Andy Schmulow [DB & Associates] makes the case for creating a regulator to have oversight over other financial regulators to ensure that they are carrying out their duties properly
In 1995, Michael Taylor published a report with the Centre for the Study of Financial Innovation entitled Twin Peaks: a regulatory structure for the new century. That began a conversation that attracted world interest.
Taylor’s proposal – two “peak” regulators for the financial system, one for system stability and the other for market conduct and consumer protection – was adopted as government policy in Australia three years later, and in the Netherlands a couple of years after that.
Following the global financial crisis, Taylor’s model was widely regarded as having provided the best response. As a result, it was adopted in Belgium, Qatar, New Zealand, the UK and, most recently, South Africa. Both in theory and in practice, this bifurcation of responsibilities is the best method of dividing what are, at times, competing and conflicting goals.
But how this is transmitted – the implementation and the enforcement of financial regulations (the plumbing) – remains problematic. This is because of challenges that all regulatory systems share. They include regulatory capture, regulator fatigue and under-resourcing, political interference, inappropriate priorities, excessive discretion leading to a capricious regulatory environment, and the difficulty of predicting why the next financial crisis may develop. It can, as with the subprime disaster, grow from market misconduct and consumer abuse. Regulators, therefore, face the challenge of foreseeing the unforeseeable.
They also have to battle time. As Thomas McCraw, the US business historian, states: “The typical agency passes through a predictable life cycle. Starting…with determination and youthful exuberance…the men and women who run the agencies…lose interest in the reform premises that underlay the agency’s creation. Under the burden of a large and trivial caseload, they slip into stultifying routine. Next they become friendly with the managers of regulated industries. And they end up, even the best of them, far different in outlook from the idealists who entered institutional service while they were young.”
Predictably, when financial regulation fails (due to poor enforcement and implementation), the solution is often more regulation. Put differently, if the cure fails, just increase the dose.
In Australia, held up as the exemplar of Twin Peaks internationally, regulatory enforcement is in crisis. So widespread, numerous and egregious have been the instances of consumer abuse, malpractice, misconduct and outright fraud that the Australian government recently established a Royal Commission of Inquiry into misconduct in the financial industry. This is, by implication, a withering rebuke of the market conduct and consumer protection regulator, the Australian Securities and Investments Commission (Asic). The system stability regulator, the Australian Prudential Regulation Authority (Apra), has not fared much better. Apra instructed Australia’s banks to limit future lending on interest-only loans to 30 per cent of their loan book. The banks responded by repricing all their loans – old and new. Australia’s four biggest banks, under the cover of adhering to Apra’s new rules, gouged an additional billion Australian dollars from their customers, thanks to Apra’s incompetence. Apra also reduced the Tax Office’s revenue by about half a billion dollars because those higher rates were offset against tax liabilities. Apra must also bear responsibility for the money laundering scandal at Australia’s biggest bank, Commonwealth.
The bank is being prosecuted for an eye-watering 53,700 alleged breaches of money laundering and terrorism financing laws. It was, apparently, washing a billion dollars a month. In cash. The bank had been warned by the Australian Federal Police and had its branches raided, yet it ignored the warnings because, as internal emails have revealed, it felt confident that the regulators would not act against it.
The predicaments that Australia face serve no one. They warp the commercial environment so that it is not the best providers that win out but the best rent-seekers – through unfair regulatory advantages over their competitors. Such environments inevitably lead to the abuse of consumers and, in turn, reputational harm for individual companies.
That damages the reputation of the whole sector and ethical players are also dragged through the mud, or in the case of Australia, before a Royal Commission. Ultimately, poor regulation can trigger a full-blown financial crisis, as was seen after the years of market misconduct and consumer abuse in the US subprime industry.
How can the faults in the architecture be fixed and regulator efficacy improved? This is important not just for Australia, but also for the other six countries that have adopted its model. The answer is a regulator for the regulators – a board of oversight – a sober second thought. This is an idea that has been around since the late 1800s, and one that has been adopted, albeit in a limited manner, in the UK.
Writing in the 1860s, Charles Adams, the US author and historian, addressed how the US railroad barons had captured state legislators. So dire was the position that Adams described it as an emergency. He proposed a commission of independent, permanent and competent tribunals that would shine a disinfecting light upon the practices that had become so corrosive to the public good. The proposal came to be called a “Sunshine Commission”.
Developing this concept further, and particularly mindful of the tendency for regulators of financial entities to become captured (greater than in any other industry), economists James Barth, Gerard Caprio and Ross Levine wrote Guardians of Finance (MIT Press, 2012) in which they proposed the concept of a “sentinel”.
This would be a guardian over the guardians of finance. Independent of the regulators and the entities they regulate, with sufficient expertise to understand the complexities of a modern financial system, the sentinel would evaluate the performance of the regulators and make the findings public. Its members would be elected for fixed terms and be better equipped to evaluate regulator performance than most parliaments have proved to be. Both in Australia and the UK prior to the financial crisis, for example, parliamentary oversight failed to keep regulators focused, effective, energetic, insulated from capture and free from group think.
As Adams stated: “Parliament is omnipotent; unfortunately, it practically is not also found to be omniscient.” In the aftermath of the financial crisis, the UK set up the Financial Policy Committee, whose obligation it is to look for the oots of the next crisis, and advise the Prudential Regulation Authority accordingly. But its remit does not extend to evaluating the Financial Conduct Authority’s performance. In light of the connection between conduct in the subprime industry and the financial crisis, this is a glaring gap.
In Australia, the 2014 Financial System Inquiry recommended that a board of oversight be created to evaluate annually, ex post, the performance of Australia’s regulators – a Financial Regulator Assessment Board. At the time, both Apra and Asic pushed back hard against this proposal and succeeded in seeing it scuppered. That was a mistake, and in light of the 2014 Australian Senate findings that Asic is a “timid, hesitant regulator, too ready and willing to accept uncritically the assurances of a large institution that there were no grounds for Asic’s concerns or intervention”, it was an indefensible mistake. It perpetuated weak, ineffective regulatory enforcement and many more conduct scandals.
The banking sector’s reputation has been trashed. It is the industry Australians love to hate the most. The Productivity Commission report in February this year painted Apra as an enabler of the four main banks assuming an unhealthy and excessively dominant role in the economy – which the Commission says has stifled economic growth.
A regulatory oversight board would fill a gap left by parliamentarians – who are generally too party political and conflicted and insufficiently knowledgeable to conduct the kind of deep analyses that a committee of experts could. Its findings on regulator efficacy would inform parliament, and not simply be another – and redundant – layer of bureaucracy. Nor would it give rise to an endless series of regulator’s regulators, like some kind of Russian matryoshka doll.
The current Australian Royal Commission, and all that preceded it, could have been avoided had a board of oversight been established and empowered to do its job. To avoid the weak enforcement that will surely manifest itself once again after the Commission has concluded its work, a board of oversight will be necessary. Australia missed that chance previously. To preserve what is left of its reputation, it would do well not to miss it again.
Andy Schmulow is a senior lecturer in law at the University of Western Australia, a member of the expert panel of advisors to the South African National Treasury on South Africa’s adoption of Twin Peaks, founder of Clarity Prudential and Regulatory Consulting, and admitted to practice in Australia and South Africa.
This article first appeared in Financial World, the journal of the London School of Banking & Finance