There are three ways of regulating behaviour – and of the three, regulation by values is much under-rated.
Professor John Kay – Annual lecture, 28 February 2000
Regulation by Rules or Regulation by Values
I want to begin by discussing a product with which you are unlikely to be familiar: artificial limbs. Not being familiar with it, you may not have read the report of the Monopolies and Mergers Commission a decade ago on the subject.
At that time the country’s largest supplier of artificial limbs by some considerable margin was a company called Intermed. Intermed was acquired by the engineering conglomerate BTR in the early 1980s.
Following that, Intermed pursued a policy of pushing up the prices it charged both patients and the health service for the limbs which it supplied. It encountered considerable resistance to that particular policy and the result was that there were frequent disruptions to the supply of artificial limbs to the health service. To quote the report’s conclusion, “this is a process which the firm concerned described as skillful negotiation”.
The view which the then MMC took of it was rather different. They judged:
“It is not reasonable that the welfare of patients should be prejudiced by the actions of a monopoly supplier”.
In the MMC’s opinion, Intermed had used its monopoly situation to place unreasonable pressure on public sector purchases, and had not had sufficient regard to the distress caused to patients as a result of withdrawing its supply and services.
Let us take it for granted that what Intermed was doing was, at the time, entirely legal. As a member of the board of Intermed, one might think that it was perfectly proper for the company to do what it wished, and to maximise profits within the framework of rules which were laid down for the operation of that particular activity.
Alternatively you might, as a member of the board, take the view that even if it were legal, this was not a way in which Intermed ought to behave. This might be simply through taking the long view: by considering the damage to the firm’s reputation and concluding that the market position of the company in the long run would outweigh any short run benefits. Or alternatively, you might think that it was wrong or impossible to do that calculation even without the long run consequences, this was not what a firm in that position, with the kind of responsibilities which went with it, should actually do.
These would be the choices you would face as a member of the board of Intermed. Consider an alternative perspective: how would you as a politician, or a concerned citizen, feel we ought to deal with the situation posed by the behaviour of Intermed?
I suggest there are three alternative courses of action which are available. You might decide that we, as the people who are concerned with public interest, should do something, or that we should do nothing. And if we should do something, then there are two alternatives available to us. One is that we might set down rules which would outlaw that kind of behaviour: either a legal framework or regulatory framework, which would discourage the kind of behaviour Intermed engaged in. Alternatively, we might as it were put in place a climate that made it difficult for Intermed to operate in that way. We could name and shame the company and if it did go on behaving in that kind of way, we might ensure that the people who ran it did not receive invitations to cocktails at 10 Downing Street, that the knighthoods which are the general reward for running a large company successfully for a period of years were rather difficult to come by. One might indeed create a climate in which the likely effects of that kind of behaviour would ultimately be commercial damage to the company.
So we might try to regulate by rules, that is, to regulate and tell the company what is admissible; or we might attempt to regulate by values to create an environment in which reputable companies simply did not behave in that kind of way. Or we might decide that the difficulties of regulation are simply too great and that one rightly shouldn’t interfere too much in the operations of a market economy. “You can’t make an omelette without breaking eggs” and if that means that disabled people have to hobble around on one leg for a few more days, that is the consequence of running a market economy in that kind of way.
These are the alternative styles of regulation which we could use, and essentially they represent the choice between three different modes of regulation in a market economy.
The minimalist says, “It’s no sin for a company like Intermed to make a profit. It’s legitimate for them to pursue profit–making opportunities in every way possible and in the main, government intervention in the functioning of markets does more harm than good”.
The second view is one that says the job of the government is to put forward a regulatory structure and then the job of companies is to make as much profit as they can within the regulatory structure which the government has set. That is rule–based regulation, or freedom within regulation.
And the third style – which I describe as values–based behaviour – is to say that we should pursue, as far as we can, a style of regulation which is based on values influencing appropriate behaviour, so that people decide for themselves what is appropriate behaviour in the context set for them by the tide of government and public opinion. I want to explore in this lecture the options which these choices give us, and the strengths and weaknesses of each.
Let me move on from artificial limbs to a somewhat different product. Mr Mole is a gentleman who runs a chain of petrol stations in the north of England. If you go to Mr Mole’s petrol stations you will discover that petrol typically costs normally about 99 pence a litre in contrast with the 75 pence you would expect to pay elsewhere. There is nothing special about Mr Mole’s petrol and there is nothing special about Mr Mole’s petrol stations either, except for one thing, which is that the price of petrol is displayed in extremely small print and only on the pumps in Mr Mole’s stations. The basis of Mr Mole’s business is that he runs his stations on arterial roads out of northern English cities, there is enough passing trade that people go into his stations from time to time, they fill up with petrol, they then discover it costs a great deal more than they expected, they curse and swear and pay up and drive off promising never to visit Mr Mole’s petrol stations again.
There are enough such customers for Mr Mole to run a comfortable business on this basis and it leaves Mr Mole with a small chain which he has expanded applying the same business model. But I promise you there really is a Mr Mole and there really are Mr Mole petrol stations.
Once again, we can react in three ways to the situation posed by Mr Mole. We can say let the buyer beware; that it is too costly, too difficult, too expensive and inappropriate to intervene in this kind of situation; and that people really ought to look at the price on the pump before they fill their car up with petrol rather than afterwards. And superficially it is a tempting answer – but if we think more deeply we will see that it is unconvincing, because in that case and in others the cost of protecting ourselves against that kind of opportunistic behaviour in everyday transactions is very high. There are places where that kind of behaviour is typical. Poor countries like Nigeria or Russia are poor countries precisely because of the costs and difficulties of doing business in that kind of environment. And indeed if such behaviour were more common in the United Kingdom than it is, if there were more Mr Moles than there are, we would devote a good deal more time to seeking out where it is we buy petrol. In addition, we would be inclined to buy petrol from companies like Shell and BP where we were relatively confident that they were not behaving in this way. This is an important issue to which I will return.
What about regulation by rules? A moment’s thought leads to the conclusion that this also leads to problems. We can – indeed we do – have certain petrol price–display regulations in place. We could have a rule that you have to have a large sign outside the petrol station displaying the price of your petrol, but then we would have to have to have another rule to say how often you have to clean the sign outside your petrol station displaying the price of your petrol. And then we would have to have yet another rule that says you may not grow trees in front of the sign outside your petrol station which displays the prices, and so on. In practice we would get exactly what experience with the existing regulatory regimes would lead us to expect: an extensive rule book which would impose considerable burdens on the perfectly honest respectable person but would not actually deal effectively with people who have not the slightest intention of complying with the spirit of the regulation, such as Mr Mole.
The third way of dealing with the kind of problem caused by Mr Mole is to have a business climate which makes it very difficult for people like Mr Mole to stay in business; they will discover that reputable petrol companies will not supply them, that the local bank doesn’t want their business and that the only accountant they can find to do their books is one whose name on the bottom of a tax return raises immediate alarm bells in the Inland Revenue. This is the oldest manner of dealing with people like Mr Mole and it is a manner of dealing with Mr Mole that is very practical.
Once again, we have these three different styles of regulation: the minimalist, the rule–based and the values–based. We have these kinds of choices in the financial services area too. Those of you who have been concerned with compliance or indeed with scams generally in the financial services business will know that there are actually only a relatively small number of basic scams available. Perhaps the simplest and certainly oldest kind of financial services racket is the one in which you pay generous returns to people, paying the people who got into the business early from the amount subscribed by the people that got into the business a little bit later. A great attraction of that type of racket is that the generous returns you pay to the people who got there first attract a lot of people into this type of business in the hope of similar returns. So for a period at least it is relatively easy to attract more business. The weakness of the scam of course is that at some point, not enough new people turn up to enable you to pay the returns to the people who were there in the first place and the whole structure of the scheme collapses. This is of course a chain letter type of scheme. Amongst connoisseurs of financial services rackets, this is generally known as the Ponzi scheme. The general idea was that you offered rather generous rates of interest and the way you obtained the interest in order to pay off the early depositors was you financed the interest paid to the early depositors from the deposits which were made by the latest depositors and of course eventually there weren’t enough later depositors to go on paying the interest, but by that time Mr Ponzi had disappeared with a fair fraction of the proceeds and was nowhere to be found. Ponzi schemes have been around in the financial services world for centuries. In the 1970s they were around as pyramid selling schemes in which people were attracted to be agents to sell detergents and other kinds of commodities by recruiting other people to sell detergents and other kinds of commodities. We all remember the results: people ended up with garages full of detergents. Meanwhile the initial promoters of the scheme had vanished.
Just as we now have laws to try to outlaw Ponzi schemes, we now have laws which try to outlaw pyramid selling. But consider what happened when a company called Titan Business Systems brought their business model, which they successfully pioneered in the United States, over to the United Kingdom 4 or 5 years ago. The attraction of the Titan Business System business model was that it was a very clean pyramid selling scheme. There was no product at all. You didn’t have to fill your garage with detergents or anything like that. The Titan Business System simply required that you recruited other agents to the Titan Business System who would pay you a fee, and these people in turn would recruit other agents to the Titan Business System who would pay them a fee. We can all see that this is bound to collapse eventually but it can make a lot of money for the people who sign up to it in its early stages. As I say, it is a very clean, simple, transparent pyramid selling scheme and it was very attractive to some people, particularly to the people who ran it but also to the people who decided to join.
Once again we have three basic mechanisms for dealing with that type of thing. One is we can apply rules: what we can say is that since Titan were perfectly honest in admitting what it is they were doing and there was no pretence that the business was anything other than what it was, there should be no rules against it. That is we should simply allow it to be explained to people what the system is, what the obvious flaws are in the nature of Titan Business Systems and if, given that information, they choose to take an interest, they should be allowed to do so.
I have heard it said that rules against pyramid selling are Stalinist bureaucracy. The accusation comes from an economist colleague of mine, Patrick Minford, who on behalf of Titan Business Systems went to the High Court and said that the DTI which planned to shut Titan Business Systems down was indeed an example of Stalinist bureaucracy in action in the UK.
The second kind of method – Stalinist, if you like – is a rule–based one. The Department of Trade and Industry believed that the pyramid selling rules which they had put in place covered the case of Titan Business Systems. This turned out not to be true: in fact the scam of the type of Titan Business Systems was so simple and so transparent that the more complicated rules which they had constructed didn’t actually cover it. After they got the rules amended so that they thought it did, Titan enlisted the aid of some fine City solicitors and barristers and managed to reconstruct their scheme in such a way that it fell outside the then amended rules. Indeed Titan went back and forwards to the High Court over some considerable period as the DTI attempted to shut successive versions of the scheme down. Titan came back with new versions of the original model, springing up like the heads of a Hydra as fast as the DTI could deal with them.
Eventually the DTI did manage to close Titan down, but the basic lesson is similar to the lesson of Mr Mole. It is actually very difficult to devise rules which would cover every single model of a pyramid selling scheme. Whatever rules you have, people will always come up with new versions that have yet a different twist, and yet a different angle to it. This has been the history of Ponzi schemes throughout the ages. We now have bank regulatory structures which would discourage or make it difficult for you to open up a bank in the UK on Mr Ponzi’s business model. When the South Sea bubble happened in the 1720s, the South Sea Bubble Act was passed which actually delayed the establishment of what we now know as limited liability companies in the UK for over a century. Today we have our own versions of these kind of Ponzi schemes in what we now see going on in the market for Internet stocks and I think we can be fairly confident that in three or five years’ time we will have regulation of the private equity market in order to make it more difficult for people to lose money in these kind of activities.
Whatever you do, people will basically come up with a new version of these schemes. And that brings us again to the third option. The way to deal with a company like Titan Business Systems is that no respectable person should have anything to do with them, that they should find it very difficult to find solicitors and barristers who are willing to take on their case and run it in the High Court. It is one thing for us to say that our legal system ought to be one which allows people, however heinous their activities, to find a lawyer to defend them if they have committed a crime, it is quite another thing to say: however preposterous your scam, you should be able to find lawyers, reputable lawyers at that, who will try to find a way of writing it in such a way that it falls outside the scope of the existing legislation. You might say that reputable newspapers should refuse to take their advertising or describe the scheme. To use a term that we are all familiar with: these kinds of people should be run out of town.
Once again, the choice is between minimalist regulation, rule–based regulation and values–based regulation. Of course it is not just in financial services that we have this choice. Health and safety is another area in which it is important. It is interesting to note that here, the United Kingdom and the United States have gone in diametrically opposite directions. The minimalist regulation – to which I think few people still subscribe – is one which says people make freely negotiated employment contracts. What is wrong with sending boys up chimneys if they voluntarily agree to the contract that enables them to be so employed? If people don’t like working on unguarded machines, they ought to negotiate a different kind of contract with their employer. There’s almost no country in the world that now believes in that sort of minimalist structure of regulation in this day and age.
But the alternatives we face again are those of regulation by values and regulation by rules. The United States, as you would expect, has taken the line of regulation by rules. This has led to the creation, over decades of elaboration, of more and more extensive rules about how health and safety at work should be provided.
The section on beards at work runs to a chapter of the Occupational Health and Safety Agency rulebook, and I will refrain from transcribing it. You will get an idea of how it goes when it says that OHSA determines that it is only necessary to apply the facial hair prohibition to tight fitting respirators, the rule making record mentions 15–11, 15–26, 15–28 etc., etc. There are about twenty extracts from the rule making record at that particular point. It also contains strong evidence that facial hair can interfere with tight fitting face based seals. According to the study, facial hair also includes stubble. And on and on it goes. Short of testing a beard in work, daily, the only proven approach is to require that facial hair not interfere with the respirator seal surface. Translation: you shave where the seal touches the face.
The alternative was adopted in the 1974 Government Safety Legislation in the UK. It simply states to employers that they have a responsibility to promote health and safety in their workplace, and it is then up to these employers to decide, on the basis of their knowledge of their business and what promotes a favourable approach to health and safety, how they actually discharge that responsibility. You can get guidance from the Health and Safety Executive but no more than that. We have that same description in our legislation. For people who are in breach of that legislation there are civil and criminal penalties. That once again is the choice we face with regulation by rules and regulation by values.
Let me take another example, again in financial services. The case of Robert Maxwell is not an easy one for people who are in favour of minimalist regulation. Even people who believe that a market economy ought to be allowed to get on with it are not in favour of the repeal of the laws against theft. The trouble is that the laws against theft were not enough to deal with Mr Maxwell. We also need preventative regulation against theft as well as laws that convict people who are actually caught in the act. In the same way, as well as having laws against burglary, we also hope and expect that the police will take action against people who walk along the streets carrying jemmies and carrying bags marked with “swag”. We want to have preventative regulation of these areas, as well as “ex post” regulation. We want rules which would not work against the kind of fraud which Maxwell perpetrated, which we know, were once again a burden for people who are engaged in normal, everyday respectful activities. Unfortunately they didn’t catch Robert Maxwell because they weren’t there at the time and no doubt will not be terribly useful in catching future Robert Maxwells, because future Robert Maxwells will engage in different and rather more ingenious types of fraud. It will be no different to the way that modern Ponzis engage in more complicated frauds than the one in which the original Mr Ponzi engaged.
Here I have a lot of sympathy for the position which is taken by Tom Bower. He says that in many ways the real scandal of the Maxwell episode was the reputable City institutions who allowed Maxwell to remain in business for twenty years after a DTI enquiry had taken the view, entirely correctly as it turned out, that Mr Maxwell would not be fit to be a director of a public company. And in relation to Maxwell, we all know that the City divided. There were a number of institutions which wanted nothing to do with him and nothing to do with his business, but there were also others who were content, up to the day he died, to go on taking money from him. That is when those supporting regulation by values in dealing with him will say that the City should not have let Maxwell flourish. Although it did not know at the time of the precise disreputable things of which he was guilty, there was ample evidence to support the DTI enquiry that he was not fit to be a director of a public company.
In retail financial services, we face the same kind of choices. In retail financial services, we can take the line of minimalist regulation, that says “caveat emptor”. It is up to people to try and establish what kind of products they are buying and the job of the regulator, so far as it is a job at all, is essentially to promote consumer education to enable people to make these choices better. We have the option of regulation by rules again, in which we try to lay down the detailed rules for the conduct of business. Or we can seek rather more to rely on regulation by values: we assume that reputable companies will not sell people products which are unsuitable for their requirements and needs, and that it is up to them to put in place internal controls and monitoring that will achieve that result.
The structures which we have put in place have typically greatly underestimated the practical significance of values–based regulation: it is largely by regulation of that type that market economies do, in practice, function. They also fail to recognise that it is by the promotion of values–based regulation that we will actually achieve what we want from a market economy.
Let us return the Intermed story with which I began. It was in the end by values–based regulation that that problem was solved. The Monopolies and Mergers Commission recommended that Intermed should be broken up into competing parts, a recommendation from which the government at the time shied away. But the Department of Health was so outraged by Intermed’s behaviour that they gave strong encouragement to a German manufacturer of artificial limbs to enter the UK market. The result was to greatly reduce Intermed’s monopoly power and market share. So by the process of regulation by values, Intermed ultimately discovered that it was not in their commercial interest to pursue the strategy.
But we cannot rely on that being the normal outcome. Regulation by values essentially operates by two methods. It operates firstly by virtue of the reputation and the damage or benefit to reputation which is provided through that kind of regulatory structure, but it also operates, and critically operates, by a kind of contagion in reputation. That is, regulation by values and reputation can only operate in what I call a contagious culture in which reputable traders will only deal with other reputable traders, so that it becomes difficult for people who are outside these kinds of norms of commercial behaviour to do business.
Having put these three different types of regulation on the table I should make some assessment of the strengths and weaknesses of each. While I have emphasised the importance of regulation by values and the degree to which we underestimate both its practical significance and its potential, there is no single answer to the problems we face in regulation. Sometimes the right answer is to do nothing on the basis that costly versions of regulation would be worse than the disease we are trying to cure. Sometimes the right answer is to have a rule–based structure and sometimes the right answer is to have a values–based structure. It depends on the particulars of the case with which we are dealing.
To see how the regulation by values has great potential but is by no means ideal, we might look at the economy which is, to my knowledge, the one most extensively regulated by values: the Swiss economy. At the moment I must be en route to membership of the order of William Tell, having said on numerous occasions recently that it is obvious that the Swiss economy is by far the most successful economy in the world. They have the highest per capita income in the world, over the last fifty years they have the lowest inflation, the lowest unemployment of any major country and they also have the attraction, despite all that, of actually being quite a nice place to live. Well quite a nice place to live in certain senses, because actually Swiss culture – particularly Swiss business culture– is suffused with regulation by values. That is part of the strength of the Swiss economy. But this regulation is quite difficult for people outside a closed community to cope with. We all know of many people who have either lived or worked in Switzerland and have found that kind of burden of Swiss regulation both in business and in Swiss society both complacent and oppressive. Indeed these are the dangers of regulation by values.
We might look at the history of the City: 25 years ago, regulation was far more values–driven than it is today. It was driven by a degree of social homogeneity among people who made up the dealings in the City and also by the City not operating in the way it does today in a global market. There were people who didn’t know the rules, because they hadn’t been to the right schools. Now not only have they not been to the right schools, they haven’t been to any British school at all and therefore cannot be expected to have learned from their prefects the way in which business is done. The main disadvantage to these value–based structures is that they can be conservative, complacent and oppressive, but they had nevertheless evolved a regulation by values which was the only way for dealing with many of the problems which I have been describing.
Let me end by telling a story of the dress code which was once adopted in British Telecom. You will all recognise that BT, deregulated and privatised rather than run by the state, dared to make the move from being in the public sector environment to being a professionally managed private sector business. And of course that had implications on the way people dressed. It was necessary for people to adopt suitable business dress in the new private sector environment, but what is suitable business dress? As with all regulatory structures, people who were subject to the regulation demanded greater clarity and greater certainty about what the rules implied. When you go to the wardrobe in a morning how do you know whether what you are pulling off the shelves constitutes suitable business dress or not? So it is evident what the answer to that is: you need a dress code. The senior male employees have to wear suits, and shirts with collars and ties. But then what happens when someone comes to the office in a red suit? To point to the terms of the dress code it is clear that red suits are covered, they’re suits, collars, ties. So you clearly have to have rules about the colours which are acceptable: red is out, grey is in, but what about blue? Well there are clearly some shades of blue which are acceptable but there are other shades of blue which are clearly not. How bright is bright? You can find methods of measuring how bright is bright to ensure that people come in muted shades of blue rather than bright shades of blue to the office. Then ties for instance can cause a rather more intractable problem. It is clearly not enough to say that people must wear a tie but there are certain kinds of ties that are appropriate for business dress and there are certain kinds of ties that are not. But how can you define a tie which is party to smart business dress and what is not? What sorts of motifs are appropriate for business dress and what are not? While it is clearly customary to lay down the rules in advance, what you have to do is to perhaps have some sort of clearance procedure by which if you wear a tie that people object to, you can have an appeal by which people can determine whether that tie represents business dress or not.
Where do you end up? The answer is that if you seek to lay down what is necessary by smart business dress you get a rulebook which gets longer and longer and longer, which covers more and more hypothetical situations and of course which no–one in their senses, other than a few obstreperous employees and people who are writing it in the legal and regulatory affairs department are ever going to read. Yet we all know perfectly well what is meant by smart business dress.
The way we deal with that kind of problem is that you have a general prescribed rule, along with a set of values within an organisation, and if people are in any doubt as to whether what they are wearing falls within or outside the values which are appropriate to that organisation you can have either a quiet word in their ear or you have some wise and experienced person who can actually make the decision.
And that is why for a whole variety of issues I believe it is only by values–based regulation that we can sensibly proceed. I understand why people in business seek the clarity and certainty that they believe goes with rule–based regulation, but at the same time we also always have to recognise that the corollary to rule–based regulation is complexity, bureaucracy and an inflexibility which is bound to inhibit the development of a sensible regulatory structure over time. That is the lesson of the comparison of the two health and safety positions. The one in the United States that says that what you must do is comply with the regulations which are described by the Occupational Health and Safety Agency and which leads to the addition every year to more pages to the rule book which only a tiny minority of people in the country are ever going to read and hardly any country is actually able to apply effectively. We have managed a much better job of that kind of regulation by saying simply that it is the job of employers to promote health and safety at work. In that contrast I think we should recognise a lesson about the structure of regulation which we should bear in mind in all the regulatory devices which we try to put in place.
Professor John Kay Securities Institute Annual Lecture, 28 February 2000