How do we get Financial Intermediaries to Police Themselves?

Posted in Blog at 2:20 pm

Patience Wheatcroft, one of the Wall St. Journal Europe’s regular contributors, had a piece on a U.K. regulator’s seeming willingness to add corporate culture to the list of things for financial regulators to attempt to control.  The occasion was a speech by Hector Sants, who was until recently head of the British Financial Services Authority, at the Mansion House on the subject, “Should a regulator seek to regulate culture?”  I had known Hector well in his earlier life as an analyst and stockbroker, and regard him as a thoughtful and intelligent commentator on the scene as well as a regulator.  While I understand that anyone with the slightest belief in free markets finds points where it makes sense to say, ‘enough already!’ I have long believed that the problem of contemporary investment banking culture needs to be addressed in some form.  This was my response to her article, on October 5th, 2010:

The problem is, that as trite as it might sound, it is the radical changes in corporate culture at the major financial institutions that created the environment for 2008′s crash. The changes in corporate culture at the investment banks in the late ’80s and early ’90s were palpable. There were always unscrupulous players before, of course, but even before these were caught out, they were usually mistrusted by most of the rest of the industry. Suddenly, over a period of less than 20 years (my impression was that it never took more than about 10 in any given country, with the U.S. leading the way) the ethos became, “Anything goes, if it makes enough money.” The question is, how do you get the genie back in the bottle?

It may be that the only way to stop individuals from reckless behavior, once the psychological barrier against unethical behavior has been broken, is to police them much more closely. This puts an intolerable burden on markets, and on regulators as well. An alternative is to consider a world in which, unlike that of our present financial markets, everyone at a firm knows what everyone else does for a living. This implies smaller, more specialized firms, and partnership-like arrangements. If someone is cutting ethical corners with what is partly your own money, you will try to rein in the behavior, or see that someone else reins it in. As long as it’s someone else’s money, you are far more likely to say, ‘What the hell,’ and let it go.

Such a radical change in market structures and financing may have all sorts of negative implications for growth, which should be studied carefully, before any such radical a reform is contemplated. But it should be considered seriously, because, as behavior within large bureaucracies has always shown (consider government agencies, police states, and the rest), individual responsibility declines in inverse proportion to the size of the organization. If there is only a limited degree of personal (read, ‘economic’) identification with it, then the process accelerates.

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