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Professor Michael Mainelli, Executive Director, The Z/Yen Group

[An edited version of this article first appeared as "“Reforming the City of London: From The Religion Of Regulation To Long Finance”, Reforming The City: Responses To The Global Financial Crisis, Chapter 11, Sam Whimster (ed), Forumpress (2009), pages 159-167.]

Opiates Or Apostates?

Wikipedia’s definition of financial services regulation “is a set of beliefs and practices, often centered upon specific supernatural and moral claims about reality, the cosmos, and human nature, and often codified as prayer, ritual, and [religious] law”. Oops, that’s the definition of religion.  Writing in 2008, financial services regulation is a religion.  But recent regulatory failure has created apostates, the worst challenge for a religion, so the establishment is performing the classic redoubling ploy, “regulation failed because you really really didn’t believe enough in regulation.  So pray harder.”

The redoubling ploy is common to many business religions.  “We’ll have a quality firm when everyone really really believes in quality”. “What we need next time is more governance and transparency”. “Next time we’ll do it better!”. The starting point in most discussions about the credit crunch, and other financial system failures, is: “What new regulations do we need”? There are rarer discussions where people question whether regulation is just an “opiate of the people” and whether additional regulation will make the system safer.  This paper goes further and questions whether regulation itself is one of the roots of the problems in financial services.  The focus is on investment banking regulation and I recognize that some of the arguments do not apply across the entirety of financial services, but investment banks such as Bear Stearns are at the core of the credit crunch and well worth specific attention.

Madmen Or Crooks?

How did this sophisticated investment banking industry get into trouble? What a misnomer, “sophisticated”! Banking is a simple, even ancient industry that handles no heavy equipment or hazardous chemicals or complex science.  The most advanced products have about as much advanced mathematics as you’ll find in a computer game.  However, the societal interactions are complex.  Some observers said that Northern Rock’s mistake was to “borrow short and lend long”. But that’s the definition of a bank.  Northern Rock’s mistake was to be a bank.  These observers seem to want to have some people who borrow short and lend long.  These bankers would have to be either madly, even suicidally, risky businesspeople, or crooks.

So, in the belief that an inherently dangerous system can be made safer, society creates regulators who try to encourage slightly mad people to become bankers (via central bank support and restricted competition) while keeping out the crooks.

The madness surrounds timing.  In any one short period the odds are that you won’t get caught short.  Nineteen periods out of 20, you look like a genius and make quite a bit of money very easily.  This starts a spiral.  Not only does it attract crooks, it makes the risky businesspeople over-confident, so they take more risks; and it makes them greedier, because deep in their reptilian brains they know they’re going to lose out one day and risk being lynched (remember Jimmy Stewart and the savings & loan in Frank Capra’s “It’s A Wonderful Life”), so they might as well make money while they can.

Of course, to keep out the crooks, the performance evaluation periods and the benchmarks are made more frequent.  Short performance evaluation periods lead to marking-to-market on very short timescales, resulting in the use of more arbitrary, short-term prices for valuation.  Aggressive benchmarking leads to finance professionals having key decisions removed from their control, such as allowable investments or the use of alternative valuations.  Knowing that there’s a need to make money in the short term leads to cheating, e.g. parking some low-risk funds overnight, every night, in a high-risk account to beat a benchmark.  And that’s OK, because society will pick up the true costs of bank-racy (sic). In fact society wants banks to unleash the power of credit.  Walter Bagehot, writing in 1873, Lombard Street:

“A million in the hands of a single banker is a great power; he can at once lend it where he will, and borrowers can come to him, because they know or believe that he has it.  But the same sum scattered in tens and fifties through a whole nation is no power at all: no one knows where to find it or whom to ask for it.  Concentration of money in banks, though not the sole cause, is the principal cause which has made the Money Market of England so exceedingly rich, so much beyond that of other countries.”

Banks are a bit special.  Their business model is fragile (the “madmen” I mentioned above); society seems willing to pay a price for their fragility in order to have faster growth; and banks lend to each other thus becoming intertwined.  BaFin’s President Sanio notes a possible new doctrine of “too connected to fail”. And Bagehot equally recognised that danger:

“But in exact proportion to the power of this system is its delicacy - I should hardly say too much if I said its danger.  Only our familiarity blinds us to the marvellous nature of the system.  There never was so much borrowed money collected in the world as is now collected in London.  Of the many millions in Lombard street, infinitely the greater proportion is held by bankers or others on short notice or on demand; that is to say, the owners could ask for it all any day they please: in a panic some of them do ask for some of it.  If any large fraction of that money really was demanded, our banking system and our industrial system too would be in great danger.”

Bagehot’s progeny, The Economist, in “A Special Report On International Banking” 17 May 2008, put the problem nicely, “Safe banks are easy enough to create: just push up their capital requirements to 90% of assets, force them to have secured funding for three years or tell them they can invest only in Treasury bonds.  But that would severely compromise their ability to provide credit.” Society is prepared to take a bit of risk with “economies of credit” for faster growth.

A previous column (“Liquidity = Diversity”, Volume 9, Number 2, 2008) explored how a diversity of approaches leads to more liquid markets, but regulation drives out diversity.  Regulation fosters an insular community, a closed culture, a culture where no one gains from being different.  The regulator, under the guise of “best practice” encourages everyone to use common approaches to controls, valuations and investments both removing diversity and encouraging bubbles.  Further the culture does not encourage learning, just common group practice.  Stuff what’s right, what does the regulator want? If that’s an easy business into which we can extend regulatory approval, then let’s dive into it.  In the event of failure should we be miserable? Not at all, we had company.  We were doing what everyone else did.

Market Failure Is Regulatory Failure

Like many large-scale systemic failures, there is no single cause of the credit crunch.  It would be rich indeed to claim that regulation ‘caused’ it, but regulatory inputs include the restriction of many US pension and investment funds to rated instruments, thus leading the funds to overpay for rated vehicles and create demand for mis-rated vehicles that rated safe but yielded higher returns, i.e. increased risk.  Regulation (SEC and NRSRO status – see this column “Assessing Credit Rating Agencies: Quis Aestimat Ipsos Aestimatores?”, Volume 11, Number 3, 2003) ensured that there was an oligopoly of two-and-a-half rating agencies throughout most of this period, and no clear path to becoming a rating agency.  Monolines and other rating insurers leaped in to arbitrage the mis-pricing of risks and ratings.  The Basel Accords I & II (BIS regulation) created incentives for off-balance sheet finance.  Bankers rediscovered the traditional approach to great short-term financial returns and increased bonuses, high gearing and high leverage.  So SIVs and conduits proliferated.  Banks were able to use their own models to argue with regulators for reduced capital requirements, and thus increase leverage again.  Money supply growth (by central banking regulators) led to asset price inflation, increasing leverage opportunities.  IFRS (accountancy regulation) pushed for harder mark-to-market, thus increasing repricing, portfolio rebalancing, volatility and liquidity problems.  Enough, and let’s leave ‘regulatory capture’ to one side…

The credit crunch is a great Christmas pudding of a problem.  Roger Luckhurst of Birkbeck College, referring to the Risk Society concepts of Ulrich Beck and others, reminds us of “our contemporary condition, where modernisation begins to curl in on itself and generate its own sets of problems and catastrophes”. You can pick out any number of candied fruits or goodies to prove many points.  There is no single cause.  However, I would like to pick out one symptom, the “too big to fail” argument for the large investment banks.  Andrew Hilton notes, “Pre-Northern Rock, everyone accepted that a regulatory system in which no institution fails is itself a failure.  It suggests too much regulation and no market discipline.  Equally, it was accepted that there are some institutions that are ultimately underwritten by the Treasury.  But Northern Rock was not one.  The fact that it was bailed out so spectacularly was in part due to Alistair Darling’s inexperience and in part to the emergence of a new doctrine - too political to fail.” [“Untidy Solution”, Financial World, April 2008, page 9]

Too big to fail reeks of market failure.  Market failure comes in three broad categories: lack of competition, information asymmetry and agency problems, and externalities.  If we see market failure we try and fix it through trust-busting or anti-monopoly laws or regulation. 

Investment banking certainly exhibits some classic signs of these:

  • Lack of competition: self-evidently excessive salaries, a banking industry with 2006 profits per employee a magical 26 times higher than the average of all other industries worldwide (according to McKinsey), and a cast list of the top 10 that would be largely recognisable back in 1929: Goldman Sachs, Merrill Lynch, Lehman Brothers, Morgan Stanley, JP Morgan Chase, Citi … need we say more?

  • Information asymmetry and agency problems: as well as recent mortgage mis-selling or excessive bonus structures, Frank Partnoy covers two decades of scandalous abuse of investment banking customers in nauseating detail in his 2003 book, Infectious Greed.

  • Externalities: whether it’s third world debt, savings and loan defaults, bubbles, or credit crunch problems at Northern Rock and Bear Stearns, the taxpayer picks up the systemic costs of investment banking failures.

Given restricted competition, people can really only choose on brand names and trust.  Society comes to depend on a small set of mega-banks.  Reputation is relational, and the regulators are now a crucial part of the commercial relationship.  Reputational risk and trust are a balloon – one prick and they burst.  Society can’t afford the “recursive” risk (that which affects other banks’ reputations) of any default, so it defends all banks and the entire banking sector.  The biggest get bigger and it becomes an all-you-can-eat buffet for bankers.  Thus we find society underwriting two global handfuls of fat, uncompetitive investment banking firms and unable to sanction any of them.  Globalisation exacerbates this, not because globalisation is bad, but because as banks spill across borders they have more opportunities to get even bigger.

Heretics Of The World Disunite!

The religious faithful of regulation now seek powers to follow the mega-banks, rather than question whether size itself might be a sign of regulatory failure.  Regulators want to go cross-border, rationalise regulation and seek ways to control the very largest banks.  SEC Chairman Christopher Cox calls for clear authority to oversee the largest investment banks on a consolidated basis.  Yet as The Economist points out, “In a world in which big financial firms were allowed to go broke, many of these [regulatory] flaws would matter little.” [“Northern Rock: Who Regulates The Regulators?”, 29 March 2008, pages 41-42] Too big to fail means too big to regulate.

This is an opinion piece, not a research piece.  Perhaps this crisis is just what we need to force us to face difficult questions.  The question I wanted to pose was – is regulation causing overly-large dangerous banks? I think regulation creates barriers to entry, promotes the large over the small, and reduces competitive variation.  In the spirit of my inquiry, I will tentatively suggest some solutions by asking yet more questions:

  • Does society overvalue size or economies of scale in investment banks? Can we prove that we need big banks? Is the cost/benefit equation of size, inability to fail and heightened booms and busts justified by better economic growth?

  • Should we be reducing regulation by tightening the definition and requirements of a bank rather than expanding it? Should we reconsider narrow banks, zero coupon discounted bond issuance, restricting the word “bank” to highly restrictive heavily capitalised deposit takers? But we won’t make a lot of money! No, but you can make a living as a bank, while all the racy are “financial services firms” or “capital managers” or “finance houses”.

  • Where is regulation crucial? Yes, the money supply, payments systems and retail deposits.  Elsewhere?

  • Is regulatory tidiness good? Andrew Hilton, quite rightly, emphasises the need for regulatory competition as well as industry competition.

  • Can we increase regulatory competition? FSA and FSB? SEC-A and SEC-B?

  • Can we move some regulation into standards markets, kitemarks and operational audits as the airline, oil and shipping industries do?

  • What can’t be regulated? Jon Moulton, managing partner at Alchemy, observes: “We should limit what they [regulators] do to what they can reasonably understand”. [“Moulton Hits Out At Ability Of Watchdog”, City AM, 14 May 2008, page 4]

  • Should we be promoting fast, efficient bankruptcy procedures?

  • Should we be promoting the failures among banks to inform the public and enhance caveat emptor awareness – “X% of savings and loans failed this year, and that’s perfectly normal”?

  • Should we be more aggressive about using anti-monopoly laws to ensure competition and prevent over-sized banks?

Some of these questions beg the question of bringing back Glass-Steagall-like legislation, but I’m actually more concerned about ensuring intense competition in investment banking.  If the competition is there, the size will be appropriate and the customers will benefit.  Competition means having companies that can fail – nothing should be too big to fail, or regulation itself has failed.  The religion of regulation works best when it worships at the altar of competition.


Without commingling any responsibility for the opinions above, nevertheless I would like to express my thanks to Adrian Berendt, Paul Moxey and Astrid Lovelace in their ACCA capacity, and to Brandon Davies and Jan-Peter Onstwedder in a personal capacity, for provoking many of these thoughts.

May I also give a special thanks to Richard D North for most kindly editing this text in a spirit of heresy.

Professor Michael Mainelli, PhD FCCA FSI, originally undertook aerospace and computing research, followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen ( Michael is Mercers’ School Memorial Professor of Commerce at Gresham College (

Z/Yen operates as a commercial think-tank that asks, solves and acts on strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (, such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks.  Z/Yen’s humorous risk/reward management novel, Clean Business Cuisine: Now and Z/Yen, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.

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