Tag Archives: regulatory capture

We need a holistic approach to regulating risk

This is a version of my column published in the Irish Examiner 29 March 2014. One thing we know from even a cursory study of economics and finance is that there are cycles. This time is rarely different. Sometimes the cycles are short, sometimes longer. But they are there.  Regulators and officials contracted to mitigate the effects of cycles need to first be aware of them and then to understand them in a holistic fashion. Understanding them requires more than just advanced quantitative techniques.

This week I hosted a  one day symposium on people risk in finance. We had a good audience composed of academics, bankers, Central Bankers (but not, as far as I am aware, from the Department of Finance) and researchers.  The general consensus at the conclusion was that we have, in modern finance regulation and oversight, lost sight of the centrality of people. And that is a problem

Consider for example the data from the Operational Riskdata eXchange Association , a non profit body which looks at financial services risk and losses. Losses are very skewed – the vast majority of losses rise from a small number of issues. These issues tend to be concentrated in areas where the ultimate control is a person. The greatest part of these losses are not down to fraud; they are down to issues such as poor business practices and poor execution of these practices.  A particular challenge for finance is that many of the problems that it faces are systemic. While in a healthcare or automotive context individuals can and do take responsibility for ameliorating risk (not leaving surgical tools in body cavities, not forgetting to reconnect brake cables) this is not the case in finance.  There we find a significant disconnect.  Take LIBOR – if an individual were to have not cooperated in the rigging scandal they would in all probability been sanctioned, and the system would have continued. Rogue traders are almost never driven by personal greed and a fraudulent aim. Therefore exemplary punishment and condign treatment of one will have no great effect on others – they fall prey to and then become trapped in system failure, and it is at the level of systems that regulation needs to work as well.

A key weakness of the modern financial regulatory system architecture is that it is not systemic. Nobody is looking at large parts (FX in particular) of the system; other regulators are nationally, industry or product bounded. As a consequence, the coupling of parts of the system to other parts can become looser or tighter without anyone being able to intervene or even perhaps notice.

A further key weakness is that it is focused on quantitative approaches. Quantification of risk is funny thing. It relies on failure – to know how often we will have a large market drawdown or a rogue trader or a systemic crisis we require a baseline of a number of these events.  In the Irish context we have financial regulator and central bank that has been very strongly hiring quantitatively skilled persons. These are ideal at looking at the probability of a mortgage default given lender demographics, or at the role of SME finance etc However, they are limited to the data which they have. This data is typically partial- nobody is looking at the system as a whole, domestically or internationally.  What is more, an over reliance on quantitative techniques alone misses the crucial human element.  Systems fail either because they are poorly designed or because people find a way around them. The best designed system will not survive contact with someone inept or determined enough to circumvent it. Chernobyl comes to mind… This raises the question – where are the holistic risk managers?

The vast majority of risk management approaches in finance, as seen in the professional risk manager programs and certification, are rigorously quantitative. But they are almost bereft of even behavioural economics or finance. They contain little if any around economic or financial history. They are not people cantered. This is a major weakness. Our regulatory bodies need  to take on board a much more holistic approach . On one level this means that we need to see a push for greater scope of regulation on areas such as the Repo or FX or commodity markets where existing regulations are weaker. At another more fundamental level it requires hiring psychologists, behavioural finance and economic specialists, anthropologists, sociologists and historians. Cross disciplinary teams need to be more than accountants and economists.  For so long as we do not regulate finance in a human cantered systemic manner we give an implicit nod that these issues are not important. They are and we should begin to signal that clearly and unambiguously.

We need more regulation and better (more holistic) regulation. We need finance to learn from other areas such as surgery or engineering, where safety and risk mitigation are inherent. We need to change culture – this can happen as we have seen in airlines- where individuals are not only empowered but required to halt the system when it is in their opinion going awry. And we need to recenter and deglamorize finance – it needs to be seen as a boring utility.



Default, Regulatory Capture and Banks

Last night in the (darkened, of course for the books and not very conducive to photography on the hoof) confines of the TCD Library Long Room Senator Sean Barrett launched “What if Ireland Defaults”, the book of essays previously noted on the irish debt and economic position. Having entered into TCD ESS (now BESS) in October 1981 I had an idea of economics as a possible route. I was still deciding when the first lecture I had in my second year was in a course which I was thinking maybe/mabe not. It was “public sector economics” and was taught by Sean. Immediatly I was captured, as Sean outlined in 20m a course that would give us a helicopter tour d’horizon (that turned out to be a tour de force) of the then myriad ills afflicting the Irish economy. And yes, dear children, they were arguably as bad as here and now.

Sean, along with such luminaries  Louden Ryan, John Bristow, Alan Mathews and John O’Hagan inspired a desire in me to work in this area and I have been honoured to have worked with Sean in particular as a student and latter as a colleague and constituent. Archaic and sclerotic as the Seanad can be at times, the reality is that the university senators have a large and diverse voting base to serve and they serve it well. Any changes in voting for Seanad Eireann should try to capture more of the essence of the university senators of all hues over the years.

Sean very kindly launched the book last night and his speech is reproduced, with permission, below.


My first duty is to congratulate the three editors, twenty-one authors and the Orpen Press on the publication of this excellent volume. It deserves to be widely read as Ireland faces a continuing crisis in which unemployment has risen over three fold and our debt has risen from 28% of gross national income in 2005 to 114% in 2011 as noted by Stephen Kinsella and the combined debt burden of the state, household and corporate sectors is almost five times GDP as noted by Peter Matthews.

In the words of a great TCD man, Oscar Wilde, Miss Prism tells Cecily to read her political economy in the absence of her tutor. “The chapter on the fall of the rouble you may omit. These monetary problems have their melodramatic side.”

Ireland’s economic policy unfortunately followed Miss Prism’s advice. We sleepwalked into the euro currency and the regulatory body played lots of golf with bankers through an unsustainable property boom.   Stephen Kinsella notes that we doubled the national debt in 2008 by bailing out the banks. Relative to GNP this was a gold medal in regulatory capture by world standards. Regulatory capture of governments by national airlines or sheltered sector professions pales into insignificance compared to the Irish bank capture of the exchequer.

Kinsella states on p.85 that “we don’t need  to default on our debt but we may need some further assistance from the EU/IMF.”   Default, austerity and restructuring of debt are all reviewed by the various authors in this fine volume.  Nobel prizewinner Joseph Stiglitz warns that “financial integration raises the overall risk of large negative shocks” and that “capital market integration could increase, instead of lower , the likelihood of a financial crisis in a given economy.” (p.40).  As we survey the lack of an exit mechanism from the euro, the large differences in the sizes of the Eurozone member states, the one size fits all interest rate, the lack of fiscal transfers and labour market mobility between the members, and the lax entry requirements to the currency we see the urgent need for a look again at the optimal design of international financial architecture. This requires from Brussels and Frankfurt the words of explorer Tom Crean.  “I heard something I never heard before in service- I made a mistake!”

“How to Survive on the Titanic- Ireland’s Relationship with Europe” is therefore an apt title for Megan Greene’s chapter 6 in  the book.  She states that bringing back the drachma would be a much faster way than austerity to revive the Greek economy.  She notes Ireland’s five austerity budgets in a row and high unemployment. She sees the fiscal compact as a surefire recipe for recession in the peripheral countries. A compact is defined in the Oxford English dictionary as a small vanity case.

My Fiscal Responsibility Bill was introduced in the Senate last December.  The competing versions from the Fiscal Council and the Department of Finance have yet to appear and are overdue.  Ireland urgently needs to reform its governance. Far too many of those who caused this crisis have been exempted from its cost. Far too many institutions remain unreformed.

Elaine Byrne and Huginn Porsteinsson point out that Iceland was lucky. Their banks at ten times GDP were impossible to save.  Irish banks at five times GDP were thought possible to save and we will take far longer to recover.  A totally ludicrous project  is thus shown to be a better protection for the citizens than a scarcely plausible one.   The decision to save Anglo Irish Bank becomes ever more difficult to understand or defend.  The continuing decision to defend a bank that has been shut is impossible to support.

Making private debt public is a naked transfer of wealth away from taxpayers as noted by Tony Philips. Karl Deeter echoes many fears about our monopolistic pillar bank strategy designed to eliminate competition.  These are just some points that caught my attention. In fact on every page of this book there are interesting and stimulating ideas. I commend it warmly And again congratulate all those involved in an excellent venture.