Learning from Failures: and the Financial Crisis Julia Black

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Learning from Failures
‘New Governance’ Techniques

and the F
inancial Crisis

Julia Black


The 2007
financial crisis had a complex cocktail of causes, and there is a significant
literature by both regulators and commentators alike
analysing just what went wrong


b; FSA
b; FSB

; de Larosière

Indeed, in a recent rev
Howard Davies identified thirty nine

different causes from the prevailing literature


from the macro to
the micro, from global imbalances and loose monet
ary policy
to the practices of US
mortgage brokers
credit rating agencies

and testosterone
fuelled bankers.

Regulation was not the sole cause of the crisis, but it certainly had a role to play
ailings were
made by

governmental regulators and by market institutions
at the global, EU and national level
ranging from transnational regulatory committees to
financial institutions and their internal
corporate governance structures
, and a
n accepted na
rrative quickly emerged as to just what the

main regulatory failures
were (FSF 2008; FSB 2009b; FSA 2009b; FSB 2009e; de Larosière
oup 2009)

The nature and reasons for the failures are extensive,

common to
regulators and market partici
pants alike. Many of these were cognitive
fundamental failures of

on the part of regulators as to how the markets were operating
, and by firms as to
the risks to which they were exposed
. There were also failures of practice, operation and
coordination. The internal self
regulation of financial institutions and their corporate
governance structures failed utterly

(FSB 2009)
. As for
state or
based regulators
the transnational committee of banking supervisors, the Base

Committee on Banking
Supervision, failings included inappropriately targeted rules or complete absence of regulation
(e.g. of the retail mortgage market in the US; inadequate regulation of the shadow banking
system); inadequate coordination and failures t
o address the mismatch between the national
nature of regulation and the global nature of financial institutions, including the ‘mortality

(that banks are global in life but national in death)

Great Britain


failures by
regulators to mon
itor individual financial institutions or individuals and / or failure to challenge
firms when failures were identified, through lack of skills, resources, resolve and / or political
support; and failure to anticipate or understand the endogenous effects o
f regulation itself,
including the role of moral hazard in shaping market behaviour

(FSA 2009b)

It is not an inspiring example of regulation, by states, markets or anyone else. There are
a significant number of sector
specific lessons which can be and a
re being drawn
by policy
from the crisis for the reform of financial regulation.

But are there more generic
lessons that can be drawn f
rom the crisis, and for whom? For those charged with designing
regulation in other sectors, what can the examp
le of regulation in the financial crisis offer them?
This article attempts to address that question by analysing how
some of the

‘new governance’


Professor of Law and Research Associate at the Centre for the Analysis of Risk and Regulation, London
School of
Economics and Political Science. Email:
. Draft: please do not cite without permission. An earlier
version of this paper was presented at the Warwick University & Law Commission Symposi
um on Regulation in
September 2011; I am grateful to participants for their comments.


techniques of regulation which have been most lauded by governments and academics in recent
years fared in th
e crisis
Analysing the individual regulatory regimes
of all the core countries
affected, however,
is beyond the scope of this
. Instead it will draw on key examples
the use of ‘new governance’ techniques in
the transnational and UK systems of


n order to draw contrasts between regulatory techniques, it will also consider
the findings of regulatory failure with respect to the Deepwater Horizon drilling disaster in the
US in 2010

National Commission on the BP D
eepwater Horizon Oil Spill and Offshore
Drilling, 2011
The regulatory regime which was in place to regulate offshore drilling was a
prescriptive, command and control based regime administered by an independent regulatory
body. That regime also failed, quite decisively. As such a technique has been unfashion
able in
the academic and policy literature for nearly two
decades, such a failure may
not be surprising

. However, exploring the reasons for failure of such a very different type of regime
provides a useful counterpoint

for analysis

The article

en considers what regulatory reformers can draw from both crises more
broadly. In so doing, it eschews the simple ‘diagnosis
cure’ model of reform of
welfare economics. Regulation is a far more complex process than that simple model assumes,

even though it is an attractive one for policy
makers to adopt. Instead it argues that those
reforming regulation need to recognise that regulation is a complex and messy process: partly
technical, partly organisational, partly political, partly economic
, partly cognitive, partly
communicative, partly social. If reforms are to be successful, regulatory designers
to understand and be
responsive to the institutional context of regulators and of regulatees; they
have to understand and be resp
onsive to the logics of regulatory strategies both of the regime in
question and those with which it interacts in practice; and they have to enable regulators to be
responsive to the regime’s own performance through learning and modification. But design
only go so far: there are limits to what designers can achieve and to what regulation can deliver.

New governance regulatory techniques

how did they fare?

Anyone who has read any ‘better regulation’ document emanating from an OECD
government in the

last twenty odd years, or picked up an academic article on regulation over the
same period, will
know that regulatory reformers
have a wide range of options open to them in
designing regulation. These range from no regulation to self
regulation to co
ulation to
based instruments to state
based regulation with various options in between. What they
must do is consider these regulatory options and assess the costs and benefits of each one. What
they must not do, however, or only do as a last reso
rt, is propose ‘command and control’ (CAC)
regulation: detailed legal rules backed by criminal sanctions overseen by a government agency

TBS 1994; OECD 1995; Baldwin 1997; Gunningham and Grabovsky 1998; Office of
Regulation Review 1999; Better Regulation
Taskforce 2000; Mandelkern Group on Better
Regulation 2002; Better Regulation Task Force 2003; Better Regulation Task Force

; Better
Regulation Taskforce 2006; Baldwin 2010

CAC is still
strongly prevalent in financial regulation in many
‘financial regulation’ is a large
, heterogenous

and amorphous
set of legal and non
legal rules and
practices which is performed

by governments around the world

as well as by transnational
committees of r
egulators and private actors, and

a number of examples of


governance’ regulatory techniques so favoured in the recent literature

Braithwaite 2000; Black
2002; Scott 2004

Ford 2008
). Notable amongst these are
principles based regulation, risk based
regulation, meta
regulation, enr
olling gatekeepers, and market based regulation

and Hamilton 2006
Ford 2008
. Many countries affected also have ‘better regulation’ processes
of consultation and cost
benefit / impact analyses.

So how did these fare in the crisis? The
short answer is: not well. From the face of it,
various ‘new gover
nance’ techniques of regulation

suffered significant blows, as did the
processes of better regulation.
The rest of this section considers each of these in turn.
However, as we will see
from the experience of the Deepwater Horizon disaster, CAC is not
necessarily a better alternative, potentially leaving regulatory designers in a quandry.

Principles Based Regulation

In the UK, principles
based regulation (PBR), so lauded by the FSA and
the UK
government just before the crisis (FSA 2007), was seen in the immediate aftermath to have
suffered a fatal blow. In the infamous words of Hector Sants (2009), then chief executive of the
FSA, ‘[a] principles
based approach does not work with people

who have no principles.’ The
FSA (2009a) instead announced that it was moving to ‘outcomes
focused’ regulation, though the
difference between the two is arguably more apparent than real. Many of aspects of PBR,
notably the focus on risks and outcomes, hav
e a strong affinity with outcomes
focused or
based approaches to regulation which a number of UK regulators are currently
adopting (FRC 2007; Care Quality Commission 2010; Tenant Services Authority 2010; Local
Better Regulation Office 2011). So th
e spirit of PBR remains, even though the branding has
altered. Indeed, within financial regulation, the narrative of regulatory failure has shifted under
the Coalition Government. Their diagnosis is that it was a failure of detailed rules and tick
gulation which was the system’s downfall, not principles based regulation at all. Indeed, in the
Treasury (and Bank of England’s) view what is needed (at least for banks) is fewer detailed rules
and more ‘judgement based’ regulation (HM Treasury 2011).

t just what does principles based regulation consist of?

Briefly, PBR can take one or
both of two forms: rule book PBR, which how the rules in a rulebook or code of conduc
t are
written, and operational
PBR, which is how the regulator performs its regulato
ry tasks


forthcoming 2011)
. Rule book PBR involves formulating rules which are broad,
general and purposive and which may or may not be elaborated in further rules or guidance, for
example, ‘you shall act with integrity’, or ‘firms shall

act in the best interests of their clients’.
These are in contrast to ‘bright line rules’, which contain specific, often quantitative provisions,
and detailed, often prescriptive rules, which contain a number of preconditions or exceptions

Diver 1983;
Diver 1989; Baldwin 1990; Baldwin 1995;

1997; Korobkin 2000; Braithwaite
2002; Schauer 2003;


2005; Black

Hopper and Band

2007; FSA, 2007, p.6; Black

Council for Licensed Conveyancers

, p.4

In PBR regimes, the principl
e forms
the ‘backstop’ to those more detailed provisions, and acts as a guide to their interpretation and
application in particular instances. Neither principles nor rules usually function particularly
successfully without the other

Black 1997;


The FSA’s own rulebook runs to
several thousand pages.

Substantive PBR regimes have one or mor
e of five key characteristics.
It should be
stressed that these ar
e elements of an ‘ideal type’.
Given the variety of regimes that are styled, or


themselves, as PBR regimes, the construction of an ideal type necessarily means that some
regimes will accord more strongly with

certain features than others.
But they have one or more
of the following features: a purposive approach to interpretation of r
egulatory norms; a reliance
on the internal management of firms; a focus on ensuring regulatees attain the purposes or
outcomes of the regulation rather than technical compliance with detailed rules; a targeted
approach to enforcement, and a re
n of responsibilities within the regulatory regime
for ensurin
g and demonstrating compliance (Black


Does the mixed experience of the FSA’s version of PBR mean that it sho
uld be
consigned to the reject

pile of regulatory techniques?
Not nec

First, PBR is a complex
and paradoxical technique,

and it is questionable to what extent the FSA was in fact operating a
based’ regulatory approach, at least with respect to the prudential supervision of
banks. As noted, the narrative of failu
re has shifted, and the political argument now being spun is
that the failure was that the FSA was not principles
based enough. There is more evidence that
PBR, at least FSA’s version of it, was practiced with respect to the retail markets in its ‘Treating

Customers Fairly’ initiative (
2004; 2005; 2006). Here it
arguably had a positive effect.

although there is a lively debate in the legal journals as to the effectiveness of
different rule types as regulatory instruments (Diver 1983; Schauer

there is no evidence
that regulation through detailed rules fared any better. The US
Securities and Exchange
Commission (
, for example, which regulates
through prescriptive and detailed rules
and with an aggressive approach to enforcement,

notoriously failed to detect the Madoff fraud
sixteen years from the first warning signs (
2009, p.41

There can be as many detailed rules
as lawyers want to write, but if those responsible for enforcing them do not understand the
activity that they

are regulating, nor the rules that are in place, then it does not matter what form
the rules take, they will be un
enforced. But detailed rules can also be quickly outdated, leaving
regulators with nothing to enforce against even if they were willing and
able to do so.

In the case
of the Deepwater Horizon incident, one of the key findings of the Commission was that
regulation through a command and control, prescriptive approach to regulation did not
adequately address the risks generated by offshore drilli

(National Commission
, p. 68)

Changing technology and changing industry structure rapidly outpaced the regulations. As
drilling technology evolved, many aspects of drilling were effectively unregulated as they lacked
any corresponding safety regula

(National Commission 2011, p

So the answer to the failings of PBR is not necessarily to use only
detailed, prescriptive
However, PBR, or more accurately substantive PBR, is not an easy regulatory technique to
Moreover, the debate s
urrounding it illustrates the impact of rhetoric on regulation. PBR
can easily be used as a marketing label to conjure up a regulatory Utopia

as it was by politicians
in the pre
crisis battle for market share. Conversely, it can be a derogatory label u
sed to conjure
up regulatory ineffectiveness

as it has been (but not universally) post
crisis to explain what
went wrong.

PBR need not equate to ‘light touch’ regulation, but that more complex and
tempering message is not one which is easy to sell to th
ose in search of a ‘quick fix’.
As noted
above, u
sing a range of rule types, principles, more detailed rules, those which have legal status
and those which are guidance, is often a more sophisticated and effective way to design a system
of rules. But the
substantive dimension of PBR is predicated on extensive trust between the
actors in the regulatory regime: including legislators, regulators, regulatees and the wider public in
whose benefit regulation is ostensibly being performed. Wherever that trust is

lacking there is

little scope for PBR to operate in any substantive way, no matter what form the rules or
principles take.

Risk based regulation

The second technique which was, and still is, used by many banking supervisors, but in particular
by the FSA
, is risk
based regulation. Risk based regulation is increasingly being adopted by
regulators in areas as diverse as the environment, food safety, health and safety, legal services and
financial regulation, and by a wide number of OECD countries

2005; Black
Rothstein Huber and Gaskell, 2006; Hutter and Lloyd Bostock, 2008; Black

2010b; Black and
Baldwin 2010

In a system of risk
based regulation, regulators identify the different risks to their
objectives and focus resources and ‘regulator
y effort’ on addressing those which they see as most
critical. Risk based regulation is easy to advocate and has immediate appeal for those seeking to
organise and prioritise regulatory action. However, it too is a challenging strategy to adopt.
based regulation holds out the promise that regulators can ‘manage uncertainty’, to adapt
Michael Power’s characterisation of organisational risk management

. But risk
based regulation is an art, not a science. Regulators and firms operate in
an unpredictable and
uncertain world, where many risks are unknown and / or immeasurable. ‘Risk based regulation’
is in these contexts a series of ‘best guesses’ as to what the future will hold and how resilient a
firm’s operations or the regulatory syst
em as a whole will prove to be should those risks
crystallise. Moreover, risk based regulation means

focusing on things that regulators
previously focused on

but reducing regulatory intensity for lower risks can be a difficult thing
for risk
averse officials to do, and for the public and politicians to accept.

In the context of financial regulation, th
e risk based models of the Canadian, Australian
banking supervisors, as well as that of the FSA, have a number of elements in common and have
provided the springboard for the development of risk based approaches by supervisors in a
number of different coun


. There is no clear correlation between the adoption
of a risk based system of supervision per se, and the presence or absence of regulatory failure
before or during the crisis.
Although their models have much in common, a
s practised by
FSA and the Dutch central bank, risk based regulation failed

(FSA 2008b; DNB 2009, pp. 138
141; DNB 2010, pp. 83
85; DNB 2010b; DNB 2011)

However, as practised in Australia
Canada, it was apparently more resilient, though the extent to which sup
ervisory practices as
opposed to other factors (such as banks’ high deposit base, non
reliance on wholesale funding,
strong local lending, and restrictions on the mortgage market) were the reason for their banks’
relative resilience is debatable (
008; Beltratti and Stulz, 2009; Ratnovski and Huang,

Again, though, we have to look to the nature and causes of failure.
Risk based
regulation, like any regulatory technique, has its own weaknesses and pathologies. In FSA’s
case, the model did ha
ve flaws, some of which linked to the wider assumptions relating to the
FSA’s role and the responsibilities of senior management, discussed below, and to the FSA’s
own prioritisation of resources, where more focus was placed on regulation of the retail mar
than on supervision of the banking and shadow banking system

(FSA 2008
; FSA 2009b;


However, the
main problem in the case of
Northern Rock

was that

simply was
. The failure was to implement the model
, though
no one outside

of the immediate
circle of officials responsible for Northern Rock was aware of this. The power of the

relationship manager was too great; the internal risk division too weak, and senior management
insufficiently engaged

(FSA 2008b)

But more generally,

perational and supervisory practices
did not match u
p to the glossy presentations.
Insufficient skills to supervise financial
institutions’ complex operations effectively and frequent turnover of staff at all levels led to poor
supervisory practices, th
ere was inadequate internal control over the implementation of its risk
based approach, and where issues were identified, supervisors had insufficient resolve to
challenge senior management

FSA 2008b;
FSA 2009b)

A similar reticence was found with

to the Dutch banking supervisors (
Scheltema Commission


ver, a
s noted above, other leading practitioners of risk based regulation, the
prudential regulators in Canada (Office of the Superintendent of Financial Institutions (OSFI)
and Australia,

the Australian Prudential Regulation Authority (APRA), had a remarkably good
he Prudential Regulation Authority, which will take over the FSA’s functions of
prudential supervision, has announced an enhanced and revised risk based approac
h which has
clearly taken inspiration from OSFI’s and APRA’s models in developing its new ‘proactive
intervention framework’

FSA 2011
. Regulators in a number of other sectors also practise risk
based regulation, so far apparently successfully. It was
recommended by the Commission
investigating the Deepwater Horizon incident as the model to adopt for the regulation of
offshore oil exploration

National Commission 2011,


So risk
based regulation is not necessarily a ‘bad’ regulatory
technique: like all techniques
of regulation, it can be done badly or it can be done well.
All too often, regulators can focus too
much on analysing the risks and too little on acting in response to them.
If regulators are too
reticent to challenge senio
r management, if they have insufficient skills to analyse firms, if they
are not sufficiently proactive to identify emerging risks and if they are too slow to act when they
do, then any risk based system will fail. In a review of supervisory practices, an
IMF report
suggested that all these failures characterised banking supervision in a number of countries, not
just the UK (
Vinales and Feicther 2010)
. The broader market
and political
context in which it
operates can also be significant.

egulators and pol
iticians may be honest about the


of regulation
, or they may raise expectations of potential regulatory success beyond
a level
is realistic, or indeed that they are prepared to fund.
Unless expectations are set appropriately,
are bound to disappoint.


A third technique which was widely used is ‘meta
regulation’ or enforced self
the regulation of firms’ own self
regulation. Under meta
regulation, regulators do not prescribe
how regulatees shou
ld comply, but require them to develop their own systems for compliance
and to demonstrate that compliance to the regulator.
In fact, regulators are always reliant on
firms’ internal systems to ensure compliance: meta
regulation simply raises this practic
necessity to a conscious regulatory strategy.
The arguments in support of the technique are that
it gives firms greater flexibility, enables them to design systems and processes which are better
suited to ensuring compliance within their own organisati
ons than could be done by generic,
prescriptive rules, and that it places the onus and responsibility on firms themselves to
demonstrate compliance, rather than placing the onus on regulators to demonstrate non


2002; Coglianese 2003;
ithwaite 2008;
Coglianese and Mendelson
The difficulty with it is that firms’ systems and processes are designed to achieve their own goals,

not necessarily those of the regulator. Compliance systems may therefore end up running
parallel to the org
anisations’ core operations, rather than being integral to them. As a result,
regulation is fundamentally reliant on
the simultaneous presence of three elements:
having the appropriate culture to support the compliance systems which are put in

place, on
having the right incentives to pursue public objectives as well as private profits, and on
regulators having sufficient skills and indu
stry experience to evaluate firms and sufficient courage
to challenge them

In the financial sector, meta
egulation was adopted as a specific regulatory technique
under the capital adequacy rules, where firms were allowed to use their own internal risk models
to provide the basis for setting their capital requirements. The key regulatory instrument,
to globally as Basle II, defined the parameters of the models they were to use, which
then had to be approved by the regulators

(BIS 2006)
. These were demonstrated to have
significantly under
estimated the risks to which banks were exposed

(FSB 2009b)

was also adopted as a broader regulatory philosophy,
though not with
this moniker,
by regulators in the UK. In part this was due to the statutory requirement that the
FSA take into consideration the responsibilities of firms’ senior managemen
t, which it
interpreted as meaning that it could not challenge the business decisions of the firm


FSA 2009b
Great Britain 2009b)

So whilst APRA
and OSFI
would happily challenge, and
prevent, financial institutions from offering 125


oan to value mortgages, for example,
the FSA felt that it had no statutory basis for doing so

(Great Britain
; Senior APRA

officials 2009

This was a business decision for the firm; it was not the appropriate place of the
regulator to determine business strategy. But reliance on firms’ own internal self regulation was
also the manifestation of a deeper philosophy, rooted in neo

which was that markets
were efficient, that individuals behaved rationally, and that therefore each firm had the
appropriate incentives to ensure that it would manage its risks appropriately. The assumption
had been that as both shared an interest in en
suring the financial institution survived, the
regulators could rely on banks’ own internal management to ensure this. Firms would manage
their risks appropriately, boards would ensure this, and shareholders would act as monitors

House 2010)

The as
sumptions themselves, therefore, as to the ability of firms to manage themselves
and of the appropriateness of regulators on trusting them to do so are arguably based on
cognitive capture and
possibly even
regulatory ‘rapture’ (
Anderson 1982
) rather than
traightforward interest group capture. However they arose, t
he crisis has shown
that these
assumptions were
deeply flawed. Relying on firms’ own internal self
regulation and corporate
governance failed, quite decisively

(FSA 2008a
OECD 2009
a; FSB 2009e
. Regulators have now
recognised that firms are not as competent in managing themselves as
either regulators or the
firms themselves
had assumed, and that their incentives are clearly not well aligned with those of
the regulators

FSB 2009a; FSB 2009e; Wa
lker R
eview 2009; OECD 2009

Should meta
regulation therefore be consigned to the dustbin of regulatory strategies?
Not necessarily. First, any such consignment ignores the fact that reliance on firms’ internal
management to ensure that regulatory obj
ectives are achieved is an inevitable element of
regulation. Regulators cannot be present at all times and in all places

even under CAC regimes
they have to rely on firms complying with regulation continually, not just when the inspector
calls. Meta
regulation does not create this reliance; rather it recognises and converts it from an
inevitable fact of regulatory life into a conscious regulatory strategy.


Second, just because meta
regulatory techniques failed in the financial sector, this does
ot mean that it is a poor regulatory strategy

just that it can be poorly executed. There is a
wealth of evidence that meta
regulation can be a successful regulatory strategy to adopt

Coglianese and Mendelson

. Again a contrast can be drawn with r
egulation of offshore
drilling in the US, where such a strategy was not used. The Commission on Deepwater Horizon
argued that the practice of regulators in Canada, the UK and Norway in requiring firms to
develop their own safety plans and to demonstrate c
ompliance to the regulator had resulted in
considerable improvements in safety regulation. Moreover, they facilitated a more fundamental
shift in responsibilities between regulator and regulatee. The prescriptive approach not only
created hostility betw
een regulators and the firm but put the risk, legal and moral, onto the
regulator to change the regulatory requirements to accommodate changes in practices,
technology or location rather than onto the operator, where it rightly belonged

n 2011, p. 69)

So, once again, meta
regulation is not necessarily a weak regulatory technique; it can
simply be badly done. The alternative is therefore not to abandon it but to understand the
reasons for failure, and thus the preconditions for success.

Incentives have to be aligned: for
whatever reason or through whatever mechanism (e.g. peer pressure, pressures from the supply
chain), firms’ aims have to be brought in line with public objectives. Regulators have to have the
resources, skills and expe
rience to evaluate firms’ internal processes. And they have to have
sufficient resolve, practical authority and political backing, to challenge them when they fall

Enrolling gatekeepers

The financial regulatory system is characterised by diff
erent patterns of enrolment, in
which different organisations

transnational or national, public or private, perform different
functions. One strategy which has been shown to be successful is to enrol gatekeepers.
‘Gatekeepers’ are those who are not d
irectly the subject of regulation, but who have a strategic
position over those who are. That position may either be conferred by legal rules (for example
the requirements that all accounts are audited, or that those performing certain activities are
red) or by market position (for example retailers (tobacco, alcohol), airlines (visas)).

benefits of using gatekeepers are

that regulators can leverage off the control that
such actors have over the regulatees, and that th
e gatekeepers
actors themsel
ves have no
particular incentives not to comply with the regulatory requirements as they would not benefit
directly from non

Kraakman 1986
. However, the incentive structures of
gatekeepers may not always be so neutral. The retailer selling
cigarettes to under 18 year olds
does not benefit from non
compliance in that he or she gets to smoke, but they do benefit from
the revenue from the sale. Auditors who pass false accounts do not benefit from the increase in
share price than may ensue, but

they do benefit from continued business with the firm. As the
corporate accounting scandals of Enron, Worldcom, Parmalat and their ilk demonstrated, those
relied upon to act as gatekeepers can be less than reliable, and need not necessarily perform the

role that regulators assume they will play. In the corporate sector, the failings arose from lawyers
and accountants


. In financial markets, the most significant failure was that of the
credit rating agencies



As is well known,
credit rating agencies normally rate the credit worthiness of
corporations. However, those creating asset backed securities and products based on them,
realised investors would be more attracted to them if they had credit ratings, so paid ratings

to rate them. Ratings agencies did not directly benefit from whether the rating they
gave was high or low. However, they did benefit from the revenue stream that came from giving
ratings; revenue streams that were directly linked to the level of rating

they gave

EC 2008)
. As
a result, the agencies rated obliged, often not really understanding what they were rating and
caring even less. In the infamous words of one official at Standard and Poors, one of the leading
CRAs, ‘it could be structured by a c
ow and we would rate it’

(CNBC 2008)

Much attention has, often quite rightly, been given to the fact that investors placed undue
reliance on ratings without performing their own due diligence. These were not products that
were available to retail
investors, but to professionals

those who should have enough expertise
to evaluate them or enough money to pay others to do so on their behalf. However, the
regulatory system has been just as negligent. In significant areas, credit ratings are hardwire
d into
the regulatory regime,


used to calculate risk weightings and changes in ratings act as
riggers for regulatory action
Van Roy 2005; FSI

. Central banks have
on credit ratings to determine what they will accept as co

Enrolment can confer benefits, extending regulatory capacity. However, as the role of
credit ratings in the crisis has demonstrated, it also creates significant dependencies and

It can also create opportunities for gaming t
he regulatory rules: for example,
banks guaranteed the liabilitie
s of their SPVs

which gained
high credit ratings as a consequence.
Banks then bought the commercial paper of their SPVs, relying on the high credit rating to
reduce their capital requiremen

(BIS 2009)

There is thus a significant re
evaluation of these
occurring (FSB 2010).

Credit rating agencies are now to be regulated within the


No 1060/2009
, and regulators and central banks are withdrawing their reliance

on them
(BIS 2009)

Gatekeeper regulation is therefore a potentially useful regulatory strategy, but whether it
is successful depends on the motivation and resources of those who are being enrolled. Unless
regulators play close attention to the regulat
ory capacity, and most importantly, the broader
market context, culture and incentives of those they are relying on to act as gatekeepers, they will
find that their reliance is dangerously misplaced.

Better regulation processes

What of the processes and
principles of ‘better regulation’? The OECD published its
first set of principles for ‘better regulation’ in 1985, which have been successively updated
(OECD 1997;

OECD 2005; European Commission 2010)
. The transnational
committees of
financial regulation also have their own principles for good regulation in their
particular areas (banking, securities, insurance), and in the wake of the crisis the OECD
published its own recom
mendations for ‘good regulation’ of the financial sector (BIS
IOSCO 2008; OECD 2010)
. The EU has its own set of better regulation principles which apply
on a cross
government basis, as do many individual countries. All these principles share certain
core elements, reflecting a broad consensus on what ‘better r
egulation’ consists of. These
include the principles that regulatory tasks of the state should be performed by independent
regulatory agencies, that processes of formulating regulation should be transparent and open to

consultation, that all proposals sho
uld be subject to regulatory impact analyses, such as cost or
benefit assessments or ‘burden reduction’ assessments, that regulators should be accountable
and not have conflicts of interest and that there should be post
implementation reviews



Is there evidence that regulatory systems that used these processes had a ‘better’ crisis
than others? Unfortunately for the protagonists of better regulation principles, the answer is no.
The extent to which regulators were independent, or trans
parent, or open to consultation, or
accountable or that implementation was subject to review has no apparent correlation with their
regulatory performance in predicting or preventing the crisis

(Black and Jacobzone


It could be argued that in contex
t of financial regulation, the problem lay not with the
national better regulation processes, but in the mismatch between the processes of national
better regulation and transnational or supranational rule

in a multilevel governance
. In the

financial sector, particularly with respect to the capital requirements for banks,
national better regulation processes come into the rule formation process too late

the rules are
set at the transnational level by the B
asle Committee on Banking Supervis
ion (B
. Even
within the EU, there is a mismatch between national better regulation processes and
supranational rule
making. As a result, in the recent consultation on the reforms to UK financial
regulation, some questioned whether there is any point

in requiring the UK regulators to
perform consultation or impact analyses on rules which emanate from the EU
(HM Treasury

However, whilst the mismatch between transnational or supranational rule making
processes and national evaluation of those rul
es does exist, ‘better regulation’ principles
ostensibly apply at both the supranational and transnational level. The BCBS in particular does
consult on its draft rules and does perform regular impact assessments, both as
ex ante

assessments and
post hoc

implementation reviews

BIS 2010)

Better regulation principles clearly did not prevent regulatory failures
, although we will
never know if they made them less worse
. Does this mean that these processes are not worth
having? Not necessarily. The norm
s which they manifest, such as openness or accountability,
have not just instrumental but intrinsic value and are part of the constitutional settlement of
liberal democracies. The ethical failings at the Minerals Management Service (MMS),

example, c
ertainly impacted on the effectiveness of regulatory oversight, but are objectionable
for more than their instrumental effects

(National Commission 2011,


The disaster
prompted an ethics reform programme across the agency

(National Commission



However, although ‘better regulation’ principles may express certain values of
constitutionalism and rationality, and they may even help to create good regulatory procedures,
they are no guarantee of good regulation, either in design or
in practice. As Hood et al
excellent analysis of the
Dangerous Dogs Act

demonstrated, compliance with the government’s
PACTT principles (proportionality, accountability, consultation, transparency and targeting) are
perfectly compatible with badly des
igned legislation


et al.

Moreover, the principles and processes of better regulation either focus on formal rules
or processes (independent agencies, consultation processes) or are so open that they depend on
the discretion of policy makers and regulatory officials for their inter
pretation and application.
For example, the difficulty with impact assessments, one of the key planks of the better
regulation agenda, is that they are open to quite considerable manipulation (as has long been

pointed out in the academic literature)

adaelli and De Francesco 2010)
. Benefits may be
difficult to calculate, and / or may relate to things that have non
monetary value. In the case of
benefit assessments, where probabilities and impacts are uncertain, changes in assumptions
as to the l
ikelihood of a risk crystallising or the nature and extent of the impact if it did can have
profound effects on the overall assessment. As a result, impact assessments can be manipulated
to provide justifications for decisions that have already been made.

One of the findings of the
DWH Report, for example, was that environmental impact assessments, where required, were
either narrowly defined and / or gave considerable discretion to the Secretary of State and the
MMS as to what weight to give to environmen
tal concerns

(National Commission 2011,

. They therefore provided no barrier to the development of a culture in which it was assumed
that the result of an environmental impact assessment should always be ‘to give a green light to
proceed’ with off

shore drilling

(National Commission 2011,

p. 8

The principles of better regulation may therefore be laudable, but again the extent to
which they actually lead to ‘better’ regulation, and for whom, depends on the skills, culture and
resources of those o
stensibly implementing them, and the political context in which they are

Common causes of regulatory failure

None of this makes particularly encouraging reading for regulatory reformers. Whether
any particular regulatory strategy succeeds
or fails depends critically on a host of factors some of
which those designing legislation have control, but many of which they do not. At first glance,
the types of failure discussed above may seem too haphazard, the causes too discrete, to allow
any ge
neralisations to be formed. But
it is suggested that
there are common types of failure, and
to a large degree,
common causes. Rather than approaching the question of ‘how to regulate’ on
a strategy
strategy basis,
, reformers would profit mo
re from a deeper analysis of
how regulation can go wrong and why.

There have been a number of studies on the unintended and counter
productive effects
of regulation
Grabosky 1995

et al.
2005; Morgan and Clarke

2007; Rauser

et al. 2009
Mason an
d Scammon

; DiNardo and



or example regulation to reduce
risks can inadvertently lead to greater risks, or clean
ups can lead to greater environmental harm,
or regulation to enhance disclosure can inhibit it (Ayra et al. 2005).

gs or bans on
activities can produce the very conditions that they are designed to prevent
s that a
particular bank is likely to fail can create a run

the bank,
so precipitating its failure

(Schetelman Commission 2011)
Regulation can produce p
erverse incentives and prompt
creative adaptation and the emergence of ‘avoidance entrepreneurs’

Morgan and Clarke

Safety regulation can create moral hazard, increasing risk
taking activity. Regulation creates
opportunity costs and can lead to neg
ative spillover effects

Rausser et al.

. It can displace
compliance to other areas within or beyond a regulatory jurisdiction or political domain
, or
to areas which are otherwise difficult to regulate (
Hoek 2004

, it can lead to
deterrence and fear generation and create deviance

through labelling otherwise compliant firms
as potential deviants

(Ayres and


Many of these counter
productive effects, and more, were in evidence in the financial
crisis. Risks we
re displaced: many of the riskier products and activities were shifted to the
‘shadow banking’ sector. Firms engaged in ‘rule entrepreneurship’ and creative compliance

with respect to capital adequacy rules, for example by using special purpose vehicle
s as ways of
reducing their apparent risk exposure and therefore their capital requirements. Risk weightings
of assets created, and continues

to create

perverse incentives
. The bail
outs created a
significant degree of moral hazard for the industry

though paradoxically banks are now finding
that the effects can work in reverse: where markets do not think that their governments will be
able to rescue them, banks’ share prices are falling rapidly.

There were
egative spillovers
: d
rooted fail
ures of nati
onal financial regulation
were transmitted to other countries by global financial systems. Thus did the Florida dream turn
into a global nightmare.

But the
consequences of national

are not only
transmitted through the mar
. They can be transmitted through channels created by the
design of regulation itself. In the EU and EEA, for example, the passporting system was put in
place to facilitate cross
border banking. It became a transmission belt for cross
border instabilit
as the collapse of the Icelandic banks illustrated.

crisis management

strategies also had
negative spillover effects. For example, when Ireland introduced a full deposit guarantee for all
its banks in September 2008 there was an immediate flight
of capital from the UK to Ireland,
prompting the UK and then the EU to raise deposit guarantee l
imits within a matter of days.

There is a further counter
productive effect not quite captured
in the studies noted
. This is that regulation can create
negative feedback loops, a
mplifying the very risks it is

meant to be controlling.
This can arise either from its own internal operation or from its
interaction with other contiguous regulatory regimes.

In attempting to become more sensitive to
the relativ
e risks of different assets, the capital rules introduced in Basle II inevitably introduced
a set of procyclical effects: as risks went down, so did the amount of capital that banks needed to
hold against them. As risks rose, so did the amount of capital
required. This makes sense from
the perspective of a banking supervisor, but not for macro
economists. For at the very time in
the economic cycle that macro
economic policy makers want banks to increase lending and put
money into the economy, financial
regulators are requiring them to withhold it

(Danielsson, J., et
2001; Goodhart

2005; Goodhart

et al.

The problems did not only lie with capital rules for banks

but with their interaction with
the accounting rules of another transnational body,
the International Accounting Standards
. Accounting rules on loan loss provisioning based on incurred losses, and in particular
mark to market accounting requirements have been shown to have profoundly procyclical effects

F 2
FSB 200
Group 2009
). As market valuations fell, banks
capital requirements rose. To meet

them, they needed to sell assets, further depressing prices.
Private sector risk management techniques had the same impact, enhancing the links between
valuation techniques, leverage and asset prices. As markets fell, requirements to put up margins
In order to meet those margin calls, firms had to sell assets, causing market prices to fall.
Triggers in debt or OTC derivative contracts and haircuts on financing transactions based on
market valuations or credit ratings added liquidity during the boom b
ut drained it out when
conditions were stressed, exacerbating deleveraging and asset sales in a vicious downward spiral


Thus the interaction of rules emanating from different regulatory
, including private risk management prac

can create significant unintended
consequences and negative endogenous effects.

regulation can fail
should be an important element in any regulatory
design. Equally important is to understand
hese failures occur


here is not space here to analyse the causes of each of the regulatory failures noted

above in significant depth. However, from the discussion above of the fate of the different
strategies, it can be seen that
a number of
had a ro
le to play in the failur
es of financial
regulation, and indeed in the failure to regulate off
shore drilling in the Gulf of Mexico.

First, there was a critical lack of information.
Successive inquiries into the
crisis have come up with

the same conclusion, that regulators need far better
information than they have had before on the both on individual financial institutions and on the
build up of risk within the system

if they are to attempt to regulate effectively (
IOSCO, 2009

Second, t
here were

significant cognitive failures
. Improving information flows is
necessary, what is also important is the development of a cognitive framework in which to make
sense of the information collected and convert it from data to knowledge


. In the
case of financial regulation, one of the significant cognitive failures was failure to recognise that
focusing on the stability of individual financial institutions is not sufficient to ensure stability of
the whole.
Conversely, i
n the

case of Deepwater Horizon, the cognitive failure was failure to
recognise that focussing on the system as a whole could blind regulators to the impact of failures
of one particular rig

(National Commission 2011, p. 83)

In the financial context,
cognitive failures

ran deep, and continue to do so.
he crisis
has prompted fundamental cognitive shifts in understandings of how the financial system
operates. If you do not understand how the system works, it is very hard to build in mechanisms
either f
or managing risk or for ensuring the system’s resilience when those risks crystallize.
Regulators and others know that they fundamentally misunderstood the system, but they are
struggling to create a new cognitive framework in which to develop policy respo



There were also significant implementation failures, again by both state and non
regulators and by firms themselves.

The financial crisis demonstrated that regulators did not
have adequate information nor did they have a means
of making sense of what they had. They
had insufficient skills and experience to evaluate the extent to which firms were managing risks,
and insufficient resolve to challenge them when doubts arose. They did not have the
organisational capacities to coo
rdinate and perform regulation in conju
ction with other national
authorities or overseas regulators. The strategic position of those purporting to perform
regulation, over firms or other regulators,
or indeed within their own organisations,
was often


FSA 2009b)
. The Commission investigating the Deep Water Horizon disaster
found the same failings were replicated, possibly on an even greater scale, with respect to
regulation of off
shore drilling

(National Commission 2011, chapter 3)

y, the

political context had a significant role to play in both cases. In particular,
each agency had a contradictory political, and in some cases legal, remit.
In the case of off
drilling, giving the same agency the task of assigning leases and co
llecting the billions of dollars
in royalties that they brought in, and regulating safety, created a fundamental conflict of interest
that politicians were simply not interested in addressing. Even where the agency sought to
improve safety regulation, it
received no support from Congress

(National Commission 2011,
chapter 3)
. The lure of billions of dollars in revenue from offshore drilling leases, combined with
effective lobbying by the oil industry, meant that safety was never a political priority

Commission 2011
, p.76

In the financial context, the UK FSA also complained of being given
a contradictory political remit. On the one hand, it had a statutory duty to regulate financial
institutions. On the other hand, the government had made it
clear that it was not regulate in a

way that would damage London’s position as an international financial centre. It simply did not
have the political licence to challenge banks’ business decisions

(Great Br
ain 2009b)


What can reformers


Any regulatory strategy ca
n fail, and many can succeed.
This is true for regulation by state
and non
state regulators alike.

The ‘regulatory toolkit’ familiar to smart regulation policy makers,
or even ‘new governance’ or ‘post
regulatory’ scholars,
can be beguilingly attractive, suggesting
that regulatory success should be simply a matter of selecting the right one. However, the above
analysis suggests that the
starting point for reform should not necessarily be to find the right
strategy for the rig
ht si
tuation, but to understand the

more fundamental reasons for failure.
t is
suggested that, d
rawing on successive research into the

dynamics of regulation, as well as the
analysis, we can
identify five core elements
that regulatory reformers need

to be alert to
when designing regulation, and that they need to consider with respect to all aspects of the
regulatory process, whether it be state or non
state or some combination of the two

and Black

; Black and Baldwin

. Attending to

these factors will not guarantee
regulatory success, but it
could at least mitigate
some of the more obvious failures.

They are first, the institutional and political context of the main regulator

actors (state or
This comprises their
normative goals and values, as well as their political ambitions
and their cognitive frameworks

It includes the organizational structures of the regulators, their
formal and informal powers
, their regulatory capacity

and their
internal cultures.
It also i
broader patterns of control over the regulator

its independence, its position within a network
of regulators or system of multi
level governance, and who has powers, formal and informal, to
veto its decisions or substantively shape its agenda.
lack 2003;
1983; Hood and Margetts

The second factor is the institutional context of regulatees. This includes

motivation for compliance or non

(Braithwaite 2003, Gunningham, Kagan, &
2004; Parker and Nielsen 2011)
their incentive structures; their organisational culture;
and their own regulatory capacities to regulate their own organisations and associated third
parties, for example their contractors. It also includes the structure of the market in which they
ate and their position within it, for example wi
thin the relevant supply chains (

The third factor is the strategies or ‘technologies’ of regulation that are proposed and
their logics: the assumptions on which they are based and the partic
ular pathologies that each
technology has.
Most regulators use a wide variety of control tools and strategies but these often
have divergent logics: they

are based on different understandings of the nature of the system
being regulated and of cause
relationships; or they

embody different regulator to regulatee
relationships and assume

different ways of interacting
Gunningham and

; Black

as the example above of the interaction of capital rules and ‘mark to market’
nting rules illustrates,

in certain conditions their interaction can create negative endogenous
needs to be a strong d
egree of coherence of policy assumptions and
responses across a regulatory organis
ation or network of regulators to ensure that they
do not
impose conflic
ting requirements on regulatees
, or indeed regulators



or result in
unwanted endogenous effects.


Fourthly, regulatory designers need to ensure that regulators
be resp

to the
regime’s performance.
One of the overriding failings of both
financial regulation and US
shore safety regulation was that the regulation was significantly out of step with market

The repeated finding of the investigation of the
SEC’s failure to detect the Madoff
fraud was that staff were simply too inexperienced and did not understand the business of
options trading

(SEC 2009)

More broadly, o
ne of the critical failures of banking supervision
across the globe was that it was sig
nificantly out of step with developments in the financial
If regulators
do not know enough about the systems that they are regulating they
cannot assess the performance of that
system or their own performance

the regulatory system has t
o be dynamic and adaptable.
Being able to adapt is
critical to preventing regulatory failures
, or at least responding to them quickly
Designers cannot
make a regulatory system adaptable, but they can prevent it from being so

by the structures they
put in


But regulators also
need to be able to recognize and evaluate unintended and
counterproductive consequences and side effects of the regulatory regime

when they arise
To do

properly is impossible: regulators do not have a crystal ball
at the least they need
personnel with the appropriate skills and attitude,
y need

appropriate powers
, for example

gather information or coordinate its collation, and their own accountability structures
to be
focused on facilitating learning from

failures rather than attributing blame.
conventional measures of performance will not be enough
. I
t is not enough to ask regulators or
others to assess whether they are performing their tasks well. It has to be asked whether they
are performi
ng the right tasks at all.
Designers and regulators need
to build in structures for
challenge and experimentation

(Black 2010;
Sabel and Simon


So the

of reflexive

regulatory design are

that it has to be responsive to

institutional context of regulators and of regulatees, broadly defined; to the logics of
regulatory strategies both of the regime in question and those with which it interacts in practice;
and it has to enable regulators to be responsive to the regime’s o
wn performance through
learning and modification

Baldwin and Black 2008

This is a complicated checklist, and a long
way from the standard prescription of welfare economics: diagnose the market failure, prescribe
the appropriate remedy, and the cure will

inevitably follow
Such an approach is popular with
policy makers because it eschews most if not all of the complexities which are involved in the
day to day business of regulation.
There is no guarantee that adopting a reflexive regulatory

design approa
ch will lead to
success, but there is evidence that
some of the key regulatory
failures arose from the dimensions of regulation
which it requires policy makers to reflect
Unintended consequences and regulatory failures, by their nature, will always oc
But unless
se complexities are recognized at the outset, regulatory reform is bound to over
promise and


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In the now seminal words of Mervyn King, G
overnor of the Bank of England


These include, at the national level, the
US Dodd
Frank Act

2010 and the reforms to the

UK regulatory architecture
proposed in the
Financial Services Bill 2011
; at the EU level, the introduction of the European System of Financial
Supervision (the European Systemic Risk Board and the three new European Authorities for financial regulation),
and reforms to the regulation of credit rating agencies, alternative investment funds, bankers’ remuneration and
central counterparties; and at the global level, reforms to the regime for the prudential regulation of banks (Basel


There is a cons
iderable academic literature on the different types of rules and their implications. Regula
tors also
stress these points.


For discussion of firms’ response to TCF see Gilad



‘As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly
examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was
operating a Ponzi scheme. Had the
se efforts been made with appropriate follow
up at any time beginning in June of
1992 until December 2008, the SEC could have uncovered the Ponzi scheme well befo
re Madoff confessed.’


However the DNB, the Dutch central bank, whose risk
based model was he
avily based on APRA’s, clearly did not
have a good crisis
. Its supervision was the subject of five separate investigations, most notably the
Commission 2010.


Those internal processes were revised and re
balanced in the immediate wake of the in
ternal audit report, when
the risk division became central to supervision, with no supervisory meeting being quorate without its presence
(FSA officials 2009).


Recommendations A1 and A2.


Financial Services and Markets Act

s 2(3)(b)
. See also his res
ponse to Q2160: ‘it [the political philosophy] was
expressed in speeches on both sides of the House but which suggested that the key priority in regulation was to kee

In the now seminal words of Mervyn King, G
overnor of the Bank of England


These includ
e, at the national level, the
US Dodd
Frank Act

2010 and the reforms to the UK regulatory architecture
proposed in the
Financial Services Bill 2011
; at the EU level, the introduction of the European System of Financial
Supervision (the European Systemic Ri
sk Board and the three new European Authorities for financial regulation),
and reforms to the regulation of credit rating agencies, alternative investment funds, bankers’ remuneration and
central counterparties; and at the global level, reforms to the regi
me for the prudential regulation of banks (Basel


There is a considerable academic literature on the different types of rules and their implications. Regula
tors also
stress these points.


For discussion of firms’ response to TCF see Gilad



‘As the foregoing demonstrates, despite numerous credible and detailed complaints, the SEC never properly
examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was
operating a Ponzi scheme. Had th
ese efforts been made with appropriate follow
up at any time beginning in June of
1992 until December 2008, the SEC could have uncovered the Ponzi scheme well befo
re Madoff confessed.’


However the DNB, the Dutch central bank, whose risk
based model was h
eavily based on APRA’s, clearly did not
have a good crisis
. Its supervision was the subject of five separate investigations, most notably the
p it light rather than to ask ever more searching questions.’

(Great Britain 2009b).


DNB felt similarly restricted, according to findings of the De Wit Commission (2010), cited in Kremers and
Schoenmaker 2010.



For example the European Central Bank only accepted A
rated products; however as the Greek crisis has
demonstrated, in times of c
risis this strict stance may have to be adjusted, and the ECB has had to say it will accept
Greek bonds regardless of their rating. (



Indeed, the crisis and its aftermath have demonstrated the fundamental reliance of monetary authorities on b
to act as sluice gates to push money out into the economy; when banks refuse to do so, monetary authorities are
almost paralysed.


he revised rules now introduce a ban on banks recognising ratings gained through such guarantees.


The US regulator

responsible for regulating off
shore drilling.


The National Commission Report on Deepwater Horizon found that failings in the regulation of offshore drilling
included the conflicts of interest that agency staff had between their statutory duties and the
ir personal relationships
with the industry, for example routinely accepting gifts of hospitality, agency officials performing inspections at sites
owned by firms they were about to go and work for, or, at the most extreme, the ‘royalty in kind’ payments s
operated by t
he Denver office of the MMS.


For criticism of the passporting system see
Great Britain



The revenue of the Minerals Management Service, the regulator, from leases for on and offshore
drilling in 2008
was $23billion


There are slightly different views on what constitutes regulatory capacity: those identified here are expanded in

; an alternative is Hood’s NATO: ‘nodality, authority, treasure and organisation’, developed
to describe
tools of government