Regulation  

The rhyme of history

Lexicons overflow with new regulatory acronyms – Foreign Account Tax Compliance Act (FATCA), Alternative Investment Fund Managers Directive (AIFMD), European Insurance and Occupational Pensions Authority (EIOPA) and their ilk.

Macro-prudential regulation and financial stability are the new buzzwords among policymakers. And thanks to Frank-Dodd, Basel III, Solvency II and their extended family, a million pages of new prescription to make the world safer is the lasting legacy of the recent financial crisis.

It is an achievement as impressive in outpouring of ink as it is self-defeating in purpose. Yet again, we have failed to learn the lessons of history. Indeed, we have made the financial system even more fragile for the years ahead.

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Change

Financial crises are not new phenomena. They have been around for centuries and have occurred with an alarming frequency – once a decade on average for the past 400 years in Western Europe alone. Coincidentally, changes in banking regulations have maintained an impressive correlation in their shorter lifespan, occurring about once a decade for the past two centuries – a Sisyphean tragi-comedy where the solution to the last crisis seems inevitably to blinker us to the next.

This perennial pattern is born of a fundamental facet of being human – our primal fear of uncertainty. Rules are written by people. And the human psyche is defined by a continual battle to reclaim islands of certainty from the turbulent oceans of uncertainty that we inhabit.

When it comes to regulation, two innate psychological biases dominate. First, there is hindsight, namely, the perfect clarity of knowing the facts after they occurred. This allows us to project a false sense of control by engendering the false belief that the crisis could somehow have been anticipated. Second, there is our extreme brevity of financial memory, which instinctively pushes awkward questions just beyond our temporal horizon.

The result is that we do not learn from the last crisis, preferring instead to find external scapegoats. The introspection needed is sorely lacking. The tools of speculation – stocks, derivatives, mortgages and so on – are scrutinised, demonised and finally rehabilitated through regulation. But the all-too-human wielders and the incentives that drove them are never mentioned.

The current crop of financial regulation has tried to make banks safer, through the ringfencing of domestic retail banking, increased capital requirements, enhanced deposit insurance and so on. At the same time, we have also aggregated many financial institutions into larger entities, many of them ‘too big to fail’.

Combined, these increase the aggregate complexity of regulation. To regulate effectively now requires more metrics, more information, more oversight and more people.

A single regulator is no longer enough. Many financial institutions now span multiple jurisdictions. HSBC and Citigroup, for example, will be overseen by over 150 different regulators globally. This presents major problems of international co-ordination. People talk hopefully of cross-border agreements and international initiatives, such as the Financial Stability Board. But in practice, these are doomed to founder on the rocks of human behaviour.