Tuesday, 6 March 2012

Complexity Costs

I have had to deal with the idiocy of modern financial regulation rather more than I would like lately. The issue involves FSA regulations which create a bias in favour of the TBTF banks. (As almost all FSA regulation is biased in favour of TBTF banks, this isn't much of a clue.) The FSA acknowledges that their rule creates a bias. They acknowledge that the bias was created in error, without principled justification. (They allowed outside counsel retained by the big banks to write the rule for them.) They acknowledge that the restrictive rule is inconsistent with European Union directives on the subject matter, and inconsistent also with UK government objectives of reducing the implicit subsidy to TBTF banks and reintroducing competition to financial services. They acknowledge that a change to the rule could improve sector competition, consumer choice and reduce costs.

Will they change the rule? No. Changing the rule would require an expensive public consultantion and cost-benefit impact assessment that hasn't been budgeted by the relevant division of the FSA for this fiscal year. Additionally, there is no proof of a market demand for the benefits of the rule change, as the existing users of the rule - the TBTF banks - are telling the FSA that existing customers aren't asking for a rule change.

It's a good thing that this is a marginal issue for the business. If it were serious, I'd have to advise doing business elsewhere than the UK. It might be wise to do that anyway, as being subject to a regulator like the FSA will be such a miserable experience based on current observation that locating a business somewhere more sensible would probably help ensure the business succeeds longer term.

The frustration of this one case raises a broader issue. Is it possible to reform a failed regulatory system sufficiently to restore a functioning market?

Regulators operate monopolies and are virtually impossible to discipline for their errors. Being bureaucrats, most regulators do not really have a stake in whether their rules do more harm than good. No one outside the regulator knows or cares who had responsibility for crafting a particular regulation, much less how it promoted or restrained market efficiency in the long run. It's almost always easier and less risky to do what they are asked by powerful incumbents than to attempt to level the playing field in favour of consumer protection or increased competition. Fifteen years of the FSA pretty much proves this point, as complaints to the financial ombudsman were at record levels last year and financial services concentration is consolidating at a very rapid clip leaving consumers very little real choice.

And then there is the complexity of modern regulation. Changing any regulation requires a publication of proposals, a consultation period, a cost-benefit impact assessment, legal consultation to ensure compatibility with EU directives, etc. Consultation responses are more likely to be from TBTF incumbents with a stake in bad regulation, and very unlikely to be from ill-informed consumers or would-be market entrants who might benefit from good regulation.

The FSA is being disbanded for its failure to properly regulate UK banks in the run up to crisis. It will be split into three, with some functions going to the Bank of England, some to a new Prudential Regulatory Authority and some to a new Financial Conduct Authority. A change in structure does not necessarily yield a change in ethos or policy. Sadly, the same bureaucrats will turn up at the same desks and largely follow the same courses that led to failure of the old system. If anything, the added complexity of co-ordinating among the three new regulators will be an additional incentive to make as few changes as possible to regulations going forward.

I am reminded of a friend who went to Eastern Europe just after the Berlin Wall came down in hopes of investing there to modernise the economy. He came back determined never to venture an investment because the same bureaucrats as held office under Communism were still showing up to work in the ministries every day and following the same rules as before.

7 comments:

Knute Rife said...

Well, LB, you could be here in the States, where you don't have Sir Humphrey Appleby in charge because the bureaucrats swap places every two years with the folks who are supposed to be regulated. This revolving door means the financial industry has executed a Borg-like assimilation of the supposed regulators.

When trying to fix a failure, it's best to first classify the failure. The FSA sounds like it has two problems: 1) insufficient internal expertise (hence handing rule-making over to the industry), and 2) typical, procedural stumbling blocks to practical regulation.

On the first point, simply declaring the FSA to be Gaul and dividing it into three parts won't cut it. The FSA needs industry pros in-house, and unlike here in the US, it needs to nail them down for a few years and prevent their jumping back to industry.

The second point is stickier. Domestic procedures can be reformed readily enough if Parliament has the will. EU procedures are tougher (a chronic problem in dual sovereign systems with supremacy clauses that are big enough to create minefields but not big enough to actually accomplish anything), but this is an issue that reaches far beyond financial regulations and should have been addressed by now, unless everyone is intent on having the system collapse under its own weight.

In other words, your current system is a car with an undersized drive train. It can be re-engineered. The US, on the other hand, has a car with the wheels on the roof and the engine in driver's seat. It is systemically incapable of doing what it is supposed to do.

Richard said...

LB, great post.

As Mervyn King said, nobody would build the financial system we currently have. I suspect that he realized that the system is flawed because of its dependency on regulators.

Unfortunately, if they fail, we end up with a financial crisis.

Even more unfortunately, the legislative response to the financial regulators failing to prevent the current financial crisis was to give them more authority.

Apparently, they need the additional authority if they are going to do their job and prevent the next crisis.

And this ended the dependence on regulators to maintain financial stability how?

PeterJB said...

@ LB

I see that you are now feeling the pains of reality. "Is it possible to reform a failed regulatory system sufficiently to restore a functioning market? "

My answer to you is: not this time. There is nobody with the will and the strength to stand up to Power.

And, you had better hope that I am correct for the current situation will get far worse before it rectifies and is reborn. Those of the Power will use every means it its control, both illegal and legal to keep the status quo for the influential as well as to maintain their own positions and status.

The US is about to implode followed by the UK and then EU. There is a shift now and it is towards Asia between Perth WA and Vladivostok. Singapore has been preparing to become the main financial services sector in the World and it is also there.

The West is dying of its own incompetence and arrogance expressed in its inept "leadership.

@LB, when you can feel it, then you can know it. Welcome.

H. Alexander Ivey said...

LB

"Is it possible to reform a failed regulatory system sufficiently to restore a functioning market?"
Yes, of course. That is like asking is it possible to reform a government. Yes it is, yes, it requires a lot of work by many people, no, it is not a short term or easy task. Still there is no need to be pessimistic. And furthermore, what do you mean "sufficiently"? Are you implying the goal of a regulatory system is to be just good enough? Good enough for what?


"Regulators operate monopolies and are virtually impossible to discipline for their errors."
I think you mis-state the purpose of regulators - which is to set the playing field and the rules of conduct. Monopolies are businesses or the players on the field, they are not the referees. And I disagree about the virtually impossible to discipline them for their errors. Regulators can be regulated - that is, be held accountable for their actions, maybe not in my lifetime again, but they have been in the past, so hope springs...

"Being bureaucrats, most regulators do not really have a stake in whether their rules do more harm than good."
Again, you are being too pessimistic. Everyone is affected, but many may not know it until it is too late. Ask a teacher about their pension funding.

You are starting from the position that regulators are less informed than those they regulate. I'm sure you are correct, but this is not the way it should be. The solution is simple - there is no action allowed that the regulator does not understand. I agree simple is not easy, and not always fully possible but as a baseline position that is the way to go.

And for the complexity - again that is cut down by the starting point that the regulators must understand the action being allowed.

My main point is this: improve the regulation by improving the (presently non-existant) enforcement of the law. Transparency and punishment when that is not done. Your argument noted the increase in financial services complaints but then it does not ask the question: why was nothing done? what is the consequence of nothing being done?

"The FSA is being disbanded for its failure to properly regulate UK banks in the run up to crisis."
One final word, while I'm not in the UK, I dare say the FSA is being disbanded as a scapegoat, not for its failures.

Knute Rife said...

Mr. Ivey hits a point that may be the crux of the whole thing: The regulator has to be able to understand the investment, and the investment should not be permitted if the regulator can not. This may seem childish at first glance, and the financial industry will snort and huff with statements like, "Well, our activities are increasingly sophisticated, and those outside the industry can't be expected...", but here's the deal, boys and girls: Either the regulatory regime is there to create transparency for the benefit of investors, or it's window dressing for a con game. It's that binary. If the purpose is the former, how is it possible for an investor to understand an investment if the regulator can't, and if the investor can't understand, how is transparency of any use or meaning? What good is transparency if it is indistinguishable from obfuscation?

London Banker said...

@ Mr Ivey
I was perhaps too pessimistic. I work optimisticly every day to make the system better than it is, but when I have to deal with the FSA despair comes too easy. I see the defensiveness of small minds, fearful of admitting their complicity in great crimes that impoverish society and degrade the lives of those financially weakened by their cowardice.

Change is possible. Change is happening. I suppose I should give it some time.

@ Knute
I have always believed in the power and purpose of bright line rules. The rule you suggest is a bright line rule. If an investment cannot be understood by a regulator, it should not be allowed for an investor. That would be a good rule. The problem is that regulators like to believe that they can understand complexity if they just hire enough economists to construct more complex models. Thus they pile on reporting requirements, but refuse to limit conduct or scope of investments.

Knute Rife said...

@LB
Then it is a case of "Regulator, heal thyself." Personally, I find economic "models" to be either wholly results-driven or dependent on a topology that can only be characterized as LSD-based.