Starfish Regulation Versus Spider Regulation

[An edited version of this article first appeared as “Starfish Regulation versus Spider Regulation", Transaction Banking by D Sign, iGTB (September 2014).]

The school boys had discovered fire. They ran round the school setting small blazes everywhere, then running away. The head teacher went to see the head gardener and asked him to fill one of the garden sheds with as much flammable material as he could find. She then called the boys together and asked them to go one-by-one into the shed. On their way in she handed each of them a match. She shut and locked the door to the shed behind them telling the boys she’d be back in a few hours. The school had no problems with fires for the rest of the year.

Burning Down The House

Central regulation versus local regulation of banking is this article’s topic. Jean Tirole was awarded the 2014 Nobel Prize for Economics for his work on taming powerful firms. The judges said that the Frenchman, “made important theoretical research contributions in a number of areas, but most of all he has clarified how to understand and regulate industries with a few powerful firms”.

A life’s work cannot be quickly summarised, but two regulatory contributions stand out. First, Professor Tirole’s work shows that a rigorous, orthodox economic approach with some game theory concludes that at some times business regulation improves social welfare, at other times it doesn’t. Regulation is complicated and easily induces unintended effects. A second contribution was to show that multi-sided markets with ‘platforms’ at the centre, such as the internet, credit cards, or payment systems, need to “get both sides of the market on board”. There is a complicated pricing and power struggle that needs to be balanced among suppliers, distributors, and consumers. Tirole sees regulation as an evolving social system. It can never be static.

Slippery People

Transaction banking is inherently multi-sided. A network of organisations move money around tens of thousands of entities through the use of industry platforms. Historically, many of these platforms were ‘mutuals’, owned by industry members, from credit card networks to stock exchanges to national payment systems to SWIFT. Many of these bodies were self-regulating, though with a diversity of members one could equally say that they were member-regulated. Over the past few decades quite a few of these mutuals have been privatised and governments have created new regulatory bodies to supervise them. In the course of privatisation several segments of the industry have moved to having dominate private players, cf credit cards, with regulators on top.

I might contrast the old system as one more like starfish, and the modern one as more like spiders. Brafman and Beckstrom's book, The Starfish and the Spider: The Unstoppable Power of Leaderless Organizations, elaborates on this metaphor. If you cut bits off a starfish they may regenerate or even replicate, but cutting off its head will kill the spider. The spider is centralised. The starfish decentralised. The spider is brilliant but brittle; the starfish soft yet resilient. Competitive markets are decentralised; that’s the glory of having freshly baked bread in a city every morning, yet not having a fresh bread planning board.

Organisations struggle with decentralisation. Traditionally, companies emulated military command and control systems. Brafman and Beckstrom ponder, "what happens when there's no one in charge - when there's no hierarchy". There are decentralised examples or organisations, such as Alcoholics Anonymous, Apache, Craigslist, Linux, Skype, and Wikipedia, yet the very need to organise means that we need to keep control. The result is layers of organisations within a market structure. Starfish containing spiders containing starfish containing spiders, etc. The organised structure of the human bodies of the boys in the school, the anarchy of the boys without supervision, the structure of a good classroom under a good teacher.

Fighting Fire With Fire

So, are we to recommend starfish regulation or spider regulation? The truth is we need a lot of both. A global, unitary, coherent regulatory system may sound great to some. Yet it is probably unachievable. If so, give thanks, because such a regulatory system would be oppressive and brittle. Pure self-regulation may sound ideal to others. It too is unachievable in today’s political climate. It too might not be ideal, leading to complacency and laxity.

Tirole’s work indicates that we must constantly redevelop our regulatory structures as markets evolve. If an industry is self-regulating, then the industry is likely to act in its self-interest. Members will get together to stop another member’s behaviour if they believe that behaviour will harm their market. They are more likely to follow another member’s behaviour if they will gain at the expense of the customers, so long as the market survives. Self-regulating old Wall Street exemplified this as noted in the title of Fred Schwed Jr’s 1940 book, Where Are the Customers' Yachts?: Or A Good Hard Look at Wall Street. The New York City guide points out - "Those are the bankers' and brokers' yachts!" The naïve visitor asks - "But where are the customers' yachts?”.

However, if everyone in an industry is sub-ordinate to a central authority, everyone will run up to the limit that they can get away with. The authority will be gamed. There is little point getting together to chastise a competitor; that’s the regulator’s job. If the regulator can’t be bothered, then you might as well do it, despite the harm to the market. If the regulator is not constantly vigilant and constantly enforcing, then when competitors see a market-harming gap they will take it. Further, while a central regulatory system focuses on protecting the customer, it requires ever smarter regulators learning about evolving harms. But in a central system, there is a single regulatory relationship, not a web. Regulators become increasingly isolated from what goes on day-to-day in the industry.

As with so much of life, in regulation what’s needed is a balanced combination. In a loosely-coupled regulatory system we need members to want to keep the market going, but also to feel they can ‘snitch’ to the regulator so the regulator learns. When the teacher was an isolated central authority, the boys tried to get away with what they could. When the teacher used her authority to force the boys to watch each other, everyone benefitted. Good regulation results from large dollops of both cooperation and competition, and central and local regulation.

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Background

For more on Jean Tirole, “Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2014: Jean Tirole: Market Power And Regulation”, compiled by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences - http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2014/advanced-economicsciences2014.pdf

Professor Michael Mainelli is Executive Chairman of Z/Yen Group and Principal Advisor to Long Finance. His latest book, The Price of Fish: A New Approach to Wicked Economics and Better Decisions, written with Ian Harris, won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.