Should regulations be clear, transparent and certain? To answer the question one must recognise the importance of informal systems of cultural regulation.
I heard a talk recently at which a Frenchman was illustrating some of the cultural differences between his business environment and that of the United States. He quoted an extract from an American union agreement. It defined the order of seniority within the workplace. The principal criterion was the date at which you joined the firm. However, if two or more employees had been hired on the same day, then seniority was determined by the alphabetical order of their surnames. The rules went on to provide that if one of these employees subsequently changed his or her name, the order of seniority remained unaffected by the change.
The Oxford audience laughed. Until someone pointed out that these are exactly the rules which fix seniority within an Oxford common room. Woe betide the newcomer, unaware of this, who sits in the senior fellow’s place: still less the upstart who thinks he could usurp the senior fellow’s place by changing his name from Zhirinovsky to Aardvark.
The Frenchman found it amusing that these rules existed at all. But what was amusing to the English was not that the rules existed. What they thought funny was that someone had written them down. The culture of rules and regulations varies across countries. The English assumption that decent people know instinctively what is the right thing goes to such lengths that we see no need for a formal constitution. For Americans, anything that is not explicitly prohibited is permitted. The French have elements of both systems, and neither: their joie de vivre rests on a curious combination of bureaucracy and anarchy.
In this climate, it is at first sight surprising to find Mr Hans de Gier, chief executive of SBC Warburg Dillon Reed leading the demand for clarity and transparency in Britain’s financial services regulation. The country he comes from has one of the most extensive systems of business regulation anywhere and almost none of it is clear, or transparent. Understanding how the Swiss economy works is something you can do only if you learnt it at the same time as you learnt to yodel and to piece together a cuckoo clock, and possibly not even then: still, the Swiss do not seem to have done badly out of it.
The globalisation of financial markets has been a major force behind the move to more explicit, more formal, regulation. Self-regulation, for long the key to effective supervision of financial services, requires that the participants share common values and assumptions. Common service in the Swiss National Army underpins the tacit values of the Swiss business community as common hardship in a public school underpinned the tacit values of the English financial community. But on the latter, at least, you can no longer rely. Nick Leeson went to a comprehensive. And a foreigner might not even notice the rising of the eyebrows of the Governor of the Bank of England, far less interpret its significance.
But who could disagree with a demand for clarity, transparency and certainty in regulation? It is easier to disagree than you might think. The inevitable corollary of clarity, transparency and certainty is fussiness, bureaucracy and inflexibility.
The Hampel Committee understood this well when they criticised regulation that took the form of ticking boxes. Good corporate governance is fundamentally about values and attitudes. But you can’t prescribe values and attitudes by rules and regulations. What you can do is suggest practices that help develop the right values and attitudes, and describe the behaviour of those who have the right values and attitudes. This is not the same thing, and the more extensive it becomes the more constraining it is for those who already have the right values and attitudes anyway.
The same thing is true of financial services. Take best advice, for example, the cornerstone of regulation in retail financial services. There is not much clarity, transparency or certainty there: it is hard enough to assess what was best advice even with the benefit of hindsight. But what are the consequences of spelling out what you mean by best advice? We already see some of these. The interview begins with a tired recital of the categories of authorisation permitted under the Financial Services Act, and continues with an apologetic fact find.
It is an improvement, at least, that the FSA does not attempt to prescribe the content of best advice: it probably wouldn’t be good at doing this, and it would make it the effective managing director of every financial services business. But so long as it is less prescriptive than this, clarity, transparency and certainty are inevitably lacking. Advisers have to make a judgement, not only about what products to sell, but about how to comply with regulations – and about whether they have.
The decisions of utility regulators depend crucially on their assessment of the cost of capital to the businesses they supervise. But what exactly is the cost of capital to a water company or an electricity distributor is inevitably a matter of subjective judgement. You can be pretty sure it is more than 3% and less than 30%: but within that range there are issues and estimates over which reasonable men could disagree.
How then to offer clarity, transparency and certainty? Clarity and certainty can only be achieved by spelling out in legislation or in regulations exactly how the calculation is to be done: in other words, the price of clarity and certainty is complexity and the loss of flexibility and common sense.
The case for transparency is a stronger one. Surely the regulator can at least spell out how the preferred answer was arrived at. Yet even here transparency conflicts with effectiveness, as it does in any case where the exercise of judgement is involved. If you require a doctor to provide a detailed defence of her diagnosis, or an interior designer to testify his recommendations, all that either can do is to play by the book: probably rather a long book at that. We all know that that is what went wrong with the Financial Services Act the first time round.
