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Eva Becker

Knowledge Capture
in Financial Regulation
Data-, Information- and Knowledge-
Asymmetries in the US Financial Crisis
Knowledge Capture in Financial
Regulation
Eva Becker

Knowledge Capture
in Financial Regulation
Data-, Information- and ­Knowledge-
Asymmetries in the US Financial Crisis
Eva Becker
München, Deutschland

Zugl. Dissertation, Universität Friedrichshafen 2014

ISBN 978-3-658-13665-9 ISBN 978-3-658-13666-6 (eBook)

DOI 10.1007/978-3-658-13666-6

Library of Congress Control Number: 2016937382

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© Springer Fachmedien Wiesbaden 2016
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“Politics works in episodes, in short stories each finishing with a collectively binding
decision, a symbolic gesture of conclusion. The political system is thus free to turn
to new topics or to await feedback from old ones. But what happens with the
risks?” (Luhmann 2008, 165)
Abstract

In 2007, the world economy was hit by a financial crisis of systemic nature and
global reach. Confronted with the failure of (potentially) systemically important
financial institutions (SIFIs), governments were forced to make a binary choice: To
either rescue these institutions or let them go down, weighing up moral hazard and
too-big-to-fail expectations on the one hand, and the risk of a market breakdown
on the other. Financial regulation had apparently not kept pace with the fast-
evolving, highly complex financial system. It is therefore widely agreed that the
crisis was rooted in economic as well as governmental failure.
A growing dependency by policymakers and regulators on private expertise,
especially in the area of financial governance, has been an issue of academic debate
for some time now. However, the severity of data-, information- and knowledge-
related problems in financial regulation became only evident in 2007 and 2008:
Then, policymakers and regulators worldwide complained about insufficient data,
information and expertise to assess the situation adequately, while they were at the
same time forced to make far-reaching decisions, including bailouts and extensive
financial guarantees. In view of an increased reliance by policymakers and regulators
on data, information and knowledge provided by the financial industry, members of
the European Parliament warned in their “Call for a Finance Watch” that the
absence of financial counter-expertise presents a danger to democracy.
The author therefore assesses the US financial crisis as a crisis of regulatory
data, information and knowledge. The US policy responses to the crisis, particularly
the establishment of the Office of Financial Research (OFR), acknowledge and
address the identified data, information and knowledge gaps. Yet, their role and
nature remains undertheorized to this date. Based on semi-structured interviews
with experts conducted by the author – complemented by speeches, testimonies
and interviews from the US Financial Crisis Inquiry Commission – this study seeks
to add definitional clarity to the debate. It is argued that data-, information- and
knowledge-asymmetries represent different sets of problems in financial regulation.
Moreover, it is shown that the US policy responses to the crisis are characterized by
a narrow focus on data and information, while they fail to address a growing
knowledge gap between regulators and their regulatees. Drawing on Capture
Theory and recent reformulations thereof, we develop knowledge capture as a
theoretic framework to assess financial regulation under conditions of 21st century
complexity.
Content

1 Introduction ................................................................................. 15
1.1 Eliminating Hobson’s Choice, Or: A Binary Model of Systemic Risk ............ 19
1.2 The Argument in Brief ............................................................................................ 24
1.3 Literature Overview and Current State of Research........................................... 27
1.4 Research Approach.................................................................................................. 30

2 Narratives of the Global Financial Crisis ............................................. 37

2.1 From 1980 to 2010: Dominant Beliefs and Paradigm Shifts ............................ 41
2.2 A Pre- and Post-Crisis Understanding of Systemic Risk ................................... 45
2.3 Entering the Stage of 21st Century Financial Folly ............................................. 60

3 Multi-Level Complexity: The 21st Century Financial System ................... 65

3.1 Interconnectedness and Contagion: Complexity at the Systems Level ........... 67
3.2 The Role and Nature of 21st Century Financial Institutions............................. 69
3.3 Complex Products – Financial Weapons of Mass-Destruction?...................... 81
3.4 Innovators vs. Regulators: Science Running Amok ........................................... 84
3.5 Can and Should Financial Complexity be Eliminated? ...................................... 87

4 US Policy Responses to the Crisis ..................................................... 93

4.1 Stretching the Law: Case-by-Case Responses in the US.................................... 96
4.2 TARP as a System-Wide, Medium-Term Policy Response .............................101
4.3 The Regulatory Overhaul: Dodd-Frank as a System-Wide Response ...........103
4.4 Putting the US into Context: A Short Look at EU Policy Responses...........135
4.5 Changes in Global Financial Governance: The Establishment of the FSB..151
4.6 Financial Reform Revisited: Where Do We Stand Today? .............................156

5 Knowledge Asymmetries in Regulation .............................................161

5.1 A Working Definition of Data, Information and Knowledge........................162
5.2 Knowledge Related Problems in Financial Regulation ....................................165
5.3 Boundedly Rational Financial Regulators...........................................................199
5.4 Representatives vs. Experts: The Privatization of Legitimacy ........................203
5.5 Keeping Pace with the Market, or: Can the OFR Enlighten Regulators?.....206

6 Knowledge Capture: A Theoretic Framework ......................................213

6.1 Introduction to the Theory of Economic Regulation......................................215
10 Content

6.2 Capture Diagnoses in the Recent Financial Crisis ............................................220

6.3 New Perspectives on Regulation: Information and Complexity Capture.....222
6.4 Knowledge Capture: Experts Hijacking Regulators .........................................230
6.5 Solutions to Knowledge Capture Problems.......................................................240

7 Conclusion: Policy Implications and Future Research...........................243

7.1 Tackling Complexity Through Regulation .........................................................245
7.2 Future Financial Reform.......................................................................................247
7.3 Future Research......................................................................................................253

References ........................................................................................257
List of Figures

Figure 1: Binary model of systemic risk .......................................................................... 20

Figure 2: Research approach ............................................................................................. 32
Figure 3: Focus and context of this book ....................................................................... 34
Figure 4: Number and size of FDIC-insured banks...................................................... 70
Figure 5: Collateralized Debt Obligations....................................................................... 83
Figure 6: The organizational environment of the FSOC............................................107
Figure 7: FSOC structure.................................................................................................108
Figure 8: The internal structure of the OFR ................................................................119
Figure 9: EU microprudential supervision....................................................................142
Figure 10: The next crisis.................................................................................................158
Figure 11: Principal-agent relationships ........................................................................176
Figure 12: Principal-agent relationships in politics......................................................178
Figure 13: Core agency problems...................................................................................193
Figure 14: Flowchart of filter failure and information capture..................................226
Figure 15: Knowledge capture in financial regulation.................................................233
Figure 16: Knowledge capture cycles ............................................................................237
List of Tables

Table 1: Analytical context of the FSOC and OFR assessment.................................. 95

Table 2: Process for nonbank financial company designation ..................................113
Table 3: Stage one of the FMU designation process...................................................115
Table 4: Four-category-framework of information asymmetries ..............................186
Table 5: Participation in the notice-and-comment rulemaking process...................224
Table 6: Differences between behavioral and structural regulation..........................249
1 Introduction

This book is yet another contribution to the large and constantly growing body of
literature dealing with the financial crisis of 2007ff. – and at first sight, it looks like
everything has been said and written about “the worst financial meltdown since the
Great Depression” (Financial Crisis Inquiry Commission 2011, 3).1 However, a
closer look reveals that despite the endless number of research papers and
government reports, experts still cannot agree on the exact causes of the crisis.
More importantly, among the various contributing factors identified and discussed,
some remain vague and require further research. The question whether systemic
risk is merely an economic (Schwarcz 2008) or rather a political phenomenon
(Levitin 2011) is exemplary in this regard.
Many believed that the music would stop one day, but only few broke off the
dance to place lucrative bets on the breakdown instead (Nakamoto and Wighton
2007).2 The crisis came as a surprise to most – Warren E. Buffet termed it an
“economic Pearl Harbor” (Buffett 2010) – yet some saw it coming. Unfortunately,

1 When we speak of the financial crisis of 2007ff. – also labeled the Second Great Contraction (Reinhart
and Rogoff 2009) and the Great Recession (Woolley and Ziegler 2012) – we refer to the financial crisis
that had its roots in the US mortgage market, spread over to financial institutions engaged in the market
for mortgage backed securities (MBSs) and collateralized debt obligations (CDOs), and ultimately
infected the entire global financial system. It remains an open question whether the financial crisis is
already over or not: Some state it is, some say it is not. The Fed’s decision not to raise the federal funds
rate as long as US unemployment remains above 6.5 percent indicates that at least the crisis policies are
not yet over. Instead of taking a final stance on the matter, we want to refer to a very interesting
interview with William Porter, Head of European Credit Strategy at Credit Suisse; he argues that “the
crisis is not observable at all. But that does not mean it’s gone away. It’s gone underground“ (Porter
2013).
2 In an interview with the Financial Times, Charles Prince, then CEO of Citigroup, described how
“[w]hen the music stops in terms of liquidity, things will be complicated. But as long as the music is
playing, we have got to get up and dance. We are still dancing” (Prince as quoted in Nakamoto and
Wighton 2007). In his interview with the FCIC, Prince complains that his statement, and a similar
statement he made at a dinner with Treasury Secretary Henry Paulson, are quoted quite often, but mostly
taken out of the context: Prince was referring to the banks’ lending business, more specifically the loans
made to private equity firms. As he emphasizes, the quote has “had nothing to do with the mortgage
business, it had nothing to do with what turned out to be CDOs. That was not part of my thinking or on
the radar screen at all” (Prince 2010, 123).

© Springer Fachmedien Wiesbaden 2016

E. Becker, Knowledge Capture in Financial Regulation,
DOI 10.1007/978-3-658-13666-6_1
16 1 Introduction

the latter and much smaller group did not include many, if any, regulators.3 In
hindsight, the ignorance of public officials towards the mechanisms and channels
through which the crisis would propagate during 2007 and 2008 is difficult to
believe. In March 2007, Federal Reserve President Ben Bernanke testified before
Congress that “the impact on the broader economy and financial markets of the
problems in the subprime market seems likely to be contained” (Bernanke 2007b),
and Treasury Secretary Henry Paulson made a similar statement (Faber 2010). It
however turned out that the problems in the subprime markets were not contained.
It appears that during the crisis months, government officials were essentially flying
blind (Mendelowitz and Liechty 2010, 3). Hence, the crisis not only shed new light
on a decade of deregulation and financial innovation, it also revealed that
policymakers and regulators were facing severe gaps with regard to financial market
data, information, and knowledge (see for example Black 2012; Financial Stability
Board and International Monetary Fund 2009; Flood et al. 2010).
German sociologist Wolfgang Streeck has asked what social scientists can
contribute to enhance our understanding of this “economic and political crisis of
global dimensions” (Streeck 2011, 1). The financial crisis of 2007ff. represents the
starting point for this book, but we do not want to add yet another analysis of the
complex interplay between financial institutions, rating agencies, mortgage
originators and regulators that finally mounted in the financial crisis. Our
contribution focuses on a phenomenon that could be observed before and through-
out the crisis, that has received little scholarly attention so far and that remains
undertheorized to this date: Against the background of increased financial system
complexity, we examine the role and nature of data-, information-, and knowledge-
related problems in financial supervision and regulation. 4 As we show, certain

3 There are of course exceptions – the people who issued warnings were just not influential or
convincing enough. As we will see throughout this book, former chairperson of the CFTC Brooksley
Born provides an example here.
4 When we speak of financial regulation, we mean “the set of rules and standards that govern financial
institutions” which aims at providing financial stability and protecting customers and takes “different
forms, ranging from information requirements to strict measures such as capital requirements” (High
Level Group on Financial Supervision in the EU 2009, 13). In line with the group chaired by Jacques de
Larosière, we distinguish regulation from financial supervision, which covers “the process designed to
oversee financial institutions in order to ensure that rules and standards are properly applied” (ibid.). We
also agree with the de Larosière Report that regulation and supervision are not only closely intertwined,
but also interdependent: Regulation cannot work if supervision is not effective and vice versa. Many of
the US federal agencies have regulatory and supervisory responsibilities: The CFTC, which is responsible
for the US commodity futures and option markets, had finalized 43 of the rules it was required to write
by Dodd-Frank as of November 2013 (Davis Polk & Wardwell LLP 2013). But the CFTC is not only
involved in rulemaking; it also oversees the futures markets, looking for abusive trading practices and
fraud. Besides the CFTC, independent federal agencies relevant to our work are the Board of Governors
of the Federal Reserve System, the Securities and Exchange Commission (SEC) and the Consumer
Financial Protection Bureau (CFPB). Just like the CFTC and the Fed as well, they have important
regulatory and supervisory mandates.
1 Introduction 17

aspects of these problems have been known and discussed in academia for decades.
The establishment of the Office of Financial Research (OFR) in Washington in
2010 in response to the crisis does nevertheless present a turning point. With the
Dodd-Frank Act (DFA)5, the US government not only acknowledged the existence
of such problems, but also set out to solve them. Among the various US policy
responses to the crisis, the OFR is therefore the most important one for the analysis
at hand.6
The crisis triggered financial reform on both sides of the Atlantic. However,
while stress tests and living wills, new resolution mechanisms and systemic risk
oversight councils have been introduced in the US and elsewhere, the OFR presents
a unique policy response to the crisis. Differences in reform reflect the fact that,
while the financial crisis was an epidemic event of global reach, it started as a
mortgage crisis in the United States, evolved into a sovereign debt crisis in the
European Union and lingers on as a social and political crisis in the most severely
affected national economies, such as Greece and Spain. The global crisis revealed
that regulators had put too much emphasis on microprudential regulation and bank-
internal risk models, that financial institutions were overleveraged and that their risk
management was not effective. But the US crisis was also perceived as a crisis of
inadequate data and information and more importantly, of missing expertise. We
therefore focus our analysis on the US crisis, but refer to the European case
wherever a comparative perspective proves to be helpful. Comparing Europe and
the United States, the second distinctive feature of the US debate is a lively
discussion about legislative and executive capture as a cause for the crisis. As we
will see, information and knowledge deficiencies and the capture diagnosis are
closely intertwined.
“Politics presents itself as a system of societal control”, and according to
Luhmann, it tends to “action rather than inaction” (Luhmann 2008, 173, emphasis
added). When the crisis erupted, the US government responded case-by-case, and it
appeared for some time as if Treasury had lost oversight and control of the financial
system – up to the point when US Secretary of the Treasury Hank Paulson
demanded a bazooka (The Economist 2008) to fight back the crisis and asked
Congress to support the 700 billion US dollar Troubled Asset Relief Program

5 The complete title is Dodd-Frank Wall Street Reform and Consumer Act ( 111th Congress, Public Law
111-203, H.R. 4173.).
6 When we write about the US policy responses to the crisis, we refer to the Dodd-Frank Wall Street
Reform and Consumer Protection Act (referred to as Dodd-Frank or DFA throughout this book) that
was signed into law by President Obama in July 2010, but also to the bodies and measures established by
Dodd-Frank: The Financial Stability Oversight Council (FSOC), the Office of Financial Research (OFR)
and the Consumer Financial Protection Bureau (CFPB), to new requirements such as the Fed stress tests
and living wills, but also to new authorities, such as the FDIC’s Orderly Liquidation Authority (OLA).
18 1 Introduction

(TARP).7 Regulation by deal (Davidoff and Zaring 2009) was followed by system-
wide short term policy responses, until Congress finally agreed on the Dodd-Frank
Act, the most far-reaching regulatory overhaul in US financial regulation since the
Great Depression (Obama 2009). Whether it constitutes symbolic politics (Edelman
1970) or substantial policy change is a question that will follow us throughout this
book.
When looking at the US policy responses to the crisis, we have to be aware of
the fact that some of the underlying causes and mechanisms of the crisis can
eventually be resolved, while others cannot be overcome and will therefore persist.
The majority of structural issues, for instance the remuneration practices for top
executives, the quality of residential mortgage loans (originate-to-sell model) and the
business model of rating agencies (issuer-pays model), either have been or could be
altered by regulators. The same applies to many regulatory issues, such as pro-
cyclical capital regulation. Yet, the systemic features of today’s global and complex
financial system remain: The interconnectedness of financial institutions via deriva-
tives contracts; the complexity of certain large and global institutions, consisting of
more than thousand legal subsidiaries each; the emergent properties resulting from
a large number of autonomous, non-linear actors; the reciprocal behavior of its
members; the interdependency of the interbank market and the real economy, to
name just a few. 8 The nation states’ ability to govern the financial system is
therefore necessarily limited.
The financial system evolves at a pace that constantly increases regulators’ non-
knowledge of the financial system. As we will see, the question whether regulators
have learned that lesson is crucial. The (over)confidence of the central actors –
including policymakers, regulators and financial institutions alike –that this time was

7 According to Abolafia, “[a]mong the first framing moves in a crisis setting is an effort to define the
degree of disruption”. In case of the US financial crisis, Henry Paulson – who was convinced of the
severity of the crisis – became what Abolafia terms a reframer: “Reframers advocating changed practices
must be able to convince their constituency that the shock requires strong action” (Abolafia 2005, 212).
8 Following Dodd-Frank, the term financial institutions covers bank-holding companies (BHCs),
financial market utilities (FMUs) and nonbank financial companies (NBFCs). BHCs are, according to the
Bank Holding Company Act of 1956 (Public Law 85-511, 85th Congress, H.R. 6227), companies which
directly or indirectly own or hold a minimum of 25 percent of two or more banks, but do not necessarily
engage in banking themselves (see Sec. 2 of the Bank Holding Company Act for a more detailed
definition). JPMorgan Chase & Co (JPMorgan), The Goldman Sachs Group, Inc. (Goldman), and
Deutsche Bank AG (Deutsche Bank) fell under this definition as of November 2013 (Board of
Governors of the Federal Reserve System 2013c). Financial market utilities are defined as systems or
entities “for transferring, clearing, and settling payments, securities, and other financial transactions
among financial institutions or between financial institutions and the system” (Board of Governors of
the Federal Reserve System 2013b). Examples for FMUs are the Chicago Mercantile Exchange, Inc. or
the National Securities Clearing Corporation. NBFCs provide banking services, but do not hold banking
licenses; they are accordingly not allowed to take deposits. In 2013, two NBFCs were designated as
systemically important by the FSOC: The insurance company American International Group, Inc. (AIG)
and the financial services and leasing company General Electric Capital Corporation, Inc. (GECC).
1.1 Eliminating Hobson’s Choice, Or: A Binary Model of Systemic Risk 19

different (Reinhart and Rogoff 2009), that they had outsmarted the market, and that
they were able to control the system was certainly the most dangerous fallacy of the
pre-crisis years (Willke and Willke 2012). The US government finds itself in the
paradox situation that it must address the existing data, information and knowledge
gaps, while it will ultimately be unable to close them. The resulting uncertainty
might prove to be the biggest challenge to policymakers and regulators. It requires
regulators to not only enhance their data and information collection abilities, but
also to introduce “mechanisms for cognitive challenge” (Black 2012, 41) that
enhance their learning capacities.

1.1 Eliminating Hobson’s Choice, Or: A Binary Model of Systemic Risk

In 2008, the collapse of a number of systemically important financial institutions

(SIFIs) – first The Bear Stearns Companies, Inc., then Lehman Brothers Holdings
Inc. and then, among others, American International Group, Inc. (AIG), Federal
National Mortgage Association (FNMA, commonly known as Fannie Mae) and
Federal Home Loan Mortgage Corporation (FHLMC, known as Freddie Mac) –
each confronted the US government with the Hobson’s choice to either bail the
SIFI out or let it go into disorderly bankruptcy at the risk that its failure triggers a
systemic financial crisis (Tarullo 2010a; see also Wilmarth 2013, 1320; Goldstein
and Véron 2011). The reference to Hobson implies that what looked like a binary
choice at first sight turned out to be, at the latest after the Lehman bankruptcy, not
really any choice at all: The US and European governments felt that in order to save
the economy there was no alternative to rescuing their respective SIFIs, and so they
did: The US government not only supported its failing financial institutions directly
through bailouts, but also engaged in extensive deal-making to stabilize the system
through mergers and acquisitions (see Blankfein 2010; Davidoff and Zaring 2009).9
Against this background, we developed a simple binary model of systemic risk (see
figure 1) that illustrates the too big to fail (TBTF) phenomenon from a
governmental perspective. In theory, governments confronted with the failure of a
financial institution have the choice to either bail it out or not bail it out. When an
institution is bailed out (B), there are two basic options: The rescued institution was
a SIFI (B.2), or it was not a SIFI (B.1). The interesting point is that once the
institution is saved, we cannot find out what was the case. The failure of an

9 Systemically important financial institutions (SIFIs, or G-SIFIs for global SIFIs) are companies that are
believed to trigger financial crises when they collapse, either because of their size or their
interconnectedness or other factors that we will discuss in detail in chapter two. When SIFIs are
perceived by the market as being systemically important, they are labeled as being too big to fail (TBTF);
since 2010, Dodd-Frank requires the FSOC to officially designate the respective institutions as TBTF,
thereby explicitly attributing systemic importance to certain market participants.
20 1 Introduction

institution (A) again implies two possible futures: That the institution was a SIFI
and its collapse triggers a systemic crisis (A.2); or that it was not a SIFI and its
collapse does not trigger a systemic crisis (A.1).

(A.1)¬ systemically important

(A) ¬ bailout

(A.2) systemically important

Collapse of a
financial institution
(B.1) ¬ systemically important

(B) bailout

(B.2) systemically important

Figure 1: Binary model of systemic risk.

As the colored arrows indicate, each option comes at a different price: A.1 neither
imposes costs on taxpayers (meaning financial costs), nor on governments (political
costs), nor on other financial institutions and shareholders (financial costs). A.2
represents the Lehman case: For reasons to be discussed in greater detail in chapter
three, the US government decided not to rescue the investment bank – a decision
that was costly as it not only required governments to rescue the global financial
system, but also resulted in a steep recession in the US and Europe. The political
costs of the crisis, as well as their long-term impact on democratic governance,
remain to be seen. A.2 puts the costs of a bailout (B) into perspective: They are
high, but significantly lower than the costs of a full-fledged financial crisis.
Interestingly, the costs for taxpayers and governments remain the same in both
bailout cases, independent of the systemic relevance of the institution at hand. As
we saw during the financial crisis of 2007ff., other financial institutions usually gain
from a bailout.10 The financial crisis reminded policymakers and market participants
alike that the failure of a too big to fail institution is by far the worst option among
the given four. Therein, it reinforced the implicit government subsidy for SIFIs – a
phenomenon that will be discussed at-length in chapter three. Even though the

10 Other financial institutions gain from bailouts both directly and indirectly: When AIG was rescued by
the US government, Goldman Sachs alone received more than 14 billion dollar from the rescue fund,
based on outstanding contracts with the insurance company (Financial Crisis Inquiry Commission 2011,
377). As other financial institutions and the overall economy, it also benefited from an increased financial
stability. Several institutions did also profit from government-backed mergers.
1.1 Eliminating Hobson’s Choice, Or: A Binary Model of Systemic Risk 21

commitments made by the US government during the crisis were much higher than
the actual payments, the fiscal costs of the crisis were immense.11 The price for the
Lehman Brothers collapse – including not only the bankruptcy fees that will exceed
two billion US dollars (O’Toole 2013), but also the costs of the events directly
triggered by the bank’s failure – remains an issue of debate.
Looking at the key events throughout 2008, the pivotal question is whether the
US government, when Bear Stearns and Lehman, AIG, Fannie Mae and Freddie
Mac were effectively insolvent, really had the choice to intervene or not to intervene
(Luhmann 2008, 173). The crisis showed that, confronted with a failing SIFI,
governments are literally being taken hostage by their financial institutions. Have
the US government and the Fed become prisoners of the markets (Yellen 2013b)?
While the receiving side – the SIFI – is characterized by its global structure and
reach, the giving side – the government and its central bank – is characterized by its
national structure and reach, constraining the policy options of the nation states:
Due to the size, interconnectedness and complexity of the institutions at stake, their
scope of action is obviously limited. Some of the problems experienced throughout
2008 were of a structural nature: How could a national agency like the FDIC wind
down a global institution like Lehman Brothers without a viable cross-border
resolution authority or the respective agreements with other nation states? Other
factors followed a political logic, and they are often overseen. Two central and
exemplary questions for the team around Treasury secretary Paulson were how the
public and the media would react to bank bailouts by a republican government and
whether the government had the support of Congress for its rescue program
TARP.12
The question whether governments have become prisoners of their markets
persisted well throughout the reform period after 2008: Policymakers in the EU and
the US expressed their concerns that tougher financial regulation could hamper the
economic recovery. Interestingly, these concerns are all but new: A century ago,
Wilson described how the US government had become the foster-child of special
interests, as it was warned “at every move: ‘don’t do that; you will interfere with our

11 The costs of the financial crisis in the US are not (yet) agreed upon. A recent Federal Reserve Bank of
Dallas research paper asked how much worse society is off compared to an estimation of the normal
developments absent a crisis. It estimated an output loss of six to 14 trillion US dollar (Luttrell, Atkinson
and Rosenblum 2013). The direct costs of the bailouts are yet another issue. As long as the money lent is
not fully returned, and the US government owns bonds of the companies it rescued – the FDIC sold its
last Citigroup bonds in September 2013, at a total profit of more than 13 billion US dollar (Henry 2013)
– the total bailout costs will remain in the dark.
12 In his interview with the FCIC, former Treasury employee Neel Kashkari describes how the team
around Henry Paulson held back its so called break the glass plan, the emergency action plan that would
later become TARP, until it could be very certain that Congress would accept it. According to Kashkari,
Treasury feared that if it would not pass, the plan itself might, in a self-fulfilling matter, reinforce the
crisis it was designed to mitigate (Kashkari 2010).
22 1 Introduction

prosperity’” (Wilson 1913). It appears that systemically important financial

institutions have authority over nation states in two ways: Firstly, they pose a
systemic threat to the financial system when failing. Secondly, the financial sectors
of many western economies have become too important in terms of GDP and
growth to get into their way with extensive regulation.13 Lindblom has illustrated
this point more generally when describing the dilemma nation states are facing:
“Either the demands are met, or the corporation goes elsewhere” (Lindblom 1977,
180).
This book begins with a decision – the remarkable decision of the US Congress
to establish an Office of Financial Research in order to address the data and
information gaps experienced during the crisis. Starting from there, we describe and
define data-, information-, and knowledge-related problems in US financial
regulation. We show that the US government addresses these types of issues to
different degrees, but largely underestimates the risks resulting from unknown
unknowns. The term waterbed effect describes the phenomenon that when
regulators cap prices, charges or payments in certain areas or market segments, an
overall re-balancing of prices, charges or payments occurs in the market and
ultimately leads to a price, charge or payment increase in another area or segment.
Remuneration practices provide a good example here: A cap on fixed income leads
to an increase in bank bonuses, and bank bonus caps induce increases in fixed
income. A similar waterbed effect can be observed in financial regulation: When
policymakers and regulators focus on one problem – e.g. to conduct micro-
prudential oversight (pre-crisis), or to close data gaps (post-crisis) – they lose sight
of other problems – in this case, to tackle macroprudential problems, or problems
of knowledge that are difficult to overcome.
Going back to the model, the situation of the US government has changed since
the crisis, at least on paper. Our simple binary model of systemic risk illustrates the
policy options of the US government back in 2008, but it does not account for the
changes induced by the Dodd-Frank Act in 2010. Once fully implemented, Dodd-
Frank has the potential to alter the situation and the model accordingly. As we will
discuss in greater detail in chapter four, the DFA limits the Fed’s ability to act as a
lender of last resort and provide direct support to single financial institutions. As a
complementary measure, Dodd-Frank strengthens the FDIC’s ability to resolve
global, complex financial institutions. A future decision not to bail out a SIFI

13 The ratio of total financial sector assets to GDP has grown massively. In the UK, the ratio of deposit
money banks’ assets to GDP in percent has increased from 110 percent in 1991 to 192 percent in 2011,
in Spain from 102 percent in 1991 to 232 percent in 2011. The increase was much more moderate in
others countries, e.g. in Switzerland (163 to 181) and the US (61 to 62). However, we have to take a
closer look at the growth of assets in other parts of the financial sector, e.g. at nonbank financial sector
assets. Here, the ratio of assets to GDP has grown from 89 percent in 1991 to 297 in 2011 in the US (all
data rounded and taken from the Worldbank’s World Data Bank as of February 17, 2014, available on
http://databank.worldbank.org/data/).
1.1 Eliminating Hobson’s Choice, Or: A Binary Model of Systemic Risk 23

should, under the Orderly Liquidation Authority (OLA) of the FDIC, not result in a
disorderly bankruptcy that triggers a financial crisis. While the OLA should improve
the crisis management of the US government, other provisions tend to prevent
SIFIs from collapsing in the first place: The Financial Stability Oversight Council
(FSOC) designates systemically important institutions, leading to increased
supervision by the Federal Reserve Bank. Higher prudential requirements and
central clearing, stress tests and living wills should reduce the possibility of failure,
too. The OFR, with a staff of 200 to 300, aims at collecting and aggregating data
and gathers financial market information; besides, it ought to build up own financial
expertise. As a result, government officials should – to use an expression coined by
Mendelowitz and Liechty – never again be flying blind throughout a crisis
(Mendelowitz and Liechty 2010, 3). Two aspects are important in this respect. First,
the fact that the financial crisis was perceived as a crisis of financial market data and
information in the US (Flood et al. 2010), much more than this was the case in the
European Union. Second, and closely related, the EU financial crisis soon evolved
into a full-fledged crisis of sovereign debt, redirecting the focus of reform to the
nation states and their respective crises, as well as at the regulatory and supervisory
architecture of the European Union. We will look at both reform agendas more
closely in chapter four, and see how they differ and overlap.
Looking at the financial crisis as a crisis of data, information and knowledge
redirects the analytical focus from mortgage lending and leverage, from macro-
economic imbalances and flawed incentive schemes, to the complexity of financial
products, financial institutions and the system as such. It enables us to ask whether
regulators actually understood the system they supervised and policed and if the set
of struggling SIFIs had in fact become not only too big to fail, but also too complex
to manage. To what degree did data, information and knowledge asymmetries
between regulators on the one hand and regulatees on the other play a role in the
recent financial crisis?14 Were regulators constrained by their bounded rationality
(Simon 1955), or were they, as one of our interview partners put it, “just chicken”
and dared not to have a closer look at certain business practices? Whenever
policymakers increased the transparency of a business or market, certain operations
and trades apparently moved into some other, darker corner of the market, while at
the same time, regulators failed to address the resulting unknowns.15 While some
argue that US regulators only need better data and information to regain control
over the financial sector – a position that we term the sufficiency argument

14 The term regulatee refers to the supervised or regulated entity – meaning the financial institution
affected by a rule or regulation.
15 In his interview with the FCIC, Gary Cohn from Goldman Sachs describes the mechanism by which
dark markets evolve wherever transparency is increased. He adds that while transparent markets are
officially regulated by the government, nontransparent markets such as the OTC market are regulated by
the markets themselves (Cohn 2010).
24 1 Introduction

throughout this book – others warn that building up the respective expertise is even
more demanding, if not impossible. Yet, our analysis in chapter two of the systems
characteristics of the 21st century financial system indicates that ultimately, systemic
crises are natural accidents (Perrow 1981) and can accordingly not be prevented.

1.2 The Argument in Brief

Former US Secretary of Defense Donald Rumsfeld is well known for his unique
speaking style. Referring to the potential existence of weapons of mass destruction
in Iraq in 2002, Rumsfeld famously said:

Reports that say that something hasn’t happened are always interesting to
me, because as we know, there are known knowns; there are things we know
we know. We also know there are known unknowns; that is to say we know
there are some things we do not know. But there are also unknown
unknowns – the ones we don’t know we don’t know. And if one looks
throughout the history of our country and other free countries, it is the latter
category that tend to be the difficult ones. (Rumsfeld 2002)

There obviously is a certain humor and, as we now know, irony to this quote.
However, the basic distinction that Rumsfeld draws between the differing
phenomena of known knowns, known unknowns and unknown unknowns is
correct and very well applicable to the situation faced by financial regulators: The
things these regulators did not know – including the degree of interconnectedness
and complexity of the financial system, as well as the risks posed by 21st century
systemic risk – did in fact turn out to be the difficult ones. Rumsfeld’s statement is
the first of several quotes that we want to cite to explain our argument in brief. The
second quote goes back to Brooksley Born, who was the head of the US
Commodity Futures Trading Commission (CFTC) between 1996 and 1999. In
1998, Born attempted to examine and eventually regulate derivatives in the over-
the-counter-market (OTC) market – a group of financial products that would later
be called “financial weapons of mass destruction” by Buffett (2002, 6; see also
Buffett 2010, for the extended argument) and that certainly was a centerpiece of the
financial crisis. Born later explained that:

I had had enormous concerns about the over-the-counter derivatives

market, including credit default swaps, for a number of years. The market
was totally opaque; we now call it the dark market. So nobody really knew
what was going on in the market. (Born 2009)
1.2 The Argument in Brief 25

Her efforts to examine what has been well termed the other and the strange land
(Tett 2010) were strongly opposed not only by the financial industry, but also by
other federal financial regulators and by Congress. In 2000, Congress passed the
Commodity Futures Modernization Act (CFMA) to once and for all restrain the
CFTC from regulating OTC derivatives. As a result, regulators’ non-knowledge of
what is now called the shadow banking system persisted and grew further. Born is a
central figure in the narrative of the financial crisis: She saw the risks arising from
unknown unknowns; in addition, she was one of the few regulators who actually
identified them and, by addressing them, turned them into known unknowns. The
case of Brooksley Born also shows that in the decades leading up to the financial
crisis, regulators such as the CFTC did not have access to the relevant data and
information to examine what was going on in certain fast evolving, highly
innovative sectors of the financial market. Looking back, the former chief executive
and chairman of Citigroup Sandy Weill asks whether regulators could have done
better – admitting that he thinks “the answer is yes. But I think they were terribly
handicapped by a lack of information. And by the direction that people wanted to
go at that point in time” (Weill 2010).
Unfortunately, the problem was not limited to financial data and information, it
also related to regulators’ general knowledge and ability to understand the market.
Former Fed president Alan Greenspan, who had always been an advocate of
unregulated derivatives markets, provides us with a third central statement. After
the risks had materialized, he admitted:

I’ve got some fairly heavy background in mathematics […]. But some of the
complexities of some of the instruments that were going into CDOs
bewilders me. […] And I figured out that if I didn’t understand it and I had
access to a couple hundred PhDs, how the rest of the world is going to
understand it sort of bewildered me. (Greenspan as quoted in Sorkin 2010,
90)

As these quotes show, the US financial crisis has not only been a crisis of bank
liquidity and capital, of derivatives and mark-to-market accounting, of evaporating
trust and herd behavior, but it has also been a crisis of financial market data,
information and knowledge.16 The crisis revealed that basic data and information,
e.g. concerning the counterparties or subsidiaries of a financial institution, were
either not available or not accessible for financial regulators. Besides, both
regulators and policymakers do apparently “face a structural, widening epistemic
gap between what they are able to know and what they need to know” (Weber

16 Unfortunately, neither experts nor policymakers do usually differentiate between problems related to
inadequate data, information and knowledge. As we argue and explain over the course of this book,
distinguishing between these three phenomena is not only important, but also a prerequisite to
addressing them.
26 1 Introduction

2012, 644f.). As Arthur Levitt, former chairman of the SEC, describes in his FCIC
interview:

There is regulatory capture without any question. [...] I think the 4000 people
that worked for me were really patriots. These guys were all overworked and
underpaid and terribly, terribly loyal. Yet, they lacked the skills to compete
with the array of power represented by the business community, and their
lobbyists and their lawyers and their staffs. That really reached a crescendo
after the development of electronic markets that my Commission was
responsible for [...]. Getting there and trying to arbitrate the battles between
the various exchanges, and dealing with technologies, that in particular
created the greatest void in terms of our ability to regulate an industry which
was light years ahead of us in terms of technology. And I think that really
went on in an accelerated pace after I left. (Levitt 2010)

The complexity of the financial market on the one hand and the limited processing
capabilities of policymakers and regulators on the other result not only in a growing
knowledge asymmetry between regulators and regulatees, but also in an increased
importance of private expertise in financial regulation. Private sector lobby groups,
“men who know so much about the matters they are talking of that you cannot put
your knowledge into competition with theirs” (Wilson 1913, ch. VII) convince and
overwhelm policymakers and regulators with technical details. While this
development has been observed for decades and in different policy fields, the
particular characteristic of the financial sector is a lack of private, non-profit
expertise. The problem loomed large during the financial crisis and became explicit
when Members of the European Parliament published their Call for a Finance
Watch:

the asymmetry between the power of this lobbying activity and the lack of
counter-expertise poses a danger to democracy […]. As European elected
officials in charge of financial and banking regulations, we therefore call on
civil society […] to organize to create one (or more) non-governmental
organization(s) capable of developing a counter-expertise on activities
carried out on financial markets by the major operators […] and to convey
effectively this analysis to the media. As elected officials from different
political families we may differ on the measures to be taken. But we are all
together in wanting to create greater awareness in the public opinion on this
risk for the quality of democracy. (Finance Watch 2010, emphasis added)

To address data, information and knowledge asymmetries between financial

regulators and regulatees, the US government established the Office of Financial
Research. While the post-crisis reform efforts in the US and the EU do partly
overlap, the OFR presents a unique policy response to the crisis, based on the
1.3 Literature Overview and Current State of Research 27

assumption that the crisis demonstrated “the inadequacies of the information

infrastructure supporting the US financial system” (Flood et al. 2010, 1).
The financial crisis did not only lead to the creation of new regulatory bodies, it
also triggered a lively debate in the US concerning the degree of capture of
policymakers and regulators by the financial industry. As we argue towards the end
of this book, a closer look on data, information and knowledge asymmetries in
financial regulation sheds new light on the phenomenon: Research that is discussed
in chapters five and six indicates that neo-liberal policies and (de)regulations were
not so much pursued to deliberately serve industry interests, but rather because
policymakers and regulators, defeated by financial market complexity, faced severe
difficulties in formulating and advocating the public interest when it came to
financial governance. The financial crisis of 2007ff. invites us to rethink the agency
relationship between policymakers and regulators on the one hand, and regulatees
on the other. Drawing on Capture Theory as proposed by George Stigler (Stigler
1971) and his fellow Chicago economists, as well as on recent capture research that
was triggered by the US financial crisis (Kwak 2013; Weber 2012; Barkow 2013),
and based on numerous interviews with industry and policymaking experts, we
offer the knowledge capture concept as a new theoretical framework for financial
regulation under conditions of 21st century complexity.

1.3 Literature Overview and Current State of Research

Providing an up-to-date overview of research related to this book is a challenging

task for two reasons: First, while central issues – especially TBTF, systemic risk and
macroprudential oversight – have been a subject of debate for several decades now,
the financial crisis has led to a renewed and continuing academic interest in these
topics. The number of potentially relevant publications is accordingly vast, and what
is worse, it is constantly growing. Second, the situation is changing constantly. The
moment we finished our analysis, new publications and reports came out and
provided potentially important information. Especially the new US institutions
remain work in progress, while Dodd-Frank implementation is far from being
completed. Third, we build our argument on contributions from the disciplines of
economics, political science, law and sociology. We are well aware that, as in every
interdisciplinary research project, we risk falling short on each of them. Yet, to
develop an adequate theoretical framework for the study of data-, information- and
knowledge-related problems in financial regulation, we had to draw on contri-
butions from different disciplines. Unfortunately, the general problem with
overviews is that they tend to be more important the more difficult they are to
provide. This section therefore presents a short introduction into the current state
of research related to this book. Because of space constraints, we only briefly
28 1 Introduction

discuss the most important contributions and recommend the respective chapters
for further information.
In hindsight, factors contributing to the crisis can be distinguished into
regulatory causes, such as the housing policy of the US government, and private
sector dynamics, such as the growing demand for OTC derivatives. Unfortunately,
only few academics look at a third category of contributing factors, the specific
system characteristics that differentiate the systemic crisis of 2007ff. from other
financial crises (see Willke, Becker, and Rostásy 2013, and ch. two of this book). In
this context, network analysis (see for example Vitali, Glattfelder, and Battiston
2011) and agent-based modeling (see for example Thurner 2011) are promising and
growing fields of research.17 Systemic risk research was, at least until the recent
financial crisis, mostly confined to the finance and economics disciplines (see for
example Davis 1995; De Bandt and Hartmann 2000; Kaufman 1996; Bisias et al.
2012, provide an overview of current research on systemic risk measures). The
deregulation paradigm of the 1980s and 1990s, which was based on a strong belief
in free markets and self-regulation, has prevented governance scholars and
policymakers alike from examining systemic risk. The situation has changed
fundamentally since 2008: Contributions by law scholars have enhanced our
understanding of systemic risk and the financial crisis (see for example Levitin 2011;
Anabtawi and Schwarcz 2011; Schwarcz 2008; Wilmarth 2002). We can also find a
growing number of interesting publications in political science and sociology (see
for example McCarty, Poole, and Rosenthal 2013; Mosley and Singer 2009, for an
overview over current research questions in the field of International Political
Economy; Lounsbury and Hirsch 2010).18 In chapter two, to provide a systems
theory perspective on systemic risk, we mainly draw on publications by Helbing
(2010), Palmer and Maher (2010) and Willke et al. (2013). Important and closely
related is the issue of financial system complexity. In chapter three, we differentiate
between three levels of complexity: The complexity of financial products (micro-
level complexity), the complexity of too big to fail, or too complex to manage
financial institutions (meso-level complexity), and the systems level (macro-level
complexity) (Haldane and Madouros 2012; Stiglitz 2009b; Gai, Haldane, and
Kapadia 2011; Haldane 2010; Hu 2012; Weber 2012; Gai 2013; Gai and Kapadia
2010). As we show, recent research indicates that complexity has increased on all
three levels. Both the US and the EU financial reforms discussed in chapter four are
not yet fully implemented. To assess these moving targets, we go back to the initial

17 Taleb doubts that agent-based models “work outside of research papers” (Taleb 2012b, 2).
18 We do not want to imply that the sociology discipline has not contributed to financial market
literature in the past – the opposite is the case. Examining the social embeddedness of financial markets,
sociologists have elaborated the role and behavior of the individuals that make markets (see for example
Abolafia 1996; Knorr-Cetina and Preda 2005, therein especially MacKenzie 2005 and Fenton-O’Creevy
et al. 2005).
1.3 Literature Overview and Current State of Research 29

government documents (including laws, reports, press releases, and speeches) and
the accompanying media coverage. We make a few exceptions, however: Sorkin,
based on interviews with government and market insiders, provides a detailed
account of the crisis events and the respective governmental decisions (Sorkin
2010).19 Davidoff and Zaring provide a detailed legal analysis of the government
bailouts in 2008 (Davidoff and Zaring 2009). Wallach discusses the US policy
responses against the background of the rule of law (Wallach 2010). And Acharya et
al., in their book on Dodd-Frank, provide one of the early analyses of the regulatory
overhaul in the US (Acharya, Cooley, et al. 2010b; see also Acharya et al. 2011). The
situation in the EU is somehow different: While Dodd-Frank has been signed into
law in 2010 and is gradually being implemented ever since, the European crisis has
triggered an ongoing debate about the EU regulatory and supervisory structure and
a future European Banking Union, a fact that is reflected in the numerous scientific
contributions on the EU developments (see for example Pisani-Ferry and Sapir
2010; Fonteyne et al. 2010; Schoenmaker 2011; Ferran 2011; Ferran and Kern
2011). At the global level, the transformation of the Financial Stability Forum (FSF)
to the Financial Stability Board (FSB) was also closely monitored by the academic
community (Helleiner 2010a, 2010b; Griffith-Jones, Helleiner, and Woods 2010,
especially: Momani 2010).
Turning towards the focus of this book, the role of data-, information- and
knowledge-related problems in financial regulation has not received much scholarly
attention so far. To begin with, “the literature often draws little distinction between
information and knowledge. Expertise is treated as the obtainment of missing data”
(McCarty 2013, 102). While financial policymakers and regulators describe
insufficient data and missing expertise, they too do not often differentiate between
problems related to data, as opposed to information, as opposed to knowledge. The
distinction we draw in chapter five is mainly based on classic contributions by
Zeleny (1987), Ackoff (1989) and Davenport and Prusak (1998), and aims to add
definitional clarity to this rather vague set of problems.
To distinguish between the types of information asymmetries according to the
actors involved, we employ and refine a four-category framework brought forward
by Willke and Becker (2013). Interestingly, information and knowledge are corner
stones of financial theory (Preda 2001, 16) – the respective literature on information
and knowledge related problems is in fact vast (see Svetlova and van Elst 2012, for
a current overview) – but financial theory focuses on asymmetries between market
participants, and mostly leaves out regulator-regulatee relationships. As Preda
complains, “information is mostly blackboxed, or seen as being mirrored by

19 The Financial Crisis Inquiry Commission referred to Sorkin’s Too Big to Fail (2010) as well as to
Lewis’ The Big Short (2011) in numerous of its interviews (see for example Blankfein 2010; Das 2010).
These contributions are not scientific analyses of the crisis, but they include many relevant insights and
basic facts and accordingly provide a good starting point to assess the crisis.
30 1 Introduction

securities’ prices. A key task would be to open up this concept and push it to its
ultimate consequences” (Preda 2001, 16). We draw on agency theory to grasp the
relationship between regulators and regulatees, and the changes induced by
increased information asymmetries (Mitnick 1984 and 1992; Moe 1984; Eisenhardt
1989; Shapiro 2005).
When we speak of knowledge, we refer to individual as well as organizational
knowledge (see Castro et al. 2007, 48ff., for an overview of literature on both
types). In our definition of knowledge we follow German sociologist Nico Stehr
who understands knowledge as the capacity to act, or to start something going
(Stehr 2007, 143; Ackoff 1989). Distinct from data and information, knowledge is
closely tied to experience and practice (Becker and Willke 2013), and it is rooted in
and confirmed by communities of practice (Willke 2002). It can be embodied in
organizational rules and structures, but it requires human judgments and
experiences to create knowledge. Boisot and Canals conclude that “there is no such
thing as common knowledge and there is common information only to a limited
extent. Only data can ever be completely common between agents” (Boisot and
Canals 2004, 63).
In chapter six, we further develop our understanding of the role of information
and knowledge asymmetries in financial regulation, based on Wagner’s
Administrative Law, Filter Failure, and Information Capture (Wagner 2010).
Wagner draws on a number of studies dealing with information-related problems in
environmental regulation to ultimately rework Stigler’s Capture Theory (Stigler
1971). Even more central to this book is Weber’s text on Structural Regulation as
Antidote to Complexity Capture (Weber 2012). Looking at what regulators know
and what they need to know to fulfill their mandates, Weber identifies “a structural,
widening epistemic gap” that he traces back to increased financial system
complexity (ibid., 644f.). Starting from there, he develops a new perspective of
capture. Together with recent contributions from Etzioni (2009), Kwak (2013),
McCarty (2013) and Barkow (2013), these two publications form a new and growing
strand of capture research that takes into account current developments in political
governance and regulation, particularly with regard to financial governance. To
these concepts of cultural and cognitive, of information and complexity capture,
this book adds a first investigation into knowledge capture in 21st century financial
regulation. It aims to explain why industry interests could become increasingly
dominant in financial regulation and how they contributed to the financial crisis.

1.4 Research Approach

In his Nobel lecture of 1974, Friedrich von Hayek warns that unlike “in the physical
sciences, in economics and other disciplines that deal with essentially complex
1.4 Research Approach 31

phenomena, the aspects of the events to be accounted for about which we can get
quantitative data are necessarily limited and may not include the important ones”
(Hayek 1974). Studies examining the causes of the financial crisis are multifaceted
and numerous. The fact that the crisis is primarily approached in numeric terms –
from the size of the rescue programs, to the increase of unemployment rates, bank
leverage ratios, and sovereign debt in relation to GDP – conveys the impression
that comprehensive studies must put quantitative research center-stage. How else
could we deal with numbers, except with numbers? And how else could regulators
counter the industry’s arguments, except with data? The mandate of the Office of
Financial Research, with its focus on data and information, clearly underlines this
point. Yet, the financial crisis of 2007ff. was also perceived as a crisis of financial
data: It decreased the credibility of the sophisticated calculations and models that
had supposedly increased the safety of the system. The complex interplay of
derivatives contracts, mark-to-market accounting, collateral agreements and
counterparty behavior was apparently too complex to be modeled adequately
(Buffett 2010). Interesting in this regard is also MacKenzie’s case study of the
LTCM collapse. Based on interviews with key participants, he describes how the
hedge fund’s sophisticated arbitrage activities were based as much in quantitative as
in cultural knowledge, in an “understanding of matters like who held which bonds
and why” (MacKenzie 2005, 77; see also Fenton-O’Creevy et al. 2005; Abolafia
1996). We therefore argue that, while quantitative analyses of the crisis are as
important as they are legitimate, they alone are not sufficient. As the explanatory
power of quantitative research is clearly limited, what is needed – not as an
alternative, but as a complement – is an interdisciplinary and qualitative discussion
of the causes and effects of the crisis. Von Hayek’s argument, made long before the
current crisis, encouraged us to approach the crisis in qualitative terms.
As the following figure illustrates, our approach combines a comprehensive
literature review with a content-based, structured analysis of interviews, speeches,
congressional testimonies, press releases and presentations. In addition, we base our
analysis on laws and regulations, as well as on accompanying media coverage (figure
2).20

20 Much of our resources – especially the interviews, but also some testimonies, media articles and
speeches – were not numbered. Several direct quotes do therefore not include a page number.
32 1 Introduction

literature review

interviews conducted by others interview

analysis, based
own interviews
on seven lead-
press releases, presentations, speeches, testimonies questions

laws and regulations

media articles

Figure 2: Research approach.

The existing interview material on the financial crisis is immense. We base our
analysis on three types of interviews, adding up to more than 60 partly-transcribed
interviews in total: The interviews conducted by the US Financial Crisis Inquiry
Commission (FCIC), interviews undertaken by journalists, and last but not least our
own interviews.21 The FCIC alone has recorded more than 300 interviews with
financial market experts that are now accessible via the FCIC’s website.22 Most
FCIC interviews follow a similar logic, starting with a brief introduction of the
commission’s mandate, followed by an introduction by the interview partner, and
then getting to the core question of what caused the financial crisis in the US and
how the mortgage business and complex derivatives contributed to the crisis. In
comparison, interviews conducted by journalists cover a much broader set of issues.
This second set of interviews, available on the YouTube channels and web archives
of broadcasting stations and government institutions, is, contrary to the FCIC
interviews and our own interviews, non-standardized; yet it contains important
information. The third group consists of a smaller number of interviews conducted
by the author herself. In order to complement the publicly available material, these
interviews explicitly examine data-, information- and knowledge-related problems in
financial regulation. They are based upon a standardized field manual, and were
fully recorded and transliterated whenever our interview partners agreed. To further
increase our data-base, we included press releases, speeches, testimonies and

21 We conducted ten interviews between November 2012 and August 2013; unfortunately, we did not
get the permission to record all of them, resulting in seven transcripts in total.
22 To sample the FCIC interviews, we took every third out of the 356 published interview files on the
FCIC website. In addition, we selected the interviews that we expected to be relevant for our research,
adding up to 163 FCIC interviews in total. Following our research questions, we partly transliterated 46
of these 163 recordings. They can be found in the appendix to this book.
1.4 Research Approach 33

presentations by central actors – policymakers, regulators and market insiders – into

our research.23
The content-based interview analysis was structured by seven guiding research
questions, not to be mistaken for hypotheses:

(1) Is systemic risk a rather economic or political phenomenon?

(2) Is financial governance exacerbated by an incongruence between nation
states and global finance?
(3) Did data, information and knowledge asymmetries between regulators and
regulatees contribute to the financial crisis?
(4) Do the US policy responses to the crisis represent a real policy change?
(5) Has the too big to fail phenomenon been resolved?
(6) Did the crisis happen due to regulatory capture?
(7) Has the financial system become too complex to regulate?

The research questions were not treated as hypotheses for good reasons. Based on a
critical rationalist viewpoint, we do not believe that we are able to verify these
phenomena (Popper 1994). At the same time, we agree with Hayek that, when
investigating complex phenomena, Popper’s approach has its limitations (Hayek
2007 [1967]). Going through the interviews and documents, we tried to find
counterevidence as well as evidence, both contributing to the theoretical framework
developed over the course of this book. During our research, we kept in mind that
interview partners who did not mention data-, information-, or knowledge-related
problems, might be counted as counterevidence, too. When confronted with an
open question about the causes for the crisis, only very few experts did in fact name
inadequate data and expertise. Therefore, despite the large number of interviews
and other documents contributing to this book, our conclusion rests more on
theoretical plausibility and deduction than on empirical data.
In addition to the material that found its way into the content-based analysis, we
also base our understanding of the financial crisis of 2007ff. on a number of
governmental reports: There are the reports and studies published by EU (Gerlach
2009; European Systemic Risk Board 2012, 2013a; European Central Bank 2010;
High Level Group on Financial Supervision in the EU 2009), UK (Financial
Services Authority 2009) and US institutions (Financial Stability Oversight Council
2011a, 2012a; Office of Financial Research 2012a; Financial Crisis Inquiry

23 We decided not to include media articles in our content analysis, yet they provided important
information on government actions – such as the Flash Crash of 2010 and the SEC’s attempts to
investigate it – and therefore allowed us to construct several smaller case studies during the research
process (Walton 1992). These in turn helped us to develop and corroborate our understanding of the
phenomena at hand. Here, we mainly relied on articles from the New York Times, from the Washington
Post, The Economist, and the Financial Times.
Another random document with
no related content on Scribd:
again.’ She then drew back and veiled her face as her father
approached, followed by Embarek and the two prisoners.
Addressing the latter, Sheikh Shashon said, ‘At the intercession of
João, whom I take to-morrow to the Court to enter the service of our
Lord and Master, as gunsmith, your lives are spared and your fetters
shall be removed. You will be taken with João to the Sultan, and
upon His Majesty’s decision your fate will depend. I swear, however,
that if you attempt to escape, no mercy shall be shown you.’
‘Take them,’ he continued to the slave, ‘to your hut and lock them
in; but remove their fetters. Let them have food from my kitchen that
they may feel well and strong for the journey to-morrow. Put a couch
for João in the courtyard: he is my guest, free to come and go as he
pleases.’ Then turning towards Rahma, he said, smiling, ‘All this I do
to please you, my loved daughter.’
‘May God bless her!’ cried João and his companions.
Early on the following morning the Sheikh mounted a fine mule,
and the prisoners the animals prepared for them; whilst, destined as
a present to the Sultan, the famous gray mare, adorned with a
handsome headstall, was led by a slave.
Rahma appeared on the threshold, muffled in her ‘haik’; but
before João left she managed, when her father’s back was turned, to
unveil her face, and drawing from her bosom, where she had hidden
them, the silver chain and cross, pressed them to her lips: which
gesture João acknowledged by raising towards heaven the finger
upon which he wore her ring.
Sheikh Shashon despatched a courier to the Court to announce
their advent, and fearing lest some enemy in the village might
forestall him, he wrote to the Uzir that he was bringing the gunsmith
João and two other Nazarenes, prisoners, to deliver them to his Lord
and Master the Sultan, to be dealt with as His Majesty might please.
When within a few hours’ journey of the capital a Kaid of the
Sultan’s body-guard, sent expressly by His Majesty, arrived with an
order to the Sheikh to the effect that every care should be taken of
João, and to inform the latter that a house and forge, where he could
work, had already been prepared for him, and that the two other
prisoners were to be lodged for the present in the same dwelling.
The Kaid also informed the Sheikh that His Majesty commended his
conduct in having brought João safely to the Court, and that the
Sheikh was therefore regarded favourably by his Lord and Master.
On his arrival João was taken before the Sultan, who informed
him that he would be provided with ‘mona’ (provisions), and a
dwelling near the palace; that the implements of a smith and piles of
old horse-shoes were also ready, and that for every gun-barrel João
made, ten ducats would be paid him. The Sultan added, ‘If you will
become one of the Faithful, I have ordered that the garments of a
Moslem be given you.’
João thanked His Majesty and replied, ‘I accept with pleasure
your Majesty’s offer of Moorish garments to replace the tattered
clothing I now wear.’
Whilst thus accepting the Sultan’s offer, João vowed in his heart
that, though assuming the outward garb of a Mohammedan in the
hope of obtaining Rahma hereafter as his wife, he would remain
always a true Catholic, and hope for the day when he would return to
the land of his forefathers.
João was very industrious, and with the assistance only of the two
Portuguese, his fellow-prisoners—for he did not wish the Moors to
discover the secret of his art—he was enabled to manufacture a
number of barrels, even before the Sheikh left the Court.

The Sultan[44], who was interested in every kind of mechanism,

was wont to go to the forge to see João work; gave him the rank of
Kaid, and marked in many ways his satisfaction.
The Sheikh was presented with a horse, with handsome saddle
and bridle, as a mark of His Majesty’s favour, and before leaving the
Court went to see João, and told him of his own good fortune, and
expressed his satisfaction at seeing from his dress that João was
now a Moslem and an officer in high favour with the Sultan.
João shook the Sheikh warmly by the hand, bidding him farewell,
saying, ‘You know that I am indebted for my life to the intercession of
your daughter. I intend to marry and settle here. Will you grant me
the hand of your daughter?’
‘It cannot be,’ answered the Sheikh, ‘I have betrothed her to my
friend Sheikh Amar. The Sultan, now that you are in such high
favour, will bestow on you, if you petition His Majesty, some maiden
with a larger dowry than I can afford to give my daughter.’ He then
departed, leaving João very depressed.
A few days after the Sheikh had left, the Sultan visited the forge of
João and found the young smith hard at work, but looking very wan
and out of spirits. Observing this, the Sultan inquired of João
whether he was unwell, or had cause of complaint against any one
at the Court, and whether the food sent daily from the palace was
plentiful and such as he liked?
João replied that he had no complaint to make against any one,
but that he had a sorrow at heart which he could not make known to
the Sultan, lest it might cause His Majesty’s displeasure.
 ‘Speak,’ said the Sultan; ‘have no fear. Any one who may have
offended you shall be punished. Whatever you ask shall be granted:
what I promise shall be fulfilled. Speak out boldly.’
João obeyed and told the Sultan the story of his capture,
condemnation to death, and release at the intercession of the
Sheikh’s daughter.
When he had concluded his tale, His Majesty exclaimed, ‘Allah
Akbar!’ (God is great!) ‘Had the Sheikh taken your life he would have
forfeited his own. This daughter of his, the maiden who is the cause
of my having you safe here to manufacture guns for the Moslems,
shall be rewarded. What do you desire?’
Throwing himself at the Sultan’s feet João said, ‘She who saved
my life I had hoped might become my wife, but alas! I have learnt
she is betrothed to a friend of the Sheikh, an old chief of a
neighbouring village, named Sheikh Amar. This it is that makes me
miserable.’
‘Before ten days elapse,’ said the Sultan, ‘if this maiden be not
already married to Sheikh Amar, she shall be brought here by her
father and become your wife, and I will give her a dowry.’
The young smith again fell at the feet of the Sultan and expressed
his gratitude.
A Kaid was despatched with all speed to the Sheikh of Beni
M’suar, with the command that he and all his family should be
brought at once to the Court. This officer was directed however to
ascertain, before he executed this order, whether the daughter of the
Sheikh had been lately married; for in such case the Royal command
was not to be carried out.
 The officer departed on his mission and found that the wedding
had not taken place, as old Sheikh Amar had died suddenly shortly
after Sheikh Shashon had left for Fas. Father and daughter were
therefore brought to the Court, and on their arrival were given a
comfortable dwelling near the palace.
Rahma’s heart was filled with joy when she learnt that João was
in high favour with the Sultan, for she remembered his last words to
herself.
The smith hastened to salute the Sheikh. Rahma was not allowed
to enter the room, but she could see her lover through the chinks of
the door, and heard João, after saluting her father, say, ‘Is your
daughter, who saved my life, well? Is she unmarried? If so, I must
not conceal from you that I have petitioned the Sultan that she be
given me as wife. For this His Majesty has been pleased to order
you to come to the Court.’
The Sheikh, who had been in great trepidation, fearing that the
Sultan might have heard of the intention he at one time had of
putting João and the other Portuguese to death, and that His Majesty
had summoned him to the Court to punish him, was greatly relieved,
and replied,—
‘Oh my son! as your garb shows you are now one of the Faithful
and in favour with our Lord and Master, His Majesty’s commands,
whatever they may be, shall be joyfully obeyed.’
The Sultan ordered the Uzir to signify to the Sheikh his Royal
command that his daughter was forthwith to be wedded to João, and
that it was His Majesty’s intention to give her a handsome dowry.
A great feast was prepared by the officers of the Court, at which
the Sheikh attended, whilst Rahma was taken to the harem of the
Hajib (Chief Chamberlain), where the ladies had also prepared a
feast. Beautiful dresses and jewelry were sent by the Sultan to
Rahma, and a marriage contract was drawn up by public notaries,
signed by the Kadi, with a note of the dowry, one thousand ducats,
given her by the Sultan.
On the day of the wedding, the bride, ensconced in a wooden
cage, covered with silk and embroidery, was conveyed on the back
of a mule to João’s house, accompanied by musicians with pipes
and drums and a large troop of men firing guns. The cage was
removed from the back of the mule by four female slaves and
brought into the room, prepared with handsome carpets, where João
awaited her. The slaves assisted her to leave the cage and retired.
As soon as they were alone Rahma threw herself at the feet of
her husband, crying, ‘Oh beloved! God has answered our prayers.
He is merciful, and now I shall be, as long as I live, your faithful,
happy wife. But, João, I beg you to repeat that you believe in God
and the Day of Resurrection. I rejoice to see you in the garb of a
Moslem, and hope you are now really one of the Faithful.’
‘Rahma,’ he said, raising her in his arms, ‘to thee I owe my life; for
thee I shall be ready to lay it down; but I must not deceive thee! I am
not a Moslem, but a Christian, and, as such, I believe in God and the
last Day. I assumed this garb in order that I might be supposed to be
a Mohammedan, and thus be able to petition the Sultan that you
should be my wife.’
Rahma drew away from his arms, saying, ‘I cannot, I must not,
offend God by marrying a Christian.’
João replied, ‘Know you not that your prophet Mohammed
married a Christian woman? Oh loved wife! I shall be a faithful
husband, and when I tell you about my belief and religion, you will
learn that we have the same laws from God, except that we
Christians cannot marry more than one wife. Does such a law
displease you, my Rahma?’
‘Swear,’ she said, ‘that you will never divorce me, never marry
another woman.’
‘I swear,’ he replied, ‘that nought but death shall part us.’
Rahma then threw herself into João’s arms, exclaiming, ‘I am for
ever your loving wife, and shall honour and obey you!’
João and Rahma were very happy. Of an evening, when his work
was done, he taught her to read and write Portuguese, and found
her quick and intelligent in learning. He explained to her the precepts
of the Christian religion, and told her that he hoped the day might
come when he could find some excuse to leave the Moorish Court
and escape with her to Portugal.
When their first child, a girl, was born, Rahma expressed the wish
that her name should be ‘Miriam,’ or Mary, the name of the Mother of
the Saviour of all men, and that she should be brought up in the
Christian faith.
João was very industrious, and continued in high favour with the
Sultan, manufacturing many gun-barrels, upon which, besides his
own name in European characters, he engraved the Arabic word
‘Sidi’ (my Lord), to denote that they were made for the Sultan, and
such barrels are occasionally to be found at the present day.
The Moorish gunsmiths having lost, since João’s arrival at Court,
the Royal custom, took counsel together how they should contrive to
discover the Christian’s secret of forging the twisted barrels; for João
was careful to allow no Moor, except the Sultan, to enter his forge
when he was at work.
 The Portuguese was of very cleanly habits, and had his workshop
whitewashed every month, for which work Jews are usually
employed throughout Morocco. One of the smiths, disguised as a
Jew, offered himself to João to whitewash the forge. He was
engaged, and returned for the same purpose every month.
The sharp-eyed spy watched the operations, and finally learnt so
much of the process as to enable him to imitate it, and he succeeded
so well that he presented a twisted barrel to the Sultan, which His
Majesty considered to be as good as any of João’s make.
The latter was summoned to the Court and asked how it came to
pass that twisted barrels could be made by native gunsmiths. The
unfortunate João declared he had been betrayed by some spy
watching him when at work.
Other Moorish smiths also acquired the art, and, as good barrels
of twisted iron were sold at low prices in Fas, the Sultan discontinued
employing João, and ceased sending him ‘mona’ from the palace.
João, however, had laid by a considerable sum of money, and he
determined to quit the capital with his wife and try to escape to
Tangier. He therefore petitioned the Sultan to be allowed to take his
wife to visit her father, the Sheikh at Beni M’suar.
This was granted, and João bought animals to carry away such
property as he had not been able to dispose of at Fas, and set out
with Rahma and her child for the village of Tsemsalla in the Beni
M’suar mountains.
After remaining some time with his wife at the Sheikh’s house,
where they received a warm welcome, João informed his father-in-
law that he must return to his work. Leaving early one morning with
his wife and child, he proceeded to Tangier, a distance of about
fifteen miles. On arrival at the Portuguese outposts, he was
challenged by a sentry. The soldier proved to be an old comrade
who had heard that João had assumed the disguise of a Moslem,
and, recognising him, allowed him to enter the town, where he was
conducted before the Portuguese Governor, to relate his adventures
and present his wife and child.
The Governor took great interest in João, who had always borne
an excellent character. Rahma, by her husband’s desire, wore the
European dress, and as a Christian no longer veiled her face. The
Governor was much struck by her beauty and gentle manners, and
on learning from her, for she had acquired the Portuguese language,
that she was already converted to the Christian faith and desired to
be baptized by a priest, together with her little girl, he took her to his
wife and daughters, by whom Rahma was made much of. They were
lodged in the Governor’s house, and the baptism was carried out,
with great ceremony, at the Cathedral[45] of Tangier; the child was
christened Miriam.
After a sojourn of some weeks, João and his family were given a
passage in a Government vessel bound to Lisbon, with letters of
recommendation to the King and Queen, to whom their history was
related. The Royal family patronised João, and took especial interest
in pretty Rahma and her daughter as being converts from the
Mohammedan faith.
Being a clever mechanic, João obtained a lucrative employment,
and lived in ease and comfort with his wife, who bore him a large
family.
Rahma wrote to her father and described how happy she and her
husband were, and that they had escaped to the land of the
Nazarenes, as they had feared the jealous and revengeful feelings of
the smiths at the capital; for João, since the betrayal of his secret,
had no longer been shown favour by the Sultan. However, for fear of
causing sorrow to her father, she did not inform him of her
conversion to the Christian faith.
João sent the old Sheikh a beautiful gun, with his own name and
that of Sheikh Shashon engraved on the barrel in letters of gold.
 CHAPTER XIX.

FOURTH MISSION TO MARÁKESH. 1872.

In 1872 Sir John was made Minister Plenipotentiary. This mark of

confidence on the part of Her Majesty’s Government was the more
acceptable as he had recently been attacked in the English press.
The most important of these attacks appeared in the Spectator,
which however afterwards withdrew its charges unreservedly. Unjust
accusations of this nature affected him only for the moment, when
his quick and passionate spirit would fire up under
misrepresentation, for, as he writes: ‘I was lugged out of my little
corner and set on a pedestal to be pelted with dirt—now replaced by
bouquets. I am getting callous to abuse. “Fais ce que dois, advienne
que pourra.”’
In a letter dated September 27, 1872, to Sir Joseph Hooker, he
says:—

They have made me Minister Plenipotentiary, and I am to go to the Moorish

Court to present my new credentials during the winter. The Sultan is at Marákesh,
or will be there when he has ‘eaten up’ a rebel tribe or two. I do not remain
permanently; in fact, I should decline to do so, though I hope the day will come
when we shall have the British Representative resident at the fountain-head, and
thus alone can we hope that the turbid waters may begin to clear.

On March 25, 1873, Sir John, four ladies, and seven gentlemen
embarked on board H.M.S. Lively for Mazagan, en route for
Marákesh. Mazagan, which was reached the following forenoon, has
a picturesque appearance from the sea; but of itself is an
uninteresting town. The country surrounding it is flat and sandy, with
only a few palm-trees and the cupolas of scattered sanctuaries, or
saint-houses, to relieve the monotony of the scenery.
The entrance to the landing-place was by a passage through a
curious old Portuguese breakwater, repaired some years previously
by the Moorish Government at Sir John’s instigation. On landing
under the customary salute, Sir John was welcomed by the
Governor and authorities, who conducted him to the dwelling
prepared for the Mission,—a house standing on what had been,
during the occupation of Mazagan by the Portuguese in the
seventeenth century, the site of a church. Its steeple, now used as a
belvedere, is still standing.
The Sultan had sent a liberal supply of saddle and baggage
animals, and a few extra tents of handsome Moorish make, lined and
decorated within in different coloured cloths. With these were a body
of a dozen ‘fraijia,’ tent-pitchers, attached to his army. These men
proved most efficient and did their work smartly and thoroughly. They
were all, without exception, Bokhári.
The Mission left Mazagan early on the 28th. The escort consisted
of a Kaid Erha and seven officers, with some thirty troopers. ‘Kaid
Erha,’ it may be explained, means ‘the Commander of a Mill,’ as,
during campaigns in Morocco, a hand-mill for grinding corn is allotted
to every thousand men. Hence the title of Kaid Erha given to every
officer in command of a thousand. Kaid el Mia, or Kaid of a hundred,
is the next grade, corresponding to the centurion of the Romans.
Besides this escort, Sir John had with him his own faithful body-
guard of half a dozen men chosen from amongst the Suanni hunters,
men upon whom he could depend in any emergency.
There was no important departure on the journey to Marákesh
from the routine observed on entering the successive provinces. On
each occasion the ‘Bashador’ was received by the Governor or
Khalífa with an escort varying in number, according to the strength
and importance of the province, from about twenty-five to a hundred
men, who invariably indulged in a prolonged display of ‘lab el barod,’
with the inevitable concomitants of dust, noise, and delay. Each
evening too, on arrival in camp, supplies of food in the form of ‘mona’
were brought and presented with the usual formalities. The Sheikh
offered the ‘mona’ in the name of the Sultan, and Sir John always
made a little speech of thanks to the donors.
The route followed for the next two days lay in a south-west
direction, over an undulating country cultivated with wheat, barley,
beans, and maize; and men were ploughing with oxen, or sometimes
even with a camel and donkey yoked together. A little girl followed
each plough dropping ‘dra,’ or millet-seed, into the furrows. Maize is
one of the chiefs exports, since the prohibition of its exportation was
removed at the instance of Sir John in 1871. The soil was a rich,
dark, sandy loam, thickly studded with limestones: these had, in
some parts, been removed and piled up, forming rubble walls round
the crops. Fig-trees and a few palms, scattered here and there,
scarcely relieved the flatness of the landscape.
On entering the hilly country of Erhamna on April 2, two horsemen
of Dukála, with a couple of falcons, joined the cavalcade. They told
Sir John that they had received orders from the Sultan to show him
some sport; but they expressed their fear that the birds would not
strike the game, as it was the moulting season and they were not in
good feather.
A line of horsemen was formed, and, after riding half an hour, a
‘kairwan’ or stone plover was started. The falcon was thrown up, and
soon stooped but missed her quarry. The plover seemed so
paralysed by the attack that it settled in the grass, and was only
compelled with difficulty by the horsemen to rise. In the second flight
the falcon struck the plover, whose throat was cut, and the hawk was
given a few drops of blood. Another trial was made, but the hawks
seemed dull, and only came back and lighted near their masters.
The falconers therefore were dismissed with a gift and many thanks.
Thus the hopes we had entertained of finding a great bustard and
pursuing it with the falcons was not realised, as none were met with.
But, on the return of the sportsmen to the regular track, Miss A. Hay,
who had remained near Lady Hay’s litter, informed them that she
had seen several of these gigantic birds, which had crossed their
path.
Hunting with falcons is in Morocco a Royal sport, and no subject
of the Sultan, unless he be a member of the Royal family, can hunt
with them, without being especially granted the privilege. A few years
before this, the Sultan sent Sir John a gift of two falcons—and with
them a falconer, capable of catching and training others, to instruct
him in the sport. The novelty proved interesting for a time; but in
comparison with pig-sticking, coursing and shooting, it was found
wanting, and the falcons soon ceased to be more than mere pets at
the Legation.
Sir John, who was a great admirer of these birds, used to relate
the following legend and its curious verification in his own personal
experience.

There is a legend that no one of the name of Hay should kill or

injure a falcon. The tradition is founded on the following tale.
At the battle of Loncarty in 980 the Danish army was certainly
routed by the Scots. Yet, at the commencement of this battle, the
Danes had been victorious and drove the Scots before them, pell
mell, towards a narrow pass. Here three stalwart Highlanders, a
father and his two sons, had taken their stand and rallied their
fugitive countrymen. Then, placing themselves at their head, they led
them in an onslaught on the Danes, whom they routed.
Afterwards, the King of the Scots, Kenneth III, sent for the three
men, and, learning from them that they—who were farmers—had
been occupied in ploughing when they saw the Scots in retreat, and
then joined in the fray, he exclaimed, ‘Henceforward you shall be
called Garadh!’ which in Gaelic signifies bulwark or fence. Later this
name was transformed to De la Haye by members of the family who
emigrated to Normandy and, establishing themselves there, joined
the Conqueror when he came to England. Subsequently it was
modified into Hay.
King Kenneth ennobled Garadh, and offered him a grant of land of
his own selection. Garadh prayed the King to grant him whatever
land his falcon might traverse, till it alighted, if thrown off at Loncarty.
His prayer was granted. The falcon flew from Loncarty and alighted
on the Carse of Gowry—as indeed might have been expected, since
Garadh was wont to hunt with falcons and frequently fed his birds on
that height. This large property was long held by the Hay family, but
the greater part passed into other hands during the last century.
My father, who told me this legend, added a caution against ever
injuring the bird which had brought good fortune to the family, and I
bore it in mind, and never fired a shot at any falcon, until one day I
received a letter from a naturalist in England, requesting me to find
some person who would aid him in making a collection of specimens
of birds of prey, as he knew that these birds migrated northwards in
the month of March—when the wind blows from the east—passing
from Morocco, across the Straits, to the Spanish coast, and selecting
generally for the point of their departure the Marshan—a plateau
within a quarter of a mile of Tangier. From here I have seen
hundreds of birds of prey, eagles, falcons, hawks, kestrels, kites and
buzzards cross the Straits during the month of March, flying against
the east wind.
Being desirous of meeting the wishes of my friend the naturalist, I
selected a spot on the Marshan, where, in a dilapidated battery, were
three or four dismounted guns, presented by King George IV to a
former Sultan. Here, ensconced between two of the guns, I waited
the passage of the birds and shot several kites, buzzards, kestrels
and other hawks; but at first, true to my rule, spared the falcons.
It was in the days of muzzle-loaders with copper caps, and I was
not using a gun of English make.
At last, seeing a fine falcon flying towards me, I said to myself,
‘What folly to believe in such silly old-womanish nonsense as that a
Hay must not injure a falcon—I shall test the truth of the legend by
firing at one.’
The bird came towards me, I fired: the gun burst at the breech,
the right-hand nipple flew out, grazing my forehead near my right
eye, and my wrist was burnt. I threw down the gun, exclaiming,
‘Thank God I was not killed! Henceforward I am a believer.’
The falcon was only slightly wounded; some few feathers fell from
the poor bird, and it continued its flight. Had it been killed, I suppose
I should not have lived to tell this story!

Two days later, the party crossed the Beheira u el Gintsor, a

district which, twenty years ago, was uninhabited and full of gazelles,
great bustard, and other game. But the present Sultan had punished
a rebellious tribe by removing them from a rich land and quartering
them on this barren plateau. It is now full of cattle, and patches of
cultivation were to be seen here and there.
The Arabs of the district brought some greyhounds, for the
purpose of hunting hare; but the attempt at sport proved a failure.
Amongst these dogs were two of the native rough-coated breed,
which much resemble the Scotch deer-hound, or sleugh-hound.
Curiously enough, the Arabic word for greyhound (in Morocco) is
slogi or sloki—plural slak. These particular dogs were poor and
stunted in appearance, but sometimes handsome specimens are
met with. They are supposed to be endowed with great powers of
endurance.
 Next day, on ascending the hill of Jebíla, the city of Marákesh
came into view, with its numerous minarets; amongst which towered
the great mosque of the Kutubía—dwarfing all others by comparison.
Through the pass at the foot of the hills, called Birra Burub—
evidently an ancient Berber name—they entered a forest of palms
and crossed the many-arched bridge over the Tensift river. The camp
was pitched on the banks of the river, which, in the swollen torrent,
was racing past—at least a hundred yards wide—carrying with it,
now and then, palm-trees washed away by the flood.
On the 5th of April the Mission entered Marákesh, passing
through the beautiful forest of palms. Soon after leaving camp, they
were met by a body of a hundred cavalry, accompanied by Kaid Bu
Aiesh, the second Chamberlain. He brought a welcome from the
Sultan—‘and a thousand times welcome.’ He added that the troop
which accompanied him was entirely composed of ‘Kaids,’ or
officers, who were sent as a guard of honour to the British
Representative on his entry.
Entering the city by the Bab Hamár, they proceeded to the
summer palace of the Maimunía, where Sir John was received by
the Governor of the city and other officials, and conducted to a
‘kubba’ or small pavilion at the end of a long avenue in the beautiful
garden, or rather orchard, attached to the dwelling. All kinds of fruit-
trees abounded, intermingled with palms and cypresses, and
intersected by broad avenues of large olive-trees. The fragrance of
the orange and lemon-trees in full flower filled the air. The only
flowers were the large white jasmine and the scented single rose of
‘Sigelmasi’—used in making attar of roses; but both these grew in
profusion.
The ‘kubba,’ the Governor said, had been prepared as Sir John’s
bedroom. It was richly carpeted and encircled by divans. A large and
handsome brass bed stood in a recess, while an ugly deal
washstand, apparently made for the occasion, furnished with utensils
of uncouth form and colour, contrasted unfavourably with the
Moorish fittings. After the authorities had taken leave, the other
apartments were investigated and found to be ample and well
furnished in the Moorish style. The doors and ceilings, which were
decorated with arabesque work, carved and coloured, had evidently
been recently repainted. Facing the entrance to the main dwelling
was a beautiful fountain, set in the wall in a horseshoe arch of tiles
and delicate geometric tracery. In the centre of the courtyard, on to
which the rooms opened, was a large marble basin in which bubbled
another jet of water. The archways of the doors were beautifully
decorated with carved filagree work.
On the morning of the 7th, as pre-arranged, Hadj Mohammed Bu
Aiesh, the chief Usher, announced in person that the Sultan would
be prepared to receive Sir John and the members of the Mission at 9
o’clock. This official was attired in the rich dress of a Moorish
courtier. Several coloured cloth caftans, or long tunics, richly
embroidered at the edges and seams with silk, were covered by
another of white cotton with flowing sleeves, and over these was
draped the creamy woollen ‘haik,’ which marks the civilian, of which
the soft folds hung to the ground. His turban of spotless white was
rolled, fold upon fold, above his brow, forming a disk of marvellous
size round the red fez which peeped above it.
Shortly after this announcement, a procession was formed. A
double line of the irregular soldiers in their picturesque and flowing
dress of all the colours of the rainbow, led the way. They were
followed by Sir John, the chief Usher riding on his left, and two
officers of the Askar, or regulars, walking on either side of his horse.
Then came the gentlemen of the Mission, all in uniform. The gates of
the palace precincts had been closed to prevent the mob crowding
in, and were only opened to admit the cortège. In the great court, or
square, were drawn up between three and four thousand Askar, who
presented arms when the ‘Bashador’ appeared.
The scene as usual was brilliant in its barbaric pomp of led horses
handsomely caparisoned, gaily dressed attendants, many-hued
soldiery, and solemn, white-robed officials. But in curious contrast to
the gaiety of his surroundings, stood prominent an old ‘deruish[46],’
with whom no one interfered. He was dirty, ragged and decrepit,
perhaps deranged, for he gazed around with a strange wild air.
During the Sultan’s ceremonious interview with Sir John the ‘deruish’
stood, with uplifted hands, loudly blessing the ‘Prince of believers.’
Next day some of the idlers of the party visited the town.
Accompanied by an escort of fourteen men and an officer, they
made their way to the ‘Mellah’ or Jewish quarter, a horribly dirty
place. The Hebrews of Marákesh are an ugly and apparently
degraded race. To add to their unsightly appearance, the men wear
blue kerchiefs with white spots, tied over their heads and under their
chins. Two long oily curls hang on either side of their faces. Their
greasy cloaks, blue or black, are similar to those worn by the natives
of Sus, and have a curious lozenge-shaped pattern in red and yellow
woven across the back. Tradition relates that these cloaks were first
woven by Spanish captives in the sixteenth century, who worked the
Spanish colours on the back of the cloaks destined for their own use.
The Jewish women, with the exception of a very few young girls,
were no better looking than the men. But their out-door dress is
graceful and pleasing, as they envelop themselves in a large veil of
soft white cotton of native manufacture, bordered with a broad band
of silk—also white—which is arranged to fall in front. Three centuries
ago this veil, with white or coloured silk borders, was worn by the
Moslem women of Marákesh, who now wrap themselves, when they
go abroad, in the more clumsy and less becoming heavy woollen
‘haik.’
The large escort which, when the party started, had been looked
on as an absurd precaution, proved to be really necessary. Though
the people showed no incivility, the pressure of the dense crowds
that thronged after the strangers would have rendered progress
without an escort well nigh impossible.
A few days later the whole party dined at the house of the Hajib—
Sid Musa. They rode thither through the deserted streets in bright
moonlight, which enabled them to avoid the holes and pitfalls
abounding in this decaying town. Well-dressed dependants waited at
Sid Musa’s door to take their horses, and, following a man with a
lantern, they soon found themselves in a small but beautiful court,
with a fountain playing in a marble basin in the centre. Near this
stood five tea-kettles on little charcoal stoves, and as many
diminutive tables, each bearing a tray covered with a silk kerchief—
suggestive of tea. Sid Musa and a Sheríf called the Bakáli, a
favourite of the Sultan, welcomed them, and led the way into a room
furnished with two gorgeous beds, chairs, sofas, and divans covered
with brocade and satin. Handsome mirrors, draped with embroidered
silken scarves, hung round the walls, which were covered with velvet
arras embroidered in gold. These hangings, which cover the lower
portion of the walls of every respectable Moorish dwelling, and vary
in richness of material according to the wealth of the owner, appear
to be a remnant of their ancient life as nomad Arabs. The hanging
resembles the side of the tent still in use among the Moors. The
design is invariably a succession of horse-shoe arches in different
coloured materials and more or less richly embroidered. In mosques
and holy places, and in them alone, mats, often very fine, are used
for the same purpose.
After the guests had been introduced to their hosts and the usual
compliments had passed, in the course of conversation Sir John
expressed to Sid Musa his desire to visit the Atlas Mountains. With
the view of preventing the objections which are often raised by the
Moorish Government when Europeans wish to penetrate into the
more remote regions of Morocco, he observed that he was born and
bred a highlander and that he longed to be once more among
mountains. Sid Musa and the Bakáli, being both mountaineers, quite
concurred in this sentiment and promised to aid in promoting an
expedition.
Dinner was long delayed, and Sid Musa became restless till the
Sheríf informed him that the guest’s servants had been consulted
regarding the feast, and that they had advised the Moorish chef (a
coal-black slave) to reverse the usual order of a native meal; as it
had been intended that the sweet dishes should be served first and
the viands afterwards.