How to Fix Financial Services Regulation

Want a very quick solution to the privatized gains and socialized losses of modern financial services…?

As I was reading of yet another spectacular mismatch between bank managers’ competence and their remuneration, and this time at JPMorgan (NYSE:JPM) no less, I realized there is a simple solution which really could be implemented.

Make the cost of regulation zero — or very nearly –� for unlimited liability partnerships. Then let judicious self-interest, exercised by the partners themselves, do the rest.

My father was what they now call an ‘investment banker’. His firm got it wrong by expanding business into the 1970s’ slump, and when it went wrong the Official Assignee took everything he owned. That was in the days when partners had joint and several liability, which meant that all the top management of a firm were personally liable for the entire debts of their business.

Joint and several liability quickly weeded out the incompetents, the gamblers and the unlucky (my poor old Dad, I like to think). It made managers look very carefully at their colleagues’ strategies, and concentrated everyone’s efforts on controlling risks, rather than seeking bonus-building nominal profits.

The approach was discarded in 1986 after 150 years of pretty effective operation. It wasn’t perfect (what is?) but we were all very stupid to think we could do better by replacing the natural damper of direct personal liability with a combination of salaried and bonused managers, and sixty thousand pages of regulations.

I realized that official regulation of financial services has become so onerous and so unsuccessful at loss prevention that joint and several liability could easily be re-introduced. All it would need would be a subsidiary arm of the regulator, set up exclusively for the regulation of investment businesses run by unlimited liability partnerships.

Lots of reputable financial professionals do not get big bonuses, because they work competently in the low-risk, low-return areas of the industry. Yet within the regulated sphere of financial services, there are so many complex rules that even these firms have to employ more compliance officers than accountants, while at the same time funding the wretchedly unfair Financial Services Compensation Scheme in the UK, or Federal Deposit Insurance Corp. in the US � which is a bit like being forced to pay for the car insurance of your drunken neighbor.

They should be given the choice of submitting to financial services, or choosing a simpler system, where they put up as collateral their house, their car, their holidays and their children’s school fees, and — within reason — are left to get on with managing their business risks as they see fit.

Making management collectively liable for their mistakes has lots of benefits.

Size � Because partners all want to be able to understand their whole business it encourages smaller and less systemically dangerous organizations � ones which are not ‘too big to fail’

Growth and competition � It encourages business formation, something which has ground to a halt now, because of the huge cost of setting up a compliant organization;

Attention to detail � It forces revenue generators to be more critical about risks, rather than leaving it to formulae which pass the rules and get boxes ticked, but do not work in practice;

Liability � It encourages senior management stability and accountability, and suppresses the job merry-go-round whereby careers advance by sweeping problems temporarily out of sight and quickly changing jobs;

Rewards � It directly links remuneration to risk, as well as to performance;

Clawback � It keeps all prior remuneration still in the compensation pot, to be reclaimed in the event of future investor losses.

Our experiment with rulebooks, regulators and salaried managers has been a bit of a disaster. Maybe a partial return to the old ways is not such a bad idea.

This article was written by Paul Tustain