Safety, Stability and Regulating the Regulators

Bernie Madoff holds the dubious title of running the world’s largest Ponzi scheme and getting away with it for almost 20 years.  Numerous analysts and journalists demanded that the US Securities and Exchange Commission investigate.  The SEC cleared him of wrongdoing in 1999, 2000, 2004, 2005 and 2006.  In 2008 it fell apart.

Afterwards, no-one could believe how he got away with it.

Turns out the regulators at the SEC spent far too much time downloading pornography off the Internet to do their jobs.  If obvious fraud was beyond them how could they hope to understand the complex securities that led to the credit crisis?

The Minerals Management Service responsible for regulating the offshore oil industry in US waters was similarly negligent.  Instead of checking that complicated pieces of equipment like blow-out preventers were in place staff spent time downloading pornography and sniffing cocaine.

Responsibility for the disaster in the Gulf of Mexico is being laid on BP, and rightly so, but the job of making sure that these tragedies don’t happen still lies with regulatory oversight.

Legislation, no matter how well designed, is of no use if those responsible for oversight have no ability to carry out their jobs.

There are certain rules about regulations:  they must be consistently applied to all, irrespective of political orientation, national origin, or financial clout; rules must then be consistently enforced; rule-makers, regulators and the regulated must be subject to transparent scrutiny; and, rules must be regularly evaluated and adjusted to ensure that they work and are not needlessly bureaucratic.

The worst-case scenario of a regulatory breakdown is a “Black Swan”, an adverse event that is far worse than anyone can afford to have happen.  Disasters of the credit crisis and the Deepwater Horizon are not failures through an absence of regulations.  Both industries are highly regulated.  These were failures of implementation.

Anyone or anything can be the one that happens to suffer a breakdown of regulatory oversight.  Lehman Brothers just happened to trigger the credit crisis.  The offshore drilling disaster just happened to be caused by BP.

Any bank could have triggered the credit crisis; any energy firm could have had a blow-out.  Singling out that company and then punishing them will not change the system that led to the breakdown.

Neither will a knee-jerk flood of new regulations.

This doesn’t mean that people are automatically criminal but the Russian proverb, “doveryai, no proveryai” comes to mind.  Trust, but verify.

Complex societies can only exist because of division of labour and trust that others will deliver on their promises.  If trust breaks down then panic ensues.  The collapse of global financial markets continues precisely because investors no longer know who to trust with their money.

The reason we must have regulators is not just because it gives people confidence, but because the complexity of some industries means that it is very difficult for the layman to have any knowledge of what “safety” means in that context.

If a ratings agency declares that a particular investment is safe, then it must be safe.  If a medicines regulator says a new drug is safe and effective, then it must be.  The likelihood that a mum rushing to pick up cough-mixture for her sick child is going to have the time to study pharmacology and read the literature on double-blind medical studies before making a purchase is unlikely.

When regulators do their jobs they can avoid disaster as the US Food and Drug Administration did in May when demanding that Johnson & Johnson recall their paediatric cough mixtures, Tylenol and Benadryl, from the market due to safety concerns.  When they don’t we get covered in oil and lose our savings.

From politicians to doctors to engineers to scientists to banks to oil companies; we are all better off if someone with appropriate and sophisticated skills is watching over them.