Bedouin justice is the answer for efficient financial regulation -- one judge, one sword

First in a series. Thirty years ago, when I worked for a time in Saudi Arabia, I saw a public execution. I didn’t attend an execution, I didn’t witness an execution, I just happened to be there. There was in the center of this town a square and in the square were gathered hundreds of people. I worked in a building next to the square and looked out the window to see what caused all the noise. At that moment a prisoner was brought forward, his arms bound behind him. He was dragged up the steps to a platform and there fell to his knees.

Another man, whom I quickly came to understand was the executioner, climbed to the platform with the prisoner and poked him in the side with a long curved sword. The prisoner involuntarily jerked up just as the sword slashed down and just like that there was a head rolling off the platform, the body falling dead like a sack of flour. The crowd roared. Beginning to end it took less than a minute.

This was Bedouin justice. Nomadic societies have no jails so their justice systems tend to be pretty simple with punishments generally limited to the loss of wealth or body parts. Convicted criminals for certain crimes in Saudi Arabia first lose one hand then two if they repeat the crime. Other crimes go straight for the head. I don’t know what this guy did back in 1982, but I remember he had both hands. It’s a cruel and arbitrary system but you know where you stand in it and convicted criminals are fairly easy to spot.

I bring up this image because this is the first of two or three columns about law and regulation, how systems do and don’t work, and what can be done to make them better. Bedouin justice circa 1982 is our baseline and it works pretty well for simple crimes, though maybe not so well for multinational corporations.

The inspiration for this column is a recent blog post by David Rubens, a security consultant in the United Kingdom. It’s a bit dense but if you fight your way through the post it makes pretty good sense about why business regulation (or any regulation for that matter) doesn’t seem to work very well these days.

Rubens writes of Game Theory and specifically multiple iterations of  The Prisoners’ Dilemma problem, which has to do with how risk decisions are made by organizations involved in dynamic systems like business. Here, with some light editing by me, is the nut paragraph:

...when it comes down to the relationship between regulators and those being regulated… the ability of the regulated organization to maximize personal benefit is based on the ability to predict what the other side (the regulators) will do in response to the two options (which are) cooperate (play nicely) or betray (screw the customer). Given that in almost all cases the regulatory body has less funds, personnel, resources and expertise than the organization it is regulating, then it becomes clear that there is little to be gained in the long run by cooperating or playing nicely, and much to be gained by ignoring the regulator and developing a strategy that focuses purely on maximizing its own personal benefit. This is not an issue of ‘right’ or ‘wrong,’ but purely, in its own terms at least (maximization of profit, increased market share, annual bonuses, career prospects), of whether it is ‘effective’ or ‘ineffective.

Rubens’s point, then, and I think it is a good one, is that absent some guiding moral principle usually embodied in a leader, the more powerful an organization the more it will act in its own self interest even if (especially if) that interest is in violation of regulations or laws. You can have a strong leader who says "We’re going to play fair", and that changes the picture. but if the leader (strong or weak, but running a powerful organization) says, "our only job is to maximize shareholder return" then rules and eventually laws will be broken to make that happen.

This makes us look again at the political argument that comes up again and again about whether free markets can be left to themselves or whether they should be regulated. I’m not attempting to answer that question here, by the way, because in practical terms it is the wrong question. The better question is in the business and regulatory structures we have now, does financial regulation even work?

Rubens says "no, regulation doesn’t work", and I agree.

End of argument for some, who would then go on to say that since regulation doesn’t work then we shouldn’t bother with it. “Let business do its job.”

Except there are instances like protecting the old and weak where even those who oppose regulation see some advantage to it. So in order to cope with those instances, we have in recent years come to talk less about deterrents and more about rewards. Most of the regulatory responses to the financial collapse of 2008 were in the form of incentives.  Instead of going to jail, the perps tended to be deemed too big to fail and actually rewarded for most of the bad things they’d already done.

Nearly every violator, even if they paid millions in settlements and fines, ended up financially ahead for having broken the rules.

What’s key here is that there’s a dual system. If you are powerful enough, you are too big to fail. If you are weak enough, you are too small to matter. In the 1980s the popularity of three strikes laws worked to displace petty criminals at immense cost to the system and to society.  Three Strikes worked to some extent, so in that respect it was an effective policy with bad side effects. Yet nobody has proposed applying Three Strikes to these civil crimes.

Why not? Can’t we find organizations that have be caught doing similar offenses three or more times? If we had Three Strikes for big banks, for example, most of them would be out of business.

What would be wrong with that? Hundreds of banks are dissolved by the FDIC every year. There’s nothing sacred about a bank.

You may notice a pervasive theme in public discourse that government is too big and ought to be made smaller, that regulations ought to be simplified or removed altogether.

Trust us.

Yet with a weak government there is only one way to have successful deterrents, which is by making them brutal. Bedouin justice is the answer for efficient financial regulation.

One judge, one sword. Float some mortgage backed securities that you rate AAA but know will fail; manipulate the LIBOR; fix commodity prices; backdate your stock options; lose a hand.

Reprinted with permission

Photo Credit:  ARENA Creative/Shutterstock