How the skies proved the limits of regulation

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Regulation as supervision can be simultaneously extensive and intrusive, yet ineffective and prone to regulatory capture. History suggests that supervision is rarely a success.

It was obvious from the earliest days of civil aviation that the industry must be regulated. Passengers cannot assess the airworthiness of a plane before they board. While an airline that did not maintain its aircraft would acquire a poor reputation after its planes crashed, that is rather too late for the victims. Even if we were content for market forces to police the relationship between passengers and carriers, few would be content to allow unsafe planes over the skies of London and New York.

It was also obvious that planes would be more reliably maintained by well run businesses with sound commercial strategies and adequate financial resources. So regulators came to review not just the safety procedures of airlines, but their business practices and profitability. As the scope of regulation grew, those unhappy with the performance of airlines naturally began to ask what the regulator was doing to address their concerns. Many regulators took up the challenge.

By the 1970s, regulation had extended to almost every aspect of the airline operation. The purpose, superficially admirable, was to promote the adoption of best practice across the industry, and best practice was naturally based on the current behaviour of the best companies. New entry to the industry became virtually impossible. Fares were set at levels that ensured that all would cover their costs, so that no one would be tempted by financial pressures to cut corners. Industry leaders would meet to discuss such important topics as the permissible fillings for an in-flight sandwich.

In the US in the 1970s, this structure was swept away by a congressional coalition of left and right. One side took the view that regulation had become a racket operated on behalf of large corporations. The other held that the interests of consumers would be better served by a competitive market. Both sides were right, as subsequent experience showed.

At first, the deregulated industry structure was unstable. Some well-established names, such as Pan American and Eastern, disappeared, while others, such as Delta and American Airlines, coped more effectively with the new environment. Some newcomers came and went, but others, such as Southwest Airlines and JetBlue, developed new business models.

Today, services are better, fares are lower – and planes are safer than ever. Europe followed the US into the deregulated world, with widely varying degrees of enthusiasm across the continent, but the European Commission has taken an admirably firm view that a European Union is one whose citizens can travel freely within its borders.

The experience of the airline industry illustrates the phenomenon of regulatory capture – the tendency for regulators to see through the eyes of the industry they regulate. It is from companies in the industry that regulators derive the information they need to do their job. Often regulators have been recruited from these businesses or hope to be employed by them in future at larger salaries.

The airline industry also illustrates the difference between regulation and supervision. Supervision is shadow management with a public interest orientation, its purpose to ensure universal adherence to good behaviour. Regulation is narrowly focused on specific issues of public concern. Supervision demands knowledge of the industry, regulation demands knowledge of the public interest and public concerns. So nine of the 11 members of the board of the Financial Services Authority occupy or recently occupied senior positions in financial services, but only two of the nine-member board of the water regulator have worked in water companies.

History suggests that supervision is rarely a success. As in airlines, regulation as supervision can be simultaneously extensive and intrusive, yet ineffective and prone to regulatory capture. As we consider reform of the regulation of financial services, perhaps there are lessons to be learnt from the experience of supervision and regulation in other industries.

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