduce the freedom of action enjoyed by a variety of actors in the financial field. The question to be asked here is: will this incentivize ethical behaviour? Will this foster integrity?

My fear is that it will not. Ethical behaviour is a result of a value judgement translated into a choice, which is then put into action – the experience of which then feed back to the value judgement/choice nexus and develops integrity and a strong ethical sense. Restrict the scope of action too far, and you remove the possibility of choice; in so doing, the entire cycle is short circuited and paradoxically, the basis of ethics disappears.

This is worrying. The only long-term protection against abuse in a changing environment is a sense of integrity. This may sound like a boast, but I’ll say it anyway: Malta’s banks sailed through the crisis almost unscathed, because they stuck to prudent core banking principles despite the temptation to go after the same skewed profits that sent so many banks into a tailspin.

Note that this is not an argument against regulation. It is an argument for the right sort of regulation.This means regulations that encourage ethical choices. I do not believe that proscriptive regulation will manage to achieve this.

Yes, there are dangers in this approach. Inevitably, this will lead to a number of wrong choices being made, some inadvertently and others willfully. The issues need not  always be clear-cut, and there will always be room for debate about which course of action was the correct one; the answer may at times be “none, absolutely”. But at least, the process of ethical thought was there, leading to a stronger base of integrity which will protect customers and the economy (and society) so much better.

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