Play it as it lies

This week in the UK, the government-to-be Conservative party announced plans to abolish the regulatory body that oversees financial markets - the FSA. In a move that sets out a major part of the policy battleground for elections coming within the next year, the Conservatives intend to lay out their full plan for regulating the financial system on Monday. Under the plan, the FSA's responsibilities will be split between the Bank of England and a new consumer protection agency. "Crucially, this will bring together the operation of monetary policy with regulation of the banking system so that the economy is not built on debt," said George Osborne, the shadow Treasury Secretary. His view is that the present regulatory structure, in which the Treasury, the Bank of England and the FSA jointly oversee financial stability, failed to spot the dangers of a build-up of debt in the banking system ahead of the financial crisis.

The truth is that the build up of debt in the system was patently clear for all parties to see, and the regulatory failings of the FSA were only a subset of a bigger systemic issue. The whole western economic model retained incentives for the debt build-up that occurred, from the resulting government tax revenues to the capacity for increased household discretionary spending. There was a complete lack of what I would term "self regulation". The system itself was not self correcting, and worse still the incentives to behave rashly weren't just limited to bankers.

While the FSA will take a bullet for the ensuing mess, the Conservative's restructuring plans will fall well short if there isn't an underlying shift in the way in which people and institutions self regulate. While that is an easy comment to make, it's a pretty big step in the real world. The world's financial system is too complicated to micro-regulate - the only way it will stay in good order is if their is a seismic shift in the moral code that its participants bring to bear everyday in their places of work. Not an easy transition at all.

Having said that, there are examples of the process of self regulation working very well, and some of the best of these examples come from the sporting world.

A couple of weeks ago, the world watched as a 59-year old came within inches of winning the British Open golf tournament - the biggest tournament in that sport. The spectacle was incredible for that alone, but the level of sportsmanship and grace he displayed in the process, makes Tom Watson a real hero of the game. The game of golf is almost unique in that it is almost entirely self regulating. Players record their own score and are expected to call penalties on themselves as they occur. In big tournaments a referee is on hand to help clarify situations where there might be a grey area in the application of the rules. Rarely if ever do the ruling bodies ever actually call penalties on the players - it is the players who are expected to regulate themselves, and if they ever fail in this responsibility then they truly become outcasts within the game.

To call a player a cheat in golf is the biggest slur possible, and to be found guilty of cheating will see you forever banished to the far corners of the golfing world. It is a far cry from the acrobatic cheats who try to con referees in football, and a far cry from the type of bankers who stealthily acted in the knowledge that their reputations weren't the most important part of their make-up.

This situation didn't just occur, so what is it about the game of golf that created such an environment? And is there an equivalent recipe that could be applied to the way in which financial markets, for example, are regulated?

In a similar vein, cricket was once the bastion of sporting self regulation. I was reading an article this week about one of the games truly great players - the Australian wicket-keeper/batsman Adam Gilchrist, who not only was one of best players of his generation, but was also deemed to be one of the most honest. The article recounted a tale of this honesty.

From Paul Kimmage in the Times: "Australia have won the toss and he is walking out to bat with Matthew Hayden against Sri Lanka in the semi-final of the 2003 World Cup. After five overs they have 34 runs on the board. Gilchrist has 22 of those runs and is feeling good. The spin bowler Aravinda de Silva has been sent on to bowl. Gilchrist blocks the first ball. The second ball is flighted and Gilchrist goes down and tries to sweep it behind square leg but the ball ricochets off the bottom edge of his bat and hits his front pad just above his ankle. He hears frantic screams of "Catch it! Catch it! and turns around to see Kumar Sangakkara, the Sri Lankan wicket-keeper with the ball in his gloves. "Well, that's that," he thinks. But the umpire Rudi Koertzen is shaking his head. "Not out." Koertzen is wrong (not for the first time). Gilchrist knows he has made a mistake. There is a voice inside his head screaming at him: "Go. Walk." He starts to walk.

There’s another voice in his head. It’s telling him he’s crazy. It’s warning him his teammates will be incensed. It’s telling him this is not what cricketers do. But there’s no turning back. He reaches the changing room, grabs a drink and joins his teammates in the viewing room. Someone asks if he had seen Koertzen shake his head and say not out. “Yes,” he replies. “I saw him.” A few minutes later, Ricky Ponting is out for two and joins them on the balcony. The team are struggling. The board reads 2-37. “Did you see Rudi give you not out?” Ponting asks.

“Yes,” Gilchrist replies.

This is how he describes what happens next: “Not much was said after that. The implications of what I’d done would play out over the next hours, days, and even years . . . All the media interest was in my decision to walk. What a bizarre world it seemed, where a simple act of honesty made such headlines. I never thought my act reflected badly on other players, and I still can’t see how an inference can be drawn that because I walked, anyone who doesn’t walk is a cheat. That’s not the case. The ethics of the matter are tangled, and I do not think there is anything dishonest or dishonourable in a policy of not walking. The matter is not black and white; you cannot put the honest people in one box and the dishonest ones in another.”

The reality for Gilchrist was that over the course of his career, his honest behaviour was preempted by umpires around the world and his reputation probably served him quite well. The umpires felt comfortable that Gilchrist would be "self-regulating" which made their jobs easier and ultimately made them less likely to give him out if he himself did not think he was out. Gilchrist had more of an issue with teammates whose perspective on the game was different from his, which made it harder and harder to act with the level of honesty that he became known for.

Gilchrist, would be described as "old school" - the way he played the game was once the standard attitude of the "gentlemen" who took the field in earlier generations. As the quality of the technology available to the umpires in cricket has improved, so the responsibility for self regulation has more and more been removed from the individuals playing the game. This greater regulation may have made the game more accurate, but the purists might suggest that it has not made the game better - more and more individuals try to cheat the system because their sense of personal responsibility has been removed and placed in the hands of the umpires.

To translate this analogy into the language of financial regulation is not straight forward. A point to consider, though, as we try to re-regulate the system after the turmoil of the last couple of years is that the "spirit of the game" cannot be forgotten in the process. In the legal world, after years of expensive training, the threat of being "struck off" stands in the background protecting (to some extent) the spirit of that game. Perhaps more needs to be done in the financial world to create an ethical backdrop - certainly the CFA qualification spends a lot of time focused on this issue, and perhaps should become an industry standard. One of the problematic differences, however, between the legal profession and the banking world is the annual bonus system, which means that not playing within the spirit of the game can be so rewarding in the short-term, that the threat of being "struck-off" may be too far in the future to be a sufficient disincentive.

Standing on a golf course the vast majority of golfers would not allow their own playing partner to cheat, let alone the opposition. That same mentality hasn't been translated into the offices of the world's financial community. To try to regulate the financial system from a purely over-sighted way (like a football referee) is both very costly to do well, and ultimately will be unsuccessful. It needs to come hand in hand with proposals to address the ethical underbelly of the whole game. Perhaps the rulers of the golfing game, the Royal and Ancient, can provide some guidance.