The theory of regulation: A review article Chibuike Ugochukwu Uche Journal of Financial Regulation and Compliance; Feb 2001; 9, 1; ProQuest pg. 67
The theory of regulation: A review article
Chibuike Ugochukwu Uche Received (in revised form): 24th August, 2000
Department of Banking and Finance, University of Nigeria, Enugu Campus, Nigeria
Dr Chibuike Ugochukwu Uche holds a doc market.2 Some forms of regulatiou, how torate in accounting and finance from the ever, tend to be paternalistic in nature, London School of Economics and Political often overriding the individual's right to Science. He is currently a senior lecturer choose, even when such an individual has in the Department of Banking and Finance all the relevant information available to at the University of Nigeria, Enugu him _3 For instance, it is common practice Campus. for people to be prevented by law from driving a motor vehicle without putting ABSTRACT on their safety belts or working under a This paper examines the various theoretical contract of employment without contri issues in regulation with a view to enhancing buting to a pension scheme. But paterna understanding cif the regulation arena. Special listic regulation is sometimes entwined emphasis has been placed otl the bar1king indus with regulation on grounds of public try. The paper shows how regulation serves dif interest. For instance, the failure to wear a ferent purposes for different iHterest groups on safety belt, when driving a car, may give differem occasions. It further argues that because rise to medical costs, which are borne by of the ever shifting concept of 'public good', the taxpayers via the National Health Ser shifting individual and group interest and, per vice Scheme. The taxpayer thus has an haps the entwit1ement of individual and public interest in reducing such costs and paterna good, ~1either the captllre theory or the public listic regulation is one way of achieving good theory has yet }illly explained the ratio this. nale for regulation. A clear understmzdin:< of the Taxpayers may also have to come to the theoretical issues involved in regulation is there rescue when the individual is left indigent fore important il the forces that drive regulation as a result of unwise fmancial decisions are to be appreciated jitlly. such as a reluctance to save for years when paid employment is no longer feasible. The Regulation generally suggests some form end point of all regulatory proces,es is the of intervention in any activity, and ranges enshrinement of some code of conduct for from explicit legal control to informal the regulated activity. Whatever rules are peer group control by government or finally agreed they usually have diverse some such authoritative body. 1 Regulation consequences for various interest groups. sometimes stems from market failure, This has made the regulatory process - which usually occurs when market transac ranging over how such regulation is pro tions give rise to spillover effects (or posed, fqrmally considered and approved, Journal of Financial Regulat1on and Compliance, Vol. 9, No.1. externalities) on third parties, or when administered, interpreted, evaluated and 2001' pp. 67-80 4 1 Henry Stewart Publications, there is information inefficiency in the altered·- a political activity. 1358-1988
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The aim of this paper is to examine the the Thalidomide incident, even though the various theoretical issues in regulation with bill had languished in committee hearings a view to enhancing understanding of the for years.'1 Examples of crisis-inspired legis conceptual issues in the regulation arena. lation 111 the UK include the Royal The emphasis is on the banking industry. Exchange and London Assurance Corpora To achieve its aim, the paper is divided tions Act (Bubble Act) of 1719. This Act, into four parts. The first part discusses the which outlawed the joint stock companies two main theories of regulation while the of the time, vvas a direct consequence of the second examines alternative styles of regu widespread abuse of the system, mainly in lation. The third part discusses the special the form of fraudulent promotion of such nature of the banking trade, which further companies, culminating in the famous 1 1 impacts on its regulation, while the fourth South Sea Company Scandal. ' Likewise, concludes the paper. the 1956 Clean Air Act, was a direct conse quence of the London 'killer smog' of THEORIES OF REGULATION 1952. 11 Two mam conflicting theories have An implicit assumption of the public evolved over time in the attempt to explain interest theory is that regulation is, in the both the origins and practice of regulation: main, aimed at protecting the public. To public interest and capture theories. The achieve its aim, regulation based on the public interest theory holds that regulation above principle should aim at equipping is supplied in response to the demand of the the public with all relevant information public for the correction of inefficient or necessary for decision making. Regulation inequitable market practices.~ It is therefore in the public interest should also strive to not surprising that until the late 1960s, protect the public from monopolies and most economists regarded the growth of industries that generate substantial external regulation as an attempt by government to costs or benefits. This docs not always improve upon the allocation of resources h appen m. pract1ce. . P- F urt h ermore, were which would otherwise occur in unregu this theory right, one should also expect no lated markets. This belief was based on the support for regulation from regulatees. 11 implicit assumption that some forms of This has not always been the case. In the activities, business or otherwise, do not USA, for instance, the railroads supported always function in the public interest with the enactment of the first interstate com out supervision or control. This view has a merce act which was designed to prevent historical antecedent: regulation in the past railroads from practising price discrimina (and even today) had almost always fol tion. This w.1s because discrimination was lowed some form of crisis or public dissent. undermining the railroad's cartels. 14 Also, It was, for instance, the protest of the popu American Telephone and Telegraph list farmers against the exploitative rates pressed for state regulation of telephone levied by railroads that led to the creation services because it wanted to end competi of the Interstate Commerce Commission in tion among telephone companies. 1 ~ the USA.r' The establishment of the Securi The image of government as a costless ties and Exchange Commission is yet and reliable instrument for altering market another example of a crisis driven regula behaviour has also been extensively ques tion. 7 The Food and Drug Act of 1938 in tioned. 1° Cmts are incurred in the provi the USA was passed following a drug acci sion of data and information to regulators. dent.K The 1962 Drugs Amendments Act, It is also possible for regulation to reduce also in the USA, was passed shortly after the reactivity and flexibility of companies
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. . . 17 R to a d apt to c h angmg env1ronmcnts. eg- available to them. Persuading a customer ulation could also affect management style. to utilise one's services will no doubt pro Management, for instance, may become duce a payoff, but so also can getting the more oriented towards satisfying the regu government to impose some form of tariff lators than towards meeting its proper on your competitors or to grant subsidies. business demands and objectivcs. 1 ~ Based The choice, therefore, between market and on the above, it has been widely claimed political action is essentially an economic that the costs of regulation are greater than one and will depend upon the relative costs any welfare losses arising from inefficiencies involved and the chances of success in each 2 in market-based allocation of wealth. case. (' It was this trend towards analysing Empirical studies consequent to these the usc of political processes from an eco contradictions in the public good theory nomic perspective, rather than implicitly show little evidence that government regu assuming that they are infallible mechan lation, especially in the form of state inter isms for the production of the 'public 1 27 vention, is beneficial to the public. 'J If good' that led to the reappraisal of gov regulation could no longer be assumed to ernment regulation. be implemented in the pursuit of efficiency Regulation imposed on the grounds of objectives, then it becomes legitimate to public interest may sometimes end up ser inquire into its effective objective. ving the interest of the regulated group. 2 Stigler, in a path-breaking article, (' An example of this can be found in the attempted an answer asserting that 'as a regulation of the tobacco industry in the rule, regulation is acquired by the industry USA (The Prohibition of Adverti>ing Act and is designed and operated primarily for of 1971). It has been argued that it was the its benefit'.21 This proposition has come to industry, not the consumers, that benefited be known as the capture theory of regula from this act which banned cigarette 2 tion?=' Bluntly put, the regulatory agencies advertising in the broadcasting mcdia. H are captured by the industry they are sup Such benefits arose mainly because of the posed to be regulating. In other words, following factors: regulation, far from supporting the general public interest by achieving efficiency the ban on such advertising made the gains, is enacted and implemented in the fairness doctrine inapplicable29 interest of specialist producer groups. n the industry saved money after the ban Proponents of this theory argue that because it reduced 1tS ad vcrtising people in their political behaviour cannot expenditures be assumed to be motivated by fundamen industry sales increased significantly tally different forces than in their private after the ban choice-making bcha vi our. Self-interest is it helped the then ex1stmg local firms usually put above all other intcrests.24 The perpetuate their control of the national industry which seeks regulation must be market. This was so because the ban on prepared to pay with two things a political advertising made it difficult for new party needs: votes and resources. In non firms to enter the market:''' democratic societies the price can some times, be remarkably less: personal friend Public and private interests, it has also been ships with the junta members or family argued, are entwined. For instance, it has relationships can be very useful. 2 ~ In gen been suggested that the best way to act in eral, people simply pursue their objectives, the interest of the public is by putting whatever they are, using the resources ones' pnvate . mterest . £:urst.- "l\
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It is also the shifting concept and varied function of adjudication and enforcement interpretations of 'public good' that have of rules from the regulated industry. "l
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The benefits of a self-regulatory scheme eral, the greater the external consequences could be immense. For instance, by redu of an industrial practice, the less acceptable cing reliance on statutes, self-regulatory self-regulation becomes. An example can schemes generally offer a speedier and be found in the banking industry. more flexible means of solving problems.47 Also, by utilising the skills of those THE SPECIAL NATURE OF THE involved in the business, self-regulation BANKING INDUSTRY schemes may be able to overcome the The b:mking industry is special in terms of information problems sometimes faced by regulation as experience has shown that government regulatory bodies, and stan failure (bankruptcy) in this industry has dards can conceivably be set higher than in external consequences?' The concern to 4 a statutory scheme. H Finally, the costs of safeguard the viability of the depositary self-regulatory regimes are normally inter industry arose from the fact that financial nalised in the trade or activitv which is failure had significant external effects that . ~ . expose d to reguI ation. reached beyond the depositors and stock Perhaps because of the variety of inter holders of the financial firm."(' The deposi ests that impact on self-regulation, in prac tary institution played an important role as tice it has not been without blemish and the chief conduit in both the payment pro some schemes have found it difficult to cess and the savings and investment pro meet some of the guidelines aimed at cess. Failure of individual firms in the enhancing the credibility of self-regula depositary industry may lead to widespread tion. 511 Criticisms of such schemes include deposit runs that could overflow to other the fact that such schemes do not necessa depositary firms. S? This has come to be 1 5 rily cover all the firms in the industry." known as the contagion eftcct. K The negotiation and bargaining necessary Institutional developments like the rise in to introduce a self-regulation scheme, in interbank lending and various money some cases, also take place without an market operations, propelled mainlv by the input from third parties. 52 Finally, it has spirit of competition with the aid of been claimed that self-regulation schemes advancements in information technology, have a poor record of enforcing their stan have also added to the contagion problem. dards against disobedient members.53 There has therefore been a steady rise in the Apart from all the above disadvantages, entwinement of banks not just with their self-regulation is not always possible. For customers, but also with other banb. There instance, the industry concerned may be fore, no matter how small a financial institu too diverse, making it impossible for the tion may be, the impact of its failure may be 5 level of agreement necessary for such regu far-reaching for the entire fmancial system. 'J lation to be obtained. An example is the The danger of contagion is particularly Estate Agency Industry in Great Britain, acute for the banking system. If a cement where the Office of Fair Trading had for a manufacturer, for instance, fails, the ill long time encouraged the industry to take effects are likely to be felt most by those voluntary regulatory measures but with who have had dealings with the institution. little success until the formation of the The repercussions for the industry and the Ombudsman for Corporate Estate Agents, general economy as a whole will tend to which still covered only half of the indus be much less serious. In fact, the l:ompeti try. This led to the enactment of the Estate tors may inherit some of their late rival's Agents (Provision of Information) Regula market share. The above scenario can of tions, 1991, by the Government."-+ In gen- course occur in an isolated bank failure
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especially when the reason for the failure helped. r, 5 In some developing countries, can be clearly seen to be specific to the this may create problems. For instance, bank or a group of banks. In certain cir new indigenous banking businesses are cumstances, however, the collapse of a likely to be small with perhaps insignificant bank could, in the absence of any official effect on the financial system should such action, lead to loss of conf1dencc in the banks collapse. Such banks will therefore entire banking system and a subsequent be unlikely candidates for assistance under mass withdrawal of depositors' funds from the above regime. It is perhaps because of the system. In such a scenario, therefore, this that the protection of infant industries formal disclosure requirements are likely to has become a reason for government inter be of little practical assistance. Irrespective vention in banking (and other businesses) of the bank's balance sheet strength, it may in some countries_c,r, Size alone, however, is still be rendered insolvent by the actions of not the only explanatory factor in the . (,1\ oth er d epos1tors. theory of which distressed bank gets assis The increased integration of the financial tance.r,7 Other factors, no doubt, are system, which has resulted in the rise in usually part of the explanatory variables. interbank dealings, has also increased the The desire by some countries to limit or prospects of contagion should one bank preclude foreign participation in a sector fail. Therefore, when the banking system which is regarded as vital to the proper cooperates to save a distressed member, it functioning of the national economy and is more an act of self-preservation than an the attainment of national policy objectives act of charity. It is mainly on the above is yet another reason for government inter 1 basis that it has been possible to secure the vention Ill banking. 'H This ts usually cooperation of the banking community in entwined with the typical infant industry times of stress. For instance, during the argument. ul It was in this respect that the 1973 secondary banking crisis in Britain, Reserve Bank of Australia cautioned that: large sums of money flowed out from the secondary banks to the clearing banks. 'Banking is a key sector of the economy These funds were recycled back to the sec providing the community with money ondary banks through the famous 'lifeboat balances and payments arrangements. operation. '(JI. Control of ownership of banks should It is thus clear that it is the problem of therefore he maintained in Australian contagion that is the reason for preventing hands to ensure concern for the national those who do not meet the minimum interest. Foreign banks may be inclined requirement necessary to achieve the status to give prior place to commercial of a bank or licensed deposit taker from advantage or to another country's 711 taking deposits. If the problem of conta national interest' . gion did not exist, there might be a case for confining regulatory action to only The protection of depositors is yet another 'club members' without going on formally objective of bank regulation. Subsequent to bar non-'club members'r,2 from carrying to the financial crisis of 1929-1933, bank . b . (,) on d epos1tary usmesses. · ing regulators around the world empha But not all ailing banks have been saved sised this objective. Such an emphasis drew in the past. Between 1933 and 1982, 620 its strength from the political and social banks failed in the USA alone.64 The size trends evident in many countries towards of a distressed bank, no doubt, plays a the protection of customers and away from major role in determining whether it gets the principle of caveat emptor. 71 There is
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. usually a case for deviating from the caveat bank. Banks have also been instructed by emptor principle in certain industries. This is the government to avoid investments in especially so where it is inherently difficult certain sectors of the economy. either by for the individual or consumer to as-;ess the direct ban or by making it unprofitable for goods or services he or she is buying or them to do so. where the learning process for society may Another reason for regulating the finan be judged too cost! y or difficult. cial system stems from the need to foster The fact that an institution is supervised the efficiency and integrity of the market may be taken perhaps inappropriately, to by minimising the problems that may arise mean that they have been given an official from conflicts of interest on the part of seal of approval. It is as a consequence of market participants. Here, there are various this that it may be argued that the supervi ways of ensuring that conflicts of interest sory authorities carry some responsibility do not arise and, where they do, that they towards the members of the public. The do not impact on the integrity of the belief may also grow up that either the market.7s In Britain, at least before the Big authorities will not allow the institutions to Bang in 1986, the brokering function was 7 fail or, where they fail, depositors will be separated from the jobbing function. (' In compensated. 7 ~ other words, stockbrokers could only act as Many countries have deposit protection agents to their clients and jobbers could schemes in operation. In the UK, the not deal directly with the investing deposit protection board provides protec public.77 The early bank charters in the tion for only 75 per cent of deposits for USA also enshrined the separation princi total deposits of up to £20,000. In the pk. By 1930, however, such a separation USA, where the bank failures of the 1930s system had been abandoned in the USA proved a more traumatic experience, and commercial banks had become the depositors have a better deal: deposits of up dominant force in the distribution and 73 7 to US$100,000 are protected in full. The underwriting of securities. K Whether the limits on the protection of depositors in the banking crisis of the early 1930s wa-; a con UK implicitly assumed that even the small sequence of the abandonment of the man should not be fully compensated for separation principle has remained a conten losses due to mismanagement. If a deposi tious issue among scholars and banking tor can earn a higher return by placing practitioners alike,79 although the advent of funds with somewhat higher risks, full the Glass Steagall Act implicitly endorsed compensation may be an undue incentive such a view. to continue doing so as the depositor will be earning higher returns while the risks CONCLUSION arc borne by another party.74 The aim of this paper has been to examine Banking regulation docs not, however, the various theoretical issues in regulation only aim at preventing banking failures. with a view to enhancing understanding of Banks may also be regulated to ensure that the regulation arena. Special emphasis has they carry out their activities in accordance been placed on the banking industry. The with the wider economic and social objec paper shows how regulation serve-; differ tives of the country. For instance, it is not ent purposes for different interest groups unusual for banks, especially in developing on different occas1ons. Furthermore, it countries to be given credit policy guide argues that because of the ever-shifting lines especially on the sectoral allocation of concept of 'public good', shifting indivi loans, either by government or the central dual and group interest and perhaps the
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cntwinement of individual and public 'The marasmus of the ICC', Yale Law good, neither the capture theory or the jo!lmal, Vol. ()1, pp. 4()7-509. public good theory has yet fully explained (7) Investigations mbsequent to the great crash of 1929 revealed that the speculative the rationale for regulation. A clear under fever of the 1920s had been worsened for standing of the theoretical issues involved thousands of small investors and specula in regulation is therefore important if the tors by fraud in the touting of equity forces that drive regulation arc to be fully securities. For instance, stocks were issued appreciated. for worthless corporations without true informatilln being made available to pur
AcKNOWLEDGEMENT chasers. Investment companies affiliated I am grateful to Professor Christopher with commercial banks also manipulated Napier and Professor Richard Maeve for market prices to the advantage of insiders and the distress of outsiders. The conse their comments on earlier versions of this quence was legislation in 1933 (informa paper. All errors however remain mine. tion disclosure regarding new securities) and 1934 (regulation of securities market) REFERENCES culminating in the establishment of the (1) Ogus, A. (1994) 'Regulation: Legal Form SEC (Reagan, M. D. 1987 'Regulation: and Economic Theory', Clarendon Press, The politics of policy', Little Brown and Oxford, p. 1. Companv, Boston.) (2) Sec Brom wich, M. (1985) 'The economics (8) The drug involved was elixir sulphanila of accounting standard setting', Prentice mide wh1ch contained a poison that killed Hall, London and Bromwich, M. (1992) more than 100 people in September 1937. 'Financial reporting, information and (T em in, P. (1979) 'The origin of compul capital markets', Pitman Publishing, sory drug prescriptions' The Journal of London for an extensive discussion of Law and Ew11vmics a11d A1anclgement market failure. Scima_,, Vol. 2, pp. 94-95). (3) Dworkin defined paternalism as 'the (9) The bill gave the Food and Drug Admin interference with a person's liberty of istration (FDA) authority to require that action justified by reasons referring exclu new prescription drugs be proven effec sively to welfare, good, happiness, needs, tive f()r the announced purposes. This fol interests or values of the person being lowed the public disclosure, m the coerced'. Quoted in Ogus (1994) op. cit., vVashin,Rt,m Post, that there was a wide p. 51. spread birth detect problem of truncated (4) Lasswell, H. D. (1950) 'Politics: who gets or missing limbs in babies born to Eur what, when, how', Peter Smith, New opean women who had used the sedative, York. Lasswell defmed politics as who thalidomide, while pregnant (Reagan gets what, when and how. For the pur (1987) op. cit., ref. 7, p. 20). poses of this study, the Chambers English (1 0) Edwards. J. R. (1980) 'British company Dictionary definition of politics as the legislation and company accounts, 1844- 'maneuvering and intriguing' involved in 1976', Arno Press, New York, p. vi. This the formulation and implementation of Act was repealed in 1825. regulation, will be used. (11) The incident, which caused the death of (5) Peltzman, S. (1989) 'The economic theory 4,000 people in Greater London, led to of regulation after a decade of deregula the government appointment of the tion', in Bailey, M. N. and Winston, C. Beaver Committee and the consequent (cds) 'The Brookins Papers of Economic legislation (Cunningham, N. (1974) 'Pol Activity', Brookins Institution, Washing lution, social interest and the law', Martin ton, p. 4; and Ogus (1994) vp. cit., p. 15. Robertsun and Company, London, p. (f>) Sec, for instance, Huntington. S. (1952) 59.)
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (12) Posner, R. A. (1974) 'Theories of eco 'Comment', Joumal of Law and Etorwmics, nomic regulation', The Bell Jotmtal (~f Eco Vol. 19, pp. 245-248, emphasised, it is nomics and l\JJ.anaY,ement Science, Vol. 5, p. best to think of an economic theory of 336. regulation rather than a theory of eco (13) An implicit assumption of the public nomic regulation. interest theory of regulation is that public (21) Stigler (1971) op. cit., p. 3. interest and the interest of regulatees are (22) The capture theory was not new m 1971. dissimilar. Well-known versions had appeared earlier (14) Posner (1974) op. cit., p. 337. (see for instance, Bernstein, M. H. (1955) (15) Ibid. 'Regulating business by independent (16) Sec, for instance, Posner, R. A. (1970) 'A commission', Princeton Universitv Press, statistical study of antitrust enforcement', Princeton). What was new was its broad Journal of Law and Economits, Vol. 13, pp. appeal to economists based on the accu 3()'1--419, Gerwig, R. W. (1%2) 'Natural mulating evidence of empirical research gas production: A study of costs of regu (Pcltzman (1!)89) op. tit., p. 5). lation', The Journal of Law and Economics, (23) Some scholars have since attempted a Vol. 5, pp. 69-92 and Stigler, G. (1 971) modification of the basic capture model. 'The theory of economic regulation', Bell For instance, Peltzman (in Pcltzman, S. Journal of Economics and 1\;fanagement (197()) 'Toward a more general theory of Sciences, Vol. 2, pp. 3~21. regulation', The Journal of Law and Eco (17) Regulated companies are sometimes nomics, Vol. 19, pp. 211 ~248, argues that required to seck approval before adopting the complete capture of any agency by new technologies or venturing into new any group would imply that the ;1ctivities areas. of the agency were run exclusive! y in the (18) Gardener, P. M. (1986) 'Supervision in interest of that group. Such a policy must the United Kingdom' in Gardener, P. M. inevitably arouse opposition from other (ed.) 'U.K. banking supervision: Evolu groups who are adversely aftccted, and a tion, practice and ISsues', Allen and more likely outcome of the regulatory Unwin, London, p. 29. process would be a balancing of opposing (19) Stigler, G. (19M) 'Public regulation of the interests. The point of political equili securities markets', The Joumal of Business, brium in the Peltzman model will depend Vol. 37, pp. 117~ 142. Stigler, for instance, upon the organisational costs faced by the compared the performance of a typical two opposing groups. portfolio of new issues before and after (24) For instance, it is a well-known fact that the setting up of the Securities and the allocation of television channels Exchange Commission which attempted among communities docs not maximise to impose regulations to ensure the accu industry revenue but reflects pre:;surcs to racy of the information accompanying serve many smaller communities (Stigler the floatation of new shares. Stigler simi (1!J71) op. cit., ref l(i, p. 7). larly concluded that 'grave doubts exist (25) This is perhaps because such governments whether, if account is taken of the cost of are usually less accountable. The absence regulation, the SEC has saved the purcha of checks and balances discourages reason sers of new issues one dollar'. Sec also and dialogue in decision making. Any Gerwig (1962) op. tit., ref 1(), and Stigler, attempt, therefore to understand the G. and Friedland, C. (1962) 'What can mechanisms of decision making under regulators regulate' The case of electri such systems becomes onerous. city', The Journal of Law and Economics, (26) Ricketts, M. and Shaw, K. (19H4) 'The Vol. 5, pp. 1-l(i. theory of regulation', in Peacock, A., (20) The title of Stigler's 1971 paper (The Ricketts, M. and Robinson, J. (eds) 'The theory of economic regulation) 1s some regulation game: How British and West what misleading. As Becker, G. S. (1976) German companies bargain with govern-
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mcnt', Basil Blackwell Publishers, again; then it continued to move up gra Oxford, p. 14. dua11y through 1972, 1973 and 1974' (27) Society's perception of 'public good' (Doron (1979) op. cit., ref 28, p. 91). changes over time. This is because such (30) Doron (1979) op. Lit., ref. 28, p. 84. The perceptions arc determined by a shifting tobacco industry in America has under interplay of a variety of forces: bureau gone extensive changes since Doron's crats, careerists, professionals, political work. This is perhaps due to the ever appointees, legislators, courts, interest increasing activities of the anti-smoking groups, the media etc, with differing campaigners. Do ron's findings, therefore, objectives, views and stakes that are sub arc unlikely to be legitimate now. See for ject to change depending on the issues and instance, Finall(ial Times, 18'h March, the circumstances (Katzmann, R. A. 1996 and 9'11 April, 1996. (1990) 'Comments on Levine and Forr (31) According to Adam Smith 'As every indi ence, "Regulatory capture, public interest vidual ... endeavours as much as he can and the public agenda: Towards a synth both to employ his capital in the support esis"', Joumal of Law, Economics & Organi- of dome-,tic[k] industry, and so to direct satimz, Vol. 6, p. 200. that industry that its produce may be of (28) Before the industry was mandated to stop the greatest value; every individual neces advertising in the broadcasting media, it sarily labours to render the annual rev was low in the ranking of profitable enue of the society as great as he can. He American industries. In the 1970s, subse generally, indeed, neither intends to pro quent to the ban, they catapulted to the mote the public[k] interest, nor knows top (Doron, G. (1979) 'The smoking how much he is promoting it . . . he paradox: Public regulation in the cigarette intends only his own gain, and he is in industry', Abt Books, Cambridge, Massa this, as in many other cases, led by an chusetts, p. 86). By 1972, the failure of invisible hand to promote an end which the prohibition of cigarette commercials was no part of his intention' (quoted in had been realised in some quarters. For Raphael. D. D. (1985) 'Adam Smith', instance, Bruce W. Wilson, then the Oxford, University Press, Oxford, p. 70. Deputy Assistant Attorney General told The invisible hand theory is not without the Senate Consumer Subcommittee hear its critics. See for instance Hahn, F. (1982) ing that 'the public interest might be 'Retlectinns on the invisible hand', Llo yds better served through the assumption of Bank Rel'iew, Vol. 144, pp. 1-21. both cigarette commercials and the anti (32) For imtance, the 1905 Companies Act in smoking messages that were so prevalent the Gold Coast (Ghana) prevented Gold before the broadcasting ban' (Doron, Coast registered companies from enga 1979, p. 89). ging in banking activities. This legislation (29) According to the American Cancer effectively eliminated Africam from enga Society, 'While this law [The Prohibition ging in such practices. At the time, the of Advertising Act] was hailed as a vic Atricans, though an interest group in the tory for the anti-smoking forces, it could Gold Coast economic arena, were not a not be foreseen that it would also produce political force to be reckoned with. The a serious drawback. Since the broadcasters political equation was altered in the 1940s. could no longer advertise cigarettes, they With the imminence of independence, the no longer were required to carry anti retention of the native exempt clause cigarette messages. How powerful these became politically inexpedient for the messages had rea11y been was demon colonial government. Thus a shift trom strated by what happened when they direct discrimination regulation to those were no longer there. By the end of 1971, that appealed to economic reasoning and the per capita consumption curve for the protection of the 'public interest'. Sec cigarettes had begun to point upward Trevor, Sir Cecil (1951) 'Report on bank-
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ing in the Gold Coast and on the question (39) Ogus (1995) op. cit., p. 99. of setting up a national bank', Govern (40) Bank of England (BOE) (1978b) op. cit., ment Printers, Accra and Uchc, C. U p. 379. This is perhaps because laws and (1995) 'From currency board to central rules often reflect compromise rather than banking: The Gold Coast experience', the interests of any one group (Gunning Sollth Aji·irall Joumal of Economic Histary. ham, N. (1974) 'Pollution, social interest Vol. 10, pp. 80- Page 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The theory of regulat1on A rev1ew art1cle tions for non observance; (8) the scheme tiny. They are usually subjected to various must be monitored and updated in the capital adequacy, liquidity, reserve, risk light of changing circumstances and management and lending regulations. expectations; and (9) there must be a (57) The losse> of depositary failure are, how degree of public accountability such as an ever, not constrained to the depositors and annual report (NC:C (1986) op. cit., p. 15). deposits. The external effects are usually (51) Those who have not agreed to follow large. For instance, the cumulative failure self-regulatory schemes arc usually the of the depositary industry has been identi source of consumer problems (NCC fied by some scholars as the reason behind (1986) op. cit., p. 6). Reynolds (1981) also the great depression of the 1930s (Spell asserted that as 'a social group grows and man, L. J. (1982) 'The depository firm becomes more complex, the efficiency of and indu-;try: Theory, history and regula non-market implicit controls declines. tion·, Academic Press, New York, p. 9. The group becomes more heterogeneous, (58) Justifying its support operations during and general agreements on ethical values the fringe-banking crisis of 1973, the and other institutional arrangements Bank of England argued that it found decreases' (quoted in Reagan (1987) op. itself 'confronted with the imminent col cit., ref. 7, p. 34). lapse of several deposit-taking institutions, (52) Ramsay, I. (1987) 'The Office of Fair and with the clear danger of a rapidly Trading: Policing the consumer market escalating crisis of confidence. This threa place', in Baldwin, R. and McMrudden, tened other deposit-taking institutions C. (eds) 'Regulation and public law', and. if left unchecked, would have W eidenfeld and Nicolson, London, p. 191 quickly passed into parts of the banking and Breyer, S. (1982) 'Regulation and its system proper. While the UK clearing reform', Harvard University Press, Cam banks still appeared secure from the bridge, p. 179. domestic effects of any run ~ indeed the (53) Graham (1994) op. cit., p. 195. money-market deposits withdrawn from (54) Ibid, pp. 195~196. the fringe were largely redeposited with (55) The supervision of banks, unlike the other them ~ their international exposure was non-financial industries arises from the such that the risk to external confidence umque fiduciary responsibility which was a nutter of concern for themselves as bankers assume when they accept other well as fnr the Bank. The problem was to people's money for safekeeping. It is avoid a widening circle of collapse therefore not surprising that the defining through the contagion of fear'. (Bank of activity for statutory control is usually the England (1978a) 'The secondary banking act of deposit. Cooke, P. W. (1982) 'The crisis and the Bank of England's support role of the banking supervisor', Bank of operations', Bank of Englm1d Quarterly Bul England Quarterly Bulletin, Vol. 22, p. 547. letin, Vol. 18, p. 233.) (56) In an attempt to safeguard such depositary (59) In line with this, the 1985 Annual Report firms, it is usual for regulating bodies to of the Federal Reserve Bank of New set up entry barriers into such activities. York, commented as follows 'The inter For instance, a licence is widely required connections among institutions and mar before any company can engage in bank kets in the new environment get more ing functions. Licensing conditions usually and more complex. A shock that starts in include: a minimum paid up capital, one market may spread quickly along this security clearance of the directors, avail network until it fmds a weakness in some ability of competent manpower among seemingly unrelated place. In fact there is others. Licensing is also sometimes influ a growmg tendency to build financial enced by the overall macroeconomic goal links along regulatory fault lines where of the territory. Established financial insti the responsibility for supervisory over tutions also come under regulatory scru- sight is weak, divided or clouded' (p. 26). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (60) Bank of England (1984) 'The business of recycled deposits; (2) that the company financial supervision', Bank of England exhibited suffiCient banking characteristics Quarterly Bulletin, Vol. 24, p. 49. to justify inclusion in the scheme (the pos (61) Reid, M. (1986), 'Lessons for bank super session of a s.123 certificate, for instance) visJOn from the secondary banking crises', and had attracted a significant level of in Gardener, E. (ed.) 'UK banking super deposits from the public; and (3) that the viswn: Evolution, practice and issues', company did not possess any institutional Allen and Unwin, London, p. 100. shareholders whose interest in the com (62) Bank of England (1984) op. cit., p. 50. pany was such that they might properly (63) There is, however, a case for protecting be expected to provide the necessary sup the unsophisticated depositor from the port (Bank of England (1978a) op. cit., ref. unreliable operators. This will be dis 58, p. 233). cussed later. (68) Reserve Bank of Australia (1979) 'Sub (64) Dale, R. (1992) 'International banking mission to the Committee of lnqlllry into deregulation: The great banking experi the Australian Financial System', Reserve ment', Blackwell Publishers, Oxford, p. 8. Bank of Australia, Sydney, Ch. 12. (65) For instance, the bailing out, in 1984, of (69) It is usually argued that it is nece"ary to Continental Illinois, was justified by the offer some form of protection to indigen then FDIC Chairman, Mr William Isaac ous companies. Such protectton IS on the grounds that 'closing the bank and required in order to protect them from paying off insured depositors could have the usually better-equipped foreign com had catastrophic consequences for other panics. This is necessary tor the 'urvival banks and the entire economy. Insured and constrained development of indigen accounts totalled only slightly more than ous companies (United Nations Centre $3bn. This meant that depositors and for Trans National Corporations other private creditors with over $30bn in (UNCTC, 1981) 'Transnational banks: claims would have had their funds tied up Operations, strategies and their effects on for years in a bankruptcy proceeding developing countries', United Nations, awaiting the liquidation of assets and the New York. settlement of litigation. Hundreds of small (70) Reserve Bank of Australia (1979) op. cit., banks would have been particularly hard Ch. 12.6. hit. Almost 2,300 small banks had nearly (71) Blunden, G. (1977) 'International co $6bn at risk in Continental; 66 of them operation in banking supervision', Bank (~[ had more than their capital on the line England Quarterly Bulletin, Vol. 17, p. 32S. and another 113 had between 50 and 100 (72) Bank of England (1984) op. rit., p. 49. per cent. More generally, closure of a (73) Ibid. bank whose solvency was apparently not (74) A pos,ible solution to the problem is to impaired, in response to its liquidity and allow privately run insurance schemes to confidence problems would have raised cater for the protection of the depositors. concerns about other soundly managed But this has its own problems: the possibi banks'. Quoted in Dale (1992) vp. cit., pp. lity of a claim does not only depend on 9-10). systematic risks but also on unsy-;tematic (66) This will be discussed later on in this sec risks. The incentive, on the part of man tion. agement, to behave with due care may be (67) In the 1973 banking crisis, the 'lifeboat' reduced if deposit insurance can be pur committee, required the following condi chased. Private insurers may tackle this tions to be satisfied before support was problem by varying the premium rates provided: (1) that the company seeking depending on the riskiness of the deposit support was currently trading solvently taker (ibid.). and was likely to remain solvent provided (7S) Fund management and bond issuing, for it received liquidity support by way of instance, involve potential conflicts of Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The theory of regulat1on A rev1ew art1cle interest, yet UK banks perform both (77) The aboYc regulations changed in 1986. activitie~ and arc able to maintain the con Both stockbrokers and market makers are fidence of their clients by ensuring that a now able to act in dual capacity. They Chinese wall of silence exists between the can, for instance, deal directly with inves different activities. An alternative way of tors (buying and selling securities from maintaining market integrity is to ensure their own books), or act as agents, putting full disclosure of the activities of the deals together f(Jt clients on commission market. This will enable customers to basis. There are however rules in place to check that they arc getting the going ensure that investors are not disadvan prices. The best approach to adopt is open taged under this dual capacity system. See to argument. For instance, it could be Bank of England (1 985). 'Developments argued that the abolition of a single capa in UK banking and monetary statistics city could lead, through agglomeration, since the Radcliffe Report', Bank of Eng to substantial economies of scale. On the land Quarterly Bulletin, Vol. 25. pp. 392- other hand, the in formation required to 396. make the disclosure system work could be (78) Sec Dale (1992) op. Lit., Ch. 2, for an ana very expensive both to produce and con lysis of c'Vents leading to this abandon sume (ibid, p.47). ment. (76) As a result of the Big Bang, jobbers were (79) Sec also Dale (1992) op. cit., Ch. 2, for a replaced by market makers. review of the debate. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.