Skip to main content

If Rules Won't Reduce Risk, Will Principles?

  • Author:
  • Updated:

We've often complained that regulatory generals are constantly fighting the last war. Following the accounting scandals that led to the collapse of Enron, we got Sarbanes-Oxley. And fear about hedge funds following the collapse of Long Term Capital Management led to calls to regulate hedge funds.
All the while, real systemic threats to our economy and financial system were being built right into the American dream by mortgage companies, commercial banks and investment banks. Our homes are now our hassles, and none of the sound and fury from the SEC, the Fed or Capitol Hill about financial regulation raised a peep about it until it was too late.
But what if this focus on regulations aimed at the last crisis is misplaced? That is, what if it basically isn't possible to regulate away the threats to our financial system because the rewards for risky behavior are just too great. After the jump, some thoughts from Graeme Yell of the Hay Group

Here's Yell arguing that rules, and attendant rewards for compliance and punishments for non-compliance, are basically hopeless at reforming finance.

Rules and regulations are little more than a form of incentive - the negative incentive of punishment for transgression.
In the City, therefore, they also have to contend with a further challenge - the massive incentives provided by bonus schemes.
Which is more real to a trader, this year's bonus, and a new Aston Martin, or the abstract threat of future investigations?
Short of draconian measures, there is little hope of a regulatory framework competing to shape behaviour. How could regulation have stopped Jerome Kerviel, for example, who was driven only to 'be the best'?

So what is to be done? Yell is a good European, and so he thinks the answer is to control risk through institutional principals. "Our recipe for a safer financial system includes strong principles capturing hard earned wisdom and leaders who protect these principles against short term greed," he writes. We can't help notice that this raises the old philosophical problem of the "philosopher king." In short, the problem is two-fold: wise leaders with appropriate principals are few and far between, and the principals that accompany wisdom are not usually those best adept at rising to the top of institutions.
Which is simply to say, we might just be condemned to muddle through without some kind of technique--rules or principles--that will somehow resolve the permanent problems of modern finance.

Can we regulate our way out of a crisis?
[Director of Finance Online]