Begin with some paradoxes. About five years ago, I undertook a review of the UK equity markets for the British government. I had to listen endlessly to complaints about financial regulation from people in the industry.^[1] They bemoaned the costs of regulation, and its complexity, and they queried its value. They had a point – Citibank reportedly employs around 30,000 people in compliance activities.^[2] But when I asked people to tell me which particular regulations they thought should be rolled back, they tended to lapse into silence. Parenthetically, I might observe that I encountered a similar reaction when I asked supporters of Brexit which of the unbearably oppressive EU regulations they wished to see dismantled first.

Another paradox. In 2005, Transparency International, which monitors corruption around the world, rated Iceland the least corrupt country in the world.^[3] In 2008, the entire banking system of the country collapsed. Subsequent enquiries revealed cronyism on a massive scale, in which regulators, government, banks and businesses were all complicit.^[4] That raises the question of what we mean by corruption?

And another paradox. Among countries of the world, the most active in the global provision of financial services to international business are probably the UK, US, France, Germany and Switzerland. Since the 2008 crisis, the countries whose political elites have been most vehement in their criticism of the financial sector and sceptical of markets more generally have been France and Germany. They are also the two countries among the five in which the least action has been taken to reform the financial sector following that crisis.

All these problems reflect the underlying reality of extended regulatory capture. In this essay, I want to discuss the determinants of regulatory capture. The concept has been familiar for over a century. The first expression of it can perhaps be found in the advice given by Richard Olney, a lawyer who had frequently represented railroad interests, and who became Attorney General in 1893 under Grover Cleveland. Olney explained to one of his former clients why their hope that the recently established Interstate Commerce Commission would be abolished was not only unlikely to be realised, but misdirected. He explained “The Commission… is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things… The part of wisdom is not to destroy the Commission, but to utilize it.”^[5]

My thesis is that regulatory capture and regulatory complexity go hand-in-hand. Complexity leads to capture, and in turn capture leads to complexity.

Step back for a moment and focus on styles of regulation. Thirty years ago, I co-authored an article with John Vickers (who would in due course become chairman of the Independent Commission on Banking in Britain appointed after the global financial crisis).^[6] Our work on regulation was prompted by the pace of regulatory reform in Britain in the 1980s. We contrasted the evolution of regulation in two areas. In the utility sector, the privatisation of  state-owned industries had created new requirements for a regulatory regime. And in financial services, technology and globalisation had rendered obsolete the traditional style of British regulation, based on self-enforcing recognition of generally shared, if not always admirable, values, and sometimes described as deriving its effect from ‘the raised eyebrows of the Governor of the Bank of England.’ Once foreigners, and boys who had not gone to  private schools, and eventually even girls, were admitted to the City of London, the raised eyebrows could no longer be relied on to have the desired effect.

Utility regulation had been largely driven by economists, financial services regulation by lawyers. This had substantial effect on both the style and the content of the regimes that developed. Economic regulation focused on the structure of the industry and the incentives of firms and individuals within it. Financial services regulation by contrast wrote specific and extensive rules and prescribed appropriate conduct. The economists were primarily interested in the determinants of behaviour, the lawyers in controlling the outcomes. In 1988 Vickers and I concluded that both styles had merits and imperfections, but on balance the economists’ emphasis on structure and incentives was likely to work better.

The paradigm case in regulatory history was the civil aviation industry. Alfred Khan literally wrote the book on aviation regulation and was – unusually for an academic – given the opportunity to implement it when he was appointed chair of the US Civil Aeronautics Board. With the objective of winding up the activities of the agency.

Even the most enthusiastic of libertarians would find it hard to deny that some regulation of aviation is necessary. There are not many people who want, or are competent, to inspect the airworthiness of a plane before they board it. And few people will wish to allow planes to fly overhead Paris, London or New York without some vetting process to ensure that proper safety and maintenance procedures have been implemented. So almost as soon as civil aviation began, regulation of the industry followed. But, it was reasoned, if planes were to be properly maintained, the airlines which owned and flew then needed to be adequately financed. They needed to hold adequate capital for these operations. And, the companies argued, they could avoid the temptation to skimp on safety only if they were protected from ruinous competition. And so regulatory activity grew in scope. Regulation limited new entry to routes and controlled fare levels. Airlines argued, as railroads had successfully argued before them, that if a regulator had established a fair level of fares it was as contrary to the public interest to charge less as it was to charge more. Before long, the regulatory regime was effectively operating a cartel on behalf of established airlines. Entry by new firms to the industry more or less ceased. And by the 1950s, rules were in place to define a sandwich, lest airlines seek to evade the restrictions of competition by offering better food.^[7]

A Congressional coalition bringing together left and right swept this structure away. The former group believed that the regulator was in the pocket of the industry; the latter argued that consumers would be better served by a free market. And both groups were right. Under the supervision of Kahn, most of the rules that imposed economic regulation were swept away. Within a few years, well-established US airline giants – Pan Am, TWA, Eastern – had disappeared and newcomers such as Southwest and Jetblue had become major carriers.

Somewhat belatedly, Europe followed suit. In the Thatcher era, a bilateral agreement between Britain and the Netherlands liberalised flights between the two countries and for a brief interval Maastricht, a pocket of Holland within Belgium and Germany, became a major international airport. (Lappeenranta, a town in Finland and therefore the EU, but much closer to St Petersburg than Helsinki, and not even connected to the latter by air serves a similar role today.)

Before deregulation, commercial aviation catered principally for business travellers. Deregulation opened a new mass market for tourism, served by low-cost carriers. Economic regulation of the industry was largely dismantled and regulatory activity focused on safety.

Once you removed the idea that firms could obtain a competitive advantage by exploiting regulation for their individual benefit, or use regulation to avoid being subject to competitive discipline at all, airlines recognised that the collective advantage in promoting safety outweighed the competitive one. Civil aviation today is not only remarkably safe, but prides itself on its ‘just culture’, with honest and largely blame-free reporting of incidents.

There are two broad lessons from this experience of regulating civil aviation. One is the way in which complexity leads to capture. The other is that appropriate industry structure and the right incentives are more important than the formulation of prescriptive rules in promoting public interest objectives.

Capture has several varieties and several dimensions. When Transparency International found that Iceland was the least corrupt country in the world, they were applying a crude concept of corruption, in which money is passed in brown envelopes or under the table. There is no doubt that Iceland was and is a country in which you would be ill-advised to pull out your wallet when stopped by a traffic policeman. And there are few if any advanced Western democracies in which such a strategy is a wise one.

But the imperatives of political campaign financing in the United States have created an environment that people from less mature societies might find hard to distinguish from outright corruption. True, the money does not go directly into the pockets of the beneficiaries of the corporate largesse of Wall Street, big pharma and healthcare, and the National Rifle Association. But these beneficiaries are no less dependent on it than they would be if they needed the money to feed their families. And the revolving door between active politics and professional lobbying now rotates routinely. It was once unimaginable that a legislator would retire to become a registered lobbyist.

The speaker circuit is now a major source of income for political figures. Is it really worth $225,000 to listen to a speech by Hillary Clinton? The way in which political prominence has been leveraged into a lucrative career after politics, epitomised by Bill Clinton and Tony Blair, but emulated by many more minor actors, is a recent development. Harry Truman eschewed the receipt of, far less the search for, fees when he ceased to be president, to such an extent that his poverty prompted the introduction of federal pensions for former presidents.

The speaker circuit is largely an English-speaking phenomenon. Campaign financing is primarily an issue in the United States, although a number of European scandals are demonstrated not just that the phenomenon practice is not confined to that country, but also that surprisingly small amounts of money may have substantial effects. In France and Germany, the issue of capture has more to do with instinctive corporatism which is central to the political climate of these countries. There is a strong tendency to equate the national interest in relation to a particular sector with the interests of the principal domestic firms which are active in the relevant industries. How else to reconcile the relative vehemence of political rhetoric in France and Germany following the financial crisis, with the virtual absence of measures in these countries to reform the operation of the financial sector?

Britain, as so often, lies somewhere in between Europe and the United States. The concept of cognitive capture is critical to understanding what happens in London. And it is in the field of cognitive capture that the association between complexity and capture is particularly evident. Once a certain threshold of complexity is reached, understanding of regulatory issues is necessarily confined to a small group of people – professional compliance staff in the regulated businesses and employees of the regulatory agency itself. Even if the latter group are scrupulously honest, and they mostly are, they share with their counterparts in the businesses affected a common language and vocabulary which quickly translates into a common view of the world.

And cognitive capture extends to journalism and academia. It is inevitable that journalists will need to cultivate sources in the industry on which they report. Thus such journalists tend to divide into two groups – sympathetic insiders, who are rewarded with tidbits of information and assistance in understanding complex issues, and outsiders, who, deprived of access, tend to exude ill-informed hostility. Neither group are well placed to contribute to the formation of a well-informed but critical public opinion.

The academic world is rarely directly corrupt, although Charles Ferguson’s film Inside Job did little good for the reputation of the economics profession. It is a lot easier to obtain research funding, and rewarding consultancy positions, if you are sympathetic to the financial sector than if you are critical. Academic finance theory since the 1960s has been based on a suite of models which are of doubtful empirical relevance, but which are well suited to promoting the interests of the established financial services sector. And it is this theory which is taught to the staff of regulatory agencies.

One outcome is what has been described as the broken windows perspective of financial regulation – the agency criticises the broken windows on the ground floor and does not intrude, except deferentially, on what takes place in the C suite in the upper stories. Minor deficiencies in administrative proceedings are identified, criticised and corrected while the key issues are largely ignored.

It has been a tenet of regulatory philosophy since the 1980s that conflicts-of-interest, which were once handled by insisting that different activities were conducted by different firms, are no longer to be avoided but are to be ‘managed’. Experience has shown that not much effort has been devoted to such  management. Much regulatory activity is now focused on preserving a traditional market-based model of how financial services should be provided, with the pursuit of liquidity – meaning frequent and inexpensive trading – a fundamental objective. It is telling that Europe has a market abuse directive, as if it were the market, rather than the customers, which needed protection from abuse. This is indeed the underlying philosophy.

And so it is that regulation, although costly for large financial services businesses, serves the interests of these firms well. There are not many economies of scale in the provision of financial services, but there are substantial economies of scale in the activities of lobbying and compliance. When we talk of corruption, we need a broader concept than is implied by the acceptance of bribes – Iceland in 2005 was, in a very real sense, a country in the grip of corruption. In Europe we have created an environment in which the best course for politicians is to criticise the industry in public and indulge it in private. Until we change that we will change little else.

^[1] J. Kay, The Kay Review of UK Equity Markets and Long-Term Decision Making: Final Report, (2012)

^[2] J. Forese, “Citi Co-President James A. Forese’s Remarks at the Sibos Conference”, Citi, 29 Sept 2014, accessed 23 Feb 2018

^[3] Transparency International, “Corruption Perspectives Index 2005”

^[4] The conclusion of the Working Group on Ethics set up to investigate the collapses focussed on the failure of institutions, but stated that “several individuals, in the financial, administrative, political and the public sphere, showed negligence and sometimes reprehensible action” (V. Árnason et al., “The Main Conclusion of the Working Group on Ethics”, Report of the Special Investigation Commission, (2010))

^[5] A private letter from Richard Olney to Charles Perkins, quoted in P. Woll, Public Policy (1981) p. 6

^[6] Kay, John, John Vickers, “Regulatory Reform in Britain”, Economic Policy Vol. 3, No. 7 (1988): 285-351

^[7] “The Great Sandwich War”, Scandinavian Traveler (2016) accessed 22 Feb 2018