A Starling Insights Deeper Dive Report

Supervisors on Supervision

— Chapter Two Preamble —

The public image of finance and financiers, on both sides of the Atlantic, is poor. Perceived as cynical about customers and the rules of the game, they parade as Homo economicus in a world of caveat emptor, buyer beware. But bailed out by taxpayers in 2008, again in 2023, and countless times in the past, this supposed embodiment of the free-market spirit turns out to be semi-socialised when things go wrong. No wonder people are fed up.

Who wouldn’t like to keep the upside while laying off the downside? Only the few get so lucky, however. Worse, they can effectively self-select by taking systemic risks.

Legislators and regulators are supposed to do something about all this but find an accommodating climate only when memories of a crash are both fresh and publicly salient — conditions met after 2008 but, sadly, not after the 2023 debacles. Otherwise, they have a tendency to bend to cries that crimping finance would hurt economic growth and efficiency, in which there are degrees of truth. 

Even when the authorities do introduce good policies, they not infrequently fail to stick to them. In Switzerland, when Credit Suisse finally imploded, having as one journalist put it “managed to scandalise itself out of existence,” it turned out the Swiss were not equipped with adequate resolution and lender-of-last-resort policies and plans. Other centres — Washington DC, London, Frankfurt, Brussels — had either not noticed or could not make a difference.

In the U.S., meanwhile, the Federal Reserve and the Federal Deposit Insurance Corporation had deliberately exempted large regional banks from group resolution planning, despite their top brass being publicly warned by colleagues and outsiders that they did not have adequate plans if any of these wholesale-deposit-dependent businesses toppled over. Compounding what was perhaps the most egregious failure in banking system oversight in recent decades: U.S. prudential supervision had been publicly deprioritised.

The common thread is moral hazard: the problem of making credible commitments.

Indeed, it would be ironic if it were not tragic that the ostensible solution to moral hazard in private finance is undone by moral hazard in the official sector. Maybe culture — in the industry, among investors, in the official sector — has something to do with it. But much discussion of culture struggles to pin down the subject. We are plainly not interested in financial analogues to how a particular country’s army salutes, or whether cheese is served before or after pudding.

What matters here is not the surface texture of commercial life. We are interested, rather, in those social and institutional norms that claim normative force because they help hold things together. Norms of complying with laws and regulations. Social norms concerning what is unacceptable even if within the letter of the law. Norms around sticking to formal promises and, in the official sector, to formal policy commitments.

But, except perhaps in a mythical age when interests were wholly aligned, social norms are not resilient unless internalised by sufficient people as intrinsically worthwhile, becoming part of what motivates them. In finance, and in politics too, there are powerful incentives tugging in other directions: in the direction of riches, and of re-election. We can say, therefore, that the values we might want to govern finance need to square with the incentives faced by its denizens.

Virtue and interests need to cohere. We are so far gone, however, that it will not suffice merely to proclaim or defend the virtues we esteem.

Compliance is these days often regarded as a cost of doing business rather than a means for maintaining a decent system. This is, in part, rooted in collective-action problems; if the cynical post better returns over the short-term, what price will others pay for trying to maintain standards? Much of the heavy lifting will have to be done by tweaking incentives.

As David Hume said of constitutional design, so for finance, it will be useful to think of each person as a knave, even though it is not true. For finance, that means attending, among other things, to the incentives of management, board members, and officialdom. For each of those spheres, I will identify, merely by way of suggestive illustration, one or two ways in which incentives bear on a cultural problem carrying major social costs.

Management & Boards

For top management, the problem is that they generally end up very rich irrespective of whether their firm is lastingly successful or merely shines brightly before bursting into flames. At present, therefore, the incentives of top bosses are not harnessed to preserving stability (and integrity). Paying them in the firm’s equity helps reconcile their objectives with the interests of other shareholders, but barely with creditors and, for firms whose failure could be systemic, not remotely with the interests of the economy as a whole.

One possible way of reconfiguring their incentives would be to stipulate that the big bosses (and other C-suite functionaries) be paid in bonds that would write down to zero were their firm to go into a resolution or bankruptcy procedure, or avoided doing so only by virtue of a taxpayer guarantee of some kind. They could earn as much as they liked but would be locked into such bonds beyond their time in charge.

This would leave the top bosses and their close colleagues with incentives to monitor and control their thousands of high-earning, risk-taking, risk-controlling staff. You could still run a bank well and get super rich. You couldn’t run a bank so badly that it crashed but you walked away rich. Banking and bankers would become part of a market economy.

Things could still go wrong. Incentives help but do not always trump incompetence, stupidity, or mendacity. Boards matter for this. But boards themselves face challenges in overseeing massive complexity via a few meetings per year. They typically seek to overcome this by having what I am going to call an inner board within the board, comprising a chair (or, in the U.S., senior independent director) and committee chairs who spend much more time on the business.

This brings its own hazards. Those semi-insiders are exposed to capture, making an outer ring of non-executive directors de facto guardians. But most directors come from the highly hierarchical world of commerce, and, with lots of board business to get through, are naturally deferential to their semi-executive peers who have painstakingly prepared for meetings. It is not obvious what to do about this, but it is obvious that some regimes can make things worse rather than better.

Take Switzerland, where every director is up for renewal at the AGM each year. This means they effectively serve at the chair’s pleasure, which is hardly likely to encourage challenge. While the chilling effect might not matter for smaller firms, it is plainly a bad thing for systemic groups that taxpayers might one day need to rescue. It seems unlikely that non-executives serving a fixed term would suffice, but it is necessary to avoid a culture of sceptical challenge being mere aspiration (or empty PR).

Officials

What, though, of officialdom? To begin with, it is important to distinguish the regulation of conduct from prudential supervision directed toward maintaining systemic stability. The former is inevitably rules-based but since regulations are issued by unelected officials and can be fiendishly complex or vague, they need to be interpreted and applied in the light of higher-level principles set out in primary legislation. In other words, legislators should move on from merely enacting vague statutory objectives but should also articulate principles of conduct that, as a matter of law, frame regulators’ rule making and enforcement. Even so, because there is no consensus around how far consumers should be protected, partisan politics cannot sensibly be excluded.

When it comes to prudential policy, by contrast, society’s severe aversion to systemic crises makes a case for insulation from day-to-day politics in order to avoid the deceptive allure of easy credit. But because finance is a shape-shifter, there is inevitably a discretionary element in any effective system of prudential oversight.

The tension is obvious. While vague standards delegate too much to unelected officials, very detailed rules undermine themselves via endemic regulatory arbitrage. A solution lies, I suggest, in not losing sight of the moral-hazard problems highlighted above. If delegation is a commitment device, what is a legislature trying to commit to?

One possible solution, therefore, would be to articulate objectives for stability that can be monitored externally by interested members of the public, commentators, and experts. Doing that was a massive step forward for monetary policy in the 1990s, exposing central bankers to public ire when, as over recent years, they badly miss their inflation targets. Nothing similar has been achieved, as yet, on the financial stability side.

Perhaps the state of knowledge is such that, as with monetary policy during the 1980s, only an intermediate objective could be framed now. For example, targeting a benchmark measure of capital resilience might spur research to find a better regime, as the use of monetary-aggregate targets during the 1980s led eventually to flexible inflation targeting. The changes entailed by such an apparently modest first step would, though, be significant. At present, we do not even know how much each bank’s equity capital requirement changes each year as internal models and regulatoryrequirements are tweaked. Something has to change if we are to avoid revisiting 2023’s mess on a greater scale. In today’s geopolitics, financial system stability is vital. 

No one cares about stability until they scream for help.

Whatever the merits of the particular ideas aired here, the importance of aligning norms and incentives in the private sector and the official sector is not going away. These issues will rise again after the next crisis or scandal. For now, with notable exceptions such as the Bank of England’s recent defence of ring-fencing Britain’s large retail banks, the industry lobbyists hold sway, fuelling the people’s cynicism about commercial cynicism.

Remember, no one cares about stability until they scream for help.

Sir Paul Tucker is a research fellow at Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government. He previously served as Deputy Governor of the Bank of England and Chair of the Systemic Risk Council. He is the author of Unelected Power (2018) and Global Discord (2022).

 His other current activities include being a senior fellow at Harvard’s Center for European Studies; President of the UK’s National Institute for Economic and Social Research; a Governor of the Ditchley Foundation; a director of the Financial Services Volunteer Corps, and a member of the Advisory Board for Yale’s Program on Financial Stability.