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Prescriptive regulation

24 January 2018

Anyone with children knows that if they believe that you, as a parent, expect them to be badly behaved then they probably will be. If, on the other hand, you make it clear that you have high expectations for their behaviour they will rise to meet them.

Anyone with children knows that if they believe that you, as a parent, expect them to be badly behaved then they probably will be. If, on the other hand, you make it clear that you have high expectations for their behaviour they will rise to meet them – though admittedly it is best not to gamble totally on that outcome.

We tend to forget that grown-ups exhibit the same symptoms. The more tightly people are controlled, the more untrustworthy they become. It is obviously not a new observation that if you want people to be trustworthy you have to trust them.

However, today’s health and safety culture and the desire of society and politicians to have risk regulated away so that nothing can ever go wrong has a curious side effect. It triggers the very behaviours in people which are likely to make things worse.

I doubt many people today remember the BBC Reith lectures of 2002 delivered by Onora O’Neill, but even back then she noted that the more targets and inspections are put in place, the more this damages rather than repairs trust. Part of the problem, as a midwife once noted, is that it takes longer to fill in the paperwork than it does to deliver the baby. Thus the accounting designed to measure outcomes inhibits the effective delivery of those outcomes.

A Work Foundation paper of 2006 noted that there were four levels of regulation, which could be graded in terms of their ability to generate trust. Self-regulation was the most effective, while peer pressure was the second most effective. Markets came third and the least effective of all was the fourth, government regulation.

On the one hand we have a mountain of regulation on the financial sector from home and overseas from numerous bodies, and on the other hand trust in the sector is at an all-time low and showing no sign of getting any better. Yet each successive scandal reinforces the drive for more regulation.
Consequently, the amount paid out by the Financial Services Compensation Scheme has risen almost every year since its inception, in spite of more financial regulation. This ought to mitigate the need for compensation but people say that this is the result because there is more financial activity today so more things to go wrong. I think this misses something important. Greater complexity of financial services may be part of the answer, but another is that more rules mean less good behaviour. Rules create an environment where people follow the law rather than the spirit. Add in bonus culture which seeks to replace the motivation of job satisfaction with the motivation of money and it is no surprise that the system ends up in trouble.

There is surely a need to find a better solution. It is has long been estimated that the private cost of regulation in the financial services sector is roughly four times the cost of the official bodies. A decade or so ago when the then Financial Services Authority had an annual budget of £200 million, the rule of thumb was that the industry as a whole spent an additional £800 million on compliance to produce an industry wide total of about £1 billion.

Today the annual budget of the Financial Conduct Authority and the Prudential Regulation Authority is not far short of £1 billion if the fines levied on wrongdoers are factored in, which implies a £4 billion cost to the industry for compliance.

The overall cost to the industry of £5 billion would be more than enough to stage the Olympics every two years, but it is sunk cost – money spent with no Olympic Park to show for it, which has prompted a search for a better way.

This is where Professor Michael Mainelli comes in. In collaboration with the Chartered Institute for Securities & Investment and the British Standards Institution (BSI), he has published a ground breaking paper which advocates greater adoption of voluntary standards in the financial sector as a way of slowing the regulatory arms race and increasing confidence in the system at a lower cost.

Most people will be familiar with BSI kitemarks and ISO standards in the non-financial area where they are recognised as a symbol that suppliers have produced goods to an agreed and recognised level of quality. Yet finance does little of this. Minnelli’s argument is that if it did more, it would go with the grain of the way people behave. We might even find that it works better than more prescriptive regulation.

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