Function assignment options - Part 4
Imprudence under prudential financial regulations
Hector McNeill1
SEEL
Following the 2008 financial crisis some changes occurred in the regulatory oversight of the financial intermediation sector including banks, credit unions, venture capital, hedge funds, building societies, insurance companies and short term lenders. In 2013, the Bank of England accommodated a new Prudential Regulatory Authority (PRA) along with the Financial Conduct Authority (FCA).
The PRA oversees the "health" of the financial intermediation sector and the FCA oversees consumer relations with financial firms.
In terms of prudence, that is, beneficial decisions associated with minimized risk, in relation to macroeconomic policy it is notable that the only authority overseeing these is the government through the Treasury working in collaboration with the "independent" Bank of England. Even although the FCA and PRA run "consultations", to which very few people respond, the impact of macroeconomic policy on the constituency is not overseen by some authority.
The fundamental flaw in this system is that because the government believes that with the PRA and FCA we have a well ordered monetary system there is a gap in necessary constitutional procedures. This gap is the lack of oversight and legitimate participation of constituents in the decisions that shape macroeconomic policy and monetary policy in particular.
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The narrative on monetary policyThe narrative on monetary policy has been owned and recounted, over many centuries, by royalty and later by governments who have survived very much as a function to the degree that they managed their relations with money providers, be these wealthy individuals or groups and banks, to their mutual benefit. This, naturally, led to the development of considerable power on the part of money providers because, at the end of the day both royalty and governments were dependent upon them to secure their own interests. Going back over some 500 years, in this relationship and in the decisions made, the constituency, making up of the majority of the population, had no part to play. It was only in 1928 that universal suffrage was "granted" through the Equal Franchise Act through which all women over 21 years of age and any income level were able to vote, increasing the female electoral number to 15 million.
The "confused jury" argument
On of the justifications for avoiding constituency oversight of legal processes involving financial malpractice and criminal acts, is the "confused jury" argument. This simply states that finance can be so complicated that juries, made up of lay persons can not understand this complexity and therefore are not in a position to pass judgment.
This problem was solved a long time ago, but not in the realm of legal practice. If one looks as a logic diagram of a miniaturized logic chip i.e. logic that was originally made up of many components, it is impossible to understand. However, by applying the "divide and rule" approach by splitting the miniaturized logic back into compact components and, in some cases, breaking them down also, one ends up with a series of pretty simple and very easy to understand steps. George Boole provided a procedure known as Boolean reduction that can break a crude logic design into a series of remarkably simple "circuits" which together can achieve what the integrated designs purpose. This is used in the design of very sophisticated integrated circuits. One of its benefits is to reduce a chip design that starts of requiring hundreds of pins (external contacts) down to, in some cases less than 100 pins. This is a truly remarkable process to witness; increased simplify and transparency, with no loss of functionality.
The case of financial dealings is no different. If a prosecutor takes the time to break the chain of causation or the determinant model that describes the financial operations into stepwise components, juries would have no problem understanding what was going on. To some extent the issue in such cases are the judges. Corrupt prosecutors can produce confusing arguments on purpose to corrupt communications and as long as the judge permits this to continue the likelihood of a hung jury or inability to pass judgment only increases. This issue is really one of inadequate standards of evidence and lack of associated procedures and analytical methods that should be applied to any "complex" case.
I have worked for over 40 years at the nexus between agriculture, renewable natural resources, economics and systems engineering. On several occasions problems have arisen because policy makers often do not understanding the complexity of the logical chain between data sets to be collected, how they are obtained and how all of this related to policy. Since such considerations involve a wide range of disciplines all speaking in their own jargon this often led to confusion. The confusion arose, generally, because some group in the chain had an agenda to push things in their direction. This often happens when there are policy makers or politicians hovering somewhere in the background. To resolve this issue I proposed a simply solution known as the Data Reference Model2 (DRM). This sets out in functional form the whole logical chain in a way that each group of specialists can contribute while all involved understand what is going on. Each section has a specific function and somewhat like the digital component division described above. This makes any agendas very obvious because they tend to break the logic which the rest of the participants are understanding. |
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Monetary policy aloofnessNow, Members of Parliament, each represent a constituency but in general follow the dictates of their party under the whip system and prime ministerial patronage based on gaining positions in the government. When it comes to voting in Parliament, party dictate will generally over-rule any constituency wishes purely to keep majorities on the government side. Almost 50 constraints on the freedom of constituents were introduced incrementally by political parties and governments over the last 500 years under pressure arising from their increasing dependency on financial support and positive media coverage. The constituents of this country are still never asked to contribute any opinions of monetary policy.
The fact that the Bank of England was established in 1694 provides some support for the fact that their approach has had something to do with the aloof nature of monetary policy in this country. Gordon Brown didn't feel comfortable with the government being overtly responsible for setting interest rates since he witnessed the Conservative's prospects following the mass house repossessions under Thatcher's experimentation. Making the Bank "independent" as his first act was more a political insurance policy for Labour. On the other hand Brown's decision also helped distance the constituency even more from any influence over monetary policy. This the way the financial sector wish to keep it. Bank governors, at strategic points in times, when the constituency becomes more concerned with conditions and their concerns threaten an opening up of the monetary policy Pandora's box, runs subtle campaigns promoting the importance of Bank "independence"; this is true now. One of the justifications for highly abstract explanations for monetary decisions is to obfuscate and maintain this distance and avoid scrutiny. One of the "justifications" for monetary policy not being open to scrutiny is the "confused jury" argument that monetary policy is such a sophisticated subject that most members of the public do not understand how it operates and therefore are not in a position to provide useful contributions to either policy formulation or any decisions on the matter (see box on right). The issue, it would seem, is that the "public" have an information and knowledge problem on this topic. It is true that for hundreds of years, there has been no conscious effort to educate and inform the general public of the functional relationships between monetary decisions and their wellbeing.
Who is financial regulation for? In the governance of a country purporting to be a democracy where the Americanism, "no taxation without representation" can be placed into another perspective of the constituency being allowed to gain a full oversight of the degree to which macroeconomic decisions are demonstrably beneficial to their wellbeing. Lets put this another way. Just because there is a notional system of "representation" does not justify the majority of the population remaining unaware of the prejudice they suffer from policy decisions related to taxation or any other decision. Providing such oversight cannot be misconstrued as "interference" in political process; this would be an absurdity. With the changes in the macroeconomic paradigm following the 1929 Crash and the advent of Keynesianism, monetarism took on an expanded role through the assumed ability of governments being able to raise money through debt to increase so-called aggregate demand so as to increase employment levels. On the other hand, by varying tax rates a similar effect could be achieved on the fiscal side. The other policy instrument is interest rates. Since government debt was raised through banks it is self-evident that Keynesianism is simply a particular configuration of monetary policy. Supply side economics which appeared in the late 1970s, ostensibly to tackle slumpflation, was also fiscal policy concerning reduced marginal rates of tax. All of these "policies" apply the logic of managing "aggregate demand". In terms of constituency oversight and analysis to determine what might be considered to be preferable policies and those they would like to oppose, the government, or at least political parties, should articulate all options available; but they don't, they have not done so for hundreds of years, and this intent remains in force.
The division of Bank of England regulation between the FCA and PRA provides the image of a package covering prudent and ethical conduct of the financial sector to lower risks on the part of the sector and consumers. In the case of monetary policy this regulation makes very little contribution to the actual macoeconomic outcomes of monetary policy on constituent wellbeing. From this perspective the form of regulation required is one that make makes available in an intelligible fashion the information and knowledge necessary for the constituency to understand the direct and indirect impacts of monetary policy decisions made by the government and by the Bank of England on the economic wellbeing of the population. This can lay the ground for a transparent insight as to whether policy is doing the "right thing". Therefore rather than concentrate on "standards" of prudence and ethics it is better to establish a regulatory function that is truly independent of both government and the Bank of England and largely concerned with the ethical outcomes of policy decisions.
The ethical regulatorIn cybernetics the ethical regulator can only understand and react in a coherent fashion to events in the economy if its functions and procedures are structured as a decision analysis model able to simulate or emulate what is happening in practice. It therefore needs to posses a full understanding of the functions (algorithms) that enable unsatisfactory impacts on constituents to be immediately traced back to their direct and indirect causes. This is useful information in preventing prejudicial trends from continuing. The qualities or attributes of the ethical regulatory function include a full understanding of policy objectives in terms of constituency interests. It should only deal with factual data (evidence) and be able to handle the full variety of circumstances that come from the natural heterogeneity of economic actors and constituents. It needs to possess the appropriate determinant functions and associated logic to enable projection and prediction of unacceptable situations so as to alert constituents and policy makers alike of these facts. It needs to maintain a consistent integrity in terms of quality and standards of work following completely open and transparent due diligence procedures.
The basic role of monitoring the economy, evaluating events and change, detecting anomalies or unexpected trends through constant awareness and the ability to take coherent and speedy action where corrections are required.
One reason this form of regulation is resisted, when suggested, is that it would expose a direct linkage between so-called prudent behaviour of participating companies in the financial sector and negative outcomes for the majority of constituents. It is entirely possible for companies to act in a prudential fashion from the standpoint of their business and at the same time act in a way deemed to be unethical or even contrary to the law in their treatment of the constituency or the economy as a whole.
Why many financial sector decisions and unethicalAll business decision making represents the outcome of a tension between prudence (interests of the decision maker), ethics (doing the right thing) and the law (avoiding sanctions, often of a financial nature). Where legal sanctions are highly prejudicial and where the law emulates a guide to ethical behaviour, then most business decisions will result in prudence being ethical. However, the reality is that sanctions for irregular behaviour and transgressing the law, within the financial sector, are fairly "light". As a direct result of this reality, decision makers are not particularly constrained by existing laws and regulations and as a result take whatever decision is in the interests of the business. This quite frequently leads to decisions which knowingly break they law and are unethical because the sanctions imposed are so small, compared with the financial gain achieved, that fines simply become a cost of doing business. As can be appreciated the typical light touch regime in the United Kingdom does not, therefore, align regulations with the direct interests of the constituency because the motivation to transgress the regulations is significant, constituting a feature of government policy, to the degree that they do little to correct this flaw in the system.
Towards a solutionThis article became somewhat extended and therefore I will complete the picture in the next article where I will describe how the DRM-type approach can not only establish a transparent oversight but by using state-of-the-art technologies one can gain an insight into how our future macroeconomic management can become fully responsive to the constituency, to reducing income disparity, enhancing carrying capacity of the environment and reducing the impacts on climate; in short how macroeconomics can have a direct role in securing human survival.
1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.
2 Data Reference Models are now a recommendation of the Open Quality Standards Initiative.
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