The Making of Good Financial Regulation

Making Good Financial Regulation Towards a Policy Response to Regulatory Capture Edited by Stefano Pagliari All rights reserved Copyright © International Centre for Financial Regulation, 2012 International Centre for Financial Regulation is hereby identified as author of this work in accordance with Section 77 of the Copyright, Designs and Patents Act 1988 The book cover picture is copyright to International Centre for Financial Regulation This book is published by Grosvenor House Publishing Ltd 28-30 High Street, Guildford, Surrey, GU1 3EL. www.grosvenorhousepublishing.co.uk This book is sold subject to the conditions that it shall not, by way of trade or otherwise, be lent, resold, hired out or otherwise circulated without the author's or publisher's prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser. A CIP record for this book is available from the British Library ISBN 978-1-78148-548-4 About the International Centre for Financial Regulation The International Centre for Financial Regulation is the only independent, non-partisan organisation to be exclusively focused on best practice in all aspects of financial regulation internationally. The ICFR believes in the promotion of efficient, orderly and fair markets which offer appropriate protection for investors and retail consumers alike. Financial centres of the future should be based upon sound principles of regulation, with supervisors, regulators and participants who act in the interest of all stakeholders. The world’s financial markets have never been under greater scrutiny. Individual governments are understandably focused on their own domestic priorities, but effective and sustainable regulation needs to be global. The role of the ICFR is to encourage dialogue that identifies best practice across the traditional financial centres in the US, Europe and Asia and embraces emerging and developing economies worldwide. The ICFR is in the unique position of being able to bring together senior representatives of both the private and official sectors in an environment where open and valuable debate on the essential issues of financial regulation can take place. Whilst it is not a lobby organisation the ICFR is focused on promoting regulation that is proportionate to the risks involved and intends that its work will influence policy and practice across the global financial system. Since its launch in 2009 the ICFR has, through the consistent quality of its work, developed a brand recognised globally. The ICFR delivers its work through research, events and training and additionally offers insights into current thinking on regulation through both its Website – icffr.org and the ICFR – Intuition Regulatory Portal. The findings, interpretations and conclusions expressed in this publication are entirely those of the authors. They do not necessarily represent the views of the International Centre for Financial Regulation and its affiliated organizations and members. Table of Contents Foreword: Regulators, Financial Industry, and the Problem of Regulatory Capture Robert Jenkins ix About the Authors xiii 1.0 How Can We Mitigate Capture in Financial Regulation? Stefano Pagliari 1 Section 1 An Academic Perspective 51 2.0 Understanding Regulatory Capture: an Academic Perspective from the United States Lawrence G. Baxter 53 3.0 Lessons for the Financial Sector from ‘Preventing Regulatory Capture: Special Interest Influence, and How to Limit it’ Daniel Carpenter, David Moss and Melanie Wachtell Stinnett 70 4.0 Who Mobilizes? An Analysis of Stakeholder Responses to Financial Regulatory Consultations Stefano Pagliari and Kevin L. Young 85 5.0 Regulatory Implementation and Capture Andrew Walter 99 Section 2 A Regulator’s Perspective 109 6.0 Regulatory Capture, Political Dominance or Collective Intellectual Failure? A View from a Former UK Regulator Clive Briault 111 7.0 Regulatory Capture and Global Standard Setters Jane Diplock AO 124 8.0 Political Capture and the Regulatory Cycle: How Should it be Addressed David Green 136 9.0 Regulatory Capture: A Former Regulator’s Perspective Andrew Sheng 149 10.0 Managing the Risks of Regulatory Capture David Strachan 159 Section 3 A Stakeholder’s Perspective 171 11.0 Addressing the Problem of Cyclical Capture Gerry Cross 173 12.0 Ensuring the Consumer Voice is Heard Christine Farnish 181 13.0 Regulatory Capture and Financial Regulation: The Experience of Non-Financial End Users Richard Raeburn 192 14.0 Lessons from the Experience of the UK Financial Sector Adam Ridley 204 Section 4 A Perspective from Outside Finance 217 15.0 Regulatory Capture: a Perspective from a Communications Regulator David Currie 219 16.0 Lessons from the Regulation of the Energy Sector John Mogg 231 17.0 Regulatory Capture in Finance: Lessons from the Automobile Industry Tony Porter 241 Bibliography 250 Foreword Regulators, Financial Industry and the Problem of Regulatory Capture Robert Jenkins1 Driven by hubris, greed and stupidity bankers led the charge off the cliff. But where were the regulators? Why did they not see it coming? Why did they not prevent it? Why did they trust bankers to know what was best for banking? In short, how could regulators have been so dumb as to believe that bankers were so smart? This publication supplies answers to these questions. It explores the ways in which regulators can sometimes be captivated, co-opted and conned by those they regulate. Best of all, it suggests a number of actionable policies to mitigate the problem. Industry influence operates at all levels of the rule making ranks – from the peak of politics to the substrata of supervision. It need not be unhealthy. Indeed, interaction between regulators and the regulated is natural and normal. Yes, industry seeks to shape the rules under which it will operate. But rule-makers need industry input in order to craft sensible policy. Some degree of influence is therefore inevitable. Unfortunately, there are times and industries where special interest groups are able to bring disproportionate influence to bear – a condition called “regulatory capture.” The financial sector is one such industry and the run-up to the crisis one such time. The obvious question which arises: is such influence still excessive and thus unduly shaping the needed regulatory response? 1 Robert Jenkins is a practitioner, regulator and academic. He is an external member of the Financial Policy Committee of the Bank of England and Adjunct Professor, Finance at London Business School. Prior to his appointment to the BoE, Mr. Jenkins spent 16 years running bank trading rooms followed by 18 years managing investment management businesses. From 2007 to 2009 he Chaired the Investment Management Association, UK. x - Jenkins My first encounter with “capture” came at a moment of meltdown in 2008. At the time I chaired both a London-based investment firm and the trade association representing the UK investment industry. As financial panic spread I watched in disbelief as bankers trooped through the doors of Downing Street to advise Government on how best to address a problem which bankers themselves had largely created. Far from being discredited, the guidance of these “experts” was eagerly sought – and with virtually no counterbalancing input from other stakeholders groups. Over the succeeding months officials went on to tap a more appropriate range of expertise. But at that key moment in time - capture was complete. “Political capture” can be fueled by campaign contributions but in the case above, it resulted from the pervasive beliefs of the day. The theology of the time maintained that: markets were efficient and would provide the necessary discipline to participants; the financial sector could be left largely to police itself; global banking and their host centers were engaged in fierce global competition; regulation should facilitate that competition and not get in its way; and therefore, when it came to regulation, less was more. This set of beliefs permeated the body politic, shaped the regulatory approach of “light touch” and, believe it or not, established a mindset amongst some supervisors that the regulated banks were to be seen as “clients.” The technical term here is “cognitive or intellectual” capture. The non- technical term is brainwashed Four years on, one might imagine that bankers’ ability to bewitch and bamboozle would have ebbed. Alas not. Their formidable lobby has led and continues to lead an effective campaign to persuade pundits, public and politicians that calls for higher capital requirements are impeding the economic recovery. It is an argument framed so as to force the gullible and well intentioned to choose between public safety and economic growth. It is a false argument and a false choice. It ignores the facts - not the least of which is an entire half century of post-war expansion during which bankers operated profitably at lower levels of leverage. That such myths find favour with otherwise intelligent commentators shows that intellectual capture is alive and well. Other stakeholders in financial stability - such as the investment Foreword - xi industry, should speak up to help counter the sway of the spurious but seductive. Indeed, a proposal to mobilize better the competing interests in the regulatory debate is one of the author’s principal recommendations. This publication is not a polemic. It did not begin with a particular point of view followed by a search for supporting facts. Its conclusions flow from a dispassionate review of the question. The objective of the author, as indeed that of its sponsoring publisher, is the making of better regulation. What therefore, could be more timely than an analysis of a key impediment to effective rule making and supervision? The work contains a series of thoughtful reflections on the topic of capture in the regulation of the financial sector. It examines the issue through the eyes of both the regulator and regulated. It taps perspectives of both the practitioner and the academic.

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