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Saturday 2 October 2010

Game On: Basel III

Bonfire of the Principles

The next set of banking regulations, aka Basel III, has arrived, albeit it'll be implemented one micro-step at a time. It has, of course, been accompanied by horse-trading of the kind that can only be done behind closed doors by an unelected and unaccountable body. After all, it’s not as though their actions will ever affect the rest of us, is it?

Regardless of what this shadowy group has decided the actual behaviour of the world’s financial community will continue to be cautious while the pain engendered by its latest fiasco remains large in the minds of its officers. Yet these memories will fade and animal spirits will once again take over, when Basel III will become, like its predecessors, an opportunity to be gamed, not a constraint on unethical behaviour. In the end we need less rules, more principles and better regulators.

Honesty’s Not Policy

Experiments have shown that most of us are only honest up to a point. As Mazar, Amir and Ariely point out in The Dishonesty of Honest People:
"People who think highly of themselves in terms of honesty make use of various mechanisms that allow them to engage in limited amounts of dishonesty while retaining their positive views of themselves. In other words, there is a band of acceptable dishonesty which is limited by internal reward considerations".
And these findings are in an experimental situation where there’s virtually nothing of importance at stake – we can only imagine what the real world is like. Well, truthfully, we know what the real world is like, don’t we? It’s just not polite to point it out.

Hypocrisy, By Right

On top of this, there’s good evidence to show that the more rich and powerful you are the more likely you are to believe that the rules which apply to other people simply don’t apply to you. In fact these people are marvellously hypocritical because they actually apply the rules more strictly to other people than to themselves. How many bosses have you known like that?

What seems to be going on is that the powerful gain a feeling of entitlement that seems to emanate from simply being powerful. In Power Increases Hypocrisy: Moralizing in Reasoning, Immorality in Behavior Lammers, Stapel and Galinsky show:
“The powerful judged their own moral transgressions more acceptable but the same transgressions committed by others less acceptable compared to low-power participants. Accordingly, across the studies only the powerful showed hypocrisy, producing a significant difference between the acceptability of other’s versus their own transgressions”.
Such people, it seems, have a very flexible notion of dishonesty: if you do it you go to jail, if they do it they pick up a large bonus. For such people rules, all too often, aren’t barriers, they’re just somebody else’s problem. In the case of banking executives it turned out that they were everybody else’s problem.

Backsliding SoBs

It’s a moot point, of course, as to whether rich and powerful people become rich and powerful because they’re two-faced slimy, backsliding sons-of-bitches or whether they casually develop these traits after they achieve success. Either way, for our purposes, the direction of causality doesn’t matter much – the world of finance is full of these people for whom rules are simply problems for others.

With this kind of psychological underpinning in place we can virtually guarantee that as soon as any set of rules is put in place the race to the bottom will commence. Rules become flags identifying areas it’s not worth working in, because regulation limits risk and risk limits potential rewards. This, ultimately, lay behind the wholesale carnage of the financial industry: many of the greatest and most long-lived of our financial institutions collapsed overnight, without directly flouting any rules.

The institutions didn’t need to bother worrying about the rules because they simply sidestepped the issues by exploiting areas that weren’t being regulated. Which, of course, by definition means that they were dealing in murky and dangerous waters: unregulated markets are not for the unwary. And, as it turns out, many of the over-compensated, hypocritical executives running financial institutions were very unwary.

Regulating Sheep

Underlying this there’s a simple principle: regulatory sheepdogs can never keep up with their errant banking sheep. As fast as one loophole is blocked they’ll find another one. Trying to manage a rule based system doesn’t work and by the time the whole system reaches critical mass and triggers a chain reaction when everyone is gaming the system in a race to the bottom it’s too damn late to do anything other than evacuate everyone you can and hope you don’t end up with too many giant three-headed carnivorous ovines roaming the streets, dumping their odure on innocent passers-by.

The moral outrage amongst most people at the havoc wreaked on economies worldwide speaks volumes for the way that the masses regard the great financial crisis. And, in fact, morality is probably at the heart of this puzzle. The fact is that the people who drove great institutions over the edge like so many demented lemmings ought to be ashamed of themselves, yet they doubtless believe that they were blameless. They always do.

Big Brother’s Principles

One of the great conundrums of all regulation is how tightly to draw the rules. The tighter you draw them the more opportunity there is to find the holes and exploit them. On the other hand draw them too broadly and you get the kind of perverse behaviour we’ve seen in the UK where our anti-terror laws have been used to, amongst other things, eject an octogenarian from a conference for heckling the Prime Minister, prosecute dog-walkers for not cleaning up after their pooches and impose 24*7 intrusive surveillance on a family suspected to trying to game the school entry system to get their child into a better school.

The other approach to regulation is to draw up general rules of behaviour – principles – and demand that people meet them in their approach to the rules. The broad principle that the UK’s anti-terror laws should be used to attempt to catch terrorists, rather than dog owning, child rearing supporters of free speech is a simple one but the difficulty in getting the message across is testimony of how difficult this can be. Indeed, principles based regulation is open to exploitation – after all, two people can have broadly different understandings of the same general principle – but it leaves less moral wiggle room for those who signally fail to discharge their responsibilities.

A relatively simple corollary to the Basel III accord would be that no financial institution should knowingly engage in any activity not covered by the regulations. Of course, some would anyway, but it’d be hard to argue that you didn’t know you were exploiting the rules. And even harder to avoid the enormous fines and prison sentences that would surely and rightfully ensue in the wake of such behaviour.

Game On

Unfortunately it isn’t that simple. Prior to the credit crisis the UK’s regulatory environment was based on so-called "light-touch" principles. Given that the landscape of UK banking is now littered with the tottering, zombie-like remains of state owned banks we can guess that this didn’t work very well. In fact the problem seems to be that the principle of principles based regulation became more a matter of ideology than analysis. As Steven L. Schwarcz points out:
"There are no general laws for regulating complexity. Complexity not only makes it impossible to predict how future financial crises will arise but also makes it more likely that regulation can lead to unintended, and often adverse, consequences".
Dealing with a complex system like global finance is virtually impossible if you start with a dogmatic ideological approach that restricts your flexibility to think for yourself. Restricting regulation to a set of principles that ignores wider risk-taking issues is as prescriptive as any set of rules and just as open to being manipulated. Basel III will be a new and different opportunity to game the system. The regulators had better figure out how to fill the gaps before the financial industry does. Fortunately they’ve got a while, since the regulations won’t come into full force until 2018. Let’s hope they use the time wisely.

Related articles: The Business of Capital is Bust, Complexity in Financial Systems, Gaming the System, Basel, Faulty?

1 comment:

  1. Thank you for another thought-provoking article.

    Don't have time to read Lammers et al now but I note something else interesting from the abstract: for those in positions of power to which they do not feel entitled, the effect is reversed - that is, hypocrisy becomes hypercrisy (their word).

    Which is suggestive of the positive potential of radical and semi-radical ideas, such as the allocation of positions of power by lot rather than merit, or the use of juries to decide not only legal cases but policies, etc.