Regulation
This is the second in a series of notes which consider the behaviour of large organisations and their interaction with those who regulate them. This note concentrates on the behaviour of regulators themselves. Other notes look at ...
Modern regulators are typically large, complex and well-established organisations, largely unaware of the problems that their size and age can cause. Also, because regulators have to follow complex legal and other processes, they typically devote little or no time to considering organisations' likely responses to regulatory pressure. (In contrast, however, large regulated organisations do spend a lot of time and money considering how best to influence the behaviour of regulators.) This note seeks to explore some of the problems that can arise. (It is also well worth reading Mannie Sher's paper on the psychology of regulation (also referred to in the first note in this series) the second part of which describes the worrying (as well as entertaining and astonishing) outcome of experiments which examined the the behavioural dynamics of regulators and the regulated.
The first note in this series includes a section on the principal-agent problem, which leads to shareholders and senior managers not knowing what is really going on in their organisations. But it is just as important to remember that regulators are themselves agents, working for a principal which is in this case the government of legislature of the day. The principal-agent problem accordingly raises its ugly head just as much in this structure, as it encourages regulators to enter into implicit understandings with the entities that they are supposed to be supervising. Such relationships are described by the participants as 'sensible', 'pragmatic' and/or 'light touch'. Critics identify 'regulatory capture', exacerbated in the case 0f economic and financial regulators by their dependence on their industries for the information they need to do their jobs.
Evidence of this behaviour includes (a) quality and safety regulators giving notice of inspection visits, (b) frequent staff interchange between regulator and industry, (c) the reluctance of either party to be strongly critical of the other, and (d) for them to engage in increasingly introverted consultation processes, baffling to the outside world. It is interesting to compare, for instance, the nature and tone of energy regulation in the 2010s compared with the fierce arguments of the 1990s. But it is important to acknowledge that politicians are ultimately responsible for the character of the regulator, through the messages that are sent (e.g. about the virtue of light regulation), the institutional arrangements that they create in legislation (regulatory boards will be less 'extreme' than powerful individuals) and through the appointments that they make (politicians may well prefer to appoint those who will not 'rock the boat' and/or attract criticism from powerful business interests).
It is also interesting to note that principal-agent theory postulates the slow growth of a number of overlapping networks or cliques within any large organisation, and so predicts that organisations will become steadily more bureaucratic as they age. This is because senior executives will learn that a substantial proportion of their employees are bound by their previous personal commitments to each other, so that it becomes imperative to overcome this by reducing the scope for personal discretion. It is also the case that organisations do learn the best way of carrying out certain tasks, and this too reduces discretion. As noted above, the cliques and teams will often respond by ignoring the bureaucratic rules. Even worse, however, the gradual reduction in tolerance for initiative and discretion leads to recruitment and promotion policies which favour those who prefer to work in rule-bound environments, so reducing the organisation's ability to innovate or to cope with problems which are not mentioned in the rule book. This is one of the factors which underlie the growth of the 'box-ticking' culture so prevalent in many modern regulatory factories.
The short answer to this question is 'No!'. There is a wealth of evidence that most of our thinking happens well below the level of our awareness, and these subliminal and/or emotional processes are certainly not logical. It is well established, for instance, that beliefs are much more powerful than rational arguments, whether scientific or otherwise. And we are certainly not self-contained individuals. Instead, we are deeply linked and respond very quickly to others in ways that we are not aware of, and we don't think about. Group-think, herd behaviour and the MacWhirr syndrome, discussed in this note about the behaviour of regulated companies, are all examples of illogical behaviour, which occurs just as much within regulators as within the companies they regulate.
Click here to read about behavioural economics.
Good governance including effective accountability and strong consultation and transparency processes are all intended to reduce the impact of these behaviours, but they have their down-sides:-
The above heading was inspired by my reading of an article of the same name by Oxford University's Christopher Hood published in Public Management Review in 2007. In that article, Professor Hood argues that the pervasive prescription of transparency and accountability as a universal prescription for good governance might lead to highly undesirable consequences when accompanied by blame avoidance by regulators and others in the public eye. The conventional assumption is that the management of political and reputational risk involves an 'upside' of acquiring credit and a 'downside' of attracting blame. But he and other academics are beginning to believe that there is a a strong 'negativity bias' - so that fear of attracting blame way outweighs the attractions of bold and effective political or regulatory decision making.
The proposition, in more detail, is that negativity bias encourages regulators to avoid making contestable or appealable judgements that create obvious losers. Negativity bias also encourages regulators to develop policies and bureaucratic routines that minimise the risk of institutional or individual liability and blame. And they introduce protocols and automaticity which minimise the exercise of individual discretion by both staff and senior officeholders.
This is not to say that access to judicial review is not a good thing if it merely encourages regulators to follow due process. But it is a very bad thing if regulators worry about losing in court. Every court case carries risk, and every court setback leads to a PR attack from the company concerned, followed by lazy journalists' easy headlines about regulatory incompetence. The fact is that good regulators are prepared - happy even - to defend their actions in court, even though this means losing on occasions. Indeed, regulators who have near 100% records in court battles are almost certainly being too cautious in the way they carry out their duties. But fighting court battles is time-consuming and expensive, and this is itself a growing problem for resource-limited regulators
A small but persistent and intractable problem is that regulators typically receive many more expressions of concern than they can sensibly handle. They therefore need to sift them so as to investigate the most serious. This can lead to their discounting concerns emanating from outside the regulatory system - as the SEC did when considering Harry Markopolos' submissions about Bernie Madoff's Ponzi scheme. And it almost always leads to their commencing more investigations than they can efficiently handle, so investigations proceed at far too sluggish a pace. This was probably a factor in the FSA's willingness to allow the UK's mini-Madoff (Terry Freeman) to continue to trade despite their receiving complaints about him, and despite his having previous convictions and being disqualified as a director. The Times reported in January 2011 that the FSA had been gathering intelligence on Freeman for more than two years but had not taken any enforcement action.
The number of complaints is a particular problem for larger regulators - see further below - and there is no easy solution, although all regulators would be well advised to have systems in place which ensure that all potential leads are reviewed by staff who are (a) experienced, (b) sceptical, as long the scepticism is directed at the regulated entities, and not the complainants.
It is tempting to assume that a larger regulator will be a stronger regulator, but this is not necessarily so. Just as the Boards of large corporations lose touch with their businesses, so the Boards of large regulatory authorities often lose touch with much of what is done in their name, and are in practice unable to ensure that their staff are as focussed, determined and sensible as they would no doubt wish. Follow this link for a more detailed discussion of this subject.
The first utility regulators were strong-minded individual Directors-General such as gas regulator James McKinnon, telecoms regulator Bryan Carsberg, and rail regulator Tom Winsor. Their clear independence of government and tough approach to their industries was initially welcomed by most observers - others than those they were regulating of course. But successive governments grew nervous that they were giving such individual too much freedom, including the freedom to be weak regulators as well as strong ones. Over time, therefore, it became the norm to appoint Boards or Commissions rather than individual regulators.
It is almost impossible to tell whether this change has led to different regulatory outcomes. Strong Board members can in theory stiffen the resolve of their more timid colleagues. Alternatively, to the contrary, one nervous Board member can inhibit the activities of a Board that wants to proceed by consensus. The truth may be that the change did not often make much difference to regulatory practice because the new full time Chief Executives generally control the flow of information and advice to their part time, non-executive and often somewhat amateur Boards. Indeed, Chief Executives' power is often strengthened by the appointment of a number of his/her direct reports on the supposedly supervisory Board. Those regulators most often accused of having relatively weak Boards include Ofgem and the OFT. Regulators at the other end of the spectrum include the Competition Commission ('CC' - whose constitution, historically modelled on Whitehall's split between Ministers and officials - provides for decisions to be taken by 'Inquiry Groups' comprised of non-staff Commission Members advised by full-time staff) and Postcomm whose constitution was modelled on both the CC (from where it recruited its first Chairman) and Whitehall (from where it recruited its first Chief Executive).
Apart from the 'pros and cons' mentioned above, it is worth noting that strong regulatory boards tend to operate to a different rhythm than their Chief Exec dominated counterparts. Staff are less empowered and so significant decisions have to await the (often fortnightly or monthly) Board/Commission meetings. But the advice presented to such demanding Boards tends to be well researched and argued and so the decisions tend to be more robust, thus permitting somewhat faster progress towards significant regulatory objectives.
I would have thought that Game Theory would offer insights which would improve the effectiveness - and maybe the acceptability - of regulation. I do not however know of any examples of the use of game theory in regulation, and would be grateful if you would email me if you have any interesting information or examples.
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This is perhaps the point to mention examples of good regulation. One such was the response of the Civil Aviation Authority (CAA) following the eruption of the Eyjafjallajokull volcano in Iceland in in early 2010. There was very little hard information available about the way in which aircraft engines respond to ash clouds of various densities etc., but it was certainly clear from numerous incidents that ash could bring down an aeroplane (see Note below). The only existing guideline was "AVOID, AVOID, AVOID". The CAA therefore very wisely insisted on getting the aircraft and engine manufacturers to assess the dangers - a role with which they were very uncomfortable given the potential for legal liability if they were to get it wrong. The CAA also liaised very closely with all other relevant bodies, including the Department of Transport who were reasonably supportive. The CAA and its Chief Executive Andrew Haines were nevertheless unfairly pilloried by the industry. His response was perfect: "We will not listen to those who effectively say 'Let's suck it and see'". It was greatly to his and his colleagues credit that they withstood the pressure. Excellent regulation!
In the three months to February 1989, five commercial jets were damaged by ash clouds from the Redoubt volcano in Alaska. And 7 airliners carrying more than 2000 people suffered dramatic engine failure amongst the total of 60 aircraft that were damaged in ash clouds in the 12 years to 1993. [The Guardian 21 April 2010]
This page was last updated February 2011
Martin Stanley
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