The regulator’s dilemma: being DUPEd

It’s pretty clear from recent issues that regulatory systems haven't worked.

Take Gordon Brown’s admittance over the weekend that we made a mistake with bank regulation.

The mistake was regulating individual institutions rather than the global system.

That’s a mistake.

But we have made many mistakes in the past and will again in the future. If we didn’t, we would never have market crashes would we?

I realised what the mistake in the regulatory process was just the other day, and it comes from the whole way that regulations are put together.

It’s a four-phase issue, which I would summarise as regulatory DUPE:

• Disaster,
• Understanding,
• Proposition; and
• Execution.

Disaster is when a major market crash occurs.

There is an immediate realisation that the regulatory framework that was in place has failed, and an immediate scurrying around to try to point fingers at how, what and where is to blame.

This is a mad moment where the blame culture rules and is the worst moment to try to draft any regulation.

Therefore, we have to get over the disaster first, before we begin to think about what to do next.

Understanding is the second phase: does the regulator now really understand the problem? Do they have the knowledge of the issue and the markets to really see what happened and why, and what needs to be done and why?

That’s a fundamental challenge as many regulators have good people, but not the best.

Equally, many parts of the investment markets are purely in existence to try and beat the regulator’s shackles by creating risk and therefore higher returns.

As a result, the regulator’s understanding of the markets and issues is usually secondary to and someway behind that of the reality of the markets.

We then move to the Proposition phase, where the regulators try to draft something that will work to address the Disaster based upon their catch up Understanding.

During the Proposition stage, interpretation is the biggest issue as just because the regulator understands the problem, it does not mean that they will come up with the right solution. They will establish a solution but, typically, the laws of unintended consequences kicks in, and they find a solution which has a knock-on effect and distorts the markets in some other way. Like a big balloon, you squeeze the markets in one end and a bulge appears somewhere else.

Finally Execution.

When the regulation is drafted, can it be implemented and effectively policed?

Often it can’t.

Just look at Northern Rock as an example, where the FSA admitted that they only ever carried out a risk assessment of the bank once every three years, with the last being in February 2006, and that the bank was not visited by supervisors at all during the run-up to the crash.

This could be put down to the fact that Northern Rock is based in an office just outside Newcastle, 275 miles north of London. Banks based in London were typically being visited once a week.

Policing the regulation is not the issue here though.

The real challenge in the Execution phase is whether the regulation can actually be implemented at all, as so many that I have seen over the years appear to be unenforceable.

The MiFID and the PSD are a case in point, where many EU member states have misinterpreted or just ignored the regulation without penalty.

So the four phase process is laced with holes.

I’ll be interested to see what happens when the latest round of global, regional and national regulations are implemented, to see what new bulge in the markets appears, and to see what the regulators discover they had not regulated when it becomes exposed.