Time to redraw our regulatory system

In the wake of the Davy scandal, Cormac Lucey identifies four urgently required changes for Ireland’s regulatory system.

The scientist Max Planck said that science advances funeral by funeral. In his 1950 autobiography, he explained, “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die and a new generation grows up that is familiar with it.”

If science advances funeral by funeral, how fast does corporate governance progress? The implication of Planck’s aphorism is that old leopards don’t change their spots and cannot be taught new tricks: if you don’t like your leopard, you must get rid of it or, if the leopard is protected by employment law, issue it with a P45. In Ireland, corporate governance advances P45 by P45.

I am sceptical of the notion that revised organisational guidelines and regular attendance at corporate governance updates achieve much. If you have to regularly teach staff the difference between right and wrong, it begs the question: are you working with the wrong people? There is a lot of common sense in a popular maxim from Charlie Munger, the sprightly 97-year-old who jointly leads Berkshire Hathaway together with the merely 90-year-old Warren Buffett. Munger said: “Show me the incentive, and I’ll show you the outcome”.

What are the incentives in Ireland? Consider the recent scandal at stockbrokers, Davy. This concerned a case where 16 key staff members purchased bonds in the then defunct Anglo Irish Bank in 2014 and concealed this fact from the vendor, who had commissioned Davy to get the best price possible for the thinly traded bonds. The bonds were sold by the vendor for 20.25 cent in the euro, realising €5.6 million. If they were held until maturity – when they were repaid in full – they would have generated gross proceeds (before funding and legal expenses) for the Davy insiders of €22 million. The maximum fine the Central Bank may issue for regulatory infractions is just €10 million. And the fine administered in this case was only €4.1 million.

This raises serious questions about the design of our regulatory system. That the Davy executives who profited from this deal will have seen the value of their part-ownership of the brokerage firm drop considerably was a merely coincidental side effect of the whole process. It seems to me that several changes are urgently required:

1. The maximum fine for a regulatory infraction should be a multiple (five to ten times) of the gross gains made.
2. Where possible, fines should be levied on individuals rather than on firms.
3. Those who have acted improperly in the past should not continue to be employed in senior roles or hold large ownership positions at financial services companies.
4. We should financially incentivise whistle-blowers, like in the USA. There, a whistle-blower can claim a share of the wrongdoer’s loot. Bradley Birkenfeld, an ex-banker, was paid $104 million by the Internal Revenue Service for exposing his former bosses who had helped US clients hide money in Swiss bank accounts. If we can’t rely on people always being honest (and we can’t), then let’s change their estimate of where their self-interest lies.

A low-cost regulatory system focused more on incentives and occasional but vigorous action aimed at wrongdoers can replace today’s expensive system, which is built on detailed rules and extensive box-ticking that largely focuses on the already compliant.

Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland.