Regulation

The Americans are busily searching for the culprits of the financial meltdown and the SEC, FBI and others are beating the bushes, but in the UK the heads of the Bank of England, the FSA and the Government make speeches - various people from the Bank of England and the FSA are moving on, but it is safe to predict that no one will be found to be responsible except, of course, the bankers and hedge funds. It is fortunate for them that burning at the stake is out of fashion.

Lloyd's of London has had some experience of failed regulation and after the failure to recognize the imbecilic behaviour of a lunatic fringe, major reconstruction became necessary (without any contribution from the taxpayer). After this near death experience Lloyd's passed hundreds of new regulations and imported herds of regulators - there were more at Lloyd's than were considered necessary for the rest of the UK insurance industry - with dire consequences. The market again sustained many billions of losses but since corporate capital had arrived and the losses were overwhelmingly sustained by this capital rather than the Names, it did not attract much notice However, it was obvious that the legions of regulators were ineffectual and the missing key component was knowledge, which was in short supply, not power, which they had in abundance.

The current Franchise Board at Lloyd’s was created in response to this so that now regulation is firmly practitioner led. The Franchise Board came to power in a fast improving market environment but the current signs are promising: it has the power and the knowledge.

It is not clear that the Bank of England or the FSA really understood the nature of the risks which financial institutions were accepting or, if they did, that they had any clue what to do about them. The new regulations and armies of new regulators which will arrive on the scene as a response to current events will be similarly handicapped. Unless the regulators are really up to speed with what the markets are doing they will prove to be as ineffectual as before.

History – In 1929 the Willcox Syndicate at Lloyd’s insured the solvency of secondhand car dealers – with predictable results. Lloyd’s, thereafter, insisted that all businesses operating in Lloyd’s should agree not to accept Financial Guarantee risks. This interdiction has been slightly modified since but is still in force – some people do learn from history.

Sir Howard and the Toxic Products

Anthony Hilton in his City Comment column in the Evening Standard on Monday June 9th 2008 pointed out that the authorities were not unaware of what the bankers have been up to over the last few years and that Sir Howard Davies, when head of the FSA, delivered a speech in which "he clearly and explicitly warned about the invention of collaterised debt loan obligations and credit default swaps and described them as toxic."

He went on to say " Nor did you have to attend the dinner to hear the speech. His remarks were reported in this column".

In fact it wasn't a dinner it was the AIRMIC Lecture of January 29th 2002 at the RAC Club. Go to the link below for Roger Miller's report and the quotes on the second page in italics.

http://www.riskrisk.com/howard-davies-comments-feb02.pdf


Anthony Hilton points out that nothing the FSA could have done would have prevented the current turmoil, the bankers were uninclined to listen and quite capable of moving to more compliant regimes if the FSA had attempted to rein them in.

How we got Sir Howard to speak I will leave for another blog.

Risk Management can never be perfect

The title of this blog comes from Alan Greenspan's article in today's Financial Times. He is referring, in particular, to the exercised state of the financial markets. He points out that the risk management models do not adequately account for human nature, in one of its manifestations he referred to "irrational exuberance" when he was Chairman of the Fed. Now he considers that "paradoxically,to the extent risk management succeeds in indentifying such episodes,it can prolong and enlarge the period of euphoria."

By which I guess he means that people rely on risk management methodology too much and that, only when it is proven inadequate, such as now, does fear replace euphoria and greed.

Timing is all

Keynes said "In the long run we are all dead." He also observed " wordly wisdom teaches it is better to fail conventionally than it is to succeed unconventionally."

It is that second quote that is mentioned in today's Telegraph obituary of Tony Dye , the Phillips and Drew Fund Manager. Dye was a contrarian who in 1996 considered the FTSE 100 overvalued at 4000 and took a sizeable part of his clients' money out of the market. In March 2000 when the index stood at 6400 he was fired , yet within a month of his leaving the stock market turned. Many of those fund managers who had followed the herd kept their jobs.

Dye's story indicates the importance of timing in risk management. If he had made the switch out of equities in January 2000 he would have been hailed as one of the greatest fund managers of all time. He was right that the market would fall, but completely out on his timing, partly because he underestimated the power of Alan Greenspan to support irrational exuberance whilst at the same time fulminating against it.

There is nothing intrinsically wrong with going with the herd although it is always worth remembering that the Gadarene swine thought the going was good for the first part of the way . Warren Buffett always reckons it is best to fearful when others are greedy and greedy when others are fearful and as for timing, Bernard Baruch said "I have made my fortune by buying too late and selling too early".