Why is the regulatory system failing?

David Rubens MSc, CSyP, FSyI, is currently completing his thesis for the University of Portsmouth Professional Doctorate in Security & Risk Management, where his research involves developing models of strategic management and critical decision making for complex crisis environments. He has just returned to the UK after spending 15 months as MD of a US security consultancy in Nigeria. 

If the proverbial Martian were to land on Planet Earth today, as part of their gap year 'Interplanetary cultural studies' programme, the report that they would send back at the end of their stay would undoubtedly comment on that fact that--at least to an educated observer--it seems that London, the UK, and much of the outside world is ruled on the basis of two basic principles. The first is The Golden Rule: namely, whoever has the gold makes the rules. The second is that in every area of public activity that has major impact on the lives of vast numbers of citizens--whether global financial matters, domestic banking, political management, MPs expenses, press oversight, power safety or border controls--though all of these actors are supposedly working within tightly-legislated and managed regulatory frameworks, they are in fact following the law of the jungle, where those that are supposed to be ruled by the rules are free to make up new rules if they don't like the present ones and to ignore even those if they decide that it is in their interest to do so.

The outstanding fact about many of the major headline stories of the past months--Fukushima meltdown, press intrusion and police complicity, the original collapse of HSBC, the trading of vulnerable girls in care for sex, Barclays and LIBOR, the recent HSBC money laundering accusations--is that all of these organisations were engaged in activities that should have had alarm bells ringing in every regulatory office in the land. Yet not only were they left to carry on their ultimately destructive activities, but it subsequently became clear there was a high level of collusion, if not outright manipulation, between the regulators themselves and those that they were tasked with overseeing.

It has become common practice to state that we are living in what has become a 'Regulatory State', with every aspect of our lives now governed by rules and regulations that are often backed up with the threat of punitive action--whether it is failing to leave the rubbish in the correct bag on the pavement, the need for tens of thousands of community-based volunteers to go through Criminal Record Checks, or the ability of increasing numbers of otherwise unauthorised people to claim access to both our private

data and, in many cases, our property. Yet when the self-interested and clearly irresponsible--if not actually illegal-- actions of high-powered individuals lead to a meltdown in the institutions that underpin every aspect of our social fabric, it seems that they can merely walk away-- often with multi-million pound pay-offs --and no one can even question them about their activities, never mind punish them for their transgressions.

We have become used to the sight of senior politicians, who are ultimately responsible for creating the regulatory frameworks that supposedly prevent these failures, standing up in Parliament or at public enquiries to decry this irresponsible behaviour, promise an enquiry as to how it happened, and introduce new regulations that will prevent any such occurrence happening in the future.

Yet if regulation is failing, then merely putting up more regulation is not likely the solution. In many cases, the activities that have led to the need for the enquiry are manifestly undesirable, almost certainly unethical, and quite often actually illegal. The question is not what more needs to be done to increase regulation, but why the systems that are already in place, and which have often been through multiple rounds of review and improvement, are not fulfilling the single function for which they were developed, namely the protection of the public and wider society from the self-interested actions of those that put their own benefit ahead of the need to observe the rules within which they are supposed to be operating.

For our visiting Martian, there would be one other factor that would undoubtedly be highlighted in their report, with a brief, and probably perplexed, background essay on the strange habits of alien cultures. In the midst of nuclear disasters, financial meltdowns, global recession and growing social disruption, the complexity of global institutionshas reached such levels of inter-dependence that it is literally impossible to calculate the impact of a specific failure of the wider local, national and global networks (for example, the tsunami in Japan triggering a breakdown in global supply-chain management of car manufacturing components, leading to the closures of factories across north-east England). Even in this highly unstable global environment, where the risks of disaster are ever present and the impact of systems failures are both catastrophic and irreversible, both the sector leaders and the political leadership in general are calling not for greater and more closely managed oversight but rather actual deregulation, claiming that the need to adhere to instructionist government diktats is the one thing that is preventing the growth and prosperity that would benefit us all.

Another notable aspect of government response to recent issues is that in many cases the behaviour that seems to us both demonstrably wrong and morally abhorrent is actually separate from any punitive framework that would allow those in power to bring the perpetrators to a court of law, charge and then prosecute them as they would any other person who acted against the laws of the country.

In fact, when it comes to the ordinary citizen, the range of activities that have been criminalized are increasing on a daily basis – whether it is renting accommodation to illegal immigrants or failing to turn up for job interviews even if one is officially disabled and house-bound. However, when it comes to bankers fixing international inter-banking rates for their own advantage, it seems that the authorities

are left publicly impotent to do anything more than plaintively claim that it is the duty of the corporate shareholders to oversee the actions of their executives, and that the shame of doing nothing would be enough to persuade global institutions to take the necessary steps to prevent these situations happening in the future.

Game Theory

In many ways, the reason that regulation should work but doesn't is that the regulators have fallen into a category error, and it is one that can be best described with a brief look at classical Game Theory—a way in which one can test various strategies, usually with the aim of maximising personal benefit. The best known example is probably 'The Prisoner's Dilemma', in which two prisoners are offered the opportunity to either deny the charge or give evidence against their co-accused. The dilemma comes about because the punishment they are given depends not only on their own actions, but also the decision of the other prisoner.

If both Prisoner A and Prisoner B stay silent, they both receive one month imprisonment. If both give up the other, they both receive three months imprisonment. But if Prisoner A rats on Prisoner B, who in turn stays silent, then Prisoner A goes free and Prisoner B serves one year.

In classical Prisoner’s Dilemma game theory analysis, the recognised optimal strategy is to give evidence against the other person. Although it results in a heavier sentence than if both sides had cooperated in remaining silent, given that Prisoner A has no control over Prisoner B and no way of knowing how Prisoner B is thinking or is likely to react, the risk is not one month (if both prisoners cooperated) against three months (if both prisoners gave up the other), but three months (again, if both prisoners grass up the other) against one year (if Prisoner A does the decent thing and remains silent, but prisoner B betrays him in the hope of a lighter sentence).

However, and this is what takes The Prisoner’s Dilemma beyond a dinner party game and into the realms of practical strategic value for regulators and strategists everywhere, the dynamics change if Prisoners A and B can change their strategy based on previous experience--that is, if the choices made by the prisoners are not based on a one-off encounter but as part of an evolving relationship.

The iconic example of the power of Game Theory strategy in what is called the 'Iterative Prisoner Dilemma' (where it involves not a one-off situation, but a series of on-going choices) was demonstrated at an event in the late 1970s when computer-game planners were invited to put forward programmes that would compete against each other in on-going games of Prisoner's Dilemma. Entries were received from academics across the world, with many going into thousands of lines of computer code, dependant on deep analysis of changing trends in the opponent’s decisions.

However, the most simple of all of the entries received, as well as the most successful, was a programme called 'Tit for Tat' which consisted entirely of four lines of code. The strategy was simple:

firstly, cooperate, then repeat what the other person did on their previous move. So if they cooperated, cooperate again. If they betrayed, then betray. This strategy rewards cooperation on the part of the other party--without leaving Prisoner B with the impression that in the long-term it is in his benefit to betray Prisoner A, who will suffer because of their inherent 'niceness' or trusting nature.

The Prisoner’s Dilemma can be seen in action in two variants within regulatory activities, and offers insight into why those involved act as they do. The first relationship is that between the various people and organisations being regulated - banks, nuclear power stations, council departments, police agencies, journalists, etc, and the clear lessons from history are that even for those organisations that are theoretically in competition with each other, it is beneficial to all sides to use mutual cooperation in order to maximise personal benefit. Whether it was Virgin and British Airways forming an illegal cartel to fix the price of fuel surcharges (a benefit to themselves which was paid for in increased prices for passengers); football shirt retailers (and Manchester United) being fined £16m for fixing the price of replica football shirts, or Barclays (and undoubtedly other banks) working together to fix the LIBOR rate, the reason why they do it is simple and unanswerable - it is in their benefit to do so.

The largest fine ever handed out by the European Commission (of over Euro 1.3 billion) was to four manufacturers of car glass who had fixed the market prices at an artificially high level. A basic understanding of economic theory would suggest that the artificially high margins between cost of production and final sale price would create an opportunity for any company that would cut its prices to gain greater market share. But that would only hold true in a theoretically pure market where each competitor independently fixes the rate at which they are prepared to sell based on their own personal strategy. Once collusion is involved, it is always in the interests of supposed competitors to cooperate, given that the cost of such cooperation is passed on to the final consumer (and which in turn directly contributes to higher profits for the colluding partners).

However, when it comes down to the relationship between the regulators and those being regulated, a completely different strategic dynamic comes into play. The ability of the regulated organisation to maximise personal benefit is then based on the ability to predict what the other side (ie the regulators) will do in response to the two options - 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 organisation it is regulating, it becomes clear that there is little to be gained in the long run by cooperating, and much to be gained by ignoring the regulator and developing a strategy that focusses on maximising its own personal benefit. This is not an issue of 'right' or 'wrong', but purely, in its own terms at least (maximisation of profit, increased market share, annual bonuses, career prospects), of whether it is 'effective' or 'ineffective'.

It seems strange therefore when regulators and politicians claim that it is the responsibility of the companies' boards of directors to control the actions of the CEO and other operating officers, especially when it is precisely those actions that have created profit and value in the company, and given that many of those CEOs will have been appointed by those same directors purely on the basis of their ability to increase and improve profitability in the market that they are trading in.

In such situations, therefore, it is a failing strategy on behalf of the regulators to go into the game believing that the regulated organisationis interested in creating a cooperative relationship. In fact, based purely on an understanding of simple Game Theory, the opening attitude of the regulators (and one that they would be well advised to repeat to themselves three times before they go into any subsequent meeting), is the famous phrase ascribed to Jeremy Paxman on his attitude to politicians he was interviewing: 'Why is this lying bastard lying to me?'

Regulation only has an impact if its main role is to deter bad behaviour rather than prosecute bad behaviour once it has occurred. If the main players are constantly being upbraided because they are not playing within the accepted rules, then it is clear that the sanctions being threatened against them are not severe enough to be effective, whether it is against newspapers using dodgy practices to gather information, celebrities using dodgy tax-avoidance schemes, or premier league footballers happily paying regular fines for constantly occurring offences. The underlying assumption of regulation is that there is a series of sanctions in place that would make the original offence non-productive in the long-term, and that therefore in terms of any rational game theory, it would not be in the player’s interest to go down that route.

Given that the regulatory systems we have in place at the moment (at least, as far as they concern the rich and the powerful) are clearly not severe enough to deter potential transgressors, then until such sanctions are put in place, it is likely that our Martian visitor will continue to be amazed at the freedom certain people are given to base their own benefit and enrichment upon the suffering of millions of their fellow citizens.

PS21 is a non-national, non-ideological, non-partisan organization. All views expressed are the author’s own.