Prevent or Punish?

Regulators often hit the headlines as they impose apparently eye-watering fines on errant companies. A flurry of fines in early 2017 included £20m for Thames Water, £42m for BT and £129m for Tesco. But are they an effective deterrent?

Analysis

There is a constant debate about whether regulators should intervene in advance (ex ante) to prohibit what they perceive as excessively risky or undesirable behaviour, or is it better to ensure that companies and their managers are suitably punished, after the event (ex post) if things go badly wrong.

In economic regulation, this is the debate that divides the Chicago and Harvard Schools of economists. The former argue that there is now far too much regulation, and that we should generally rely upon markets and litigation to address market imperfections and bad behaviour.  The Harvard school think it better to act so as to forestall harm.

In traffic regulation, it is the debate between those who favour speed cameras and those who would punish only those who speed and then cause injury to others.

I recommend Andrei Shleifer's analysis of these issues in which he makes the quotable comment that "we are happier knowing that [a regulator has ensured that] trains and airplanes are safe than savouring the thought of a fortune which our loved ones would collect ... should we die in a fiery crash" !

And it is all too easy to be over-critical after the event.  Anthony Hidden QC, who wrote the Clapham Junction Rail Accident Report, noted that "There is almost no human action or decision that cannot be made to look more flawed and and less sensible in the misleading light of hindsight".

The question is essentially one of psychology and politics.

Let's look at psychology first. Many (most?) of us are naturally law-abiding and anxious to comply with reasonable regulations. Others of us comply for fear of getting caught. These two groups are probably those that design regulatory systems and they will naturally assume that natural decency and/or the risk of punishment will keep most others on the straight and narrow. They typically argue that fines:

The contrary argument is that a proportion of the population are not naturally compliant; nor do they spend much time worrying about being held to account. Senior executives, in particular, have big egos, and don't expect to get caught. And they are just as likely to be the victim of Group-Think and the Prevention Paradox as the rest of us - or maybe more so. They will therefore only comply with (to them over-restrictive) regulations if they are subject to firm and effective prior enforcement regimes.

There is also the point that the consequences of getting caught are seldom cause for serious concern.  Although Chief Executives may know they may eventually lose their jobs, they also know that they would then receive very generous compensation for loss of office to add to all the millions they have saved whilst in that office. And they are almost never held legally responsible for even the most dramatic misjudgements. This is particularly the case in the USA where 50% of public companies are incorporated in Delaware - the second smallest state but a notable 'corporate haven' with very CEO-friendly 'business judgement rules'. Even Delaware's own Senator Ted Kaufman noted somewhat despairingly in September 2010 that "We have seen very little in the way of senior ... level prosecutions of the people ... who brought this country to the brink of financial ruin."

The company may suffer reputational damage, of course, but this is seldom of great concern. Only weeks later, as I write this, I am not aware that the early 2017 fines on Thames Water, BT and Tesco have done much to affect their reputation amongst the general public. Indeed, I am pretty sure that hardly anyone took much notice of the fines when they were imposed, let alone remembering them months later.

And do the fines hurt the companies or their shareholders? Not a lot, I suspect. Thames Water's £20m fine was pretty small beer compared with its annual profits of around £750m.

Serious prosecutions - for corporate manslaughter for instance - are a different matter, but they again have no deterrent effect for hardly anyone can imagine that cutting through a bit of red tape could ever land them in the dock.  A fuller discussion is here

Politics

I conclude, therefore, that fines and other ex post regulation have relatively little deterrent effect on those who are not naturally inclined to comply with sensible regulation. It is vital, therefore, that important regulations are backed up by effective quality management - and strong inspection and enforcement regimes. This is often the case, of course - think Nuclear and Aviation industries. But there are plenty of areas where powerful lobbies have persuaded politicians to 'reduce red tape' and introduce 'light touch regulation'. There is often much to be said for this - see the 'Getting the Balance Right' section of this website, accessible via the homepage. But it can be taken far too far - and was a major factor in the development of the 2008 financial crisis. More detail follows ...

Examples

Recent regulatory failures certainly seem to point to the need for ex ante intervention rather than ex post punishment in many environments.

Alan Greenspan famously put too much faith in the self-correcting power of free markets. Joseph Stiglitz, writing in the FT in August 2010, said "Alan Greenspan ... express[ed] surprise that banks did not do a better job at risk management. The real surprise was his surprise: even a cursory look at the incentives confronting banks and their managers would have predicted short-sighted behaviour with excessive risk-taking."

Much the same point can be made about the Gulf of Mexico oil spill. The New Scientist (July 2010) reported that conservationist Sylvia Earle had previously pleaded for stiffer penalties for oil companies - after the 1989 Exxon Valdez disaster - to prevent anything similar happening again. Sadly, it would have made much more sense if she had argued for stronger ex ante regulatory activity, for neither the fear of penalties nor the fear of other financial damage seems to have affected the behaviour of BP and its contractors. Indeed, the apparently huge $4.5bn fine imposed on BP in November 2012 was met with relief in financial markets, especially when compared with BP's annual profits of $26bn. This reaction also serves to make the point that penalties hurt only shareholders, not directors or managers. Shareholders are of course quite incapable of (and uninterested in) altering company culture.

Martin Wheatley, the new head of the Financial Conduct Authority, seemed to have got the point when he said, in March 2013, that big fines don't change the behaviour of the big banks, not least because "... a financial penalty ... simply gets passed on to shareholders through lower dividends ... you could put [up the level of fines ] three or five times, but it would not make much difference unless individuals are held to account." He went on to say that his goal was to change the culture of bank boards - see the discussion (above) of the need for integrity in banking.

But Chancellor of the Exchequer George Osborne chose the crowd-pleasing ex post route when he introduced a new criminal offence of so-called reckless banking with effect from March 2016. Senior managers in UK financial institutions will have committed a criminal offence if:

I suspect, however, that this law will have negligible impact in the real world. It is notoriously hard to prosecute white collar crime and to prove reckless or criminal behaviour. As Dominic O'Connell put it in the Sunday Times: 'Was Fred Goodwin reckless in buying ABN Amro, the deal that helped make Royal Bank of Scotland a basket case? Only in hindsight; at the time he was cheered by the City. Did the management of HBOS set out deliberately to ruin the bank? I doubt it.'

And it was noticeable that the Furman Report argued that ex ante regulation would be need to control competition concerns in the digital economy.  This area was too big, too important and too fast-moving to be left to cumbersome ex post regulation such as fines for abuse of dominance.

 

Martin Stanley

 

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