Watchdog says markets not rational
Hector Sants, the chief executive of the Financial Services Authority, has delivered two thoughtful speeches in the past couple of days, in advance of the City watchdog's publication next week of its initial proposals on reforming the "structural regulatory architecture".
For me, the most striking assertion by Sants was this: "Markets have shown not to be rational; excesses have not been corrected by market discipline".
This represents quite an ideological shift by the regulator. It's a recognition (which many would describe as long overdue) that the disciplines of the market place are no guarantee that the management of businesses - and Sants is particularly concerned about banks and other financial firms - won't routinely make calamitously stupid decisions.
Sants elaborates: "The managers of the future must acknowledge and fight against 'the herd mentality'... The recognition that financial markets are not rational, but rather that they are a behavioural system built around personal aspirations, is critical to us effectively changing this time round".
As I pointed out in a recent note ("FSA admits huge mistakes"), the implications of this abandonment of free-market dogma are profound in respect of how the FSA will henceforth be doing its job.
In particular, it will not trust that the strategic decisions made by those running our biggest financial institutions are in the interest either of their own respective organisations or of the financial system.
So here's the question: if the FSA had been operating under the presumption that the private sector can routinely go bananas, would it have prevented banks like HBOS and Royal Bank of Scotland from expanding too fast and lending too freely?
That seems pretty far-fetched.
Would the regulator really have had the backbone to go against the grain of the prevailing market orthodoxy that only fuddy-duddy, boring, second-rate banks grew slowly and maintained a substantial protective cushion of capital?
Would it really have risked being chastised by shareholders, the business establishment, politicians and media for being Neanderthal opponents of entrepreneurism and wealth-creation?
To put it another way, we probably can't rely on the regulator alone - even a regulator with its eyes wide open - to protect us from a repetition of the current debacle.
Reform has to extend to the attitude of executive directors, non-executive directors and owners.
Sants, for example, says that the non-executives of banks and other systemically important financial institutions can no longer be part-time, well-meaning, business generalists.
They will have to become experts in banking, or insurance or other aspects of finance. And they may have to become full-time independent directors, rather than part-time, semi-detached coves.
However, recruiting such highly-skilled individuals, with relevant experience and no competing commitments, is easier said than done.
It is, for example, almost impossible to find a senior banker right now who hasn't been tainted by the current crisis - as is demonstrated by the torrid time the Bank of England is having in trying to find a brainy, tough individual to chair its soon-to-be reformed court (what it calls its board).
Goodness alone knows who has the relevant wisdom and character to act as a proper counterweight to the Governor.
But I digress.
For me, the most interesting challenge of the current crisis is for institutional shareholders, or the pension funds and insurance companies who hold shares on behalf of millions of people saving for retirement.
Since time immemorial (well, for the past 30 odd years), the presumption of many of these shareholders is that when they don't like what a company is doing, they'll sell the shares.
That seemed less bothersome than the alternative, which would be to act as owners and tell the company to mend its ways.
But the near total collapse of the financial system over the past 20 months, and the associated rout in global stock markets, may well have demonstrated that it's a massively sub-optimal approach to cut-and-run rather than to intervene and instruct the managers of businesses to change their behaviour.
The big point is that if the owners of banks, the institutional shareholders, had taken the time to understand the crazy risks the banks were running and had then done something about it, they would have avoided not only the losses they've incurred on their holdings in banks themselves but the far bigger losses they've suffered from the consequential meltdown in global markets.
Of course, when I say "they've suffered", what I mean is "we've suffered" - since these institutions are looking after our money, if we're saving for a pension.
And as millions of people are finding out as their pension statements land on their doormats, there's been a devastating collapse in the value of pension pots.
So perhaps the onus is on us to instruct those who look after our money that they are to become responsible owners, rather than neglectful absentee landlords.