Reforming Financial Regulation

The Annual Report of the Financial Services Consultative Industry Panel has been widely reported, and in particular an Addendum which addresses the theme Structural Reform of Financial Regulation in Ireland. The Irish Times report was headed “Quality of regulatory staff must be a priority…” and captures effectively the views of the Panel to the effect that the structure and rules associated with financial regulation may be less important than the personnel recruited to carry out the regulating. The Panel suggests that at all levels of the regulatory organisation responsible for financial regulation there should be staff with the necessary knowledge and expertise in national and international financial markets and that this can only be achieved through the recruitment of senior managers from the financial sector, with appropriate financial rewards.

I should first say that my expertise is in regulatory regimes generally, not in financial regulation in Ireland or any other jurisdiction. From this generic perspective I agree that an emphasis on the people, the knowledge and the competencies within the regulatory organisation is correct and that this may be more important than the content of the rules (since an effective regulator can blow the whistle on practices which are permitted but undesirable). However, expertise is not the only requirement for a credible and effective regulatory regime. Such a regime additionally requires a degree of independence both from the industry and from ministers. The requirement of such independence is not simply a matter of legitimacy – there is likely to be limited tolerance for putting foxes in charge of chicken coops in the current climate – but also a key aspect of effectiveness.

Expertise is a complex idea. Industry experience is valuable because those who have it know how things are done and understand the strategies of those they are overseeing. They understand the narratives put forward by regulated businesses and know what to look at to assess their credibility. Thus strong industry expertise gives a regulator a form of independence in the way that it uses knowledge. But in some instances it is equally important that a regulator is is capable of challenging the working knowledge of an industry. On one analysis the primary failure underlying the current financial crisis is the failure of banks to understand the systemic risks which their actions created.  A regulator which fully mirrors the industry which it oversees is unlikely to be able to re-think the appropriateness of industry conduct, but only to assess whether particular businesses are within the normal range of what is considered appropriate at a given time.

A further issue surrounding the recruitment of regulatory staff from an industry arises from the observation that regulators who exhibit a high degree of shared experience (educational, industry, inspection) with those they oversee are liable to be less stringent in their application of regulatory rules than those with less shared experience. This ‘relational distance’ hypothesis, developed by Donald Black in the 1970s, has been tested and found to have considerable validity both in the context of business regulation in Australia ((by Grabosky and Braithwaite, 1986) and in the context of regulation of public bodies in the UK (by Hood, Scott and others, 1999). In the latter study we were struck by examples of regulatory design which opted for a deliberate ‘mixed relational distance’. So, for example, within the Inspectorate of Prisons, noted for robust independence and with a strong track record of re-thinking the appropriateness of prison standards, the head of the Inspectorate was routinely recruited from outside the prisons industry (a judge, a retired general, etc), whilst the next tier down within the organisation comprised seconded prison governors with strong industry expertise.The mixed approach can be developed at other levels of a regulatory organisation. In a small country such as Ireland we should be aware that shared educational and social experience is likely to be as important in generating low relational distance as shared industry experience. I believe this is one of the reasons why some have suggested a need to look outside Ireland for key regulatory officials in the financial sector (as has happened in the case of the Garda Inspectorate).

I do not think this mixed approach to staffing regulatory agencies is inconsistent with the views of the Consultative Panel. But it is important to recognise that an approach to staffing the new regulatory structures which fails to look beyond the experience and knoweledge of the industry is likely to be limited both in effectiveness and legitimacy.

Author: Colin Scott

Colin Scott is Principal, UCD College of Social Sciences and Law and Professor of EU Regulation and Governance at UCD. He is a Co-Editor of Legal Studies (Wiley-Blackwell).

14 thoughts on “Reforming Financial Regulation”

  1. This post manages to nimbly avoid what I would consider to be the crux of the issue, the problem of regulatory capture.

    It doesn’t matter whether your regulators are skilled or incompetent, experienced or complete novices, beholden to politicians or independent ; if the power and money is flowing from the regulated to the regulator, there will always be a problem.

    Nor is this synonymous with ‘relational proximity’, unless that is meant as a euphemism. What I am talking about here is straight-up, bare bones corruption.

    Regulators and the politicians who appoint them are beholden to the regulated for their careers and financial well-being.

    Relational proximity is not the way to describe the relationship between Washington DC and Wall Street. The proper description is that DC is the political wing of Wall Street.

    Any debate on financial market reform which doesn’t start and finish with a discussion of the problem of regulatory capture, I personally would just dismiss as a captured debate.

  2. @Graham Stull
    I do not thank capture could be a complete explanatory variable for the financial meltdown. However defined capture involves the serving of regulated interests by regulators. Whose interests have recent events served?
    A key weakness in capture discussions generally is an assumption of rationality and complete knowledge as to interests and how they might best be served.
    Thus, even if politicians, civil servants and regulatory officials are pursuing some version of their own self interest that still begs lots of questions. Furthermore it is not a bilateral game involving regulatees and regulateds. Regulated interests are diffuse (contrast Irish banks, overseas banks, insurance companies and financial advisers). Other stakeholders have had a key role in shaping both the broad political and economic environment – notably IBEC and the unions. Even if you wanted to engage in capture who would you try to capture?
    My own view is that debates about capture have removed the naive assumption that regulation always serves the public interest, but that this is a beginning and not an end to the question of what is going on.

  3. Colin,

    Before the full extent of the handling of the financial crisis became apparent, I probably would have agreed with you.

    But we have since seen a ridiculous amount of bail-outs all approved by public “servants”, none of which have been in the public interest. TARP and Nama just couldn’t happen unless the banks owned the government.

    “Whose interests have recent events served?”

    “Recent events”, on their own, have of course served nobodies interests. But they represent the culmination of a long cycle which has served the interests of the (non)regulated.

    Now, these same (non)regulated who lobbied hard to have their capital untethered are lobbying even harder to get some else (the taxpayers) to pay the resultant losses.

  4. Tackling corruption is, of course, a somewhat different and more general agenda. I have long thought that the kind of structures that exist in Hong Kong and Australia – standing anti-corruption commissions with investigatory capacities of their own – are superior to most alternatives in detecting corruption and, more significantly, in addressing instititutionalized cultures of corruption of the kind that were identified in some Australian states (for example in government and policing) in the 1970s. It is widely suggested that political heroism is required to establish such regimes – given that they frequently act against the short term interests of politicians.

    Such a reform could go alongside financial regulatory reform.

  5. What was bizarre in the Irish siutaion was that the level of informal communication in the Regulator’s office must have resembled the East India company or maybe a Trappist monastery.

    The CE must have had no contact with frontline staff and their reporting managers as he remained ignorant for almost a year of the FitzPatrick loans scheme.

    Apart from TK Whitaker 50 years ago, there has been no tradition in the Irish public service of tolerating anyone who had the gumption to express a view that could be perceived a veering, even ever so slightly from received “wisdom.”

    The cue to follow on Dame St was obvious. Go with the flow.

    So a regulator should not be someone who has spent 30 years tugging the forelock.

  6. @Colin,

    Many thanks, once again, for an insightful post. Let’s hope it provokes the debate it deserves.

    There are many points I could comment on, but I think the protection of consumers’ interests and the advocacy of their interests receives less attention than it does. Symptomatic of this is the fact that there is no consumer representative on the Financial Services Consultative Panel (FSCP). I am not suggesting there is a need for a Consumer Financial Protection Agency as is being advanced in the US (though the vociferous opposition of the financial services industry there might give one pause for thought). But there should be some formal advocacy of the consumers’ perspective when deliberations of the financial regulator impact on consumers.

    I was struck by the assertion in the FSCP Report Addendum “Solvent financial institutions are the most important form of consumer protection.” I agree they are necessary; but they are not sufficient.

    In addition, as you have pointed in a comment, regulation is not some gamme between the regulator and the regulated entities. Regulators in the financial and economic sphere will be required to balance the interests of the regulated entities with a host of potentially conflicting public policy objectives and competing interests – not least those of consumers.

    There is a strong case for quasi-judicial regulation (similar to that in US, but completely different to the totally ineffective public consultation based approach used in Ireland – following the approach in Britain) where regulated entities requiring any change in regulation or regulatory decisions present their arguments for this change. All those affected (including consumers) are free to present their submissions and there are opportunities for rebuttal and counter-rebuttal. Once all the evidence is presented and fully contested, the regulator reviews the material and makes a decision.

    Developing a competence in the NCA to advocate consumers’ interest effectively in deliberations of the financial regulator (and similar competencies to do so in other regulated sectors) in my opinion would be a major advance. However, following the Government’s decision to combine the NCA and the Competition Authority, this is unlikely to happen.

    Unfortunately far more effort is put into presenting the optical illusion of effective regulation than there is in the development of effective regulatory structures and processes.

  7. The European-wide move to IFRS-based financial reporting may provide a mechanism to somewhat mitigate the effect of regulatory capture. Since Irish bank prudential regulations are built on IFRS, Ireland now has a common regulatory platform with a lot of European countries. In the absence of EU-wide regulation (doesn’t look like it will happen soon) you could feasibly do a bilateral agreement with, say, The Netherlands whereby the Dutch regulator would do the review of AIB and have an Irish team do a review of a Dutch bank. Since the labour markets are still largely nationally segmented, this may go some way to mitigating the effect of regualtory capture.

  8. @Donal Byard
    Your suggestion of the Republic of Ireland availing of other country’s agencies has merit – given the our size and history. Do such arrangements in other states, especially those with non-Federal structures?

    If not, then we can reach out and invent our own way of making such arrangements. We have done this in many sectors eg. promoting FDI, the work of SFI and the Garda Inspectorate.

    While I am aware (slightly) of different models of regulating public utilities in North America, are there different models of regulating financial institutions

    It seems to me that we need to look beyond those parts of English-speaking world that invariably dominate our thinking here. Do the Dutch, Danes, Swedes, Finns, Austrians, Norwegians, New Zealanders, Swiss – have examples we could draw on?

    This is an extension of Colin’s comment on “look(ing) beyond the experience and knoweledge of the industry is likely to be limited both in effectiveness and legitimacy.”

    Any other ideas of getting beyond the kind of stasis that Mancur Olson pointed out?

    It seems to me that we need to look beyond the (native) English-speaking world for such support.

  9. there are a few things the regulator needs to do (from a banking regulation perspective)

    1. stop barking and bite, nobody is afraid of them, that needs to change. there isn’t a need for more rules, there is a need of enforcement.
    2. they need a few crooks to advise them, in the same way as blackhat goes to whitehat in IT security, most of them are not aware of the ways and means that abuse takes place – get some of the offside guys and mak them consultants.

  10. Karl D’s second suggestion has some historical (even if partly anecdotal) evidence to support it. When FDR oversaw the establishment of the US Securities and Exchange Commission in 1933 he appointed Joe Kennedy as its first chairman. Some of his closest advisors were aghast. Joe’s reputation was ‘colourful’ to say the least. FDR allegedly silenced them by responding: “Set a thief to catch a thief”.

  11. @Donal O’Brolchain

    I don’t know of any current regulators that are outsourcing work across jurasdictions.

    There is a lot of regulatory cooperation to harmonize standards. For securities regulation you have IOSCO and CESR in Europe. At the momne

  12. @Donal O’Brolchain

    I don’t know of any current regulators that are outsourcing work across jurasdictions. I spent the last 12 months working in a regulatory policy section of the SEC, so if it is going on somewhere, we would have seen it (I dealt with international accounting issues). But, there is no reason why Ireland can’t be a regulatory innovator. Just borrowing everything from the UK does not seem to have work well.

    Historically each national jusrasdiction having its own accounting standards (and bank prudential rules built upon these different accounting standards) would have been a big barrier to coordination. But, huge progress has been made in the last 20 years in putting everyone on a common platform. So, there is much more scope for regulatory “sharing” in the world today.

    Glad to see someone else reads Mancur Olson. I did my grad studies at the University of Maryland where he was on the faculty.

  13. Regulatiry Capture = yellow card……Relational Distance = 2nd yellow card….. Yep that about covers Irelands Regulatory framework for the past ehhh 100 plus years.” good man willie” I used to believe as an Academic that its necessary to formulate the theory,run models etc. before incurring the practical expense but recent events in Ireland have changed My mind regarding Financial Regulation and with this in Mind I would humbly suggest to this Forum that the most immmeadiate impact to change for the good could be achieved with the use of 1 x bulldozer, 1 x large loading shovel, 3 x earth moving trucks (round trips to landfill to be assessed on site) and finally 1x large(preferably new ) drawing board.

  14. @donal byard
    So we have a few more challenges here in Ireland!
    But at least we can draw on people with insight and experience if our powers-that-be choose to do so.

    It is a question of managerial imagination.
    (Aside. I met Mancur Olson when he visited Dublin during the 1980s.)

    @jim
    Concentrate on the drawing board, which is my take on what Colin Scott has been doing in most of his postings in this forum.

    It is much harder work coming up with new appropriate structures, incorporating the kinds of checks and balances, which on one hand promote innovation (what kind of a banking system can we now create for ourselves?) while limiting the scope for excess.

    As we have seen, Colm McCarthy is leading the charge of the demolition gangs, as only he can!

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