Regulators’ competition: Towards an objective based regulatory architecture

Lawmakers, regulators and academics spend much energy reforming the substantive regulatory subject matter. The equally important question of how to transform this „law in the books“ to the „law in action“ is less prominent. This is astonishing, given that the prevalent systems of both sectoral (banks, capital markets, insurance; e.g. the US system with OTC, Federal Reserve and SEC etc.) and uniformal regulators (e.g. the German BaFin or former UK FSA) were each exposed to their unique flaws during the crisis. To do away with these deficits, I propose a regulatory system that predicates on distinct regulatory objectives and thus lets regulators compete. In fact, some supervisors are already committed to specific goals. The upcoming review of the European supervisory architecture and the necessary rearrangements following Brexit offer a good opportunity to address the issue.

The set up: Let regulators compete!

In short, regulatory agencies should be geared towards specific regulatory goals. Among these are the promotion of financial stability, investor protection, of informational efficiency on markets, the facilitation of competition and the prevention of financial crime. Agencies are deployed on a horizontal level and jurisdiction is not unambiguous, which will set them up for competition with one another. This arrangement is not only justified by the paramount goal of financial regulation, namely financial stability, but will also provide for the best overall realisation of all other associated purposes. As compared to the currently dominant sectoral or uniformal approaches of supervision, an objective-based approach helps overcome many of the problems inherent to unified regulators and a model of sectoral division of competences.

Regulator A will focus on securing financial stability, while Regulator B pays attention to the protection of retail investors, depositors and insurees.

By focusing on activities rather than legally defined categories, three fundamental advantages can be secured: First, the system is uniquely able to adapt to the dynamism of financial markets. Second, it makes transparent problems concerning the prioritisation relating to regulatory goals, which subjects them to external (public) pressure. And third, the competition-oriented structure makes them less prone to regulatory capture by the regulated industry and changes their internal culture.

Obviously “regulatory overlaps“ will arise in an objective-oriented regulatory structure. This being precisely the mechanism from which the improvements spring. To allow for regular discussion, information-sharing and conflict solving between the agencies, a regulatory forum  can and should be created (The US Financial Stability Oversight Council in the US already draws on this idea). As a consequence, prioritisation processes are shifted from an internal agency level to a superordinated level. Here, priorities can be readjusted and different options for legal regulatory action be discussed and their respective merits weighed against each other – arbitrated by the majority of members of the regulatory forum. To reflect the dominance of financial stability as a goal of financial regulation, the required burden of proof should best be imposed on those regulators committed to other goals.

1. Adaptability to the dynamism of finance

Sectorally competent agencies can only act within static remits. These are defined by the legislator’s historically contingent view of the regulatory subject matter. Such a fixed scope of regulation contrasts with the dynamism of a financial industry that is constantly innovating to avoid financial regulation (regulatory arbitrage). Not only do financial institutions claim informational advantages over their respective regulators because of a time lap between financial “action“ and regulatory “reaction“. Fixed sectoral remits also allow for „regulatory underlaps“, the exploitation of certain areas not covered by the agencies’ jurisdiction. This is illustrated by the buildup of risks in the US shadow banking sector in the vicinity of the financial crisis 2007/2008. Neither SEC nor Federal Reserve felt obliged to comprehensively regulate this industry, ultimately bringing the financial system as a whole to the brink.

Regulatory agencies committed to specific goals, on the other hand, are not bound by fixed statutory competences and are therefore able to take a rather holistic view on the industry. They are actually forced to make use of this wide perspective in order to achieve their goal in the first place. Hence, they will quickly adapt to the constant dynamism and innovation within the financial industry that facilitates the shifts of risks to hitherto uncovered areas and will not be held back by restrictions contingent on the legislator’s earlier view of an industry.

2. Transparency and external pressure

The uniformal approach, on the other hand, is characterised by the agencies’ all-encompassing remit. While this theoretically allows to deal with a dynamic subject matter, the wide discretion brings about an organisational problem: in cases of conflicting goals, the agency has to prioritise certain objectives. While unified regulators might be able to develop a comprehensive understanding of how to tackle prioritisation issues, it has to adequately manage its internal flow of information between different departments to make sure the issue is raised in the first place. The difficulties of this internal struggle are exemplified in the FSA’s failure as regards the supervision of Northern Rock.[1] On top of that, hierarchical structures within one agency are likely to prematurely stifle discussion and may therefore foster what can be deemed dangerous “conceptual conservatism“ or “group think”.

To be sure, objective-based agencies do not have advantages in relation to the flow of information per se. However, their need to internally set and discuss priorities itself is greatly reduced. This enables them to think more clearly about instruments to achieve their respective goals. As a consequence, prioritisation processes are shifted to the regulatory forum. Here, conflicts will be thoroughly discussed and made visible. Shining light on the prioritisation at the same time provides for a constant external (public) accountability of the regulating agencies. This is likely to suppress possibly arbitrary or inconsiderate decisions being made on the basis of irrelevant and solely agency-internal grounds (for instance, budgetary self-interest of departments).

3. Lower risk of regulatory capture and regulatory competition

The objective-based model offers unique advantages in terms of political economy.

First, agencies committed to specific goals are less prone to regulatory capture by the regulated industry. This danger is especially conspicuous in sectoral agencies. It is said to spring from the self-identification of civil servants with the subjects regulated on the one hand (“revolving door“) and the possible consequences of regulatory intervention on the agency’s importance and standing on the other hand. Unlike sectoral of uniformal agencies, an objective-based agency is not responsible for an industry alone. Neither can civil servants identify with a specific industry nor does the agency’s (budgetary) status depend on the welfare of those at which necessary regulatory interventions are directed.

Second, the competitive setup is likely to foster an atmosphere of cooperation within the agency itself, benefitting the work ethic and lessening the propensity to be captured by special interest groups: Being part of a team with a common goal improves staff motivation.

Only an objective-based institutional setup can appropriately reflect the dominance of financial stability in regulatory practice. It is uniquely able to deal with the dynamism in finance, will increase transparency and promises substantial political-economic advantages.

  • Focus regulators on specific policy objectives
  • This will increase transparency, lower political-economic risks and in general provide for more appropriate financial regulation
  • Problems between agencies should be solved in a superordinated regulatory forum

[1] FSA, The Supervision of Northern Rock: A Lessons Learned Review: March 2008, p. 97 pp.

3 thoughts on “Regulators’ competition: Towards an objective based regulatory architecture

  1. Pingback: Regulators’ commitment to bail-in – is it credible? The case of MPS and Banco Popular | REGULATION-Y

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s