The Markets and the Regulatory Wikipedia

by David Rouch

Posted: 2 Jul 2010

You might expect lawyers secretly to relish the prospect of more rules for the financial sector. However, many of us are suspicious.

Markets are essentially fora in which standards are set through the process of transactional decision-making. Regulators cannot feasibly intervene in each decision to set their own standards. Even if they could, that level of prescription would eventually leave no market to regulate with a substantial social cost. The international reform agenda recognises this; there is manifestly no proposal to regulate markets out of existence. Choice must ultimately remain in the hands of market participants, which brings us back to the question of how that fits with rules.

There has been considerable emphasis on using new rules to address perceived flaws in pre-crisis regulatory regimes. The continuing centrality of standards set by private actors has received less attention. Perhaps that is not surprising. The pre-crisis period is associated with regulatory laissez-faire, even if our current condition has more to do with macro-economic laissez-faire. Making rules is also the stock-in-trade of professional regulators and panders to the needs of politicians to be seen to "do something".

But regulatory rules are not a panacea. They can work, after a fashion. However, they do not always have the intended effect; after all, in some respects the pre-crisis period saw unprecedented levels of public sector regulation. Like measuring absolute zero or using risk models, regulatory interventions can alter the reality they seek to address. They can be based on false assumptions.

Remember the well-known 1970s study of voluntary versus incentive-based blood donation - the outcome of the latter was poorer, it concluded, because it undermined underlying positive motivation.[1] Regulatory rules can come to be normative, even if intended to set minimum acceptable standards. They can also be gamed, so that a given target is hit, but only in a technical sense or at the cost of other goods; think of hybrid capital instruments..

How far this understanding underpins the international reform agenda is unclear. It is certainly present in the conclusions of the Walker Review, which favours stimulating effective private sector standard-setting over regulatory intervention in the boardroom. However, it is sometimes seen more clearly outside the public sector reform process or at its margins, for example, in the challenge to the rational view of homo economicus presented by behavioural finance. It is also apparent in growing attention to the role of ethics in sustaining markets, ranging from the Chief Executive of Barclays and the Chairman of HSBC to the BBC's 2009 Reith Lectures and the salutation in the pages of this newspaper, "Morality: welcome back."

It is easier to identify behavioural problems than find solutions. However, a regulatory regime that consistently recognised the importance of sound private sector standard-setting could be expected to have a number of emphases including: removing factors that predispose private actors towards flawed behaviour (i.e. "moral hazards"); fostering market discipline in other ways, particularly by using transparency to inform effective decision-making; encouraging accurate self-assessment by market participants (for example, as to the risks and vulnerabilities they face); nurturing private standard-setting where possible to avoid the potentially distortive effect of rules; and, where rules are made, using them only on a targeted basis, following effective impact assessment, with appropriate reliance on "regulated self-regulation".

Most of these elements appear in one way or another in the international reform agenda. However, does that reflect a shared commitment, coherently applied, to stimulating sound market-based standards-setting as foundational in the emerging regulatory architecture?

The different starting points among the nations involved may suggest something closer to a regulatory version of Wikipedia. Policy-making, particularly in an international arena, is rarely a case of grand design, even at a time like the present. It is a messy, imperfect process bounded by what is politically feasible. Yet building a consensus on this is important if we are to begin to take our eyes off the rear-view mirror.

The limited use of regulatory impact assessment does not help. Impact assessments have well-known shortcomings which can only be amplified in the context of a major international reform project. However, they are an important means of clarifying regulatory objectives and assumptions, ensuring a disciplined and transparent assessment of measures proposed and aligning thinking.

Significantly, many of the G20 nations through their membership of the OECD are associated with a range of international statements benchmarking good regulatory practice which recognise the importance of impact assessment. These include the OECD's checklist for regulatory decision-making, which poses ten questions to address before embarking on regulatory intervention. In view of the OECD's membership of the Financial Stability Board as one of the major international standard-setting bodies, perhaps here would be a good place to start in ensuring that we do not get carried away by the notion that salvation can be found in a perfect set of rules.

[1] The Gift Relationship, R.M. Titmus, Allen and Unwin 1970.

About this author

David Rouch is a partner in a leading City law firm, based in its financial institutions group.


The opinions expressed in this article are those of the author, and do not necessarily represent the views of St Paul's Institute or St Paul's Cathedral.