How Might Regulation Be Made More Effective?

The Organisational Behaviour section of this website summarises the difficulties caused by the often unpredictable and sometimes antisocial behaviour of larger organisations.   This page examines a number of ways in which government might ensure that the regulation of key industries might be made more effective. 

Most obviously, there could be more emphasis on prevention rather than punishment.  This is the subject of a separate web page.

Other improvements might include the following.  More detail is below.

  1. Regulators could become more sceptical and/or tougher and/or less forgiving.
  2. Larger institutions might be placed under a duty to act with integrity.
  3. Regulation could be carried out by quite different people.
  4. Governments and parliaments could exercise much more effective oversight of regulators, and regulated industries.
  5. Greater use might be made of Oversight Regulators.

My advice on Effectiveness Reviews is also relevant.

1. Should regulators become more sceptical and/or tougher and/or less forgiving?

See Note 1, below, for early responses to the financial crisis. But it was hardly surprising that the FSA then began to make a lot of noise about its new tough approach to the financial services industry, whilst politicians in parallel began made a lot of noise about the need to cut bankers' bonuses. The FT reported on 30 December 2010 that 'Fines levied against companies and individuals by the UK markets watchdog nearly tripled this year as the regulator further stepped up its enforcement operations in the wake of the financial crisis. ... the regulator ... also banned 60 people from working in the financial sector, raided high-profile City institutions and won its first overseas extradition request.  In addition, it launched its first cross-border insider dealing case in conjunction with US authorities.' "These are not just random cases. The industry is not popular and the regulator has to take and be seen to be taking action," said Jonathan Herbst, partner at Norton Rose. But the scale of this activity remained tiny in comparison to the profits made by, and the numbers employed by, the industry (see Note 2) and it was far from clear that the threat of this ex post activity had any significant deterrent effect. Nor was there any sign that other regulators were becoming more aggressive in their approach to other industries.

There were fewer signs that the FSA or other regulators had learned the need to employ staff who have the guts and determination to find out exactly what is going on in their sector, to understand the larger trends, and to act when they become concerned, whatever the howls of outrage from vested or complacent interests. It had been very depressing to hear Alan Greenspan admit, after the financial crisis, that he "didn't understand what they were doing or how they actually got the types of returns ... that they did". And it was equally depressing that David Einhorn was able to say, of the United States SEC, that 'The SEC has been very tough ... on [less-powerful entities]. But when it comes to large corporations and institutionalized Wall Street, the SEC uses kid gloves, imposes meaningless non-deterring fines, and emphasises relatively unimportant things like record keeping rather than the substance of important things ...'.

But there were occasional welcome signs that Martin Wheatley, the new head of the FSA's successor body, the Financial Conduct Authority, was gearing up to take a tough line with the banks etc. Asked in March 2013 why the banks disliked him so much, he said: "I'm sorry they don't like me. I like them."! But his tougher approach did not go down well, of course, and subsequent developments, including the sacking of Mr Wheatley, are summarised here.

Felix Hufeld, the Head of Germany's financial regulator BaFin, was cut from a quite different cloth to Martin Wheatley.  He could not believe that Wirecard, the darling of German's stock market, was deliberately misleading him and many others.  He argued that the company had fallen victim to a conspiracy by short-sellers and even took legal action against the Financial Times journalists that had set out to expose the €1.9 billion scam.  Mr Hufeld was eventually sacked, of course, but not until his prevarication had caused considerable damage.

More general lessons, from what we have learned about the psychology of large organisations are that:

2. Should Larger Companies have a Duty to Operate with Integrity?

It is often argued that current law (and in particular the law pertaining to directors' fiduciary duties) requires companies to maximise profits at the expense of behaving ethically. But this is a mis-reading of the law:- Click here for a fuller discussion of this subject including interesting legal advice from Farrers.

It is interesting that some informed commentators (including Cranfield's Professor David Parker) began to wonder whether we might nevertheless not need a totally new approach, perhaps policed by totally different people. Maybe company directors should be put under a duty to operate with integrity?

Many senior business people have in the past thought it perfectly proper to 'pull the wool over the eyes' of regulators (and to avoid taxes, and exploit their less savvy customers) and so on. There was a game to be played and, if the regulators did not have the wit and experience to ask the right questions, or spot misleading or incomplete answers, then that was their problem. So maybe there is something to be said for requiring directors - and their advisers - to ensure that their businesses operate in good faith, so to speak? One solution may therefore lie in company law. Another might be to strengthen the existing codes of banking practice etc. The public certainly seem astonished and angry when they learn learn about the way in which many large corporations are allowed to behave, even when they are operating entirely within the law.

And there was an interesting article in New Scientist in March 2013 where Christopher Boehm wondered whether moral indignation, which had helped cement modern human society, was losing its power:

"(a) where immoral and/or selfish behaviour behaviour becomes embedded in large, hard-to-understand economic systems,
(b) when the immediate damaging consequences seem to be diffuse and institutional, rather than direct and personal, and
(c) where reform is in the gift only of elected politicians who are in turn strongly influenced by powerful lobby groups and corporate donations."

Coincidentally, this article was published in the same week that newly appointed head of the Financial Conduct Authority, Martin Wheatley, said that his goal was to change the culture of bank Boards. He doubted that ex post fines were effective - see further below.

Against this general background, it was interesting to note that Ofgem had already announced, in March 2009, that they were minded to provide that energy suppliers must:

There was a somewhat related development in March 2010 when the FSA announced that it would in future intervene in order to stop risky products being sold to the public, rather than merely require the industry to pay compensation after things had gone wrong. This change of style (which stopped short of requiring products to be vetted before they went on sale) did not immediately apply to the regulation of financial institutions themselves (as distinct from their retail products) but it showed that the regulator was at long last willing to consider taking firm action. It remains to be seen whether these good intentions will in practice be implemented on behalf of the public.

And Lord (Adair) Turner, Chairman of the Financial Services Authority, writing in the FT on 7 December 2010, raised the possibility that senior bankers might be required to operate in a more risk-averse way than their counterparts in other industries:

"[RBS Executives were] doing what executives and boards in other sectors of the economy do: sometimes getting judgments right and sometimes wrong. But banking is not like other sectors. The fact that many banks made decisions in the same way as other companies was itself a key driver of the crisis, a big problem, but not one that regulators had adequately identified. In some other sectors we want bold risk-taking, which might sometimes result in failure, shareholder loss or even the danger of bankruptcy. But banking is different. Failure in banking, or even the threat of failure offset by public intervention, carries huge economic costs quite different from non-banks. In banking, higher return for higher risks is also sometimes achieved not by socially valuable product innovation, but by leveraging up and taking liquidity risks, increasing the danger that society must clean up the mess. The question is should we reflect these fundamental differences in a more explicit recognition that the attitude of bank boards and executives towards risk-return trade-offs should be different from other sectors, and should we create incentives to adopt this different attitude?

It would, for instance, be possible to set a rule that no board member or senior executive of a failing bank will be allowed to perform a similar function at a bank unless they can positively demonstrate to the regulator that they warned against and sought to reduce the risk-taking that led to failure. Such automatic rules would recognise that while the financial crisis entailed some instances of professional incompetence, recklessness and fraud, the more general problem was that some executives and boards made risk-return trade-offs that might have been appropriate in non-banks, but were hugely harmful to society when made by banks. Investigations focused on whether individual executives breached rules have a role and the FSA has successfully brought some enforcement cases relating to breaches revealed by the banking crisis. But achieving a general shift in attitudes to risk and return may require that bank directors and executives are made subject to quite different incentives than those that are appropriate in other sectors of the economy."

Comment: It is interesting to consider the consequences of substituting the names of other highly regulated industries for the references to the financial services industry in Lord Turner's proposal.

The United Nations Human Rights Commission published its Guiding Principles on Business and Human Rights in 2011.  It is of course very difficult to assess whether such guidance has any effect in the real world, but its 'Protect, Respect and Remedy Framework' was widely welcomed.  In simple English:

(Human Rights in this context means those in the International Bill of Human Rights and the principles concerning fundamental rights set out in the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work.)

Martin Wolff addressed the responsibilities of large corporations, writing in the FT in January 2012:

The core institution of contemporary capitalism is the limited liability corporation. It is a brilliant social invention. But it has inherent failings, the most important of which are that companies are not effectively owned. That makes them vulnerable to looting. Incentives allegedly provided to align the interests of top employees with those of shareholders, such as share options, create incentives to manipulate corporate earnings, at the expense of the long-term health of the company. Shareholder control is too often an illusion and shareholder value maximisation a snare, or worse. What is the answer? Unfortunately, no simple remedy exists. The corporation is the best institution we know of for running large, complex and dynamic businesses. It is surely important to ensure that taxation and regulation do not obstruct other forms of ownership, including partnerships and mutuals. It is vital to encourage the creation of genuinely independent, diverse and well-informed boards. It is sensible to ensure that pay packages are transparent and any incentives for destructive forms of remuneration are removed. But except in banks, where the public interest demands intervention in the incentives of management, governments should not intervene directly.

And Business Secretary Vince Cable pushed the debate along and made some perceptive comments in an interesting speech Trust: why it matters in July 2013.

The issue came up again in 2018 with the publication of Professor Colin Mayer's book Prosperity. Here is a substantial extract from Martin Wolf's review of the book.

The public at large increasingly views corporations as sociopathic and so as indifferent to everything, other than the share price, and corporate leaders as indifferent to everything, other than personal rewards. Judged by real wages and productivity, their recent economic performance has been mediocre. Furthermore, corporations have been allowed to corrode competition, as Jonathan Tepper and Denise Hearn argue in another important new book, The Myth of Capitalism. In short, bad ideas have seized the corporation and let competition waste away.

Prof Mayer’s main target is Milton Friedman’s argument that the purpose of companies is only to make profits, subject to law and (minimal) regulation. Today, this is presented as the obligation to maximise shareholder value. Behind this is the view, which goes back to Adam Smith, that the principal challenge is the “agency problem” — the relationship between owners and agents (the managers). “The problem with the Friedman view,” insists Prof Mayer, “is that it is hopelessly naive.” It is based on “simple and elegant economic models that simply do not hold in practice”. The idea that businesses pursue profits and only profits, can, he argues, only produce bad businesses and dire outcomes. This is so for three reasons: human, social and economic.

The first is most important. Profit is not itself a business purpose. Profit is a condition for — and result of — achieving a purpose. The purpose might be making cars, delivering products, disseminating information, or many other things. If a business substitutes making money for purpose, it will fail at both. …

[How can] long-term trust be sustained if the constantly reiterated aim of the corporation is to serve the interests of those least committed to it, while control is also entrusted to those least knowledgeable about its activities and at least risk of damage by its failure? Yet these are reasonable descriptions of the place of shareholders in publicly-owned companies with widely-distributed shareholdings.

Shareholders are least committed, because, unlike employees, dedicated suppliers and the locations in which businesses operate, they can divest themselves of their engagement in the company in an instant. Shareholders are the least knowledgeable, because they are not engaged in the activity of the company.

Crucially, contrary to economic wisdom, shareholders are not, in the actual world, the bearers of the residual risks in the business (other than relative to bondholders). The incompleteness of markets ensures that employees, suppliers and locations also bear substantial risk. Moreover, stock markets allow shareholders to diversify their risks across the world, something employees, for example, cannot hope to do with respect to their company-specific capital stock of knowledge and personal relationships. Moreover, everybody else is at risk from shareholders’ opportunistic behaviour. This has to weaken the commitment of everybody else.

In addition, given the mantra of shareholder value maximisation and the inability of shareholders to monitor management, rewards have increasingly been linked not to the performance of the business in delivering on its purposes, but to accounting profits and the share price. Yet both are subject to manipulation. Some would argue that the result has been excessive remuneration, (the theme of Are Chief Executives Overpaid? by Deborah Hargreaves) and chronic under-investment, too. These books suggest that capitalism is substantially broken. Reluctantly, I have come to a similar conclusion. This is not to argue for the abandonment of the market economy, but for better companies and more competition.

I wouldn't get too excited, but there was an interesting signal from the USA in August 2019 when the influential Business Roundtable amended its two decade old declaration that that "corporations exist principally to serve their shareholders" as follows:

Statement on the Purpose of a Corporation

Americans deserve an economy that allows each person to succeed through hard work and creativity and to lead a life of meaning and dignity. We believe the free-market system is the best means of generating good jobs, a strong and sustainable economy, innovation, a healthy environment and economic opportunity for all.

Businesses play a vital role in the economy by creating jobs, fostering innovation and providing essential goods and services. Businesses make and sell consumer products; manufacture equipment and vehicles; support the national defense; grow and produce food; provide health care; generate and deliver energy; and offer financial, communications and other services that underpin economic growth.

While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:

  • Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
  • Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
  • Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
  • Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
  • Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.

Finally, in this section, it is worth noting that, under the American Responsible Corporate Officer Doctrine, senior managers are held to account for events that happen in their company even if they are not aware of them - a bit like government ministers in the UK who are (up to a point) held accountable for what their officials do, even without the minister's knowledge.

3. Should regulation could be carried out by quite different people?

Maybe, too, we need fewer city experts in financial and other regulation, not more experts? It is after all very hard for anyone, steeped in any background, to seriously and energetically challenge their ex-colleagues who are very likely to be their friends and their future colleagues and bosses. And it is very difficult to discard 'group-think'. If everyone - absolutely everyone - is behaving in a certain way, how can a member of that circle possible challenge it? And how do they withstand the contemptuous suggestion that they must be a little too stupid, or inexperienced, to understand why everything is just fine. It takes a very brave regulator to press for an explanation that they can understand when faced by a very senior person, or renowned expert, who is baffling them with complex and incomprehensible explanations. There are many circumstances in which outsiders ask better questions, and see things more clearly, than supposed experts.

Another way of improving the financial regulator's gene pool might be to aim to raise its status, and the status of other regulators. (This is not the same as paying them more. Indeed, high salaries may be counterproductive.) The culture of regulation seems to be more ingrained, and less resented, in the American psyche; bright US lawyers and economists see working for a US regulator as a key career stepping stone; and, though far from perfect, US regulators are generally more willing to 'kick doors down' than their UK counterparts.

We certainly need to employ regulators who don't just focus on their KPIs, budgets and business plans. John Braithwaite made this telling point in his contribution to Achieving Regulatory Excellence edited by Gary Coglianese:

[An] excellent regulator [would] have seen in 2001 the huge opportunities to make America safer and stronger by responding to suspicious flight training ... [An excellent regulator would have taken] the opportunity an Australian environmental regulator had in 2009 to respond to an oil spill caused by Halliburton's cementing of a drilling rig that spilled oil into the Timor Sea for 74 days ... an opportunity that could have prevented the Deepwater Horizon spill for 86 days in the Gulf of Mexico a year later".

4. Should governments and Parliament exercise much more effective oversight of regulators, and regulated industries?

Surely, too, governments and parliaments are going to have to put much more effort into overseeing regulatory structures and practices. The buck must, after all, stop with our elected representatives. Follow this link to access a further discussion of this topic.

5.  Oversight Regulators

A welcome development has been the creation of two new regulators to oversee the activities of certain (to some extent self-regulating) professional bodies. The first of these was the Council for Healthcare Regulatory Excellence (CHRE) which was set up in 2003 to keep an eye on healthcare regulators such as the General Medical Council and the Nursing and Midwifery Council. This was followed in 2008 by the creation of the Legal Services Board (modelled on the CHRE) to oversee the legal professions. Both of these bodies are themselves quite small, thus allowing them to consider a wide range of regulatory and consumer issues without suffering the disadvantages of super-regulation or the demolition of the principle of self-regulation.

Notes

1. The general conclusion of the political and regulatory establishment, following the financial crisis, was that they or their predecessors had been perfectly competent, but underpaid and not allowed to regulate large parts of the financial services industry, and so taken by surprise by unprecedented turmoil. They concluded, therefore, that pretty much the same people - including regulators recruited from the industry itself - should carry on working broadly as before - albeit in different configurations. (I am not aware of a single UK regulator who suffered any form of penalty after the crash. It was particularly startling that the FSA's Hector Sants - responsible for regulating the wholesale and institutional markets from 2004, and Chief Executive from 2007 to 2012, i.e. well before and then throughout the financial crisis - was made "Sir Hector" at the end of 2012. (One Parliamentary committee had accused him of being 'asleep at the wheel'!) He also picked up a very senior job at Barclays Bank after leaving the FSA at the end of 2012.)

But it was thought that attempts should be made to strengthen the financial regulators by recruiting even more senior bankers etc. Perhaps the regulators' role should be expanded so as to provide much more effective regulation of the previously unregulated 'shadow' parts of the financial services industry? There should certainly be improved cross-border regulatory co-ordination. And maybe banks should split into their 'more risky' and 'less risky' parts? (The discussion of changes to the detail of banking regulation such as increases in capital adequacy ratios are outside the scope of this website, but follow this link to read about the debate about the structure of the industry and ways of increasing the effectiveness of competition within the industry including the deliberations of the Independent Commission on Banking.)

Lord (Adair) Turner, the incoming Chairman of the FSA, gave a very interesting interview to Prospect Magazine in August 2009, saying that:

"[We need] a very major reconstruct of the global financial regulatory system", and "The way that the tripartite system worked post 1997, and especially the relationship between the Bank of England and the FSA reflected a particular philosophy of the time, and in retrospect, I think everyone recognises that a different approach would have been better. The bank was focused on its monetary policy mandate. The FSA focused on micro-prudential supervision on an institution by institution basis, and on an interpretation of that which was fairly legalistic and focused on systems and processes. Somewhere between the big picture got lost; the overall trends in credit extension across the economy and in assets prices were not put together with certain business developments to sound a warning ...
... There clearly are bits of the financial system, and particularly the bits that relate to fixed income securities, trading, derivatives, hedging, but possibly also aspects of the asset management industry and equity trading, which have grown beyond a socially reasonable size ...

It is hard is to distinguish between valuable financial innovation and non-valuable. Clearly, not all innovation should be treated in the same category as the innovation of either a new pharmaceutical drug or a new retail format. I think that some of it is socially useless activity. On the other hand, I don't know whether that means the world would have been better off without any credit default swaps, or simply some credit default swaps. I just think it's difficult to work out where one can draw the line with this. And that leads me away from the idea that regulators should be saying: product X bad, product Y good, and more towards a set of mechanisms such as high capital requirements which create hurdles for new products, but do not stop those that are of obvious value."

The media inevitably jumped on the phrase "socially useless" but it is hard not to agree with the way it was used when read within the context of the surrounding sentence.

2. The Centre for Analysis of Risk and Regulation published an interesting discussion paper Regulation scholarship in crisis? in 2016, focussing on the academic response to a series of apparent regulatory failures.

 

Martin Stanley

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