News here in the UK yesterday was dominated by the Parliamentary Ombudsman’s investigation of the role of regulators in the near failure of Equitable Life. The ombudsman’s report concludes that the regulators had failed to properly or effectively supervise the mutual insurance company over many years. Instead they were “passive, reactive, and complacent”.
In essence, the scandal of Equitable Life is that the regulators continued to permit Equitable Life to sell investors “guaranteed” investment products which it could not possibly have fulfilled under more realistic projected investment returns long after Equitable Life started to run into trouble. The company was finally forced to stop taking on new clients in 2001, with existing clients realising large portfolio losses.
The report suggests that regulators should have known better and acted sooner. Of course, Equitable Life’s executives, actuaries and salesmen should have known better and acted sooner too, but no one seems interested in holding them to account, forcing them to disgorge the years of high salaries, bonuses and City lunches. The ombudsman recommends instead government compensation for regulatory failings on the order of billions of pounds to investors who lost much of their life savings in the fiasco.
The report and its recommendations raise several interesting problems for which there are no good or easy answers.
First, of course, is that if Equitable Life investors are eligible for compensation for the serial failures of supine and co-opted regulators, then just about everyone else in the retail investment universe will be eligible for compensation soon too. If we agree that many of the existing banks, broker-dealers, investment funds, pension funds and insurance companies have exaggerated their performance and will face profitability/solvency issues – as seems quite likely – and that regulatory passivity, reactivity and complaisance over the past two decades is a contributory factor, then hundreds of billions in compensation may be claimed by investors when the systemic crisis now emerging intensifies. If we go further and suggest that many of the securities and investment products originated, packaged, underwritten, and sold by banks and investment banks during the past two decades made exaggerated claims as to likely performance, and that regulators collaborated in this process by relaxing accounting, disclosure, underwriting and capital adequacy standards, then the case for compensating the entire world of retail investors is close at hand.
Expect the Chancellor of the Exchequer (British for treasury secretary) to resist the ombudsman’s recommendations. Expect delay and obfuscation.
Second, market regulation and prudential supervision are a public policy means of building confidence in the integrity of financial markets which are a modern and systemic reflection of the old confidence scam of “The Pigeon Drop”.
Without the intervention of the “shill” who recommends safekeeping of the money, the scam wouldn’t work. The scam requires someone to reinforce the dupe’s perception of the con man as an honest actor trying to do the right thing while he is struggling with the impulse to make a quick gain in a doubtful enterprise.
For the past two decades the regulators of the world may have thought they were contributing to the integrity and efficiency of financial markets by acceding to every request from the banks and investment banks for relaxation of former strict standards of market regulation, accounting, underwriting, disclosure, and capital adequacy. In reality, they were just aiding and abetting the Big Con. That con game that got three generations of investors to trust their life savings to high living con artists. It wouldn’t have worked without the regulators and governments assuring us that the con artists were straight shooters respecting our best interests.
Investors relying on the professionals and the regulators to look out for the little guy were duped. They are going to lose much of their life savings. Some will be lost to fraud, some to insolvency, some to illiquidity, some to credit reassessment, and some to asset deflation. The rest will be lost to inflation and taxes as the rescue socialises trillions in liabilities to the public purse.
The serial mega bubbles in real estate, securities, derivatives and other asset classes were all a big con, convincing us to part with our cash on the premise that it would be returned to us with high yield returns. The central banks and regulators played the part of the shill to convince us that we stood to gain from handing our cash to the con artists.
David Maurer, in his book The Big Con puts it like this: “Con games never remain stationary. The principle may be old, but the external forms are always changing, for con men know they must adapt their schemes to the times. This is especially true of the big con. A good grafter is never satisfied with the form his swindle takes; he studies it constantly to improve it; as he learns more about people, he finds a way to use what he has learned.”
Third, I’m not sure that human nature doesn’t dictate the complaisance of regulators. People become regulators early in their careers, as a rule, and often lack the understanding or credibility to challenge rich and successful bankers. Also, both sides are keen to be seen to be reasonable, plausible and likeable – leading the bankers to be just as convincing with the regulators as with the dupes, and leading the regulators to be accommodating and credulous.
Rising income inequality since the 1970s exacerbated this natural human impulse. It is the nature of everyone, even regulators, to want to be liked and respected by the rich and influential. It is no accident that income inequality and political corruption are very highly correlated. When the bank CEO made 30 times the floor worker’s wage, he had much less influence relative to his regulators than when he made 3,000 times, or on occasion 30,000 times, the floor worker’s wage.
Regulators might be strict with a banker earning not much more than they are. They are lax and conciliatory when that same banker earns a huge multiple of their salary – especially if they have an eye on promotion or a later lateral shift to the private sector to top up their income and pension before they retire.
Perhaps this erosion of public values and civil service career commitment is the true evil of income inequality. It becomes impossible for the government to constrain greed, abuse and excess in the private sector when the executives have disproportionate wealth. Instead, everyone from the top down in the public sector curries favour with the super rich in the private sector. And the little guy who trusted the regulators when he handed his hard earned savings to the bankers, brokers, pension fund managers and investment fund managers loses job security, economic stability and a comfortable retirement.
If you wouldn’t trust your brother-in-law with $250,000, why would you trust a complete stranger? Because the government told you it was okay. They assured you it was the right and responsible thing to do and would help you make even more money. The regulators were there to ensure your interests were respected. Only they weren’t.
We didn’t know that the regulator and the complete stranger were in on the big con together. Maybe they didn’t know it either.
What we’ll all soon realise is that we’ve been duped.