Does good financial regulation only happen in legislatures, regulators’ offices, and at international meetings of central bankers? What about what goes on between lawyers and their clients, between back office clerks and front office traders? Inside computer systems? What about the mountains of documentation, the procedures surrounding confirmations and disputes? What about all the people, and their tools, that make up a market?
One way to think about this is to ask, what are we trying to achieve, when we talk about creating more stable, efficient, fair financial markets? The answer is that we are trying to change the way things are actually done inside the market. Done by real people, in real situations.
At any moment, thousands of people around the world—from managing directors to administrative assistants and everyone in between—are making decisions, making choices, taking actions—file this document, call Leslie or Hiroshi about this deal, interpret this contract clause this way, buy this company, call the PR firm to see if they could put an ad in the newspaper about this political issue, have lunch with this regulator, and on and on. And those millions of actions, those decisions, are all we mean by markets. When we say we want more stable markets, we really mean that we want to shift people’s ordinary actions.
So all this regulation is just an effort to change real people’s actions, every day, sometimes in big ways, but often in small ways. The next time a middle level staffer at a ratings agency has a gut feeling that the rating of a bank does not fully reflect the bank’s exposure, we hope they will take the time to ask a few more questions, and then pass those questions on to superiors who will do the same. The next time a lawyer for a hedge fund is asked to find a technical legal interpretation of cross-borders securities laws that will limit their client’s fiduciary duties to their own investment clients, we hope they will take the time to ask whether such an interpretation really conforms with the spirit of the law, and to push their client on whether such an interpretation is really in the client’s own long term best interest. The next time a dispute between counter-parties to a swap transaction develops, we hope that the people working inside each of those hedge funds, companies, or banks think work out a negotiated solution rather than deploying “the nuclear option” with domino effects throughout the market.
What do these steps look like, to someone in the thick of things? They can require a little bit of courage—a choice to make just a little bit of trouble for a transaction by asking for more information or raising an issue with a superior. They can require a little bit of extra effort—a choice to take a little more time to go check the facts on a problem when you would rather head out early on a Friday afternoon. They can require a little bit of vision and creativity—to find a win-win solution to a conflict or to see one’s own personal interests, and the institution’s interests, in a longer term perspective. They can require some tools, like workable informal dispute resolution protocols developed by industry associations.
Now in fact, good decisions like these happen all the time. They even happened right in the midst of the last financial crisis. Things could have been far worse than they were in 2008 had not many thousands of people taken reasonable steps to bring whatever stability they could to their little corner of the market. And it could happen a lot more.
What bothers me about much of the talk about financial regulation is that it proceeds as if markets participants were rats in a scientific experiment, motivated only by simple desire for immediate gratification or fear of pain: We will either beat you over the head with penalties if you don’t comply with our securities laws or offer you cash incentives if you do comply (think, the new obscenely large incentives for whistleblowers to now make money on informing the government about the shady practices they made money engaging in before). In fact my ten years of research in the derivatives markets has convinced me beyond a shadow of a doubt that this view of market participants as selfish, brutish and stupid is not an accurate picture. There are many kinds of people working in many capacities in the market, with many different, complicated motivations. But all the people I know, money is only one such motivation. Others include respect from peers, a sense of intellectual challenge and fun, and yes, the satisfaction that one has built something good and done the right thing. If I were to ask many of my informants in the markets why they did the right thing in this or that case, I doubt the first thing that would come to mind would be “because a regulator said I should.”
So what does this all mean? It means that government regulation is one important route to changing markets by changing the actions people take in markets, but it is not the only route. We need much more conversation about what happens, in those key situations, when a person at a critical (but ordinary) juncture in the market chooses Path A or Path B. What are the pressures? What are the options? What influences those choices? What resources do employees need to make the best choices—more time? more knowledge? More support from peer groups? And yes (but not only), financial incentives and fear of penalties? We need to start building a culture of good decision-making.