Evaluating the Performance and Accountability of Regulators

• Publication year: 2013
• Citation: Vol. 37 No. 02

SEATTLE UNIVERSITY LAW REVIEWVolume 37, No. 2, Winter 2014

Evaluating the Performance and Accountability of Regulators

Colin Scott(fn*)

I. INTRODUCTION

The global financial crisis came in the wake of significant reforms to the structures, processes, powers, and rules of the regulatory regimes for financial markets in many of the countries adversely affected by the crash. It is striking that the reformed regulatory regimes lacked the capacity both to anticipate and prevent the crisis that engulfed the world. Furthermore, even after this experience, it remains unclear whether regulators account effectively for what they do. What we mean by "accountability" in this context depends on what we think accountability is for. If we think of accountability as an aspect of democratic governance, concerned with reassuring us that regulators uphold their public mandates, then we might envisage a formal type of accountability. However, a claimed virtue of much regulation, including in the financial sector, is that it is informed as much or more by technical rather than democratic concerns. Giving priority to the technical character of much regulation might lead us to downplay the formal mechanisms of democratic accountability, but we should do so only if we have in view mechanisms appropriate to the technical conception of regulatory roles. The issue is further complicated by the observation that much apparently technical regulation, whether carried out by public or private regulators, has capacity to profoundly affect interests and is therefore necessarily political, even though it may have technical dimensions.(fn1)

In this Article, I follow the logic of an argument that regulation necessarily has political dimensions, even where it may appear technical. I am asking questions about how we might best think about accountability processes that encompass both democratic and technical dimensions of regulation and how their respective concerns might be combined within accountability regimes. Conceived of in this way, accountability needs to go beyond traditional public accountability forms, largely concerned with process, to include effective evaluation of performance in terms of better regulation, direct performance evaluation, and more sophisticated forms of regulatory audit.

I consider the appropriateness and robustness of these mechanisms in light of significant trends that point towards continuing fragmentation of regulatory relationships generally and within financial markets in particular. Elements of this fragmentation include the gradual move in the centering of international financial markets from North America and Europe to Asia, a change accelerated by the global financial crisis and which is liable to reduce not only the market significance of New York and London, but also their concentration of public regulatory power. Second, there is the continuing pressure to move the emphasis of regulation from the national level toward the supranational and even global level. While the ambition of such trends may be directed toward seeking to harmonize and create more uniform and robust regulation, imperfect globalization of regulation is likely to create opposite outcomes, leading to further fragmentation. Third, there is the increasing recognition of the centrality of transnational private regulation in setting norms and in monitoring compliance in financial markets. Taken together, these fragmenting effects require a significant reevaluation of what effective accountability for regulators should mean.

Conceiving of accountability as embracing both technical and political requirements draws us towards a parallel world in which the efficiency and effectiveness of regulation is a core part of oversight concerns, alongside the issue of democratic concern with procedures. Policies of deregulation, regulatory reform, better regulation, and smart regulation pursued in one form or another in most of the Organization of Economic Cooperation and Developement (OECD) member states are centrally concerned with promoting proportionate responses to problems defined as regulatory, with varying degrees of effectiveness. Distinct from better regulation are strategies of public sector audit concerned with promoting efficiency, economy, and effectiveness in the expenditure of public monies, including on regulation. A further distinct set of concerns within regulatory policy are measures targeted at developing performance indicators and the evaluation of performance.

When we look at these concerns with process and effectiveness together, it is helpful to conceive of the overall oversight, or regulation, of regulation as a legitimate and distinct set of concerns and operational activities of government, addressed not only to public regulation but to increasingly important regimes of private regulation. Thus, there is a discipline of regulating regulation, not fully recognized, and comprising a variety of different fields of activity and disciplines that should increasingly be concerned with promoting accountability based on both process and performance.

II. THE GLOBAL FINANCIAL CRISIS

The global financial crisis struck major financial markets in 2008, following a period of quite extensive reform of structures and process of financial regulators across many of the leading national regimes.(fn2) There was a good deal of confidence amongst regulators that, armed with new powers, new knowledge, and new techniques, they were more than equal to the tasks of protecting the public interest in financial markets. This confidence was based not simply on what they knew about regulation, but also on what they thought they knew about efficient markets.(fn3) As Julia Black argues, it was not so much that the new tools of regulation were faulty but rather that they were applied poorly,(fn4) whether for reasons of lack of understanding, as some of the official reports discussed below suggest, or because of a combination of ideologies and interests that favored the key actors in financial markets.(fn5)

Many hypotheses have been advanced to explain the global financial crisis. A common thread running through many analyses is attribution of responsibility to weaknesses in the management of risk by market actors and poor understanding and implementation of oversight regimes by regulators. Clearly market actors did things, and were permitted to do so, that were against the interests both of their own organizations and of the states in which they were located. There was limited knowledge amongst banks and regulators of the systemic risks being created through extensive interdependence of transactions.

In subsequent inquiries, each jurisdiction has sought to identify the causes of the problems each faced from the financial crisis. In Ireland, a report from the Central Bank of Ireland concluded that major responsibility lay with bank directors but also with weaknesses in regulation. The report found that the Financial Regulator emphasized processes over outcomes and failed to develop independent evaluations of risks presented by banks. Patrick Honohan, who led in authoring the report, noted that the undue deference shown to the banking sector constituted a form of regulatory capture:Thus, it would have been known within the [Financial Regulator] that intrusive demands from line staff could be and were set aside after direct representations were made to senior regulators.(fn6)

The British Turner Report identified weaknesses in the capacity of financial markets that had not been understood by banks or regulators. National regulators were depending on regulators operating in the home jurisdictions of banks doing business transnationally, but home regulators were typically looking only at the national and not the global footprint. Key examples included the collapse of Lehman Brothers and the Icelandic Landsbanksi.(fn7) The official European Union (EU) investigation, chaired by Jacques de Larosiere, identified failures in risk assessment by banks and regulators but also in poor sharing of information by regulators and over-dependence on ratings agencies.(fn8)

The United States Financial Crisis Inquiry Commission concluded that the crisis was avoidable:The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.(fn9) These now well documented regulatory failings occurred in part because of technical and cognitive weaknesses, but also because of the political factors of deference to banks and an ideology that believed in efficient markets.(fn10)

Independent regulation is, of course, supposed to be a solution to the problem of politicians favoring powerful industrial interests.(fn11) It is striking that this cataclysmic regulatory failure occurred at a time when the "rise of the regulatory state" had occurred, offering solutions to at least two sets of governance problems. The first of these problems is the risk that where the state regulates directly through government departments headed by elected politicians, decisions may be driven by consideration of short-term political gain. Such political short termism yields, at best, regulation that is incapable of supporting the mature development of regulated markets over time and, at worse, regulation the purpose of which is to support the interests...