15 December 2014
Be realistic about regulator reform, says Anthony Hilton
A professor at London Business School recently said that we invested too much faith in regulators to reform the banking sector. We need to be more realistic – our objective should not be to try to ensure that there will never again be a collapse of the banking system. We should have the more limited ambition that when it does happen its impact will be less damaging.
We should not expect to achieve more than this, he said, because none of us have the ability to foresee how markets will develop or behave under all circumstances. Yet that is what regulators set out to do. Regulation is based on the premise that intelligent people can devise rules which will be one step ahead of the market.
He said that if you believe this regulatory model can work, you would believe that the Soviet Union could have worked. This was based on the premise that people would devise rules which could deliver a better outcome than relying on market signals. What they found was that even the most sophisticated central planning was too inflexible and too wasteful. A rigid document could not substitute the flexibility, immediacy and variety of market signals.
All regulation seeks to temper market signals or curb the behaviour of market participants. Obviously in many circumstances this is necessary and needs to continue. The point however is that we should always be mindful of its limits and of what it cannot achieve. If we forget this, we create a system which over-promises and under-delivers, and we end up disappointed.
That failure comes with costs. Over regulation can do considerable damage to business before its failure of purpose becomes manifest. The potential damage in the longer term is the cost of coping with the backlash from disappointed public and politicians, who, because their hopes had been raised to unrealistic highs, then feel badly let down and distrustful.
It is quite easy to see how this might happen with regulation, particularly of banks, in the current political climate. What is harder to pick up on immediately is that the same arguments can be projected onto corporate governance: if you believe corporate governance will work, for exactly the same reasons mentioned before, you would believe the Soviet Union would work. The core principle of governance is that intelligent people can devise a system which delivers better outcomes than the unfettered working of the market.
This is not to say that all corporate governance is wrong, nor that it should be swept away. It does question however whether the layering of revised code upon revised code is in danger of going too far. There is a tendency to respond to every corporate failure with an investigation to find the governance gaps which allowed it to happen. This inevitably leads to the creation of another board committee and another set of obligations on directors to fill these gaps.
The fact is that business is uncertain and to be successful will involve taking risks. One should seek to identify and manage these risks but not to remove them. Yet so much of governance seems designed to remove all uncertainty so that equities behave like bonds. Not only is that objective never going to be met, but it is also wrong in principle.
It also presents a moral hazard. Being a shareholder brings with it a moral, if not a legal, obligation of ownership in terms of the stewardship of the assets. In an ideal world, the shareholder would fulfil these obligations. What we have today, however, is the shareholder passing these obligations on to non-executive directors via ever more demanding corporate governance codes. They are shirking their own responsibilities for delivering good outcomes while still expecting the benefits.
Perhaps one of our senior business leaders got it right when he remarked that the only thing that matters in governance, now that it is accepted that the roles of chairman and chief executive are separate, is that the board has the right person as chairman. If they do, issues would be tackled before they became toxic; if they do not then all the codes and other paraphernalia are irrelevant.