Submission from the International Centre
for Financial Regulation (ICFR)
EXECUTIVE SUMMARY
1. The need for a contextual framework:
Without a clear understanding of why and when regulation needs
to exist, what purpose it fulfills, and whether it is fit for
purpose, it is difficult to succeed at regulatory reform.
2. The need for an international outlook:
The interaction between the decisions of this Committee and the
broader European and international context cannot be ignored,
particularly where (1) there is overlapping legislation within
the European Union, particularly on banking, insurance and consumer
protection, and (2) more globally when regulation addresses an
industry or constituency which operates across national boundaries.
The "unintended consequences" caused by the creation
of national regulation extend in increasing order of importance
to: decreasing private sector efficiency by ensuring compliance
with a variety of similar but not identical regulations in the
various jurisdictions within which they operate, making it impossible
to operate in certain jurisdictions due "conflicts of law"
for companies operating across borders, as far as effectively
imposing barriers to the free trade in goods and services by way
of regulation unintended for that purpose.
3. Lessons for regulation from the current
crisis:
— To be effective the shape of regulation
must match the shape of the industry being regulated.
— It is almost impossible to have successful
regulation without effective leadership.
— Consider the potential "unintended
consequences" of any regulation.
— The interaction across players or reliance
on outside or unregulated parties can create dependencies on third
parties not originally recognized in regulation.
— The alignment of interests is key.
4. The need for consultation across user
groups: One of the best means to consider possible unintended
consequences is a broad and wide consultation process in advance
of major regulation.
5. The need for focus on compliance and
enforcement: In most cases, regulation without any commensurate
oversight, supervision, or enforcement makes it extremely unlikely
to achieve compliance, unless the very act of complying is of
direct positive utility to the regulated.
TERMS OF
REFERENCE
1. Current developments:
— Implications of the recent economic developments
for the design and delivery of the regulatory reform agenda, including
risk-based regulation?
— How does the Government balance the need
for an effective regulatory framework—providing the necessary
benefits and protections—with the commitment to improve
the conditions for business success?
— How might a proportionate and targeted
response to improving the regulatory framework in the wake of
the financial crisis be made? What lessons are there for the wide
regulatory reform agenda?
— How could the government improve its
capability to regulate in a proportionate and effective manner?
— Whether there is a coherent package of
regulatory measures for improving the conditions for business
success; and how regulatory reform initiatives fit into wider
Government support.
— Balance between knee jerk political pressure
for action and the correct and thoughtful response which relies
on understanding what regulation is trying to achieve.
The need for a contextual framework
6. The current economic and financial crisis
demonstrates the need for a genuine understanding of why and when
regulation needs to exist, what purpose it fulfills, and whether
it is fit for purpose. Without a clear understanding of these
issues for regulation in general and for the specificities of
each regulation under discussion, it is difficult to succeed at
regulatory reform. With a clear framework for these questions,
it becomes a fairly quick process to determine which regulations
meet the criteria and which do not.
7. It is our understanding that your remit
currently addresses only a portion of these issues; that is to
ensure regulatory activities should be carried out in a way which
is transparent, accountable, proportionate and consistent; and
that regulatory activities should be targeted only at cases in
which action is needed. It is not clear to us how "need"
is defined, and this may be a critical area on which your committee
may want to reflect. In particular, it is very difficult to determine
the utility of regulation without understanding what it is intended
to achieve, and the need for what it is trying to achieve. Perhaps
the Regulatory Reform Committee's remit is achievable if it works
closely with departments actually proposing regulation in order
to understand the need and purpose for such regulation.
8. Current public opinion seems to be calling
for "re-regulation" or increasing regulation to prevent
any future financial or economic crisis from occurring. This is
both unrealistic and populist. A better approach is to use current
circumstances to ask if and where existing regulation failed,
and why, and then to draw lessons from that about how better to
approach your remit in future. Continuing along the path of trying
to ensure the conditions for business success is clearly in everyone's
interest and at no time more so than in the current economic climate.
9. We note that the questions largely address
new regulation and regulatory reform. It is absolutely critical
to look at existing regulation as well. Keeping existing regulations
"on the books" when new regulations are written often
causes both duplicative work and conflicts. Moreover, existing
regulation can often outlive its usefulness. A regular review
schedule for the effectiveness of existing regulation would be
fruitful if not already in place.
The need for an international outlook
10. While the remit of the Regulatory Reform
Committee is clearly purely domestic, the interaction between
the decisions of this Committee and the broader European and international
context cannot be ignored, particularly where (1) there is overlapping
legislation within the European Union, particularly on banking,
insurance and consumer protection, and (2) more globally when
regulation addresses an industry or constituency which operates
across national boundaries. The "unintended consequences"
caused by the creation of national regulation are manifold. They
extend in increasing order of importance to: decreasing private
sector efficiency by ensuring compliance with a variety of similar
but not identical regulations in the various jurisdictions within
which they operate, to making it impossible to operate in certain
jurisdictions due "conflicts of law" for companies operating
across borders, to effectively imposing barriers to the free trade
in goods and services by way of regulation unintended for that
purpose.
11. While it is a valiant task to attempt
to ensure regulatory activities should be carried out in a way
which is transparent, accountable, proportionate and consistent
within and across domestic government departments, it is equally
critical to do the same thing across jurisdictions, however difficult
or unpalatable this may be. Now more than ever, when as a nation,
the United Kingdom's economy is a primary beneficiary of international
trade, capital and labour flows, national regulation cannot be
done in a vacuum if we are to avoid the "beggar thy neighbour"
policies that have led to such disastrous consequences in previous
recessions.
The Current Crisis
12. There has never been a better time to
examine what worked and what did not within the regulatory framework.
It is only in times of crisis that we have a "living laboratory"
to help us understand where and why regulation proved an ineffective
restraint for the financial crisis and to learn from this for
the future. There is still enormous work to be done on causality
and lessons from the crisis, but this paper posits five tentative
conclusions.
13. First, the regulatory framework was
not tailored to the nature of the financial system in the case
of many of the institutions. Many institutions had a global business
with a largely domestic regulator. While this is an oversimplification,
a key condition of an effective regulatory structure is that it
fits the shape of the industry. This reinforces concern that the
committee remit does not permit you to look at the purpose of
regulation, and only its implementation.
14. Second, often it is not merely a question
of the quality of the written regulation or compliance with the
letter of that regulation that drives the quality of the regulation,
but rather, a much broader evaluation of the quality of the supervision
and enforcement that accompanies it (see below) as well as the
leadership strength of the department, regulator or supervisor
in question to influence behaviours. This is almost impossible
to write into regulation, but it is almost impossible to have
successful regulation without effective leadership.
15. Third, the cause of the crisis may be
outside the scope of the initial regulation. Within the financial
world this is the oft-heard distinction between micro-prudential
regulation and macro-prudential regulation. Even if the risks
did look manageable within each institution, no one was paying
attention to the accumulation of these risks across all institutions.
The implications of this for non-financial risks are not immediately
obvious, but they are important to consider. Addressing a problem
with regulation can often create another problem unintentionally.
Indeed it is argued by some that the new Basel II regulations
helped create the current crisis by encouraging banks to moving
to an originate and distribute model in order to reduce their
Basel II capital requirements while maintaining product lines
and profitability. The lesson is perhaps to consider the potential
"unintended consequences" of any regulation.
16. Fourth, the interaction across players
or reliance on outside or unregulated parties can create dependencies
on third parties not originally recognized. This can be for subcontracting
or outsourcing regulatory work, or subcontracting of information
provision or verification, or data processing or financial models
with insufficient oversight which leads to mistaken decisions.
While this does not in any way intimate a need for wider or broader
regulatory powers the remit to look across departments at regulation
can be useful in helping to determine where such regulatory dependencies
exist and their possible consequences.
17. Fifth, the alignment of interests is
key wherever possible. Often regulation is perceived as something
to be avoided by the regulated. Or rather, intense effort is made
to produce work which complies with the letter of the regulation
while completely violating the spirit of the regulation. However,
where the regulated can understand and agree with the purpose
and need for the regulation under consideration, and in some cases
even see benefit in the regulation, compliance is likely to be
far easier and far higher. One essential way to encourage this
is to encourage those likely to come under the regulatory regime
to comment on the proposal, and on the proposed implementation
(see below).
18. Each of these lessons demonstrates the
importance of considering the possible unintended consequences
of any regulation.
The need for consultation across user groups
19. One of the best means to consider possible
unintended consequences is a broad and wide consultation process
in advance of major regulation. This is not always fruitful, as
it is often only the dissatisfied who submit to such a consultation,
but it permits a look at the regulation from a broad spectrum
of those affected.
2. Design of new regulations
— Does the Government understand businesses
sufficiently to design effective regulations? Is sufficient emphasis
given to small business and competition issues?
— Is there sufficient consideration of
how regulations will be implemented, including an appropriate
focus on compliance and enforcement issues?
20. The ICFR has limited background and
knowledge of working with Government to fully answer these questions
competently. Our answers are limited to our relatively narrow
range of experience and expertise.
5The need for research and consultation across
user groups in advance of legislation
21. Government is increasingly reaching
out to the private sector in a variety of ways to improve working
relationships. In addition, a broad variety of consultative bodies
and trade associations exist specifically to provide input on
legislative issues that affect them. These should be actively
used in advance of legislation so that the purpose of the regulation
is achieved in an efficient, transparent manner. Legislation without
this consultative process, as seen here and in many other jurisdictions,
often leads to regulation that both inhibits business success
and results in ineffective regulation. It is not the purpose of
government to understand business sufficiently to be able to write
good legislation, but rather, to ensure that all appropriate voices
are heard to determine that legislation is suited to purpose in
a way that nonetheless permits business to operate efficiently.
The need for focus on compliance and enforcement
22. Rafts of research have been done on
this subject. While cultural norms do have some impact on the
likelihood of effective compliance with regulation, it is evident
that in most cases, regulation without any commensurate oversight,
supervision, or enforcement makes it extremely unlikely to achieve
compliance, unless the very act of complying is of direct positive
utility to the regulated. With regulation around data collection,
you can sometimes achieve compliance by sharing the results with
all those asked to comply, if the information collected is of
value to them. Otherwise some reason for the regulated to comply
must exist.
27 February 2009
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