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Centre for Law and Governance

in EuropeUniversity College London

“Law and Governance in Europe”

Working Paper Series

008/10

Enhancing Responsibility in FinancialRegulation – Critically Examining the Future

of Public – Private Governance

Iris H-Y Chiu

2009/10

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Abstract

This paper will be published as an article in two issues of the Law and Financial Markets Review

(Oxford: Hart Publishing, 2010). Section 1 of the article argues that “financial regulation” is

essentially a decentred regulatory space. A regulatory space refers to a landscape where a variety

of actors and interest groups may have resources, capacity and ability to exert influence over the

governance of issue areas in the landscape. Where the financial services landscape is concerned,

the regulatory space is dominated by the industry and regulatory agencies, giving rise to

governance driven by industry interests and objectives as well as public interest. Section 2 of the

article then provides a literature review of modern governance and regulation theories to show

how “public-private” models in governance have been developed in contemporary theory and

practice. Section 3 draws on the literature review to discuss specific areas in financial regulation

represented by different models of “public-private governance” and critically examines the nature

of “public-private governance” in the context of the global financial crisis. Section 4 argues that

“public-private governance” in financial regulation has given rise to problems of unaccountability,

agency and capture, and some suggestions are made in relation to the dynamics of the “public-

private governance” going forward.

1. The Nature of Governance in the Financial Services Landscape

Modern financial regulation, following international financial liberalisation and deregulation in many

nation states, may be characterised as follows: the prevalence of the legitimacy of market based

solutions as a form of governance; the recognition of the limitations of state-based regulation in

favour of internationalised governance and the acceptance of internationalised governance as adynamic and participative process that could be termed as a “regulatory space”.

1

With globalisation and financial liberalisation,2

the growth of the global investment economy and

the power of private entities have led to financialisation3- often explained as the dominance of

financial services and products in global wealth creation, and the empowerment of private entities

Senior Lecturer, University College London. This article has been commissioned as part of the European

Central Bank (ECB) Legal Research Working Article Series, but does not represent the views of the ECB in any

way. All errors and omissions are mine.

1Term first used in Colin Scott, “Analysing Regulatory Space: Fragmented Resources and Institutional Design”

(2001) Public Law 329. The “regulatory space” is a metaphor used to describe the idea that resources and

information are often dispersed and fragmented among a group of constituents that are interested in an area

of governance, and hence the exercise of powers of governance or regulation may actually be dispersed rather

than concentrated in the hands of the government.

2An account of financial liberalisation may be found in John Williamson and Molly Mahar, A Review of

Financial Liberalization (World Bank, Washington,1998).

3

Gerard A Epstein (ed), Financialisation and the World Economy (Cheltenham: Edward Elgar 2006), esp atchapter 1 “Introduction”.

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involved in this economy. Financialisation is characterised by deregulation4

in financial services and

markets, and the rise in power of non-public and state based entities involved in standard setting,

supervision and securing compliance.5

This phenomenon also sets the backdrop for the ideological

movement from liberal political economy to neo-liberalism, and the predominance of economic

theories of regulation.6

The market itself would be regarded as the first port of call for solving

problems generated in the market.7

Globalisation has often been described as the precursor to a

gradual phenomenon of denationisation or de-statisation,8

and the rise of non-state actors to lead in

the real governance of various internationally connected issues. Such non- state actors could be

international organisations or networks of policy-makers, technocrats or members of the industry,9

or powerful financial institutions themselves.10

Financialisation has not only transferred wealth and

4Simon Deakin, “The Rise Of Finance: What Is It, What Is Driving It, What Might Stop It?” (2008) 30

Comparative Labour Law and Policy Journal 67.

5Sol Piccioto and Jason Haines, “Regulating International Financial Markets”(1999) 26 Journal of Law and

Society 351; Caroline S Bradley, “Private International Law Making for the Financial Markets” (2005) 29

Fordham International Law Journal 127.

6Frequently known as the Chicago school, for eg see Richard A Posner, Economic Analysis of Law (7

thed, New

York: Aspen 2007); “Theories of Economic Regulation” (1974) 5 The Bell Journal of Economics and

Management Science 335 where regulation is itself argued to be subject to the rational self interest of

participants on the supply and demand side for regulation (also George Stigler, “The Theory of Economic

Regulation” (1971) 3 The Bell Journal of Economics and Management Science 21). Also Friedman, above. The

rationality of objective behaviour underpins accepted trust and reliance in market based solutions and

governance, now commonly questioned, see Justin Fox, The Myth of the Rational Market (New York:HarperCollins 2009) but earlier already warned in Joseph Stiglitz, The Roaring Nineties (London Penguin 2003);

Amartya Sen, On Ethics and Economics (Oxford: Blackwell 1987). Also see Anthony Ogus, Regulation: Legal

Form and Economic Theory (Oxford: Clarendon 1994). See also critical discussion in David M Driesen,

“Regulatory Reform: The New Lochnerism” (2006) at http://law.bepress.com/expresso/eps/1030.

7See for eg chs 1 and 4, Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press 1962).

See useful summary in Ioannis Glinavos, “Regulation and the Role of Law in Economic Crisis” (2009) at

http://articles.ssrn.com/sol3/articles.cfm?abstract_id=1425782 , (2010), European Business Law Review,

forthcoming (on file with author).

8EJ Hobsbawm and Prem Shankar Jha, “The Twilight of the Nation State” in Anne Marie Smith and Kate Nash

eds, Globalisation and Contemporary Studies on the Nation State (Pluto Press 2006); RL Brinkman and JE

Brinkman, “Globalization and the Nation State-Dead or Alive” (2008) 42 Journal of Economic Issues 425; But

see Martin Shaw, “The State of Globalization: Towards a Theory of State Transformation” (1997) 4 Review of

Political Economy 497 and a line of literature arguing that the eclipse of the state is a matter of perspective

and that states maintain strong influences in international coordination and the perpetuating of Western

capitalistic hegemony.

9J Rosenau (ed), Governance Without Government (Cambridge: Cambridge University Press 1992, rep 2000);

Anne-Marie Slaughter, A New World Order (NJ: University of Princeton Press 2004).

10Joseph J Norton, “A Perceived Trend in Modern International Financial Regulation- A Reliance on a Public-

Private Partnership” (2003) 37 International Lawyer 43, on how “elite banks” have taken over the standard

setting of prudential standards in governing themselves; and John H Walsh, “Institution-Based Financial

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resources to the global financial sector but has also allowed the financial sector to become a credible

player in designing the governance and infrastructure surrounding its activities.11

Such governance

often results in outputs of “law”,12

from legalisation such as under the World Trade Organisation13

to

more pluralistic forms of soft law.14

The sources of what may be termed “law” have become more

varied, as private sector participants have increasingly produced “codes” and other outputs of

governance and regulation that have a norm-like character.15

The plurality of the nature of law and

governance is a consequence of the plurality in participation in the “regulatory space”. “Public-

private governance” is a form of new governance encompassing a range of public and private actors,

competence, resources and centres of influence and power.16

Public-private governance in the financial services industry is situated in a “decentred” regulatory

space. Black argues that decentred regulation is premised on five preconditions, namely complexity,

fragmentation, interdependencies, ungovernability and the rejection of a clear private-public

Regulation: A Third Paradigm” (2009) 59 Harvard International Law Journal 38 on how financial institutions

may “institutionalise” a certain function within, in order to represent self-governance.

11Such as the Basel Committee on Capital Adequacy.

12Kal Raustiala, “The Architecture of International Cooperation- Transgovernmental Networks and the Future

of International Law” (2002) 43 Virginia Journal of International Law 1. See also Sol Piccioto, “Networks in

International Economic Integration: Fragmented States and the Dilemmas of Neo-Liberalism” (1996-7) 17

Northwestern Journal of International Law and Business 1014.

13Judith Goldstein, Miles Kahler, Robert O’Keohane and Anne-Marie Slaughter, “Introduction to Legalisation

and World Politics” (2000) 54 International Organisation 385, defining legalisation as a process increasing state

participation in multilateral arrangements that would increasingly commit them to formulate clear anddependable norms which would either become hard or soft law. The form of “strong” legalisation such as

found in the WTO arrangements are discussed in Sol Piccioto, “The WTO’s Appellate Body: Legal Formalism as

a Legitimation of Global Governance” ((2005) 18 Governance 477. Less “strong” forms of legalisation often

manifest in various forms of soft law.

14Kenneth W Abbott and Duncan Snidal, “Hard and Soft law in International Governance” (2000) 54

International Organisation 421; Andrew T Guzman and Timothy L Meyer, “Explaining Soft Law” (2009) at

http://ssrn.com/abstract=1353444, defining what “soft law” is; Mario Giovanoli, “Reflections on International

Financial Standards as Soft Law” (Essays in International Financial & Economic Law ; No. 37, London : London

Institute of International Banking, Finance and Development 2002) and Jost Delbruck, “Prospects for a World

Internal Law? Legal Developments for a Changing International System” (2002) 9 Indiana Journal of GlobalStudies 401, both arguing that governance in international finance is provided by the rise of soft law; Warwick

Tie, Legal Pluralism: Toward a Multicultural Conception of Law (Dartmouth: Ashgate 1999), discusses concepts

of legal pluralism that may form the basis for recognising soft law as law.

15Generally ibid but see Simon Roberts, “After Government? On Representing Law Without A State” (2005) 68

Modern Law Rev 1.

16Scott Burris, Michael Kempa and Clifford Shearing, “Changes In Governance- A Cross-disciplinary Review of

Current Scholarship” (2008) 41 Akron Law Review 1; Orly Lobel, “The Renew Deal: The Fall of Regulation and

the Rise of Governance in Contemporary Legal Thought” (2004-5) 89 Minnesota Law Rev 342 where

governance becomes a shared process where different public and private actors may contribute towards, andregulators may act more as facilitators than prescribers.

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distinction.17

“Complexity” refers to the nature of problems that may need to be governed.

“Fragmentation” refers to the fragmentation of knowledge, resources, and capacity for control,

much like the analysis of the “regulatory space”. “Interdependencies” refers to the dynamics

between the participants in the regulatory space, co-producing and co-enforcing norms of

governance. “Ungovernability” refers to the autonomy and unpredictability of actor behaviour in the

regulatory space, which will pose challenges to assumptions made by regulatory authorities. In a

decentred landscape, there is, some argue, no public-private distinction as all participants contribute

to and influence governance. The decentred analysis has frequently been applied to financial

regulation.18

The era of decentred regulation or governance gives rise to access, participation, multipartite

representation, the sharing of tasks and responsibility, credible private ordering, collaboration with

regulators, discourse and mutual accountability, shared problem-solving and synergy.19

However,

commentators have pointed out that the problems of multiple centres of influence and governance

also produce a chaotic “market for regulation” where participants in the regulatory space compete

with each other, engage in arbitrage and become subject to coordination dilemmas.20

Further, lack

of coordination in decentred landscapes then results in protracted dialogue and “learning” and this

may cause ambiguity in the objectives that are to be achieved (which may not be the focus of

decentred regulation anyway).21

Contemporary regulatory theories arguably sustain the decentred

analysis by constructing models that proceduralise governance i.e. that deal with the processes that

take place within the regulatory space, so that the governance framework in its decentred condition

may be supported by the establishment of internal order/coherence and/or transparency or

democracy.22

17Julia Black, “Critical Reflections on Regulation” (2002) 27 Australian J of Legal Philosophy 1.

18Julia Black, “Enrolling Actors in Regulatory Systems: Examples from UK Financial Services Regulation” (2003)

Public Law 2003 63-91; “ Mapping the Contours of Contemporary Financial Services Regulation” (2002) 2.

Journal of Corporate Law Studies 253-287.

19Orly Lobel, “The Renew Deal: The Fall of Regulation and the Rise of Governance in Contemporary Legal

Thought” (2004-5) 89 Minnesota Law Rev 342; Shann Turnbull, “Self Regulation” (1997), article presented at

International Conference on Socio-Economics, Montreal, arguing that where there are diverse centers of

information, expertise and resources, power is fragmented and issues are complex, and hence, governance hasto be provided in part by ground-up private sector locations.

20Liesbet Hooghe and Gary Marks, “Unraveling the Central State, but How? Types of Multi-level Governance”

(2003) 97 American Political Science Review 233.

21John SF Wright and Brian Head, “Reconsidering Regulation and Governance Theory: A Learning Approach”

(2009) 31 Law and Policy 192 in which decentred regulation is regarded as part of the post-structuralist

ideology.

22Julia Black, “Proceduralising Regulation: Parts I and II” (2000) 20 Oxford Journal of Legal Studies 597, (2001)

21 Oxford Journal of Legal Studies33-58; see also Joshua Cohen and Charles Sabel, “Norms and Global

Institutions” at

http://www.princeton.edu/~pcglobal/conferences/normative/articles/Session4_Cohen_Sabel.pdf , where

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On the other hand, it is not entirely true that public regulatory governance as a distinct form of

governance has become irrelevant in the financial services landscape. Regulators arguably remain

unique in the regulatory space, and are representations of perspectives of “public interest”23

or

“public good”24

(in the economic sense of public goods that are not supplied for failure of collective

action on the part of the market). The “public” character of regulators in the regulatory space is

arguably distinct, and this is conceptually sustainable even if the regulatory space is decentred.

Donahue25

asks “[g]overnance and markets... tend to be tangled with each other....”, but “does

engaging the market offer the most promising blueprint for accountability in the pursuit of particular

public goals?” Goodhart et al have also argued that there is a place for “regulation” in governing the

activities of the financial services sector where market failures26

and public goods such as systemic

stability are concerned.27

There is an acknowledgement that concerns such as “public goods” would

still likely be addressed by the type of governance that is characterised by public interest, and would

articulate values and objectives of a communitarian character. Such “public” governance, as argued

by Donahue is based on a form of “extensive accountability” to a variety of stakeholders, in

furthering a variety of different “mandates”.28

This is different from “intensive accountability”

represented by market-based governance which seeks rather single-mindedly market efficiency and

individual wealth creation. Hence, there is a unique role for “regulation” as a form of public

governance.29

mention is made of global governance as a “deliberative polyarchy” where decision-making and learning takes

place in a continuous dialogue and deliberation.

23Geoffrey RD Underhill, “Theorizing Governance in a Global Financial System” in Peter Mooschlechner,

Helene Schuberth and Beat Weber eds, The Political Economy of Financial Market Regulation (Cheltenham:

Edward Elgar 2006) at 4.

24Robin P Malloy, Law in a Market Context (Cambridge: Cambridge University Press 2004) at 122ff.

25John D Donahue, “Market-based Governance and the Architecture of Accountability” in John D Donahue and

Joseph S Nye eds, Market-based Governance (Mass: Brookings Institution Press 2002) at 1 and 4.

26Frank B Cross and Robert A Prentice, “The Economic Value of Securities Regulation” (2006-7) 28 Cardozo

Law Review 333 explains in detail the economic rationale for investor protection. Economists such as Ronald

Coase of the Chicago-school would not necessarily subject social costs to regulatory intervention, see “The

Problem of Social Cost” (1960) 3 The Journal of Law and Economics 1, in dealing with externalities bycontractual solutions. Critical analysis may be found in RL Gordon, Economic Analysis of Regulation (Springer

1994).

27Although the authors tend to be cautious about the role of public regulation as optimal governance in

financial markets, see Charles Goodhart, Philip Hartmann, David Llewellyn, Lilian Rojas-Suarez and Steven

Weisbrod, Financial Regulation: Why, How and Where Now? (London: Routledge 1998) at 3-4.

28Donahue, “Market-based Governance” (2002), above at 5-8.

29“Regulation” may be defined as a phenomenon that seeks to provide a sustained and focused approach to

modify the behaviour of the subjects of regulation, so that compliance may be secured according to the

standards and goals in such regulation, see P Selznick: "Focusing Organizational Research on Regulation", in

R.G. Noll (ed.), Regulatory Policy and the Social Sciences (Berkeley, University of California Press, 1985) at 363-

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Further, Levi-Faur argues that the economic society rests on the bedrock of regulation, a

phenomenon known as “regulatory capitalism”.30

Regulatory capitalism refers to the existence of

governance frameworks that shape economic functioning and the protection of certain political or

social values, representing a landscape where economic functions and needs are facilitated, and

distributive or social goals are also being pursued. Braithwaite31

supports this by arguing that it is a

myth that the laissez-faire nature of markets have been allowed to flourish as such in the ideology of

neoliberalism and deregulation. In fact, he argues that the public character of governance continues

to exist extensively and has evolved into a form of regulatory capitalism. Regulators continue to

define governance over businesses in competition policy and laws, laws relating to health, safety and

product quality. Empirical research has also pointed out that citizens’ acceptance of the level of risk

associated with any economic or social activity is directly correlated with the level of institutional

trust, and hence, the presence of the “public character” of regulatory governance as an institution

underpinning the investment economy is necessary to facilitate acceptance of private investment

risks and participation in the investment economy.32

Further, the global financial crisis has brought the “public-private” distinction back into discussion.

Although the crisis is a failure of private market institutions and the market, the response from most

nation states hit by the financial crisis has been not only to activate the central bank’s capacity as

lender of last resort to a number of large and significant global financial institutions,33

but taypayers’

money has been directly injected into ailing banks to rebuild their balance sheets,34

and

governments have intervened to effect banking rescues by compelling certain corporate mergers

and acquisitions.35

Hence, recourse to “external” measures beyond the market would put into doubt

the self-sufficiency of private market-based governance. The trailing social costs and effects of the

7. See also G. Majone (ed.), Deregulation or Re-regulation? Regulatory Reform in Europe and the United States

(New York, Pinter, 1990) at 1-6; A Ogus, On Regulation: Legal Form and Economic Theory (Oxford: Clarendon

1994); Karen Yeung, Securing Compliance (Oxford: Hart 2004) at 5 and 11. Margot Priest further discusses

regulatory control in 7 parts in “The Privatisation of Regulation: Five Models of Self-Regulation” (1997-8) 29

Ottawa Law Rev 233, closely correlating to the 3 main tenets of standards, supervision and compliance as

referred to above.

30David Levi-Faur, “The Global Diffusion of Regulatory Capitalism” (2005) 598 The ANNALS of the American

Academy of Political and Social Science 12-32.

31John Braithwaite, Regulatory Capitalism (Cheltenham: Edward Elgar 2008) at 4-29.

32 Nicolás C. Bronfman, Esperanza López Vázquez and Gabriel Dorantes, “An Empirical Study for the Direct and

Indirect Links Between Trust in Regulatory Institutions and Acceptability of Hazards” (2009) 47 Safety Science

686.

33Although contemporary literature has doubted the continued relevance of the lender of last resort, eg see

Steven Lawrence Bailey, “New Zealand’s Alternative Approach to Banking Supervision” (1998) 3 Yearbook of

International Financial and Economic Law 393. But see Xavier Friexas, Bruno M Parigi and Jean-Charles Rochet,

“The Lender of Last Resort: A 21st

Century Approach” ECB Working Article No 298 (2003), arguing that the

facility of the lender of last resort is relevant although it needs to evolve.

34Lloyds/HBOS and RBS in the UK, Fortis in Belgium, The Netherlands and Luxembourg.

35Bank of America and Merrill Lynch, and Washington Mutual, Lloyds TSB in the UK with HBOS.

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crisis, as manifested in the real economy of many countries, call for an acknowledgement of a need

for governance over the financial services industry that involves some “public” values and objectives

and the type of “extensive accountability” referred to in Donahue’s arguments mentioned above.

Further, the legal harmonisation in the EU’s financial services law as part of the movement to create

an integrated market for financial services and products, rests heavily on identifying regulatory

leadership and empowering the regulatory role to bring about coordinated standard-setting,

supervision and enforcement.36

The “public” character of governance deals not only with public

goods and objectives and extensive accountability, but the public policy of fostering an integrated

internal market.

The article has attempted to present an overall picture of the governance of the financial services

industry- on the one hand decentred, populated by resourceful, competent and powerful industry

participants, and on the other hand consisting also of agencies of authority that that have a public

character, whether state-based, regional (such as EU committees) or international s (such as IOSCO).

The relative lack of direct influence of stakeholder groups such as consumers in this regulatory space

arguably means that the governance in the financial services landscape is essentially a public-private

governance, which could be defined as a sharing and morphing together of competence between

actors of a public and private character, in addressing regulatory concerns and problems.37

The key

feature of the public-private governance is the relational paradigm between the actors of a public

character, dominantly regulators (whether EU or state-based) and the private sector, and this

paradigm characterises the nature of financial regulation and governance. For example, public-

private governance may be represented in regulatory approaches such as meta-regulation, smart

regulation, soft law and responsive regulation. These regulatory models reflect the changing role of

regulators not as platforms of authority, but as participants in a relational paradigm with the

industry in providing governance over the financial services landscape.

The Relational Paradigm – The Regulator and the Industry

In 1998, Goodhart et al published Financial Regulation- Why, How and Where Now 38 to shed light on

this relational paradigm. This remains an important book that has taken stock of the realities of

financial regulation up to the 1990s and consolidated a vision of the workings and mechanics of

financial regulation as a relational paradigm- an open-ended relational contract between the

regulator and regulated. The authors argue that it is practically impossible to intrude in an extensive

regulatory manner into the highly innovative working of the financial services industry, but it

remains important that the regulator is able to pursue and provide certain necessary public goods

such as systemic stability and to address market failures. Hence, the authors also contend that the

36Iris H-Y Chiu, Regulatory Convergence in EU Securities Regulation (The Hague: Kluwer 2008); Eilis Ferran,

Building an EU Securities Market (Cambridge: Cambridge University Press 2004), and the extensive

bibliography in both books.

37For example the Hague Institute of International Law established by the Dutch government is a public-

private governance network harnessing competence of the private and government sector in addressing issues

in international law.

38London, Routledge 1998.

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nature of financial regulation will become a relational outworking between regulator and industry in

terms of specific “bonding” commitments by the industry to conduct itself and to achieve certain

outcomes acceptable to the regulator. The article agrees that this relational paradigm will remain

dominant in the financial services landscape, but one of the key problems in this paradigm is the

relative weakness of other stakeholders as will be explained.39

The risk-based approach to supervision of the UK’s Financial Services Authority (“FSA”) ,40

although

not a relational contract between regulator and regulated, is heavily based on a relational paradigm.

The risk-based approach to financial regulation has also been accepted in many other countries,

such as Australia and parts of Canada.41

Risk-based regulation is a modern compromise between the

acknowledgement of the realities of the decentred regulatory space and the limitations of the

regulators, and the role of regulation in providing public goods. Risk-based regulation seeks to define

the regulator’s responsibility within the parameters of economic resources, efficiency and cost-

benefit analyses.

Risk-based regulation is often interpreted as a preventative or pre-emptive regulatory approach, 42

whereby the private and social risks of financial activities are measured, adjusted and assessed so as

to inform the regulator of the appropriate regulatory approach to take with respect to a firm or the

industry in general, having regard to the regulator’s resources.43

The FSA has been committed to

risk-based regulation since its establishment in 2000.44

Although the intention of risk-based

39See Section 3, in Part 2 of this article, forthcoming.

40Christopher Hood, Henry Rothstein and Robert Baldwin, The Government of Risk: Understanding Risk

Regulation Regimes (Oxford: OUP 2001).

41 Julia Black, The Development of Risk-based Regulation in Financial Services: Canada, the UK and Australia- a

Research Report (London: ECRC Centre for the Analysis of Risk and Regulation, LSE 2004).

42Jonathan B Wiener, “Whose Precaution After All? A Comment On The Comparison And Evolution Of Risk

Regulatory Systems”(2003) 13 Duke J. Comp. & Int'l L. 207; Sidney A Shapiro and Robert L Glicksman, Risk

Regulation at Risk (Stanford U Press 2003) where the concept of preventative regulation based on risk is

defended against charges of excessive social cost and paternalism. In the liberal tradition of America, risk-

based regulation may be seen as being paternalistic, communitarian and quite against the grain of

individualism and laissez-faire, against which Shapiro and Glicksman defended risk-based regulation as a

pragmatic and socially useful approach. In the UK however, the same risk-based approach is actually seen as a

move of retreat from the social state. See Better Regulation Task Force, Alternatives to Regulation, and Risk,

Responsibility and Regulation, infra.

43A detailed examination of what risks are identified, how risks are adjusted to “net” levels after

considering firms’ mitigation approaches, how regulators decide if particular risks ought to be addressed in

regulation or supervision and the impact of regulation on firm activities, is presented in Julia Black, The

Development of Risk-based Regulation in Financial Services: Canada, the UK and Australia- a Research Report

(London: ECRC Centre for the Analysis of Risk and Regulation, LSE 2004).

44See speech by Michael Foot, FSA, at

http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2000/sp69.shtml. The historical context of

strong self-regulation in the financial services industry prior to the establishment of the FSA may be important

to the adoption of risk-based regulation, which promises proportionality and a relational paradigm in the FSA’s

approach. For some history, see Julia Black, Rules and Regulators (Oxford: Clarendon 1998) at chs 2 and 3. This

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regulation is to ensure that regulatory attention and resources may be prioritised in an efficient

manner to address the riskiest issues that may affect the delivery of regulatory goals, Black has also

critically commented that risk-based regulation could be used to redefine blame and the parameters

of accountability.45

- A risk-based approach in regulation could allow regulators to carry out uneven

levels of supervision depending on the risk profiles of firms, and hence allocate resources according

to those priorities. This may legitimate any perception of regulatory shortfall involving firms that are

regarded to be “safer” by regulators. However, if the risk profiles of firms are in any way mistaken at

any given time,46

then the FSA may run the risk of allocating insufficient resources to manage

unperceived risks. It is arguable that the global financial crisis that hit two of the UK’s largest high

street banks i.e. Halifax Bank of Scotland and the Royal Bank of Scotland in late 2008/early 2009

could be due to the misperception of either bank’s health under the risk-based regulatory

framework.47

In 2006, the then-Chairman of the FSA, Callum McCarthy identified about 1,500 firms

that were subject to medium-to-high risk-based supervision, which entailed the FSA’s regular visits

and continuous monitoring. The rest of the industry, some 28,349 firms, were subject to low risk

supervision, which meant compliance with reporting requirements established under FSA rules.Most of the financial services industry then was arguably subject to a form of self-certifying

discipline.48

In a risk-based regulatory approach, the regulator constructs the risk profile of the regulated and

that provides the blueprint for how the regulator supervises the regulated. The spectrum below

shows the varying degrees of closeness in a regulator-regulated relationship in a risk-based approach

to regulation.

is also the general thrust of public regulation in the millennium, see Stephen Bundred, “The Future of

Regulation in the Public Sector” (2006) 26 Public Money and Management 181.

45Julia Black, “The Emergence of Risk-Based Regulation and the New Public Risk Management in the United

Kingdom” (2005) Public Law 512. Warnings on the limitations and subjectivities in risk based regulation are

also discussed in relation to the medical profession in Sally Lloyd-Bostock and Bridget M Hutter, “Reforming

Regulation of the Medical Profession: The Risks of Risk-Based Approaches”(2008) 10 Health and Risk Society

69; A.L. Camp, “Treatment of Uncertainties in Risk-Based Regulation” (2008) at

http://www.osti.gov/servlets/purl/46555-dl5dVd/webviewable/.

46The risk profile of a firm may take between 1-3 years to be constructed and it is uncertain how periodic

reviews may be carried out by the regulator, see Stuart Bazley and Andrew Haynes, Financial Services

Authority Regulation and Risk-based Compliance (London: Tottel Publishing 2006) at 4.30.

47Most representations to the Regulatory Reform Select Committee of the Parliament after the onset of the

financial crisis seemed to agree that the application of risk-based regulation by the FSA had been faulty but the

approach itself remained valid. See “The Implications of the Financial Crisis for Regulation” (20 Aug 2009) at

http://www.publications.parliament.uk/pa/cm200809/cmselect/cmdereg/329/32906.htm#n35 . Kern

Alexander also commented that the risk-based approach to regulation had been faulty for its failure to

consider systemic risk in its risk profiling, see “Principles v. Rules in Financial Regulation: Re-assessing the

Balance in the Credit Crisis” (2009) 10 European Business Organisations Law Review 169.

48Bazley and Haynes argues that risk-based regulation relies heavily on enhancing the internal compliance and

risk management processes within firms, see Bazley and Haynes, Financial Services Authority Regulation (opcit) at 4.46ff.

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If the risk profile of a regulated entity is “low-risk”, greater reliance may be placed upon the

regulated’s submission of data and reporting, amounting to a form of self-certification by the

regulated. The relationship is characterised by trust and paradoxically, distance. Further down the

spectrum would be more intensive regulator monitoring or supervision to steer aberrant conduct

into line, ie greater distrust and scrutiny but closeness in intensity. The main challenges for the

regulator in the risk-based approach are that:

(a) The relational distance between the regulator and regulated in low risk firms could amount

to a longer term “delegation” to the regulated to monitor itself, and such delegation may

entail agency problems in due course. If the construction of the risk profile of a firm is based

on faulty assumptions,49

then such an agency problem may become augmented over time.

(b) The relational closeness between the regulator and regulated in more intensive monitoring

may actually result in a bias towards decreased enforcement over time.

In an earlier work, I have discussed how the relational paradigm of risk-based regulation may affect

the discharge of legal duties of regulated financial investment intermediaries. I have specifically

drawn attention to the possibility that the relational paradigm in risk-based supervision may allow

room for investment intermediaries to adjust and change sub-optimal practices through dialogue

and negotiation with the regulator, and this process would render it inappropriate for bright line

pronouncements (especially judicial ones) to be made that the regulated has fallen below a

particular standard of care or breached a rule.50

Risk-based regulation also allows issues with the

regulated to be first pursued within a relational paradigm, perhaps by moving from a medium

supervisory level to a high-medium or high level, and hence, this relational paradigm may indirectly

encourage less resort to enforcement, leaving governance issues internalised in the relational

paradigm. Although the relational outworking could encourage more effective change of

behaviour,51

it could also mask shirking by firms and create opacity as to how firms are monitored.

Although policy-makers are keen to distinguish between risk-based regulation and the now-

discredited light-touch regulation carried out by the FSA,52

it could be arguable that the nature of

49 See general discussions in Sally Lloyd-Bostock and Bridget M Hutter, “Reforming Regulation of the Medical

Profession: The Risks of Risk-Based Approaches”(2008) 10 Health and Risk Society 69; A.L. Camp, “Treatment

of Uncertainties in Risk-Based Regulation” (2008) at http://www.osti.gov/servlets/purl/46555-

dl5dVd/webviewable/.

50Iris H-Y Chiu, “The Nature of a Financial Investment Intermediary's Duty to His Client” (2008) 28 Legal Studies

254.

51Karen Yeung, Securing Compliance (Oxford: Hart 2004).

52UK Parliament Regulatory Reform Select Committee, “The Implications of the Financial Crisis for Regulation”

(20 Aug 2009) athttp://www.publications.parliament.uk/pa/cm200809/cmselect/cmdereg/329/32906.htm#n35 .

Reporting towards self

certification

Communications to be vetted,

audited, inspected, proved

Steps to secure

compliance

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risk-based regulation lends itself to an atmosphere of relational outworking between regulator and

regulated, which has led to an enforcement deficit.53

In sum, risk-based regulation may fail to take

into account of its relational side risks- the risks of being too far or too close to the regulated.

Further, the relational paradigm of financial regulation in this area has gradually eclipsed

jurisprudence in civil actions as being an important source of governance.54

The twin themes of being too far and too close to the industry will remain dominant as we examine

contemporary governance models in the literature review, and specific models in financial

regulation. In the context of the global financial crisis, it will be argued that issues in the relational

paradigm have been persistent although they are more of “background” rather than front line

problems. However, background problems could have exacerbated frontline problems. For example,

the UK Turner Review has acknowledged how key beliefs in market efficiency may have been

important in contributing to the financial crisis- background beliefs affecting frontline regulation

and governance. This article however does not amount to a simplistic call for re-regulation but an

examination of how the relational paradigm in the governance of the financial services industry may

be re-oriented so that the nature of governance in the financial services landscape may be able to

reflect common values of responsibility and sustainability.55

Section 2 will provide a literature review of contemporary perspectives of governance, much of

which have influenced the governance in the decentred financial services landscape. Section 3 will

then show how the contemporary models of governance have shaped specific areas of financial

regulation. I will look at specific areas of financial regulation as conceptualised in 8 models derived

from the contemporary perspectives in governance. Discussion of the 8 models of financial

regulation will arguably show that the governance of the financial services landscape is dominated

by relational problems including over-reliance by regulators on industry governance, and the agency

problem where public goods or regulatory goals have been delegated to the industry. Section 4 will

draw out some broader observations from the examination in Section 3 and will argue that

regulators need to address the relational sub-optimalities in the public-private governance of the

financial services industry in order to develop overall governance.

2. The Concepts of Contemporary Governance

This Section will discuss concepts of governance generally and will present a literature review of the

concepts of self-regulation, market-based governance, meta-regulation, smart regulation and

responsive regulation. These will further form the rubric of the 8 models of financial governance

discussed in Section 3. Contemporary perspectives in governance are based on the underlying theme

53FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (March 2009) at p88 which

acknowledged that the FSA’s approach in relational outworking with firms was not aggressive enough and a

more intrusive and systemic approach is now needed.

54Chiu, “The Nature of a Financial Investment Intermediary’s Duty” (2008), above.

55Yochai Benkler, “From Greenspan's Despair to Obama's Hope: The Scientific Basis of Cooperation as

Principles of Regulation” in David Moss and John Cisternino eds, New Perspectives on Regulation (The Tobin

Project, 2009), arguing for the reaffirmation of common values such as caring for one’s fellow man,normativity, fairness, participation and transparency.

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that boundaries in governance such as private and public are continuously being challenged, and this

is certainly present in the governance landscape for financial services.

Self-Regulation

On a basic level, self-regulation falls within the sphere of personal autonomy in which privateactivities or ordering may take place. Psychologists define self-regulation as behaviour controlled by

internal guidance,56

often based on perceptions of utility, goals, emotions or constitution.57

Hence,

the Better Regulation Task Force suggests that often “no intervention”, leaving to the good sense of

personal self-regulation, is a better alternative to regulation even where risks may be perceived.58

Self-regulation in the microcosmic sense is typically represented in the leaving to the individual to

determine an appropriate course of action, such as leaving to sophisticated investors’ good sense to

govern their own investments. For example, a sophisticated individual making a decision to purchase

an investment product is self-regulatory. Limitations are imposed on retail investor access to certain

investment products such as the Qualified Investors’ Collective Investment Schemes regulated by

the UK FSA59 or participation in funds managed by Alternative Investment Funds proposed to be

regulated by the EU.60

By and large, the microcosm of a sophisticated investor’s decision is largely at

will, and this has also allowed sophisticated investors such as banks and financial institutions to own

large quantities of complex assets such as collateralised debt obligations whose liquidity has always

remained a paradox.61

Responsibilisation

Self-regulation in the microcosmic sense may also be complemented by responsibilisation on the

part of financial product investors or consumers. Responsibilisation refers to the enhancement of

awareness of personal responsibility on the part of investors or consumers for their choices and in

56See generally “Preface” in Charles S Carver and Michael F Scheier, On the Self-Regulation of Behaviour

(Cambridge: Cambridge University Press 2001); Katherine D Vohs and Roy F Baumeister, “Understanding Self-

Regulation: An Introduction” in Vohs and Baumeister eds, Handbook of Self-Regulation: Research, Theory and

Application (Guilford Press 2004).

57Maya Tamir, Chi-Yue Chiu and James J Gross, “Business or Pleasure: Utilitarian versus Hedonistic

Considerations in Emotion Regulation” (2007) 7 Emotion 546 on utility, and see Vohs and Baumeister,

Handbook, ibid.

58Better Regulation Task Force, Alternatives to Regulation (2004), op cit.

59FSA Handbook COLL 8.

60Proposal for a Directive of the European Parliament and of the Council for Alternative Investment Fund

Managers, COM(2009) 207 final.

61Peter D Marzo, “The Pooling and Tranching of Securities: A Model of Informed Intermediation” (2005) 18

Review of Financial Studies 1; Edward L Glaeser, “Thin Markets, Asymmetric Information, and Mortgage-Backed Securities” (1997) 6 Journal of Financial Intermediation 64.

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finding solutions for their investment or financial problems.62

This is often purported to be achieved

by improving financial literacy and education.63

However, responsibilisation is principally appropriate where investors can govern their own choices

and decisions and where information asymmetry and inequality in bargaining power do not occur.

Where investors and consumers may not be able to differentiate between lemons and peaches in a

reliable manner, responsibilisation would only entail the privatisation of losses.64

Schürz also argues

that for the abjectly impoverished in the US, for example, financial literacy education has not made

much headway in either imparting knowledge, understanding or application.65

Even if

responsibilisation empowers individuals to seek private benefit in an informed and empowered

manner, it is individualistic in nature and does not address the wider issues of public and collective

goods such as collective information and action.66

It will be argued in Section 3 that the

empowerment of stakeholders as a collective force and as assisting regulators could be important in

re-orienting the relational paradigm between the regulator and industry, but this will be beyond the

sense of responsibilisation for individual choice as discussed above.67

Transactional Governance

Transactional governance refers to contractually established rules, rights and obligations that

provide governance over behaviour. Williamson opines that bilateral private ordering could involve

parties in providing “good order and workable arrangements”.68

De Minico describes the private

transactional paradigm as an autopoietic and self-referential system of self-regulation.69

This means

that participants to the transactional paradigm see themselves as actively making the rules by which

62

Ronen Shamir, “The Age of Responsibilization: On Market-Embedded Morality” (2008) 37 Economy andSociety 1.

63Toni Williams, “Empowerment of Whom and for What? Financial Literacy Education and the New Regulation

of Consumer Financial Services” (2009) 29 Law and Policy 226; www.moneymadeclear.gov.uk, which is the

FSA’s website for improving consumer financial awareness according to its objective in s3, FSMA 2000.

64Williams “Empowerment” (2009), above.

65Martin Schürz, “Financial Education for the Poor in the US”, in Peter Mooschlechner, Helene Schuberth and

Beat Weber eds, The Political Economy of Financial Market Regulation (Cheltenham: Edward Elgar 2006) at

140.

66Above.

67Shamir, “The Age of” (2008), op cit; N.J. Fox, and K.J Ward. “What governs governance, and how does it

evolve? The sociology of governance-in-action” (2008) 59 British Journal of Sociology 519-538. Larsson et al

also argue that this is crucial to the regulatory and governance of the Swedish banking sector after its crisis in

2003, Berg Larsson, “Neo-liberalism and Polycontextuality: Banking Crisis and Re-regulation in Sweden” (2003)

32 Economy and Society 428.

68Oliver E Williamson, “The Economics of Governance” (2005) 95 American Economic Review 1.

69

Giovanna De Minico, “A Hard Look at Self-Regulation in the UK” [2006] 17 European Business Law Review183.

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they bind themselves as they navigate the dynamics of bargaining and negotiation with their

counterparties. The transactional paradigm emerges from the bottom-up, and is self-referential as

the paradigm functions without the need for external intervention. Many commentators would

agree that many transactional rules in finance, particularly in international finance have developed

in relational paradigms of transactions, and those that are regarded as popular or efficient have

become standardised, creating a body of transactional private law that governs international

financial transactions.70

However, transactional governance may have certain limitations. First, although transactional

standardisation may provide certainty and efficiency, it may contribute to snowballing of risks

(perhaps systemic risk) if it is subsequently realised that certain transactional rules are flawed.71

The

relational paradigm in transactional governance could be myopic as to wider communitarian effects.

This could be seen in the use of derivatives for risk management purposes. Derivatives are used to

hedge, a key element of risk management for the real economy as well as the investment economy,

and many derivative transactions are carried out over-the-counter in the interests of low cost and

speed.72

The International Swaps and Derivatives Association has over the years overseen the rise of

standardisation in derivative transactions.73

However, in the wake of the financial crisis, the sharp

rise in counterparty risk in OTC markets after the collapse of Lehman Brothers in September 2008

have resulted in the snowballing of losses in derivative markets and the intensification of the

financial crisis.74

Policy-makers globally are now concerned as to whether the volume of unregulated

OTC derivative trades would pose systemic risks in the future.75

The proposals to bring the OTC

derivatives market within a regulatory/governance framework will be discussed in Section 3.

70Maria Chiara Malaguti, “Private-Law Instruments for Reduction of Risks on International Financial Markets:

Results and Limits of Self-Regulation” (2000) 11 Open Economies Review 247; Caroline S Bradley, “Private

International Law Making for the Financial Markets” (2005) 29 Fordham International Law Journal 127; Eddy

Wymeersch, “Standardisation by Law and Markets especially in Financial Services” (2008) University of Ghent

Financial Law Institute Working Article.

71Viral V. Acharya, “A Theory of Systemic Risk and Design of Prudential Bank Regulation” (2009) 5 Journal of

Financial Stability 224.

72 Thomas F Siems, “Financial Derivatives: Are New Regulations Warranted?” (1994) Financial Industry Studies

1; J David Cummins, Richard D Philips and Stephen D Smith, “Derivatives and Corporate Risk Management:

Participation and Volume Decisions in the Insurance Industry” (Wharton Financial Institutions Center Working

Article, 1998); Darrell Duffie and Henry TC Hu, “Competing for a Share of Global Derivatives Markets” (2008) at

http://articles.ssrn.com/sol3/articles.cfm?abstract_id=1140869 .

73For eg, the ISDA Master Agreement 2002.

74Jacques de Larosière, Report from the High Level Group on Financial Supervision in the EU (25 Feb 2009) at

http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf .

75

US Department of the Treasury White Article, A New Foundation: Rebuilding Financial Supervision and Regulation (March 2009); HM Treasury, Reforming Financial Markets (July 2009).

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Second, transactional standardisation provides a form of governance that facilitates transactions,

but may not provide a blueprint for dealing with failures and externalities.76

Partnoy argues that in a

transactional paradigm, participants will each look after their selfish interests even if they perceive

problems that may occur to other participants. Opportunistic behaviour may occur, participants in

the market may pass risk onto the next available participant and when trouble occurs, collective

action is not likely.77

Coase’s seminal article on the “Problem of Social Cost”78

argues that

externalities can be managed within transactional contexts, and stakeholders can enter into the

transactional paradigm to exert bargaining power. Hence, ex ante provisions of regulatory

governance may not be necessary or efficient. However, where derivatives trading is concerned, the

participants are heterogenous, diffuse and international, the externalities may be dispersed and

borderless. The relational connection arguably breaks down for transactional governance to arise.

Hence, there would be a gap in addressing externalities that arise in such a context.

Smart Regulation

An extended form of transactional governance may lie in “smart regulation”. Gunningham and

Sinclair propose that smart regulation involves levering on the expertise, interests and resources of

second and third parties in the regulatory space to act as “surrogate” regulators, and this therefore

provides a range of policy instruments and instrument mixes for addressing any governance issue.79

Smart regulation encompasses a partnership between first, second and third party stakeholders,

certifiers, gatekeepers and regulators.

In terms of levering on parties in the “regulatory space”, whether counterparties, stakeholders,

certifiers or gatekeepers, the increased diversity in participation may introduce checks and balances

in the regulatory space, and improve the legitimacy of such governance. However, there may be

challenges in seeking coordination and reconciliation between regulatory goals and the private

interests pursued by these entities. Further, the key vulnerability of the smart regulation model is

that too much trust and reliance may be placed on “surrogate regulators” such that they are no

longer regarded as instrumental in a fabric of regulatory design- regulators simply choose the path

of the least resistance and allow the surrogate regulators to provide the entire rubric of regulation

or governance.80

Market based Governance

76Malaguti, “Private Law Instruments” (2000), op cit. Particularly if the contract may not be a long and

continuous one, see Williamson, “Economics of Governance” (2005), op cit.

77Frank Partnoy, “Financial Derivatives and the Costs of Regulatory Arbitrage” (1996-7) 22 Journal of

Corporation Law 211.

78Op cit.

79Neil Gunningham and Darren Sinclair, “Designing Smart Regulation” (2000); Neil Gunningham, Peter

Grabosky and Darren Sinclair, Smart Regulation: Designing Environmental Policy (Oxford: OUP 2004).

80Janice Graham, “Smart Regulation Will the Government’s Strategy Work?” (2005) 173 CMAJ 1469;

Christopher Hodges, “Encouraging Enterprise and Rebalancing Risk: Implications of Economic Policy forRegulation, Enforcement and Compensation” (2007) 18 European Business Law Review 1231.

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The “Market” is classically understood to be based on the freedom of participation and exercise of

will by individuals in their own self-interest, but it has developed into an institution, a model81

and

even a collective entity which today, may be arguably providing a form of “governance”, a collective

good over and above individual private goods exchanged in a market context. Market-based

governance may be described as “[the motivation] of private interests to further public good”.82

This

could mean allowing the activities of participants in the market to provide solutions to problems that

may be generated by the market itself, such as (a) transactional solutions evolved into standardised

ones;83

(b) the aggregation of market participants’ incentives to provide discipline and monitoring,84

(c) using market-based institutions such as stock exchanges to provide discipline,85

(d) allowing

“governance” goods such as certification goods to flourish in a market for such goods,86

(e) using

market concepts to refashion the supply of public goods or services,87

(f) outsourcing to the market

functions that may have been carried on by the government,88

or (g) seeking private investment into

partnerships with the government in providing quasi-public services such as healthcare or

education.89

“Market-based governance” is very much in sync with the decentred regulatory space which sees

the amorphous collective entity of the “market” as being a source of governance.90

Shamir argues

81James G Carrier, “Preface” to James G Carrier ed, Meanings of the Market (New York and Oxford: Berg 1997)

at vii.

82R Dhumale, “An Incentive-Based Regulatory System- A Bridge Too Far” (2000) at

http://www.cbr.cam.ac.uk/pdf/wp170.pdf.

83Maria Chiara Malaguti, “Private-Law Instruments for Reduction of Risks on International Financial Markets:


International Law Making for the Financial Markets” (2005) 29 Fordham International Law Journal 127; Eddy

Wymeersch, “Standardisation by Law and Markets especially in Financial Services” (2008) University of Ghent

Financial Law Institute Working Article.

84Dhumale, “An Incentive-Based Regulatory System” (2000), op cit; Mark JK De Ceuster and Nancy

Masschelein, “Regulating Banks Through Market Discipline” (2003) 17 Journal of Economic Surveys 749;

Charles Calomiris, “Financial Regulation, Innovation and Reform” (2009) at

http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf.

85Such as how credit rating agencies have been used to provide information regarding issuers’ credit-

worthiness, using stock exchange membership to provide discipline to members, the role of trade associations

for the financial industry, and the role of the corporate governance industry.

86Such as credit, corporate governance, social responsibility ratings.

87See chs 11-13, John D Donahue and Joseph S Nye eds, Market-Based Governance: Supply Side, Demand Side,

Upside and Downside (Cambridge: Mass, Brookings Institution 2002).

88Chs 2, 5 and 6, Donahue and Nye eds, Market-Based Governance (2002), above.

89Above, also see D Asenova, M Beck, & S Toms, “The Limits of Market-Based Governance and Accountability -

PFI Refinancing and the Resurgence of the Regulatory State” (2007) University of York Working article number

35.

90Dhumale, “An Incentive-Based Regulatory System” (2000), op cit.

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that market-based governance allows information to be discovered from the market, innovations to

take place, providing a reflexive form of governance that is derived from and feeds back into the

open and porous nature of the market itself and into society in general.91

(a) Market-based Standardisation as Self-regulation

The market may be able to generate standards of behaviour that could provide self-regulation and

arguably a form of collective or social good. This could be a standardisation process, sometimes led

by trade or industry associations or international associations or networks, or could be a market for

standards itself. Supply side and demand side factors would play out to determine the evolution of

standards or a market for standards. Supply side factors may include the perception by industry

participants that self-regulatory standards would stave off more costly regulatory intervention,92

the

interest in industry participants in developing technocratic standards that would be appropriate to

industry needs,93

and competitive pressures amongst market participants in producing standards of

credible self-regulation where there are also demand side pressures for such generation.94

On the

demand side, it may be argued that self-regulatory standards generated by the market are well

regarded , usually relevant to the technocratic issues at hand, and perceived to be more persuasive

and inspire compliance to a greater extent than externally imposed regulatory standards.95

In

financial regulation, many self-regulatory standards have been generated as a form of

standardisation, and this is largely due to the leadership of organisations such as trade and industry

associations or international organisations, associations or networks.96

Examples of such standards

91Ronen Shamir, “The Age of Responsibilization: On Market-Embedded Morality” (2008) 37 Economy and

Society 1.

92 Cary Coglianese and Robert A Kagan, “Regulation and Regulatory Processes” (2007)

http://articles.ssrn.com/abstract=1297410.

93Such as the Basel II Capital Adequacy standards produced by the Basel Committee, an international

association of the banking industry, see John C Pattison, “International Financial Cooperation and the Number

of Adherents: The Basel Committee and Capital Regulation” (2006) 17 Open Economies Rev 433; Joseph J

Norton, “A New International Financial Architecture? Reflections on the Possible Law-Based Dimensions”

(1999) 33 International Lawyer 891; Tony Porter, “Why International Institutions Matter” (2009) 15 Global

Governance 3.

94Peer pressure racing to the top may be seen as an effective market force that compels financial institutions

to adopt best behaviour, see Michael D Pfarrer, Ken G Smith, Kathryn M Bartol, Dmitry M Khanin andXiaomeng Zhang, “Institutional Influences on Voluntary Disclosure” (2005) at

http://mba.tuck.dartmouth.edu/mechanisms/pages/Articles/Pfarrer.pdf , an empirical study that shows that

mimicking practices in the industry is often an important driver for change in behaviour in financial

institutions, in this case, on restatement of earnings.

95Margot Priest, “The Privatisation of Regulation: Five Models of Self-Regulation” (1997-8) 29 Ottawa Law Rev

233.

96Eddy Wymeersch, “Standardisation by Law and Markets especially in Financial Services” (2008) University of

Ghent Financial Law Institute Working Article; David Zaring, “Three Challenges for Regulatory Networks”

(2009) 43 International Lawyer 211, discussing how the Basel Committee became a leading standard setter forinternational prudential standards.

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may be the Basel I and II capital adequacy standards led by the Basel Committee.97

Faerman et al

also argue that regulators seek out the industry to come up with industry standards or solutions as

they are generally recognised to have more expertise and resources, providing more convincing

leadership in complex technocratic issues.98

However, standards such as the Basel II capital adequacy standards have been criticised to be open-

ended and imprecise, pandering to the needs of flexibility and self-interest of financial institutions.99

.

Roubini has pointed out how the open-endedness of the standards served the interest of risk-taking

executives in financial institutions, instead of the good of public interest.100

Where market-generated standards are not standardised, but rather subject to a market for

standards itself, competitive pressures may produce a race to the top or a race to the bottom.

Commentators refer to the “gaming efforts of corporations” as a natural tendency when subject to

forces of regulation or pressures for self-regulation, in attaining standards of a cosmetic and minimal

character that entails least cost to the corporations.101

This is a race to the bottom. Gerding has also

suggested that where financial institutions could develop their own standards, in the case of risk

management under the Basel II open-ended mandate, the market for standards did not produce a

race to the top. Each financial institution protected the secrets of its proprietary risk management

system, and this actually subverted any open competition amongst alternative systems. The risk

management systems developed by each financial institution were technologically and scientifically

limited, and tolerated sub-optimalities and faults in the safety of remaining opaque.102

(b) The Aggregation of Market Participants’ Disciplining Incentives

97Mario Giovanoli, Reflections on International Financial Standards as Soft Law (London: University of London

2002).

98Sue R Faerman, David P McCaffrey and David M Syke, “ Understanding Interorganizational Cooperation:

Public-Private Collaboration in Regulating Financial Market Innovation” (2001) 12 Organisation Science 372.

99John C Pattison, “International Financial Cooperation and the Number of Adherents: The Basel Committee

and Capital Regulation” (2006) 17 Open Economies Rev 433; Edward J Kane, “Connecting National Safety Nets:

The Dialectics of the Basel II Contracting Process” (2007) 35 Atlanta Economic Journal 399; Kern Alexander,

“Global Financial Standard Setting the G10 Committees and International Economic Law” (2009) 34 Brooklyn

International Law Journal 861.

100Nouriel Roubini, “Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of

Financial Innovation and Globalization” (31 March 2008). Peter Grazjl and Peter Murrell, “Allocating Law-

Making Powers: Self-Regulation vs. Government Regulation” (2005), http://articles.ssrn.com/abstract=870888

arguing that market-based governance often obscures the real question of public good and goals.


Current Scholarship” (2008) 41 Akron Law Review 1 at 50.

102Erik F Gerding, “Code, Crash and Open Source” (2009) 84 Washington Law Review 127.

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Where financial regulation is concerned, many commentators have suggested that market-based

governance can take the form of market discipline by market participants who have a stake in

shaping the behaviour of others, ie that certain market participants that have something to lose may

be incentivised to ensure that other connected participants behave in such a way that may avert

losses. The discipline provided by these participants may in turn provide a general discipline towards

socially good behaviour. Commentators have suggested that large equity or bond holders in financial

institutions, and subordinated debt holders may be particularly well-disposed to carry out such

market discipline.103

This also seems to find consensus with policy makers, especially in the UK.104

Further, perhaps shareholders and creditors of financial institutions could provide a form of market-

based governance over firm behaviour? In the recent financial crisis, much critique has been levied

against shareholders of failed banks in the UK acting as “absentee landlords”105

or “ownerless

corporations”.106

However, commentators have suggested that shareholders are likely to act as

monitors only if the equity stake is sufficiently large.107

On the other hand, empirical literature has

suggested that shareholders with large stakes in financial institutions are more likely to encourage

management to engage in excessive risk taking activity, in order to drive earnings up for

shareholders’ short term interests.108

Hence, there are opposing possibilities as to how shareholder

monitoring may develop as a form of governance. Further, empirical literature also provides

interesting findings as to the effectiveness of shareholder or public forms of activist monitoring

against corporations. Calveras, Ganuza and Llobet109

argue that where a minority group of activists

are relied on to provide monitoring against corporations in, for example, corporate social

103Dhumale, “An Incentive-Based Regulatory System” (2000), op cit; Mark JK De Ceuster and Nancy

Masschelein, “Regulating Banks Through Market Discipline” (2003) 17 Journal of Economic Surveys 749;

Charles Calomiris, “Financial Regulation, Innovation and Reform” (2009) at

http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf.

104HM Treasury, Reforming Financial Markets (July 2009); Paul Myners, “We Need More Responsible

Corporate Ownership”, Financial Times (11 Oct 2009).

105Hector Sants, CEO of the FSA, speaking to the Financial Times in “FSA Chief Lambasts Uncritical Investors”,

Financial Times (11 March 2009).

106Paul Myners, “We need More Responsible Corporate Ownership”, Financial Times (11 Oct 2009). The

Review of Corporate Governance in UK Banks (Nov 2009) by Sir David Walker intends to boost stewardship

responsibility on the part of institutional shareholders most of whom hold only minority stakes in major UK

banks and financial institutions. It remains to be seen if such policy leadership can actually motivate greater

gatekeeping by shareholders.

107Mark JK De Ceuster and Nancy Masschelein, “Regulating Banks Through Market Discipline” (2003) 17

Journal of Economic Surveys 749; Charles Calomiris, “Financial Regulation, Innovation and Reform” (2009) at

http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf ; R Dhumale, “An Incentive-Based Regulatory System-

A Bridge Too Far” (2000) at http://www.cbr.cam.ac.uk/pdf/wp170.pdf.

108Luc Laeven and Ross Levine, “Bank Governance, Regulation and Risk-Taking” (2009) 93 Journal of Financial

Economics 259.

109

Aleix Calveras, Juan-Jose Ganuza and Gerard Llobet, “Regulation, Corporate Social Responsibility andActivism” (2007) 16 Journal of Economics and Management Strategy 719.

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responsibility, regulators will overestimate the effectiveness of such market-based governance and

provide regulation at a socially sub-optimal level. Hence, the unintended consequences flowing from

market-based governance may have to be examined carefully. That said, there continues to be a

significant amount of emphasis in the UK placed on institutional shareholders to monitor financial

institutions more carefully.110

I have elsewhere argued that although institutional shareholders in the

UK are motivated highly by policy leadership and the work of proxy voting agencies to engage with

their investee corporations, significant challenges remain for them in engaging in activism and, in

particular, collective activism.111

Further, the evidence of better financial performance from

shareholder activism in corporate governance or social performance is still arguable,112

and hence

the purely financial motivations for shareholder activism may remain equivocal for some time.

In general, Donahue argues that the incentives of private participants are often geared towards the

maximising of private interests, or profit-seeking behaviour. This is fundamentally different from the

nature of regulatory governance which is characterised by multiple objectives and yardsticks in

evaluation of progress and achievement. Hence, the working out of market participants’ behaviour

as a form of governance may not always be aligned with the achievement of collective good or

regulatory objectives.113

(c) Market-Based Self Regulation in the Form of Self-Regulatory Organisations or Associations

Market-based self-regulatory organisations may exist in the form of trade and voluntary

associations, either domestic or networked and international. The market itself may also be a self-

110HM Treasury, Reforming Financial Markets (July 2009); David Walker, A Review of Corporate Governance in

UK Banks and other Entities in the Financial Services Industry (Nov 2009).111

Chs 2 and 4, Iris H-Y Chiu, The Foundations and Anatomy of Shareholder Activism (Oxford: Hart 2010,

forthcoming).

112David F. Larcker et al., “How Important is Corporate Governance?” (May 2005) (unpublished manuscript),

available at http://ssrn.com/abstract=595821; Lawrence D. Brown & Marcus L. Caylor, “Corporate Governance

and Firm Performance”(2004) (unpublished manuscript), available at http://ssrn.com/abstract=586423; Sanjai

Bhagat and Brian Bolton, “Corporate Governance and Firm Performance” (2006) at

http://w4.stern.nyu.edu/emplibrary/Corporate_Governance-Performance.pdf ; . K. Chidambaran et al.,

Corporate Governance and Firm Performance: Evidence from Large Governance Changes (2008) (unpublished

manuscript), available at http://articles.ssrn.com/sol3/articles.cfm?abstract_id=1108497 ; Carol Padgett and

Ammana Shabir, “The UK Code of Corporate Governance: Link between Compliance and Performance” (ICMA

Centre Discussion Article 2005); Sunil Wahal, “Pension Fund Activism and Firm Performance” (1996) 31 Journal

of Financial and Quantitative Analysis 1; Jonathan M Karpoff, “The Impact of Shareholder Activism in Target

Companies: A Survey of Empirical Findings” (Sep 2001) at

http://articles.ssrn.com/sol3/articles.cfm?abstract_id=885365 . In terms of the relationship between corporate

social performance and financial performance, see Maria Gaia Soana, “The relationship between corporate

social performance and corporate financial performance in the banking sector” at

http://ssrn.com/abstract=1325956 which found no correlation, and Sandra Waddock and Samuel B Graves,

“The Corporate Social Performance-Financial Performance Link” (1997) 18 Strategic Management 303 which

found such correlation.

113Ch 1, Donahue and Nye eds, Market Based Governance (2002) op cit.

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regulatory organisation, such as the stock market which produces rules for product issuers whose

securities are being traded on the market, and rules for the intermediaries accessing and using the

market.

The governance provided by self-regulatory organisations may be in the form of standards as

mentioned above, coupled with a sense of quality assurance, and discipline or enforcement through

membership. Discipline or enforcement could be levied by way of membership denial, exclusions,

withdrawals, suspensions limitations of privileges or access, reputational discipline or even punitive

gestures.114

Although membership of a trade association with standards and best practices may provide a form

of governance as quality assurance, empirical literature suggests that industry often sees

membership with a trade association as a way of camouflaging firms’ sub-optimal behaviour.115

For

voluntary membership with self-regulatory organisations, firms that “behave badly” are generally

more enthusiastic embracers of trade association membership, in the hope that the membership will

provide a cloak of credibility for them. Firms may or may not actually improve their behaviour but

they believe that they would less likely be targeted by regulators as they are shielded behind the

credibility of trade association membership. Further, where the self-regulatory organisation may be

in competition with other self-regulatory organisations, it is uncertain if the standards and extent of

discipline or enforcement would be a race to the top or a race to the bottom. Some empirical

literature suggests a possibility of racing to the top, as self-regulatory organisations may care about

reputation, and members themselves value the reputation associated with membership.116

Some

literature, such as those dealing with stock markets, suggests otherwise. Commentators are of the

view that competitive forces compel stock markets to seek private interests such as profit

maximisation over public interest, and this interest would be aligned with the private interest

maximisation of its members. Hence, stock markets are unlikely to be effective self-regulatory

organisations in disciplining against member abuses or sub-optimal behaviour.117

However, can one

argue that investors may be able to make their demand pressures known by withdrawal from less

reputable markets, and hence that there are still incentives for markets to align themselves with

investor interests?

Lima and Errázuriz118

argue that although there would be investor pressures to demand that a self-

regulated stock exchange be vigilant in supervision and credible in enforcement, the extent of

114Alan C Page, “Self-Regulation: The Constitutional Dimension” (1986) 49 Modern Law Review 141.

115Andrew A King and Michael J Lenox, “Industry Self-Regulation without Sanctions: The Chemical Industry's

Responsible Care Program” (2000) 43 Academy of Management Journal 698.

116Franco Furger, “Accountability and Systems of Self-Governance: The Case of the Maritime Industry” (1997)

19 Law and Policy 445.

117Roberta S. Karmel, What Should Market Infrastructure Institutions Regulate? (forthcoming); Cally Jordan

and Pamela Hughes, “Which Way for Market Institutions? The Fundamental Question of Self Regulation”

(2007) 4 Berkeley Bus. L.J. 205.

118

José Luis Lima and Javier Nuň

ez Errázuriz, “Experimental Analysis of the Reputational Incentives in a Self Regulated Organization” (2004) at http://articles.ssrn.com/abstract=639661.

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discipline stock exchanges are engaged in would depend largely on what the public already perceives

or knows about the quality of the stock market. Where the public already trusts or perceives the

stock market favourably, the lack of enforcement or discipline will not give rise to doubt about the

quality of discipline or enforcement. In fact, the occurrence of discipline or enforcement may

decrease the level of favourable perception, giving the market no incentive to be vigilant or to carry

out enforcement. However, where the public has no particular perception of the quality of the

market’s discipline or enforcement, then the public is unable to tell if the lack of discipline or

enforcement is due to low vigilance or, in fact, effective policing so that no scandal has erupted.

DeMarzo et al119

also argue that stock markets are more likely to use a carrot instead of stock

approach to discipline and enforcement. This is because a carrot approach is less costly in terms of

relational cost and administration. A stick approach may be preferred by investors but the threat of

withdrawal may be a loss for stock markets, and hence they will tend towards the choosing lower

cost discipline or enforcement. This would mean that enforcement or discipline is usually carried out

in a friendly, unthreatening and perhaps not necessarily effective manner. In sum, empirical

literature shows that stock markets may not be disciplined by demand side pressures to undertakediscipline or enforcement against issuers or members, as such actions may have no effect or the

opposite effect on how the market is perceived on the demand side. Further, empirical literature

also shows that in general, self-regulatory organisations tend to rely on merely reputational effects

to discipline their members, and even where discipline is pursued the enforcement may be very

lenient.120

What about particular designated self-regulatory organisations that demand compulsory

membership? Would the governance provided by such organisations be more credible or effective?

Economists argue that self-regulatory organisations tend to serve the interests of their members,

and members’ needs and interests generally feed into the design of organisation rules andstandards, as the self-regulatory organisations see their members’ needs and interests, not users’

interests, as the “demand side” for its rules.121

The history of self-regulatory organisations in the UK

under the Financial Services Act 1986 has generally been acknowledged not to be terribly effective in

protecting investors.122

Besides, the credibility of self-regulatory organisations providing governance

and discipline could be in doubt as these organisations may first run into the problem of not being

accepted by the industry as legitimate, and may secondly not be perceived by the public as credible,

as they often do not need to be subject to transparency and accountability to the public. On the first

problem, compulsory self-regulatory organisations may have to overcome dissidents within the

industry and provide a set of norms that can be bought into by all. This may involve a challenging

process, and compromises that are made may not always reflect the governance necessary for

119Peter M DeMarzo, Michael J Fishman and Kathleen M Hagerty, “Self Regulation and Government Oversight”

(2005) 72 Review of Economic Studies 687.

120Peter M DeMarzo, Michael J Fishman and Kathleen M Hagerty, “Reputations, Investigations and Self-

Regulation” (2007) (unpublished working article).

121Craig Pirrong, “A Theory of Financial Exchange Organisation” (2000) 43 Journal of Law and Economics 437.

122Chs 2 and 3, Julia Black, Rules and Regulators (Oxford: Clarendon 1998).

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consumer or investor protection.123

For the second problem, transparency and procedures to involve

public participation and accountability often help in improving the perceived legitimacy of such non-

state organisations,124

as the governance provided by self-regulatory organisations behind closed

doors may not be seen as credible. Hence, the procedural legitimacy of such self-regulatory

organisations could be improved, but Koppell125

suggests that this does not substitute for the

efficacy of rules and enforcement, which remains a weak point in the governance provided by self-

regulatory organisations.

(d) The Market for Governance Products

The market may provide sub-markets for governance products such as ratings and gatekeeping

services to facilitate the investment market itself. Market demand for third party verification and

reputational certification is found in relation to the evaluation of issuer products, such as an

underwriter’s reputational involvement, credit ratings and analyst recommendations. Increasingly,

where social responsible investing is important, the corporate governance and social responsibility

ratings of the issuer may be crucial to the marketability of an investment product. Such third party

verification or reputational certification is thus a commodity demanded for and supplied by the

marketplace, but could provide a form of quality assurance to investors. Gatekeepers such as

auditors and lawyers however perform a different function, as their involvement is generally

demanded by issuers and financial institutions for compliance purposes, and as such, the market in

these services may arguably have arisen as a result of regulatory imposition.

Taking the first group of gatekeepers whose reputational output may also provide a form of quality

assurance, could this output be regarded as a type of market-based governance? Jessop opines that

the capitalistic notion of commodification refers to putting a quantifiable value on all goods and

services.126 Thus, reputational verification and quality assurance type services in the financial sector

are also commodified and appeal to the demand for reputational output or services in an

informationally asymmetric market. If we perceive reputational output as offering a form of market-

based governance, it may be argued that we are expecting these services to provide a form of

quality assurance that can amount to a form of investor protection. Although this “non-value” based

consequence may result, in the recent financial crisis, it may be queried as to whether reputational

output such as a credit rating has served that purpose. Reputational output such as credit ratings has

been subject to information asymmetry, sub-optimal assumptions and models127

and the lack of

123Steven Bernstein and Benjamin Cashore, “Can non-state global governance be legitimate? An analytical

framework” (2007) 1 Regulation and Governance 347.

124Jonathan GS Koppell, “Global Governance Organizations: Legitimacy and Authority in Conflict”(2008) 18

Journal of Public Administration Research and Theory 177.

125Ibid.

126Bob Jessop, “Capitalism and its Future: Remarks on Regulation, Government and Governance” (1997) 4

Review of International Political Economy 561.

127This lies behind the European Commission’s proposal to require registration, disclosure and supervision of

rating agencies in the EU, by CESR, see European Commission, Proposal for a Regulation of the EuropeanParliament and of the Council on Credit Rating Agencies (2008), as accepted by the Council.

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independence on the part of the reputational provider.128

The lack of independence and potential

conflicts of interest have been identified not only to affect credit rating agencies but also research

analysts.129

If the reputational output is not reliable, then instead of adding to information efficiency

in the market, the reputational output would have performed the opposite function.130

Jessop also

argues that the commodification of market-based services encourages a “value perception” of these

services instead of their “non-value” purposes or effects,131

and hence, providers of reputational

output look to the interests of those that provide its revenues, ie. mainly issuers, and may be less

concerned with the investors who are users of the reputational product, and the wider purposes of

social good. The hope that such market-based reputational output may also serve the purposes of

investor protection may be misplaced.

The next group of gatekeepers who may provide some form of market-based governance are

entities involved in corporate transactions who professionally verify certain disclosures made by the

corporations, such as auditors, underwriters and lawyers. It could be argued that the professional

verification provides a form of assurance for market participants, and hence a form of investor

protection.

Auditors have been heavily criticised for the failure to detect Enron’s fraudulent financial

statements, causing significant investor losses after the collapse of the company.132

Although the

auditors in that case have been compromised,133

it is questionable as to whether auditors generally

provide a governance function for public good. Auditors have argued that their auditing function is

defined by professional discipline134

and contract, and possibly would not amount to the type of

governance required for detection135

and policing corporate wrongdoing.136

However, as Section 3

128

John C Coffee, Gatekeepers (Oxford: OUP 2004); ‘Understanding Enron: ‘It's About the Gatekeepers, Stupid’(2002) 57 Business Lawyer 1403. See also Stephen Choi and Jill E Fisch, ‘How to Fix Wall Street: A Voucher

Financing Proposal’, (2003) 113 Yale Law Journal 269. The lack of independence of research analyses has now

been addressed in the Sarbanes-Oxley Act 2002, and the Markets in Financial Instruments Commission

Directive, Art 24-25.

129Frank Partnoy, ‘The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating

Agencies’ (1999) 77 Washington University Law Quarterly 619; Choi and Fisch (2003), above.

130Coffee (2002), (2004), above.

131Jessop, “Capitalism and its Future” (1997), above.

132Coffee (2002), (2004), above, Frank Partnoy, ‘Strict Liability for Gatekeepers: A Reply to Professor Coffee’,

(2004) 84 Boston University Law Review 365; Gary Fooks, “Auditors and the Permissive Society: Market

Failure, Globalisation and Financial Regulation in the US” (2003) 5 Risk Management 17.

133John C Coffee, Gatekeepers (Oxford: OUP 2004); ‘Understanding Enron: ‘It's About the Gatekeepers, Stupid’

(2002) 57 Business Lawyer 1403.

134Kristi Yuthas, Jesse F. Dillard, Rodney K. Rogers, “Beyond Agency and Structure: Triple-Loop Learning”

(2004) 51 Journal of Business Ethics 229.

135Most empirical literature doubt that detection is that easy. T Bell, S Szykowny. and J Willingham, Assessing

the Likelihood of Fraudulent Financial Reporting : A Cascaded Logit Approach . KPMG Peat Marwick, Montvale,

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will argue, the “governance” role of auditors has been largely minimalised as regulators have ceased

to perceive the audit as a delegated form of governance and regulators may not further check on the

quality of the audit or subject it to question.137

It will be argued that there is a need to re-orient the

importance of third party stakeholders and gatekeepers such as auditors in the relational paradigm

between the regulator and industry.

As for underwriters of public offers, Choi argues that they are naturally placed to provide

informational signalling to the market as they are involved in certifying the financial position of the

companies they are underwriting.138

Lawyers are also often regarded as gatekeepers in two senses:

external transactional counsel may be able to detect matters that are amiss, and internal in-house

counsel may be able to act as whistleblowers. The US Sarbanes-Oxley Act 2002 has placed some faith

in lawyers acting as gatekeepers, and compels in-house counsel to report up the ladder if they

discover matters that may be amiss.139

In-house counsel could also act as whistleblowers under the

enhanced whistleblower protection regime in the Act.140

A caveat suggested here is that although

whistleblowing may be an important source of information for regulatory enforcement, the social

legitimacy of whistleblowing has always been questioned.141

As for external lawyers, they may act in

transactions on an ad hoc basis and may not have enough corporate information or access to the

NJ. Working Article, 1993; JV Hansen,.JB McDonald, WF Messier and TB Bell, “A Generalized Qualitative-

Response Model and the Analysis of Management Fraud” (1996) 42 Management Science 1022–1032;

Ashutosh Deshmukh, Khondkar E Karim and Philip H Siegel, “An Analysis of Efficiency and Effectiveness of

Auditing to Detect Management Fraud: A Signal Theory Detection Approach (1998) 2 International Journal of

Auditing 127; Kurt M Fanning and Kenneth O Cogger, “Neural Network Detection of Management Fraud using

Published Financial Data” (1998) 7 International Journal of Intelligent Systems in Accounting, Finance and

Management 21.

136Jeremy Markham, ‘Accountants Make Miserable Policemen: Rethinking the Federal Securities Laws’ (2003)

28 North Carolina Journal of International Law and Commercial Regulation 725.

137Howard C Kunreuther, Patrick J McNulty and Yong Kang, “Third Party Inspection as an Alternative to

Command and Control Regulation” (2000) (The Risk Management and Decision Processes Center, The Wharton

School of the University of Pennsylvania).

138Stephen Choi, ‘Market Lessons For Gatekeepers’ (1998) 92 Northwestern University Law Review 916. Choi

provides a market-based proposal for regulators to compel more disclosure on the part of underwriters so that

they may become a market for certifiers for investors. Investors can then make discerned judgments as to the

quality of such certification, and be able to rely on the information signals provided by such certifiers in

choosing whether or not to subscribe for particular securities. This proposal thus introduces regulation of

certifiers in order to overcome information asymmetries between investors and certifiers.

139Section 607, Sarbanes-Oxley Act 2002.

140Although that remains a challenging call, as whistleblowers often find that their turning against the

corporation severely affects their legitimacy even if the matter raised is in public interest. KR Sawyer, J Jackson

and M Holub, “The Necessary Illegitimacy of the Whistleblower” at SSRN, at


141

KR Sawyer, J Jackson and M Holub, “The Necessary Illegitimacy of the Whistleblower” at SSRN, athttp://articles.ssrn.com/sol3/articles.cfm?abstract_id=917316.

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senior management of the corporation to act as its monitors.142

Gatekeepers will be discussed in

greater detail in Section 3.

(e) Market Concepts in the Delivery of Public/Regulatory Goods

Next, we proceed to discuss if the utilisation of market concepts to fashion the provision of regulatory or public goods, is effective. Risk based regulation, as discussed above, is very much a

manifestation of market-based perspectives being infused into the provision of regulatory or public

goods.143

However, Donahue explains that regulatory governance is “extensive” in nature, serving

multiple goals and the attainment of goals could be measured in many ways. But the market is

“intensive” in nature, as there is usually a single-minded focus on the part of market participants to

seek profits and minimise cost. Hence, some forms of market-based governance may be a way of

“engineering into public undertakings a greater degree of intensive accountability that typifies

markets”.144

There is, however, a fundamental tension between the extensive nature of governance

and the intensive nature of the market. Existing literature on outsourcing145

and public-private

financing projects146 may provide evidence of such tension, although this article will not discuss

these in detail (i.e. points (f) and (g) above).

Section 3 will discuss in particular the delegation of governance to credit rating agencies and

auditors in achieving public/regulatory goals, and will highlight that market-based governance is

highly attractive when expertise is perceived to be credible and to be relied upon. But such expertise

may, as Donahue suggests, not be entirely amenable to serving public/regulatory goals. Where trust

in expertise becomes unquestioning, a situation of “capture by technocracy” can occur, and market

based governance may not achieve public/regulatory goods and may also be unaccountable.

Shared Governance

We next turn to a number of regulatory paradigms where, although leadership is provided by

regulation, the regulated may be co-opted to provide governance within discretionary parameters.

Where regulatory provision is made to provide governance over an issue, it may not be able to

capture all of the situations that it should govern, and hence, many regulatory provisions would be

142E Burger, ‘Who is the Corporation’s Lawyer?’ (2005) 107 West Virginia Law Review 711.

143Better Regulation Task Force (2004), (2006) and (2007), op cit; see some critical remarks in Anthony Ogus,

“Economics and the Design of Regulatory Law” in Stephen F Copp ed, The Legal Foundations of Free Markets

(London IEA 2008) at 115.

144Ch1, Donahue and Nye eds, Market-Based Governance (2002) at 7.

145This author has earlier discussed how “outsourcing” may work in providing the public good of consolidated

stock market information under the EU Markets in Financial Instruments Directive 2006, see Iris H-Y Chiu,

“Delegated Regulatory Administration in EU Securities Regulation” (2006) 40 International Lawyer 737 and

citations therein.

146The article will not go into detail into PFIs, generally see Darrin Grimsey and Mervyn K Lewis, Public Private

Partnerships: The Worldwide Revolution in Infrastructure Provision and Project Finance (Chelltenham: EdwardElgar 2007).

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“open-textured”.147

Some regulatory provisions may be more “open-textured” than others, giving a

degree of discretion to the regulated to implement or interpret the regulatory requirement. In this

Section, we will deal with the open-textured forms of regulatory governance which in reality

produce forms of delegated and outsourced governance to the regulated. Regulation typically

provides for certain principles to be adhered to, or certain outcomes to be achieved, but there is

flexibility in how the regulated may “comply”. Such flexibility in compliance co-opts the regulated in

co-designing their compliance. There may be a few manifestations of such “flexibility”, in spite of the

existence of a regulatory framework.148

One is “enforced self-regulation”, where the self-regulatory

devices discussed above may be subject to customised regimes for regulatory intervention, such as

the relational contract envisaged by Goodhart et al.149

Second is “meta-regulation” which provides

regulation with the role of activating the internal capacity for the regulated to self-regulate and

create outcomes aligned with regulatory objectives, and finally, a possible reliance on ethical

evolutions in the conduct of business which may have become attractive now that “business ethics”

has become increasingly important in business management education.150

Enforced Self-Regulation

Ayres and Braithwaite propose that the regulated should be subject to a form of self-regulation that

harnesses the benefits of the reflexivity, innovation and commitment inherent in self-regulation and

avoids the disadvantages of cosmetic compliance, ineffective enforcement and sub-optimal rules.

This is enforced self-regulation where both the regulator and regulated play an active role in

designing and ensuring compliance. Enforced self-regulation allows the regulated to set out the rules

by which it is bound. The regulator vets and approves those rules in accordance with minimum

standards and regulatory objectives. The regulator is then entitled to inspect the regulated to see if

compliance is taking place and is able to enforce against the regulated where the rules are breached.

Enforced self-regulation may also include appointing an in-house compliance unit to report on non-

compliance with the firm’s tailor-made rules.151

Ayres and Braithwaite identified a number of pros

and cons in this approach but concluded that the approach offers a balance between credible rule-

making and securing compliance, and introducing flexibility and innovation to meet business needs.

In Financial Regulation: Why, How and Where Now 152

Goodhart et al see the potential of

sophisticated financial institutions being able to design rules they would be committed to be bound

by and regulators having a greater role in inspection and enforcement. Norton has also commented

147

Black, Rules and Regulators (1998), op cit.

148Discussed in Robert Baldwin, “The New Punitive Regulation” (2004) 67 Modern Law Rev 351.

149Financial Regulation (1998), op cit.

150Timothy L. Fort, Ethics and Governance: Business as Mediating Institution (OUP, Oxford, 2001), Michael

Segon and Christopher Booth, “Business Ethics and CSR As Part Of MBA Curricula: An Analysis of Student

Preference” (2009) 5 International Review of Business Research Papers 72.

151John Braithwaite, “Enforced Self-Regulation: A New Strategy for Corporate Crime Control” (1992) 80

Michigan Law Review 1466.

152(1998), op cit.

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on the regulatory adoption of the Basel II Capital Accord as being of the type of enforced self-

regulation designed by elite banks.153

Although enforced self-regulation may in theory overcome some of the weaknesses of mere self-

regulation, in that the regulator is involved to provide supervision and enforcement, would the

regulator’s supervision and enforcement be mere smoke and mirrors? Norton points out the fact

that regulators are often too ill-resourced and ill-equipped to make meaningful assessments of the

adequacy and appropriateness of the regulated’s own design,154

particularly when such designs may

be tailored to subjective needs and shrouded in technical mysteries. Empirical literature also points

out that there are gaps between the regulator and regulated in communication and expertise, where

enforced self-regulation is in place (in Italy regarding risk management for banks).155

The lack of

sufficient understanding and matching critical capacity on the part of the regulator could create a

situation where the regulator may give the benefit of the doubt to the industry if it does not

sufficiently understand in order to be able to critically evaluate. This could produce a “capture by

technocracy”, where the regulator may relegate the enforced self-regulatory model, to one more

like a self-regulatory model. Further, many financial institutions also actually adopt similar models

competitors adopt, and such models need not really reflect the institution’s risk or needs, and hence

it becomes even more difficult to judge models that may appear to be popular and supported by the

majority of the technocracy.156

Meta-Regulation

“Meta-regulation” refers to a regulatory approach which empowers and enhances the capacity of

corporations to self-regulate, but connects “the private justice of the internal management system”

to the “public justice of accountability”.157

Parker proposes that such capacity to self-regulate may

be enhanced by value orientation, management commitment, the acquisition of skills and

knowledge and the design of internal processes and systems. The “self-regulation” of each

microcosm should then be accountable to regulators and stakeholders in order to achieve not just

“compliance” but responsibility towards the democratic polity. Parker envisages that “meta-

regulation” would improve the permeability of the corporation to public accountability.158

This approach may be manifest in the emphasis placed on corporate governance, risk management,

ethical business management and even corporate social responsibility- encouraging corporations to

153

Joseph J Norton, “A Perceived Trend in Modern International Financial Regulation- A Reliance on a Public-Private Partnership” (2003) 37 International Lawyer 43.

154Above.

155Alessandro Caretta, Vincenzo Farina and Paola Schwizer, “Banking Regulation Towards Advisory: the

“culture compliance” of banks and supervisory authorities (2005) at


156Kern Alexander, R Dhumale and John Eatwell, Global Financial Governance (Oxford: OUP 2004)at 174ff.

157Christine Parker, The Open Corporation (Cambridge: CUP 2000) at 246.

158Parker, The Open Corporation (2000), above.

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improve and self-reflect from the inside. The meta-regulation of risk management in financial

institutions is in particular, a key feature of financial regulation in the EU and the UK. The Markets in

Financial Instruments Directive provides for broad principles of organisational soundness, the

establishment of a compliance function, risk management systems, internal audit, and the

responsibility of senior management for compliance generally.159

These cannot be excessively

prescribed as regulators are not in a position to micro-manage firms, and hence, these represent a

meta-regulatory approach where regulators expect certain internal measures to be in place in firms,

and the regulators’ role is to monitor the performance of such measures. Some commentators have

lauded this approach as being reflexive and cost-effective, and likely to entail more permanent

solutions that would be viewed as convincing for firms.160

Parker suggests that the monitoring role of the regulator may be carried out in two aspects ie an

outcomes approach and a process approach. The first means that regulators look at what is achieved

in terms of the firm’s behaviour, and as long as the regulator’s objectives are met, the process of

achieving them is left to the regulated to determine. This is similar to the principles-based approach

taken by the FSA.161

However, as with the enforced self-regulation model, where the firm’s designs

are subjective and technical, the performance of the designs may be difficult to evaluate. Under the

meta-regulatory approach, there is also a risk of “capture by technocracy”. The process approach

means that regulators would also look critically at the systems and processes that the regulated has

put into place and may review such arrangements with the regulated.162

Parker has pointed out the

dangers of leaving to the regulated to define the processes for compliance- the regulated can design

processes to enhance cosmetic compliance and pass blame from senior management to weak and

vulnerable employees when things go wrong.163

Further, Parker and Braithwaite both point out that

it is essential for firms to have sufficient resources and capacity for self-reflection to design optimal

systems, and that the regulator must not be evading the difficulty of supervising firms by latchingonto meta-regulation.

164Where the regulator may not be well-equipped to discern outcomes or

satisfactory processes, the regulator would in effect have delegated to the regulated not only to self-

159Arts 5-9, MiFID Commission Directive 2007.

160Fiona Haines, “Regulatory Failures and Regulatory Solutions” (2009) Law and Social Inquiry 32; Jonathan

Edwards and Simon Wolfe, “Ethical and Compliance-Competence Evaluation: a key element of sound

corporate governance” (2007) 15 Corporate Governance 359 arguing for the potential in firms to institute

corporate governance that is beyond the letter of best practices if the spirit of sound corporate governance is

internalised by the firm, further also see J.Edwards, “ Individual and Corporate Compliance Competence: an

ethical approach” (2003) 11 Journal of Financial Regulation and Compliance 225–235.

161Financial Services Authority, Principles-based Regulation: Focussing on the Outcomes that Matter (April

2007).

162Parker, The Open Corporation (2000) at 276.

163Above at 144.

164

John Braithwaite, “Meta Risk Management and Responsive Regulation for Tax System Integrity” (2003) 25Law & Policy 1.

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regulate processes, but also to define the goals to be achieved. This would in fact be no different

from pure self-regulation.165

Meta-regulation is likely to continue as an important feature in the shared governance framework.

This is probably underscored by the emphasis business management professionals and consultants

place on the future of risk management, particularly Enterprise-wide Risk Management (ERM). ERM

is an approach that attempts to consolidate and integrate the risks faced by firms and the processes

used by firms to manage those risks.166

Firms therefore become microcosmic centers of self-control,

identifying, pooling together and strategising with respect to the risks and opportunities to which

the firm is open. ERM is described by Power as a tool for self-governance for the entire organisation

of the firm,167

although he is sceptical if ERM will consist only of systems and processes that are

designed to provide compliance and box-ticking comfort without true engagement with the risks

facing the corporation, ranging from financial to social, reputational and strategic risks.168

Further,

ERM may be said to be based on an extension of the audit framework, as its practice is closely linked

to instituting systems in an organisation that capture data and provide audit trails.169

This may be

due to the support of mainly accounting consultants who are professionally involved in developing

ERM.170

More will be discussed in Section 3 of the specific issues in financial regulation that are

governed by meta-regulation.

In sum, meta-regulation risks not being capable of evaluation by regulators, if they are “captured by

technocracy” and find it difficult to judge the performance of the firm’s systems and designs. In this

respect, shared governance such as meta-regulation that allows and entails reliance upon the

internal expertise of firms may create a presumed legitimacy.171

An excessive emphasis on process

165As pointed out by Parker in relation to the meta-regulation of corporate social responsibility issues, see

Christine Parker, “Meta-Regulation: Legal Accountability for Corporate Social Responsibility?” in Doreen

McBarnet, Aurora Voiculescu and Tom Campbell (eds), The New Corporate Accountability: Corporate Social

Responsibility and the Law (Cambridge University Press, 2007), chp 8.

166Christopher L Culp, “The Revolution in Corporate Risk Management” in Donald H Chew (ed), Corporate Risk

Management (New York: Columbia Business School 2008) at 42.

167Michael Power, Organized Uncertainty: Designing a World of Risk Management ( Oxford: Oxford University

Press 2007). See also Richard Ericson and Myles Leslie, “Review Article, Michael Power (2007) Organized

Uncertainty: Designing a World of Risk Management. Oxford: Oxford University Press.” (2008) 37 Economy and

Society 613.

168Michael Power, “The Risk Management of Nothing” (2009) 34 Accounting, Organisations and Society 849.

169Brian W Nocco and Rene M Stultz, “Enterprise Risk Management: Theory and Practice” (2006) 18 Journal of

Applied Corporate Finance 8.

170Rene M Stultz, “Rethinking Risk Management” in Donald H Chew ed, Corporate Risk Management (NY:

Columbia Business School 2008) at 119 where it is said that “the primary goal of risk management is to

eliminate the possibilities of costly lower-tail outcomes”.

171Bronwen Morgan and Karen Yeung, An Introduction to Law and Regulation (Cambridge: CUP 2007) at 299

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and learning may produce a continuous dance in process rituals172

without giving rise to public goods

and social outcomes. Further, meta-regulation may also be seen as an excessively microcosmic

approach to regulation. It offers no particular insight as to the collective effects of firm self-

regulation and issues of social risk or communitarian concerns, or systemic risk. Morgan suggests

that meta-regulation is often premised upon the language of economic efficiency and the

technocratic expertise of the firm itself, and this discourse risks eclipsing the bigger picture of

redistributive issues, social rights and justice.173

Ethical Self-regulation

“Business ethics” has become a staple discipline in business management education and is arguably

crystallising into a body of values and standards for behaviour within a for-profit organisation.174

Could the existence of “business ethics” become a credible form of self-regulation or meta-

regulation?

In a narrow sense, ethics may relate to the prevention of fraud or other anti-social and detrimentalbehaviour that may inflict organisational and social costs. Seen in that light, ethical self-regulation

would include risk management, social responsibility in the sense of prevention or mitigation of

externalities, and corporate governance.175

Ethics may also relate to “proactively” adding to social

good, such as community participation and volunteering, related to the perspective of the

corporation as a social institution being socially responsible and accountable.176

Ethics has been defined as an internal regulatory map that leads to self-regulation, i.e. that

individuals or the organisation have a coherent moral awareness, make moral judgments, may be

driven to act by moral motivations and hence produce moral behaviour.177

However, the motivation

towards ethical behaviour may also be rational, such as for the management of reputation or image,

172These may be network “games” where entities in the network may spend time and effort influencing their

capacity and communication in the network, and using extensive resources towards that end. The network

may hence become an end in itself. See Erik-Hans Klijn, Joop Kopperjan and Katrien Termeer, “Managing

Networks in the Public Sector” (1995) 73 Public Administration 437.

173Bronwen Morgan, “The Economization of Politics: Meta-Regulation as a Form of Nonjudicial Legality” (2003)

12 Socio-Legal Studies 289.

174Mark S Schwartz, “A Code of Ethics for Corporate Code of Ethics” (2002) 41 Journal of Business Ethics 27.

Robert Elliot Ellinson, “Circles within a Circle: The Condition for the Possibility of Ethical Business Institutions

Within a Market System” (2004) 53 Journal of Business Ethics 17 however argues that there is still an inherent

irreconciliability between the market values pursued by firms and many ethical values.

175Lynn T Drennan, “Ethics, Governance and Risk Management: Lessons from Mirror Group Newsarticles and

Barings Bank” (2004) 52 Journal of Business Ethics 257; D Schroeder, 'Ethics from the top: Top Man agement

and Ethical Business' (2002) 11 Business Ethics: A European Review 260—267.

176BE Joyner and D. Payne: 'Evolution and implementation: A Study of Values, Business Ethics and Corporate

Social Responsibility' (2002) 41 Journal of Business Ethics 297-311.

177

Linda K Trevino, Gary R Weaver and Scott J Reynolds, “Behavioral Ethics in Organizations: A Review” (2006)32 Journal of Management 951.

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if reputation or image is an important asset.178

Hendry argues that we live in a bimoral society where

both the pursuit of individual wealth and social good are equally lauded and hence where choices

may have to be made between the two, individuals and institutions are often placed in a difficult and

challenging situation.179

Internal dispositions towards moral behaviour are often challenged by

countervailing forces, such as rational calculations in game scenarios,180

organisational

indifference,181

or the market perceptions of the value of such behaviour.182

Hence, whether ethical

dispositions may become a potent self-regulatory force or not would depend on the interplay of

internal dilemmas, incentives and perceptions of the individual or organisation. Commentators have

argued that it may be possible to provide “direction” for ethical self-regulation through pre-

determined goals, i.e. “goal setting” could be effective for self-regulation to take place.183

However,

it is also discovered that although goal-setting may help in driving self-regulation, it is susceptible to

being redefined by the individual or organisation, and could also allow self-congratulatory

behaviour, complacency and slack once the “goal” is perceived to be attained.184

On a governance

level, could ethical self-regulation be reliable in producing a consistent pattern of self-regulatory

behaviour in a firm, and an even pattern of behaviour across the industry?

Nevertheless, there is also literature suggesting that “ethics” as a self-regulatory force is often not

self-induced, but follows the occurrence of a crisis, whether on an organisational or market level. A

crisis often triggers the effect of “flinging far from equilibrium”185

for an organisation or entity, and

in seeking to restore or redefine fundamental identity, reliance is placed on ethical reform to learn

178George Stansfied, “Some Thoughts on Reputation and Challenges for Global Financial Institutions” (2006)

31 The Geneva Articles 470 at

http://www.genevaassociation.org/PDF/Geneva_articles_on_Risk_and_Insurance/GA2006_GP31(3)_Stansfield.pdf.

179John Hendry, Between Enterprise and Ethics (Oxford: OUP 2003) at 168ff.


Current Scholarship” (2008) 41 Akron Law Review 1.

181Kristi Yuthas, Jesse F. Dillard, Rodney K. Rogers, “Beyond Agency and Structure: Triple-Loop Learning”

(2004) 51 Journal of Business Ethics 229.

182Boatright argues that rather than championing individual business ethics or even organisational business

ethics, the model of a moral market should be championed to define rules of transactions and engagement so

that communitarian values and good can be achieved. See JR Boatright, “Does Business Ethics Rest on a

Mistake?” (1999) 9 Business Ethics Quarterly 583, and critical review in Jeffrey D Smith, “Moral Markets and

Moral Managers Revisited” (2005) 61 Journal of Bus Ethics 129.

183Anton Suvorov and Jeroen van der Ven, “Goal Setting as a Self Regulation Mechanism” (2008) at

http://ssrn.com/abstract=1286029.

184Above.

185The term is used in complexity theory as a systems theory that explains how social, economic, physical,

technical and other systems work, see E Mitleton-Kelly, Complex Systems and Evolutionary Perspectives of Organisations (London: Elseiver 2003) especially at ch2.

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from the crisis.186

Crises are “push factors” towards a re-examination of ethical culture (or the lack

thereof) and a rejuvenation of ethical consciousness.187

The global financial crisis may thus provide a

context for re-examination as to the potency of ethical self-regulation as a form of self-governance

by firm and industry. However, the self-regulatory potency of ethics is still questionable. To what

extent are ethical references representative of change? Is recourse to “ethics” a flavour of the

moment in response to crisis management? Will ethics have a permanent appeal for businesses?188

It is also arguable that ethical questions are often asked only with the benefit of hindsight, i.e. that

pointing to the lack of ethical behaviour as an important factor leading to crisis usually takes place

after the fact.189

Hence, on an ex ante basis, it could not be ascertained how far ethical behaviour

would have prevented or mitigated any crisis, and this lack of ex ante proof of the value of ethical

behaviour may undermine the self-regulatory potency of “ethics”. In sum, the various internal

motivations towards or away from ethical self-regulation and the lack of ex ante correlation

between ethical self-regulation and the prevention of crises are key factors in considering the place

of ethical self-regulation in any aspect of financial regulation.

Regulator-led Governance: Regulation

“Regulation” may be defined as a phenomenon that seeks to provide a sustained and focused

approach to modify the behaviour of the subjects of regulation, so that compliance may be secured

according to the standards and goals in such regulation.190

This perspective sees regulatory control

rights as being vested in the public authorities, in order to achieve predetermined regulatory goals.

Hence, “regulation” is a form of governance with public character as discussed earlier, largely

exercised through the rights of control in standard setting, supervision and enforcement.

Regulatory control may range from facilitative regulation, such as default provisions in law that

could be adapted by the regulated, viz various provisions in company law; constitutive regulation

that sets out parameters, frameworks and structures as to how power may be exercised or activities

may be carried out, such as mandatory disclosure regulation for investment and securities products;

186Richard P Nielsen and Ron Dufresne, “Can Ethical Organizational Character Be Stimulated and Enabled?:

"Upbuilding" Dialog as Crisis Management Method” (2005) 57 Journal of Business Ethics 311.

187“Bankers Lectured on the Value of Morals”, Financial Times (7 Oct 2009).

188

Jean-Pierre Galavielle, “Business Ethics is a Matter of Good Conduct and of Good Conscience?” (2004) 53Journal of Business Ethics 9, arguing that the rise of the importance of ethics must be contextualised and what

is regarded as important by the public is still often not reflected in corporate practice.

189EJ Kane, “Ethical Failures in Regulating and Supervising the Pursuit of Safety-Net Subsidies” (2009) 10

European Business Organisations Law Review 185; D Weitzner and J Darroch, “Why Moral Failures Precede

Financial Crises” (2009) 5 Critical Perspectives in International Business 6.

190P Selznick: "Focusing Organizational Research on Regulation", in R.G. Noll (ed.), Regulatory Policy and the

Social Sciences (Berkeley, University of California Press, 1985) at 363-7. See also G. Majone (ed.), Deregulation

or Re-regulation? Regulatory Reform in Europe and the United States (New York, Pinter, 1990) at 1-6; A Ogus,

On Regulation: Legal Form and Economic Theory (Oxford: Clarendon 1994); Karen Yeung, Securing Compliance(Oxford: Hart 2004) at 5 and 11.

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and regulative regulation that prescribes behaviour.191

Mandatory disclosure regulation is widely

used in financial regulation. Its nature and rationale have been well canvassed in extensive academic

literature.192

Regulative command-and-control type regulation is still prevalent in financial

regulation, particularly in dealing with certain aspects of legal duties imposed on financial

intermediaries, and in regulation dealing with market abuse.

Regulatory control is heavily attenuated with industry input in contemporary financial regulation.

The industry is often asked to input into the policy making and standard setting process, the market

may be asked to assist in surveillance, and responsive and risk-based regulation shows that

enforcement is no longer a straightforward and polarised event between the regulator and industry.

“Responsive regulation” was proposed by Ayres and Braithwaite193

in their classic book explaining

that enforcement should not be looked at simplistically as a tit-for-tat strategy which regulators

impose when non-compliance is detected. Rather, a pyramid of enforcement options should be

devised to encourage long term compliance with the spirit of regulation. Regulators should generally

start with informal persuasion and warnings in order to encourage future commitment towards

compliance, escalating the severity of enforcement as the severity of the case merits. This allows

regulators to put in place a graduated deterrence model that achieves social control with

proportionate cost. Baldwin and Black further argue that there is potential to extend the responsive

regulation model into a “really responsive” model, understanding the firm’s contextual, industry-

based and cultural factors in compliance deficits.194

It is arguable that the risk-based regulation

model adopted by the UK Financial Services Authority is an extension of the pyramid of

enforcement, putting emphasis on proportionate regulatory intervention. The need for

proportionate regulatory intervention is not only due to the lack of regulatory resources to use a big

stick for every transgression, but also due to ideological and political acceptance of a

“proportionate” and not invincible role of the state.

Modern regulation has evolved to become more participative, especially in relation to the industry,

and restraint from overregulation stems from the perception of regulation as costly, stifling

innovation195

and subject to public choice.196

However, one of the key issues in the global financial

191JL Porket, “The Pros and Cons of Government Regulation”(2003), IEA Discussion Article.

192Charlotte Villiers, Corporate Reporting and Company Law (Cambridge: CUP 2006) generally, ch 1, Iris H-Y

Chiu, Regulatory Convergence in EU Securities Regulation (London: Kluwer Law International 2008) for a range

of citations dealing with mandatory disclosure as a regulatory instrument.

193Ian Ayres and John Braithwaite, Responsive Regulation (New York: Oxford University Press 1992) at ch2.

194Robert Baldwin and Julia Black, “Really Responsive Regulation” LSE Law, Society and Economy Working

Articles 15/2007.

195JL Porket, “The Pros and Cons of Government Regulation”(2003), IEA Discussion Article.

196George Stigler, “The Theory of Economic Regulation” (1971) 2 Bell Journal of Economics and Management

Science 3; Alistair Alcock, “Are Financial Services Over-Regulated?” (2003) 24(5) Company Lawyer 132, but see

Steven P Croley, “Theories Of Regulation: Incorporating The Administrative Process” (1998) 98 Columbia Law

Review 1; Regulation and Public Interests: The Possibility of Good Regulatory Government (NJ: PrincetonUniversity Press 2008).

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crisis is the management of systemic risk, particularly, the regulation of systemic risk. As the specific

studies into OTC derivatives markets and hedge funds will show later, systemic risk management

suffers from a collective action problem and is arguably a public good.197

Hence, the role of

regulation of systemic risk may remind us of visions of social objectives198

and public good199

that are

the representations of the concept of what essentially is “regulation”.200

This review of governance models will form the rubric of the 8 models of governance in the financial

services landscape along a spectrum as follows:

The graph represents a linear spectrum, showing from left to right, a decreasing amount of private

or self- governance, and an increasing amount of external or public regulation. All of the above

models along the spectrum can be found in financial regulation, whether in the EU or internationally.

Each model of governance arguably encapsulates the relational paradigm of regulators and the

industry in different degrees of partnership or interdependence as a result of different policy,

efficiency or political factors. The article does not delve too much into how these models of

interdependence have come to be, but will critically examine selected areas of governance in the

financial services landscape represented by the models. The critical examination will flesh out

specific issues in relation to each specific area of governance discussed. However, the article also

intends to suggest that the fundamental issues in the nature of governance in these models are as

follows:

197Steven Schwarz, “Systemic Risk” (2008) 97 Georgetown Law Journal 193.

198Nicolás C. Bronfman,*, Esperanza López Vázquez and Gabriel Dorantes, “An Empirical Study for the Direct

and Indirect Links Between Trust in Regulatory Institutions and Acceptability of Hazards” (2009) 47 Safety

Science 686; empirical findings in Peter Lunt, Sonia Livingstone and Sarita Malik, “Public Understanding of

Regimes of Risk Regulation” (2001) at http://www.kent.ac.uk/scarr/.

199Stephen P Croley, Regulation and Public Interests: The Possibility of Good Regulatory Government (NJ:

Princeton University Press 2008).

200Bronwen Morgan and Karen Yeung, An Introduction to Law and Regulation (Cambridge: CUP 2007).

No

regulation-

transactional

overnance

No

regulation-

self

certification

Self regulatory

organisation,

inc market

overnance

Soft Law,

External

standards

, comply

or explain

Regulatory

standards,

meta-

regulation

Regulatory

standards,

audit

Regulatory

standards,

adjudication/

responsive

regulation

Regulatory

standards,

strict

liability

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(a) Models of governance in the financial services landscape are largely decentred and shared,

as in the models discussed in the literature review, but it is arguably the industry that has

become overly dominant in this landscape;

(b) The models of contemporary governance are susceptible to the problem of regulator

“capture by technocracy”, and has resulted in the lack of accountability and checks and

balances;

(c) The marginalisation of the regulator and other stakeholders in the landscape needs to be

addressed;

(d) The contemporary models of governance do not sufficiently address issues of collective

needs or public good such as systemic risk, whose ownership arguably falls to the regulator.

I will now discuss the 8 models of governance in the diagram above and selected areas of

substantive law or governance in financial services represented by the models.

3. Eight Models in the Governance of the Financial Services Landscape

No Regulation Model

The first two models along the spectrum refer to governance that is not chiefly provided by

regulation ie microcosmic self-regulation and transactional governance.

Prior to the global financial crisis, there have been significant areas of “no regulation” in the financial

markets. An example of a microcosmic area of self-regulation is the self-regulation of sophisticated

investors in investment decisions. The Markets in Financial Instruments Directive obliges investment

advisers to categorise clients into retail, sophisticated or eligible counterparties.201

Investment

advisers are placed under lesser obligations to be responsible for the suitability or appropriateness

of investment products where sophisticated investors are concerned, and eligible counterparties

such as financial institutions themselves would have the complete freedom to decide their

investments with no external adviser being held to account for those decisions.202

The freedom of

many financial institutions to purchase complex asset-backed securities which have turned out to be

toxic may raise the question of whether the freedom in respect of investor choice or product design

should be curtailed. The Turner Review in the UK has also left this question open.203

Three areas of

discussion will now be made: the OTC derivatives market, the offshore entity of hedge funds, and

the providers of “certifier” products such as credit ratings, corporate governance, socialresponsibility ratings. The next Sections will discuss how these issue areas are “governed”, the

concerns highlighted in the global financial crisis and any implications from changes proposed to

these governance models.

OTC Derivatives Transactions

201Article 24.

202Articles 27-33, MiFID Commission Directive 2006.

203Chapter 3.1(ii), The Turner Review (2009), op cit.

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OTC (over-the-counter) derivatives have come under scrutiny following the risk of default by

American insurance giant AIG in credit default swaps in the financial crisis. The looming default was

ultimately prevented by the bail-out granted by the US Treasury. Derivative transactions are not

subject to product regulation204

in the leading jurisdictions of financial regulation such as the US and

the UK, but the financial institutions dealing with them are generally subject to regulatory

supervision under financial or corporate regulation. Derivative trading is generally regarded as part

and parcel of the financial risk management not only of financial institutions but of corporations in

general, although some empirical research shows that corporations also use derivatives not only to

hedge but to add value.205

Although Enron is an extreme and spectacular failure of speculation in

derivatives, it cannot be ruled out that some extent of derivative speculation goes on in corporate

life.

Exchange-traded derivatives are not subject to product regulation as they have developed into

standard forms, and exchanges act as central counterparties to all such derivative transactions.

Hence, the credit risk of such transactions are passed to the exchange, and the exchange manages

risk of default through risk monitoring, centralised loss-sharing mechanisms, collateral and margin

policies, netting and settlement facilities and controlled accessibility to the exchange by

membership. For example, LCH Clearnet was able to resolve the defaults by Lehman Brothers after

the investment bank collapsed in September 2008, by using the collateral posted by Lehman and the

loss sharing arrangements in place.206

Bilateral OTC derivatives are generally tailor-made to suit the purposes of counterparties and are

therefore less standardised. They are settled bilaterally, which means that counterparties will have

to bear the credit risk of each other, and this could be augmented as the settlement time frames of

derivatives could be long, and could vary, and could also have many periodic runs. In order to

mitigate the risk of bilateral OTC derivatives, the International Swaps and Derivatives Association

(ISDA) has developed a Master Agreement to standardise certain terms such as collateral policies,

netting of open positions and how counterparty credit risk should be evaluated. Many OTC

derivatives are based on the ISDA Master Agreement. Further, Kroszner is of the view that

developments such as the ISDA Master Agreement, the availability of credit ratings made by rating

agencies such as Standard and Poor’s or Moody’s, and better risk management technology overall

204

Partnoy points out the difficulties in regulating derivative “products” directly, as rules often give rise tomore opportunities for arbitrage and unintended consequences, and risk being too prescriptive. See Frank

Partnoy, “ISDA, NASD, CFMA, and SDNY: The Four Horsemen of Derivatives Regulation?” (2002) at

http://ssrn.com/abstract_id=293085.

205J David Cummins, Richard D Philips and Steven D Smith, “Derivatives and Corporate Risk Management:

Participation and Volume Decisions in the Insurance Industry” (1998, Wharton Financial Institutions Center

Working Paper).

206Randall S Kroszner, “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives

Clearing Houses and Recent Over-the-Counter Innovations” (1999) Journal of Money, Credit and Banking 569;

Robert R. Bliss and Robert S. Steigerwald, “Derivatives Clearing and Settlement: A Comparison of CentralCounterparties and Alternative Structures” (2006) Economic Perspectives 22.

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has mitigated the risk of OTC derivative transactions to the extent that a “dis-integration” from

exchange traded derivatives would occur.207

In the wake of the financial crisis, thought is being given as to the risks that derivative trading poses

to the financial systems of the world. In particular, bilateral OTC derivative trading is highlighted to

attract concern as a heavily exposed counterparty such as AIG could pose systemic risk, in addition

to the credit risk borne by counterparties. As Schwarz points out,208

Without regulation, the externalities caused by systemic risk would not be prevented or

internalized because the motivation of market participants “is to protect themselves but not the

system as a whole .... No firm ... has an incentive to limit its risk taking in order to reduce the danger

of contagion for other firms.”

Left to transactional governance between counterparties in a bilateral OTC derivatives contract,

neither party would take ownership of the systemic risk that could entail from the overall exposure

either party may have. The leading recommendation in the US and EU is that the market-basedgovernance provided by exchange-traded derivatives could mitigate the systemic risk in bilateral

OTC derivatives trading, through standardisation and oversight by central counterparties. Blair and

Gerding209

argue that the central counterparty mitigates credit risk and is able to provide orderly

resolutions upon default, thus mitigating systemic risk. Further, they also argue that central

counterparties are ideal data repositories that can show up excessive exposures, highlight risk and

bring in prudential monitoring by the central counterparty to exert discipline, for example, by

requiring more collateral. The information collected by the central counterparty may also highlight

industry trends, and whether firms have similar exposures, and how these exposures may affect

systemic risk. Hence, Blair and Gerding are of the view that moving OTC derivative trading to be

exchange traded would be a step in the right direction. This is also to be the position in the US

Treasury White Paper on reforms required post the global financial crisis,210

and the Over-the-

Counter Derivatives Markets Act 2009.211

Although the European Commission has not proposed that

all derivatives trading should become concentrated on exchange, it proposes to encourage exchange

trading by levying higher capital charges on bilateral transactions, and to mandate all standardised

derivatives contracts to be centrally cleared.212

207Randall S Kroszner, “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives

Clearing Houses and Recent Over-the-Counter Innovations” (1999) Journal of Money, Credit and Banking 569.

208Steven Schwarz, “Systemic Risk” (2008) 97 Georgetown Law Journal 193 at 206.

209Margaret Blair and Erik Gerding, “Sometimes Too Great a Notional: Measuring the “Systemic Significance”

of OTC Credit Derivatives” (2009) at http://ssrn.com/abstract=1475366.

210US Department of the Treasury White Paper, A New Foundation: Rebuilding Financial Supervision and

Regulation (March 2009).

211See esp s113.

212Commission Press Release, July 2009 at

http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1546&format=HTML&aged=0&language=EN&guiLanguage=en.

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In essence, the issue of systemic risk is the key driver for thoughts behind reforming the basically

transactional governance that exists in bilateral OTC derivatives transactions. The transactional

governance between counterparties supported by the ISDA Master Agreement is not regarded as

sufficient, as transactional governance by its nature deals with the microcosm of the transacting

parties and the risks attaching to those parties only. Transactional governance is arguably unable to

deal with systemic risk such as caused by multiple similar exposures by other firms in the market.

Acharya213

argues from empirical evidence that financial institutions deliberately take similar risks

although they are aware that the multiplication effects of risk materialising would cause systemic

effects through the financial system. This is because financial institutions see that the chances of

them being bailed out would increase in the event of joint failures than in the event of individual

failures. This seems to suggest that private market institutions do not inherently see themselves as

the ultimate owners of the responsibility for mitigating systemic risk. Bookstaber’s analysis of

derivatives such as portfolio insurance in the 1980s would go as far as to say that the nature of some

derivatives is such that when analysed in a microcosm, the hedge looks sensible, but on a macro

level, the adoption of the same hedge across the industry would itself be responsible for triggeringsystemic effects in losses that would multiply and cascade across similar transactions.

214

However, under the reform proposed in the US and the EU, reliance would be placed on market-

based governance supplied by the central counterparty. This also means that reliance is placed on

the central counterparty not only to take ownership of the responsibility for credit risk in each

transaction but also the systemic risk of the patterns and volume of derivatives trading as a whole.

Culp argues that substituting bilateral transactional governance for central counterparty governance

may not be ideal as the exercise merely offloads risk onto the central counterparty. Although the

central counterparties have been robust and resilient thus far, they have existed in a framework of

competition with the market for bilateral transactions. The removal of that diversity could create asignificant burden on central counterparties, and if central counterparties fail, the effects could be

systemically catastrophic.215

However, central counterparties have extensive experience in

managing risk, and hence the risk of central counterparties failing may be small.

Nevertheless, if the concentration of derivatives trading on exchange becomes significant, central

counterparties can be too big to fail. This may mean that reliance on central counterparties may

have to be underlined by government support, as a form of lender of the last resort. Hence,

addressing systemic risk may require the participation of public governance, and such participation

could be in the form of underwriting the robustness of private market institutions such as central

counterparties. If central counterparties dominate in governing derivatives transactions in goodtimes, but public governance is envisaged to have a role in bad times, then there may arguably be an

213Viral V. Acharya, “A theory of systemic risk and design of prudential bank regulation2 (2009) 5 Journal of

Financial Stability 224.

214Chs 2 and 3, Richard Bookstaber, Markets, Hedge Funds and the Perils of Financial Innovation: A Demon of

Our Own Design (NJ: John Wiley & Sons, 2007).

215Christopher L Culp, “The Treasury Department’s Proposed Regulation of OTC Derivatives Clearing and

Settlement” (2009) at http://ssrn.com/abstract=1430576. Further, if central counterparties become too big tofail, then another problem in moral hazard may be created.

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effective delegation of governance to central counterparties for achieving public goods such as

financial stability. Delegation of governance raises the relational issues of accountability and

agency,216

which if not dealt with, could result in moral hazard.217

.

One such principal-agent issue may be conflicting objectives that the central counterparty has to

address, between satisfying its members and taking tough measures to manage risks. Lima et al and

De Marzo et al, as discussed earlier, have highlighted the tendency of self-regulating organisations to

maintain harmonious relationships with members and hence may be unwilling to take tough

enforcement or discipline against them.218

The mitigation of any potential agency problems is

arguably key to delegating governance in derivatives markets to central counterparties.

In the UK, the FSA arguably has oversight of the financial resources of central counterparties before

giving them recognised status.219

However, as there are no clear bright lines as to continuing

prudential management, this area may arguably have to be relooked if central counterparties are to

become more important as a source of governance in the OTC derivatives market. In the EU, the

Settlement Finality Directive already provides for the harmonisation of approaches in the EU

markets to protect settlement and netting carried out by clearing houses and central counterparties

from domestic insolvency proceedings, and the Financial Collateral Arrangements Directive provides

for the recognition of a range of possible collateral, the processes for realisation of collateral when

necessary, and the adoption of close-out netting for the transfer of collateral even upon the onset of

a participant’s insolvency.220

In addition to the above, perhaps it should be considered whether the

prudential regulation of central counterparties should be continuing and harmonised to ensure that

216

Iris H-Y Chiu, “Delegated Regulatory Administration in EU Securities Regulation” (2007) 40 InternationalLawyer 737.

217Often discussed in relation to guarantee and underwriting schemes provided by public governance see

Steven Lawrence Bailey, “New Zealand’s Alternative Approach to Banking Supervision” (1998) 3 Yearbook of

International Financial and Economic Law 393; Zeyneb Onder and Suheyla Oziyldirim, “Market Reaction to

Risky Banks: Did Generous Deposit Guarantee Change it?” (2009) World Development (forthcoming); Ramon P

De Gennaro and James B Thomson, “Anticipating Bailouts: The Incentive-Conflict Model and the Collapse of

the Ohio Deposit Guarantee Fund” (1995) 19 Journal of Banking and Finance 1401; but Ross Levine,

“Ownership and Control of Banks”, paper presented at the European Corporate Governance Institute

conference (Brussels, Sep 2008) argues that deposit guarantee schemes may not increase levels of bank risk

taking and moral hazard for widely held banks, and hence there is no general link between the existence of

moral hazard and deposit guarantee schemes.

218José Luis Lima and Javier Nuňez Errázuriz, “Experimental Analysis of the Reputational Incentives in a Self

Regulated Organization” (2004) at http://papers.ssrn.com/abstract=639661; Peter M DeMarzo, Michael J

Fishman and Kathleen M Hagerty, “Self Regulation and Government Oversight” (2005) 72 Review of Economic

Studies 687.

219FSA Handbook REC 2.

220The most recent amendments to the Settlement Finality Directive and the Financial Collateral

Arrangements Directive, Directive 2009/44/EC further support the protection of the actions taken by centralcounterparties in settlement and finality.

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systemic risk may be managed when the volumes of trades mandated through central

counterparties increase.

In addition to enrolling central counterparties to provide governance over derivatives trading, the US

and EU are also adopting a post-trade transparency approach221

that would require all trade data in

derivatives to be reported and disclosed. Such trade data would then be centrally stored in data

repositories. As the EU embarks on systemic risk regulation for the internal market, with the

leadership of the European Securities Markets Authority, European Banking Authority and European

Insurance and Occupational Pensions Authority,222

accountable to the European Systemic Risk

Board,223

such information could potentially feed into general prudential regulation undertaken at

the EU level.

The European Systemic Risk Board (“ESRB”) is supported by the work of 3 pan-European regulators

for banking, insurance and securities markets, who are currently networks of member state

regulators. Member state regulators are however also accountable to their respective governmental

authorities in respect of systemic risk, such as the UK Council of Financial Stability that comprises the

Treasury, Bank of England and FSA. It is queried as to how information may be coherently processed

and evaluated in this multi tiered structure, and the diversity in goals that may be brought to the

table may be significant as well.224

The ESRB has a right to have regular data reporting by the 3 pan-

EU regulators, and the right to gain access to any necessary information.225

However, the

information transmission, processing and aggregation between the 3 pan-EU regulators and national

regulators, and within national frameworks may still need to be worked out. The complex structure

for overseeing systemic risk at the EU may need to be revisited to ascertain if systemically relevant

information could be effectively discerned and analysed. The potentially voluminous disclosure of

post-trade data would have to be put to effective study and use, in a coherent and coordinated

manner.

221S113(4), s114, Over-the-Counter Derivatives Markets Act 2009; CESR, “Commission Consultation Document

on the possible initiatives to enhance the resilience of OTC Derivatives Markets” (14 Sep 2009).

222Directive Of The European Parliament And Of The Council Amending Directives 1998/26/EC, 2002/87/EC,

2003/6/EC, 2003/41/EC, 2003/71/EC, 2004/39/EC, 2004/109/EC, 2005/60/EC, 2006/48/EC, 2006/49/EC, and

2009/65/EC in respect of the powers of the European Banking Authority, the European Insurance and

Occupational Pensions Authority and the European Securities and Markets Authority, 26 Oct 2009.

223Proposal for a regulation on Community macro prudential oversight of the financial system and establishing

a European Systemic Risk Board (ESRB), Sep 2009.

224Larry D Wall and Robert A Eisenbeis, “Financial Regulatory Structure and the Resolution ofConflicting Goals”

(2000) 17 Journal of Financial Services Research 223; Young Han Chun and Hal G Rainey, “Goal Ambiguity in

U.S. Federal Agencies” (2005) 15 Journal of Public Administration Research and Theory 1 arguing that

dilemmas between redistributive and efficiency goals are very common in agencies.

225

Arts 14 and 15, Regulation Of The European Parliament And Of The Council on Community macroprudential oversight of the financial system and establishing a European Systemic Risk Board.

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Finally, Stout226

suggests the direct regulation of access to derivative trading, i.e. transactions in

breach of the rule against difference contracts should be void. The “rule against difference” was in

force in the US until the liberalisation of derivative trading in 2000, and basically required that

derivative trading would only be valid if based on an actual interest in the underlying subject matter

of the derivative transaction. In the absence of such an actual interest, a derivative contract would

be no different from a mere speculative transaction and would be outlawed. This could reduce the

amount of derivative trading being carried out, cutting down the amount of “socially useless”

activity in the financial services sector.227

Lord Turner’s suggestion that risky and “socially useless”

activities may attract higher tax could be taken in the same vein as Stout’s suggestion. Shrinking the

volume of speculative derivative trading may actually be a way to preserve erstwhile transactional

governance in OTC derivatives trading, as the systemic risk may be abated with a smaller sector,

lower volumes and lower impact resulting from risky exposures. However, it would probably be

unrealistic to turn the wheels of time backwards.

Hedge Funds

Hedge funds carry out a range of complex investment strategies to “generate absolute returns” and

some take on significant risk such as leverage in that process.228

Bookstaber offers a view of hedge

funds, viz:

“The hedge fund/alternative investments moniker is a description of what an investment

fund is not, rather than what it is. The universe of alternative investments is just that: the universe. It

encompasses all possible investment vehicles and all possible investment strategies minus the

traditional investment funds and vehicles.”229

Bookstaber is of the view that “traditional investment funds and vehicles” are regarded asmainstream only because they have been defined in scope by regulation, and are hence a subset of

the wider world of investment. To regulate hedge funds would be tantamount to regulating the

investment activity itself in total. Prior to the global financial crisis, although many recall the debacle

of Long Term Capital Management in 1998,230

there are mixed views as to whether hedge funds

should be subject to some extent of regulatory supervision.231

After all, the losses that may entail

226Lynn A Stout, “How Deregulating Derivatives Led to Disaster, and Why ReRegulating Them Can Prevent

Another” (2009) at http://ssrn.com/abstract=1432654.

227 “Financial Services Authority chairman backs tax on 'socially useless' banks”, The Guardian (27 Aug 2009),

quoting Lord Turner’s remarks in an interview with a current affairs magazine, Prospect.

228F S L’Habitant, Hedge Funds: Myths and Limits (Wiley Finance 2002) at chapter 4.

229Bookstaber, Markets, Hedge Funds and The Perils (2007), op cit at 244.

230Dick Frase, “Regulatory Creep and Convergence: Hedge Funds and the Regulators” in Iain Cullen and Helen

Parry eds, Hedge Funds: Law and Regulation (London: Sweet & Maxwell 2001) at 17ff, arguing that the LTCM

debacle has resulted in “regulatory creep” around hedge funds, such as the regulation of investor restriction

and market abuse.

231 The Report of the Alternative Investment Expert Group to the DG Internal Market (European Commission,

July 2006)at para 1.3 quite clearly arguing that hedge funds should be left unregulated, and the FSA, Discussion

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from hedge fund failure are those that fall on the fund itself and their usually sophisticated

investors. However, the concern now is that institutions such as pension funds also invest in hedge

funds and hence investment losses may also be social losses. Further, the volumes under hedge fund

management have grown and hence failures of funds may pose a systemic risk if cascades of failures

result.232

Hedge funds present micro-type risks affecting the survival of the fund, to macro-type systemic risk

that could affect the industry and related institutions. For micro-type risks, it is perhaps worth

considering the room for hedge fund counterparties to exert transactional governance to mitigate

those risks. This is because the equivalent sophistication on both sides may provide “good working

order”233

in transactional governance. Banks financing hedge funds are in a position to monitor

credit risk, and prime brokers may be in a position to mitigate fund exposures to market risk by

collateral and margin requirements. Prime brokers generally perform the services of execution,

custodianship, clearing and settlement and securities lending against collateral. They are intimately

connected with hedge fund activities and could be in a position to monitor the risks of hedge funds.

King and Maier234

argue that left on their own, although prime brokers have the ability to impose

certain controls and undertake monitoring of hedge fund risks, they are unlikely to do so as the

competition in the market entails incentives to race to the bottom in order to attract hedge fund

engagement. They argue that regulation should be increased for prime brokers, so that direct

regulation over prime brokers could provide indirect governance over hedge funds through

transactional controls that prime brokers would have to implement. Such transactional controls

could relate to prudential monitoring of hedge fund exposures, and could relate to margin and

collateral posting and leverage ratios. The irony in the recent global financial crisis is that, instead of

perceived risky hedge funds falling out and causing systemic risk, Lehman Brothers was the prime

broker that fell, resulting in controversies as to whether hedge fund assets held in Lehman accounts

at the time of the filing for bankruptcy would be ringfenced on trust.235

Investors in hedge funds may also be in a position to monitor the fund’s market and operational

risks. In the smart regulation model, hedge fund activities are carried out in a web of many

interacting actors that could supply governance to mitigate the risks of hedge fund activities.

However, it could be argued that although the theoretical smart regulation model would co-opt

these actors in the “regulatory space” as “surrogate regulators”, the faith in them could be

Paper on the Risks and Regulatory Engagement of Hedge Funds (DP05/04) available at

http://www.fsa.gov.uk/pubs/discussion/dp05_04.pdf , pointing out the possibility of serious market

disruptions from hedge fund fallouts and the risks to investor protection due to opacity in hedge fund

operations.

232Mila Getmansky, Andrew W Lo and Shauna X Mei, “Sifting Through the Wreckage: Lessons from Recent

Hedge Fund Liquidations” (2004) 2 Journal of Investment Management 6.

233Williamson, “The Economics of Governance” (2005), op cit.

234Michael R King and Philipp Maier, “Hedge Funds and Financial Stability: Regulating Prime Brokers will

Mitigate Systemic Risks” (2009) 5 Journal of Financial Stability 283.

235In the Matter of Lehman Brothers International (Europe) [2009] EWHC 2545 (Ch).

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misplaced. These “surrogate regulators” can fail when they are overly optimistic, riding on market

bubbles and behaving in an irrational manner, or where prime brokers are concerned, racing to the

bottom in a competitive market to be engaged by hedge funds. When “surrogate regulators” in the

market succumb to the heuristics and biases236

of bounded rationality, banks may offer excessive

leverage, prime brokers may be lenient with margin discipline and investors may not ask for

sufficient accountability.

The European Commission’s proposal237

to directly regulate alternative investment funds including

hedge funds and private equity funds may however exert more control than is necessary for the

purposes of public good ie the mitigation of systemic risk. As it is not easy to define a hedge fund,

the Proposal for a Directive to Regulate Alternative Investment Fund Managers238

covers all

alternative funds that are not within the scope of UCITs (undertakings in collective investments

relating to transferable securities, which can be offered on a passport under home country control in

the EU239

). This may capture non-UCITs240

funds that could be marketed to members of the public

under FSA authorisation, and other miscellaneous collective investment schemes that can now

legitimately operate in other Member States beyond the harmonised UCITs schemes. Although the

Proposal has de minimis rules that exempts smaller collective investment funds in Member States

from being captured, perhaps more consideration may be given as to whether the scope of the

Proposal can be designed to capture the regulation of risk and not the regulation of all non-UCITs

funds managing above a certain volume.

That said, the Proposal has a few notable features. The Proposal arguably provides a mixture of

micro-regulation of hedge fund risks, and macro-regulation of the type of systemic risk that hedge

funds may pose. On micro-regulation of hedge fund risks, the Proposal arguably strengthens the

position of investors in hedge funds, and this could empower them as monitors of hedge funds in

the smart regulatory space. Investors could benefit from the duties imposed on fund managers to

treat them fairly and act in their best interests, and investors would receive annual and periodic

disclosure protecting their interests and rights over issues such as the integrity and independence of

valuation, termination terms and rights, hedge fund investment policies and strategies, risk

management and profile.241

However, it is queried if sophisticated investors in hedge funds should

have more arsenal than the above. Sophisticated investors may often be subject to lock-in periods

236Thomas Gilovich, Dale Griffin and Daniel Kahneman (eds), Heuristics and Biases: The Psychology of Intuitive

Judgment (Cambridge: Cambridge University Press 2002);Daniel Kahneman and Amos Tversky (eds), Choices,

Values and Frames (Cambridge: Cambridge University Press 2003).237

European Commission, Proposal on a Directive for Alternative Fund Managers (2009) at

http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm.

23829 April 2009.

239Proposal for a Directive of the European Parliament and of the Council on the coordination of laws,

regulations and administrative provisions relating to undertakings for collective investment in transferable

securities (UCITS) (recasting the Directive of 85/611/EEC, 16 July 2008.

240For example, non-UCITs retail schemes see FSA COLL 1.2.

241Arts 9, 10, 15-17, 19 and 20 of the Proposal, op cit.

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and limitations of withdrawals, and such provisions may greatly undermine their ability to exert

discipline on hedge funds. However, it may also be argued that readiness to “exit” is not necessarily

an optimal disciplinary strategy, and that the exercise of “voice” may achieve a dimension beyond

the mere market force of the invisible hand.242

This area may be revisited to see if it is necessary for

regulation to empower investors in exit rights in order to enhance their monitoring of hedge funds.

Further, although not in the Proposal, the UK recommendations in best practices for hedge funds

made in the Large report243

suggest that specific disclosures on risk profiles and management, and

valuation policies be disclosed to prime brokers, so that prime brokers may be kept in the loop of

monitoring hedge funds’ levels of exposures. Hence, the smart regulatory model may be enhanced

by appropriate regulation to empower transactional parties such as investors and prime brokers, as

these actors could act as “surrogate regulators”.

The strength of transactional governance lies in its bottom-up nature. Contracting parties are

intricately involved in addressing issues and can provide solutions in a reflexive and innovative

manner.244 Where contracting parties may have equivalent amounts of sophistication such as hedge

funds, prime brokers and the sophisticated investors in hedge funds such as institutional investors,

regulatory provisions that empower and enhance their knowledge and informational capacity245

could be important to the micro-governance of hedge funds. Perhaps the transactional governance

that could be provided by investors over hedge funds could further be supported by the availability

of joined civil actions by investors against hedge funds for fraud, breaches of contractual duties or

duties of care, diligence and trust.246

On the macro-level of overseeing the risks the hedge fund industry may pose to the overall financial

market, the Proposal empowers regulators to receive key information regarding risk management,

profiles, leverage, short selling and other such information regularly from hedge funds.247

Information is likely to be key to the management of systemic risk by regulators. However, there is a

need to meaningfully process, understand and use the information received in ascertaining the

242Albert O Hirschmann, Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations, and States

(Cambridge, MA: Harvard University Press 1970).

243Hedge Fund Working Group (led by Sir Andrew Large), Hedge Fund Standards: Final Report (Jan 2008).

244 Maria Chiara Malaguti, “Private-Law Instruments for Reduction of Risks on International Financial Markets:


International Law Making for the Financial Markets” (2005) 29 Fordham International Law Journal 127.

245Also earlier proposed by the Hedge Fund Working Group (led by Sir Andrew Large), Hedge Fund Standards:

Final Report (Jan 2008), largely based on information disclosure as a set of best practices.

246The hedge funds of failed US investment bank Bear Stearns have been sued by numerous investors

including Barclays, Barclays, PLC v. Bear Stearns Asset Mgmt. Inc., et al ., No. 07-CV-1140 (S.D.N.Y.). Greater

open-ness to civil actions in investment enforcement is seen in the HM Treasury, Reforming Financial Markets

(6 July 2009).

247Arts 20-24, the Proposal, op cit.

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patterns of industry wide risk and weaknesses.248

Besides disclosure, the Proposal also recommends

certain prescriptive risk management measures such as the management of liquidity risk.249

The

Proposal also intends to impose limitations on hedge fund investments in respect of risky investment

decisions such as in relation to asset-backed securities.250

However, it is queried if such specific

prescriptions could be drafted as more general framework principles so that Commission legislation

could in due course provide for specific measures. This would allow the public governance of

systemic risk to develop in an incremental and informed way.

It may be argued that the imposition of direct regulation inevitably undermines transactional

solutions, as regulation has the effect of replacing and centralising transaction costs and removes

the impetus towards private solutions.251

This may arguably stifle innovation in transactional

governance that prime brokers and investors could exert for accountability. However, as King and

Maier have pointed out, enhanced regulatory empowerment of the “surrogate” regulators in the

smart regulatory model may be necessary in order for them to act at all. In addressing micro-type

risk concerns, transactional governance in particular should be encouraged. Perhaps the Proposal

should also empower prime brokers as proposed in the UK Large Report,252

and to improve

informational transparency to them to support transactional governance that could be provided by

them.

However, where systemic risk issues are concerned, the lack of collective ownership of systemic risk

issues often means that regulatory governance is necessary. The Proposal’s template for disclosure

and possible specific prescriptions into investment activity where systemic risk issues loom large

represent an appropriate scope for public governance. It would however be important that the

Proposal is not anti-gold-plating and that Member States may be able to introduce measures specific

to their concerns. The key challenge in the management of systemic risk in the EU would lie in the

coordination between national and EU levels of governance. The primary level of regulatory

oversight lies with national regulators who register the funds, and continuing information disclosure

by funds would be made to them. But systemic risk issues likely have to be addressed beyond the

national level, especially in the interconnected markets of the EU. It remains to be seen if the multi-

tiered structure in the EU dealing with systemic risk information and coordinating governance action

would be effective.

A multi-tiered structure in dealing with systemic risk issues could be effective as ground-level

information may be ascertained by national regulators and be transmitted to pan-European

248 Fanto for example doubts that regulation of risk is possible based on the technical and subjective nature of

risk information, James Fanto, “Financial Crisis Reforms: Maintaining the Status Quo?” paper presented at

Centre for Commercial Law Conference, Queen Mary University of London, 11 Dec 2009.

249Art 12, the Proposal, op cit.

250Art 13, the Proposal, op cit.

251O Williamson, “Strategising, Economising and Economic Organisation” (1991) 12 Strategic Management

Journal 75.

252

P67, recommendations 9-20, Hedge Fund Working Group (led by Sir Andrew Large), Hedge Fund Standards:Final Report (Jan 2008).

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authorities and the Systemic Risk Board. On the other hand, national regulators could filter out

information they choose to disregard, and seemingly irrelevant or local information which might

prove to be important upon hindsight. The potential for coordination and economies of scale in

processing local and cross-border information is immense, but the potential for conflict of goals is

equally so, as national governments with political concerns may be involved in systemic risk

governance with the national regulators.253

Moreover, Member States do not necessarily desire

coordinated action if such action encompasses risks to the autonomy of any particular Member

State in dealing with what it may perceive to be issues of national concern. The autonomy of

Member States also faces another challenge- the pan-European authorities in banking, securities,

insurance and occupational pensions are mandated to produce hard law that would secure

convergent technical standards and supervisory approaches in Member States.254

Although these

authorities are heavily underpinned by the network of national regulators,255

the institutionalisation

of management and hierarchy in the authorities entail the independence of the authorities from the

networks.256

Further, the Systemic Risk Board has the power257

to issue non-legally binding warnings

which would no doubt be highly persuasive, although it could be arguable that Member States coulddistinguish high-level indications from the Board, from their local conditions, in deciding what weight

to attach to such warnings. It remains to be seen if the combination of soft law from the ESRB and

the hard law that can be issued by the pan-EU regulators may produce an overall EU level

governance for the regulation of risk, and how this may work with national management of systemic

risk.

Self-Certification by Providers of “Certifier” Products

Investment products are often referred to as “credence goods”,258

and hence the market produces

“certifier” products to help investors discern the quality of such credence goods. The purchasers of

such certifier products are however not investors, but issuers, for the purposes of enhancing the

attractiveness of their products. Credit ratings are intended to provide information on the credit-

worthiness of investment issuers, ratings on corporate governance provide information on how the

agency problem in a corporation is managed, social responsibility ratings and achievements provide

information on the ethical, social and environmental reputations of the corporation. Certifier

253The UK Council of Financial Stability would include the Treasury as representative of the government.

254To be endorsed as Commission legislation, see Art 7, and 11-15, Regulation Of The European Parliament

And Of The Council establishing a European Securities and Markets Authority, Sep 2009.

255Art 25(1)(b), Regulation Of The European Parliament And Of The Council establishing a European Securities

and Markets Authority, Sep 2009, for example.

256For example, Art 4, 25 of the above Regulation setting out the institutional structure, and Art 3 giving the

Authority separate legal personality, and Arts 6-24 dealing with the tasks and responsibilities of the Authority

and its powers.

257Art 16, Regulation Of The European Parliament And Of The Council on Community macro prudential

oversight of the financial system and establishing a European Systemic Risk Board, Sep 2009.

258

Ch1, Charles Goodhart et al, Financial Regulation: Why, How and Where Now? (London: Routledge 1998),op cit.

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products potentially also include analyst recommendations to buy or sell, but this discussion will

exclude the issues pertaining to analysts as the Markets in Financial Instruments Directive already

provides direct regulation over certain aspects of research products. The Directive prohibits research

analysts from receiving inducements to promise favourable research259

and the FSA Handbook

further requires that research must be labelled as non-independent if conflicts of interests are

involved, and that dissemination of research must be done fairly including highlighting the existence

of conflicts of interests.260

There has hitherto been no need for the certifier products themselves to be regulated, in respect of

the processes giving rise to them, and the soundness or integrity of these processes. It is not

suggested that this is therefore a regulatory gap. Products released into a marketplace are subject

fundamentally to market discipline, i.e. that the market could itself test the accuracy of such

products and user feedback may affect issuer demand and provide a form of market discipline for

certifier products. However, market discipline would only be effective if there is competition in the

supply of the products, and information is supplied to the market to help in discerning the quality of

the products. In the market for credit ratings, there is an effective international oligarchy of

Standard & Poor’s, Moody’s and Fitch.261

Further, the competition on the demand side for ratings

comes from issuers, and issuers would shop for the most favourable rating. These demand-led forces

do not encourage credit rating agencies to issue ratings to benefit their stakeholders, ie investors

who rely on the ratings.262

Hence, the competition actually produces a race to the bottom rather

than a race to the top to meet stakeholders’ needs. Further, there is also information asymmetry

between the users of the ratings and the rating agencies, although the US “NRSRO” Regulation and

the IOSCO Code of Fundamental Best Practices for Credit Rating Agencies provide for disclosures to

be made of rating methodologies and management of conflicts of interest. These disclosures may

not provide sufficient insight for users to discern if a rating is in substance “accurate”. The accuracyor otherwise of a rating may only be settled after an investor has taken a risk with the purchase of

an investment and either made a gain or suffered a loss. Although there are market imperfections in

terms of rating agencies’ incentives and the situation of information asymmetry, those alone have

not warranted regulatory intrusion into governing the supply and quality of certifier products.

Where corporate governance ratings are concerned, there is a greater number of players including

the “Corporate Governance Quotient” by the Institutional Shareholder Services (ISS) and RiskMetrics

Group, Governance Metric Index by Governance Metrics International, and The Corporate Library

259Articles 24-5, MiFID Commission Directive.

260FSA Handbook, COBS 12.3 and 12.4.

261Many argue that the US SEC’s regulation to register only established and tested credit ratings agencies

created further barriers to entry for competitors, protecting the incumbents’ oligarchy, see Regulation on

“Nationally Recognised Statistical Rating Organisation” (2006), and Jeffrey Manns, “Rating Risk After The

Subprime Mortgage Crisis: A User Fee Approach For Rating Agency Accountability” (2009) 87 North Carolina

Law Review 1011.

262

Chester Spatt, “Discussion of “Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation” (2009)56 Journal of Monetary Economics 696.

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Ratings by The Corporate Library (founded by Robert Monks, an avid activist investor in the US).263

Social responsibility ratings are provided by leaders such as the Socrates Database managed by

Kinder, Lydenberg, Domini Research & Analytics (KLD) and Intangible Value Ratings provided by

RiskMetrics. It remains to be seen whether the market for such ratings would be dominated by

issuers as well, and the incentives driving the provision of these services would then be similarly

affected by issuer demand. Corporate governance and social responsibility rating services however

exist alongside other not-for-profit initiatives such as the Sunday Times Best 100 Companies to Work

For, and World’s Most Ethical Companies (Ethisphere). Thus, these initiatives may be able to provide

some balance in the landscape so that issuer domination on the demand side would not necessarily

produce a race to the bottom, and stakeholder needs may be met by aggregating the information

available to the market from rating providers and not-for-profit initiatives.

Another factor that aggravates the lack of healthy competition in the market for certifier products is

the fact that the market is likely subject to network effects, i.e. that the more use is of made of the

product, the appeal to the market of such products increases and more users are attracted to the

product. As White explains, users’ desire for consistency of ratings across investment products helps

to sustain reliance on the few incumbents in the credit rating market.264

The market for corporate

governance and social responsibility ratings also consists of a few incumbents, but the oligarchic

structure may be ameliorated by the range of not-for-profit initiatives mentioned above designed to

provide information to stakeholders for free. Hence, compared to corporate governance and social

responsibility ratings, perhaps market discipline in terms of information and competition would be

relatively weaker for credit rating products.

Where market discipline is weak, sub-optimal rating products may be provided on the market and

the externalities may be occasioned to stakeholders who use the ratings. In the absence of

contractual redress between investor-users of the rating products and the rating agencies,

stakeholders may have considerable difficulties in exerting discipline upon rating agencies through

civil enforcement.265

It remains to be seen how CalPERS’ suit will fare against all three rating

agencies in the US for erroneous top ratings given to toxic structured securities products based on

subprime mortgages. Stakeholder discipline through judicial redress is likely to be costly and ad hoc.

The externalities would in essence be mistaken investment choices and hence investment losses. On

a certain level, it is not that different from a consumer who has relied on a Which? Magazine review

and bought an electrical appliance that subsequently does not turn out to last. Risk of consumption

loss may be regarded as a private risk to be mitigated by private diligence or private law redress.

One way out would be to regulate for an “investor-pays” model of credit ratings so that direct

263Although some empirical research queries as to whether the ratings are of any predictive value as to

existing and future performance, and whether the ratings actually correlate with the governance findings

behind them, see Robert Daines, Ian Gow, and David Larcker, “Rating the Ratings: How Good Are Commercial

Governance Ratings?”, Arthur and Toni Rembe Rock Center for Corporate Governance, Stanford University

(June 2008).

264Lawrence J White, “The Credit Rating Industry: An Industrial Organization Analysis” (2001) at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=267083.

265

Arthur R Pinto, “Control and Responsibility of Credit Rating Agencies in the US” (2006) 54 American Journalof Comparative Law (Suppl) 341.

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accountability can be constructed between rating agencies and users.266

However, Rousseau is of the

view that this may preclude some users from being able to access ratings information.267

Or should

there be regulation to either mitigate the externalities that would arise, or else order that the

externalities be borne by the rating agencies or issuers?

This paper suggests that regulation to mitigate the externalities that mistaken ratings would cause to

stakeholders who rely on them becomes necessary when ratings are not merely a private good, but

also a public good. Bruner and Partnoy point out that regulators have prematurely given their seal of

approval to credit rating products and have integrated credit ratings into their regulatory

schemes.268

Hence, the issue with credit ratings is that they are no longer merely certifier products

for the market, they are certifier products that regulators have bought into, for example, in order to

work out the required level of minimum capital in financial institutions. This has not happened yet

with corporate governance and social responsibility ratings. Regulatory approval without further

checks has obliterated market discipline for credit rating products,269

as the market is no longer

being asked to ascertain accuracy. The market assumes accuracy due to regulatory approval, but

regulatory approval itself may have been unfounded. It remains open to regulators to retreat from

such product endorsement and leave the credit rating market to be disciplined by user preferences

and litigation.270

In the alternative, if regulators need to continue relying on rating products, then

regulators may arguably have to develop yardsticks by which to evaluate the credibility of such

products. Arguably, regulatory monitoring would be needed as if the production of public goods has

been outsourced and the lack of evaluation would result in practical unaccountability.271

266Manns, “Rating Risk” (2009), op cit argues that an aggregated user-fee model can be implemented, to be

administered by the regulator, and such a model could allow users to sue ratings agencies and for theregulator to decide the thresholds for any action.

267Stephané Rousseau, “Regulating Credit Rating Agencies After the Financial Crisis: The Long and Winding

Road to Accountability” (2009) at http://ssrn.com/abstract=1456708.

268Christopher M Bruner, “States, Markets and Gatekeepers: Public-Private Economic Regimes in an Era of

Economic Globalisation” (2009) 30 Michigan Journal of International Law 125; Frank Partnoy, ‘The Siskel and

Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies’ (1999) 77 Washington

University Law Quarterly 619. For example, Regulation AB provides that historical performance disclosure can

be omitted for offering of Asset-backed securities if such as “investment grade” with reference to an NRSRO

rating. Hence, ratings from recognised credit ratings agencies may be used as proxies for traditional disclosureregulation. Further, the Basel II Capital Accord prior to the financial crisis recommended that minimum capital

requirements for banks be implemented with reliance upon credit ratings issued for the assets banks hold, as a

part of the “standardised” approach, see eg P van Roy, “Credit Ratings and the Standardised Approach to

Credit Risk in Basel II”, European Central Bank Working Paper 2005 at

http://www.ecb.int/pub/pdf/scpwps/ecbwp517.pdf.

269Bruner, above.

270Very unlikely, according to Spatt (2009), above, although some intimation towards has been reported in the

US.

271 Mark R Freedland, “Government by Contract And Public Law” (1994) Public Law 86, discusses the

constitutionality of such contracting out. Sidney A Shapiro, “Outsourcing Government Regulation” (2003) 53

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Prior to the global financial crisis, regulators all over the world have “outsourced” the development

of rating methodologies to credit rating agencies, but unlike any outsourcing partnership between

the public and private sectors, regulators have not assumed any oversight or monitoring over the

development of rating products, relying on the reputation of the giant incumbents.272

The financial

crisis has shown up the weakness of this self-regulatory model of certifier products. Rating agencies

have not applied ethical self-regulation to provide the most credible ratings, and have instead

succumbed to issuers’ demands and have not prioritised their user stakeholders’ interests .273

The EU Regulation274

to regulate credit rating agencies envisages that the European Securities

Markets Authority (“ESMA”) would have to approve of rating agencies and monitor their operations,

and that rating agencies should be subject to periodic disclosure of their key methodologies,

assumptions, conflicts of interests and remuneration policies. A similar approach has been found in

IOSCO’s Code of Conduct for Rating Agencies issued in 2004, now updated to incorporate more

rigorous principles and accountability to stakeholder in rating complex structured products.275

Information disclosed to ESMA would be useful only if the regulator has expertise in critically

appraising how ratings systems should be designed and operated and be able to test the

performance of these systems in delivering accurate ratings. There may be a gap between having

systems and procedures that actually deliver credible and reliable ratings and having systems and

procedures that look adequate and intelligent enough to the regulator. Regulators have to avoid

succumbing to the acceptance of processes adopted by the regulated, and need to be in a position

to test the performance of these systems and determine if the regulatory good is delivered.

Stolper argues that it is inherently very difficult for regulators to detect whether optimal and

accurate ratings have been delivered by agencies, and if agencies collude with each other instead of

compete with each other to deliver accurate ratings, then regulators will unlikely discern if accurate

Duke Law Journal 389, discusses the drawbacks of contracting out, especially if the costs of monitoring agency

drift may outweigh the benefits.

272John C Coffee and Hilary A Sale, “Redesigning the SEC: Does the Treasury have a Better Idea?” (2009) 95

Virginia Law Review 707.

273

M Brunnermeier, A Crockett, C Goodhart, A.D. Persaud and Hyun Shin, “The Fundamental Principles of Financial Regulation”, Geneva Reports on the World Economy (2009); Jerome Mathis, James McAndrews and

Jean-Charles Rochet, “Rating the Raters: Are reputation concerns powerful enough to discipline rating

agencies?” (2009) 56 Journal of Monetary Economics 657, arguing that rating agencies succumb to issuers’

wishes as issuers are the source of their income. Reputational discipline from a sense of responsibility or ethics

is very weak. An opposing view is found in Fabian Dittrich, “The Credit-Rating Industry: Competition and

Regulation” (2007, unpublished).

274COM(2008) 704 final.

275IOSCO, Final Report on the Role of Credit Rating Agencies in Structured Products (2008) at

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD270.pdf ; and IOSCO, Code of Fundamental Practices for Credit Rating Agencies (2004) at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD180.pdf.

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ratings have been delivered.276

Further, there is the issue of whether the regulatory regime will now

be regarded as tantamount to underwriting the quality of the rating product.277

It is not insurmountable for ESMA to develop actual critical expertise in vetting rating agencies’

methodologies and findings. In areas of regulation over medicines for example, regulator approval

more or less warrants the quality and safety of use for such products and such guarantees are only

possible because the regulator has developed matching expertise with the industry. There is some

justification for ESMA developing the capacity to vet the information submitted by rating agencies

and to evaluate the quality of the rating product.278

Besides, ESMA has been tasked to develop

technical standards in its establishing legislation.279

In developing ESMA’s technical, knowledge and informational expertise, ESMA is rightly expanding

its relational paradigm to include stakeholders,280

so that its relational paradigm would not be

dominated by the industry. The enrolment of stakeholders allows diverse input into knowledge and

capacity building, as well as critical views and input. The diversity of views ESMA is exposed to could

help develop greater critical capacity in evaluating the rating agencies’ performance. However, it is

submitted that the Stakeholders Group281

should not be of closed membership, and should facilitate

a platform allowing other stakeholder views to be submitted and stakeholder discussion sessions to

be conducted.

Gerding also suggests that regulator expertise in rating methodologies and standards can be

enhanced via the development of open technical standards for rating products.282

This argument

borrows from the idea of “open source” in software developments that open participation in

information pooling and technical development by any interested party can help shape and build a

robust product. The ethics in open source lies in no one being able to claim proprietary rights over

such product. However, unlike the ethos in “open-source”, rating agencies are unlikely to give away

their proprietary systems voluntarily and regulation may be needed to compel the establishment of

that open platform. Forster argues that the chief difficulty in discerning the reliability of ratings lies

276Anno Stolper, “Regulation of Credit Rating Agencies” (2009) 33 Journal of Banking and Finance 1266.

277Rousseau, “Regulating Credit Rating Agencies” (2009), op cit argues that governments should perhaps have

direct input and control over the ratings methodology and process, but this paper suggests that moral hazard

may entail from reliance on the government stamp of approval, and this puts undue burden on governments

to get the ratings “right”, which could be very difficult for complex assets.

278 Piero Cinqueguana, “The Reform of Credit Rating Agencies” (2009), ECMI Policy Brief No 12, 13.

279Art 7, Regulation Of The European Parliament And Of The Council establishing a European Securities and

Markets Authority, Sep 2009.

280Art 22, above.

281Art 22, Regulation for the European Securities Markets Authority, op cit, which envisages a closed group of

30 members selected for a term of two and a half years and may only be re-selected for an additional term.

282Erik F Gerding, “Code, Crash and Open Source” (2009) 84 Washington Law Review 127, arguing that the

technical systems and methodology used by ratings agencies should become open source rather thanproprietary as opaque systems hide flaws and increase risk.

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in the opacity of the standards and methodologies used to achieve the ratings. By using economic

analysis, Forster shows that if certain minimum standards for ratings can be made open, perhaps at

the international level, this would offer significant improvements in regulatory efficacy and user

reliance, leading to increases in social good.283

Opening up the technical standards and

methodologies in ratings is likely to meet with opposition by the industry as their rent-seeking

behaviour would be affected, even if economic rents have been sought based on flawed systems

they have used.

That is not to say that developing open technical platforms to enhance the informational capacity of

regulators and stakeholders should not be encouraged. This is an area where perhaps international

soft law for a platform for open technical standards of credit ratings can be developed, so that the

industry and stakeholders may both be involved in fashioning and evaluating the technical

methodologies and standards to be used. This would require the industry to develop value added

services beyond the use of proprietary methodologies to issue rating products. The development of

open technical standards may be key to enhancing the regulator’s competency in evaluating the

quality of the certification.284

The main issue with credit rating agencies is that ratings have become a quasi-public good and

governance over the rating process has been outsourced to the industry without practical

accountability, as regulators are unable to evaluate the ratings which have been subject to opaque

and proprietary processes. The way forward is for regulators to have in place expertise or capacity to

monitor how the public goods are delivered, and to determine if they have been adequately

delivered.285

Regulator expertise and capacity may be further enhanced by facilitating open

information flows and technical standard development at the international level, although this

would not likely be welcomed by the industry.

Market-Based Governance

The next two models along the spectrum refer to a form of governance that is “self-regulatory” plus

some external form of discipline in the market. As suggested in the literature review in Section 2,

market-based governance can take place via various arrangements. There is an abundance of

literature looking into the nature of stock exchanges and the governance it provides over issuers and

intermediaries.286

Although the US and Hong Kong are jurisdictions that still rely heavily on exchange

283Josef Forster, “The Optimal Regulation of Credit Ratings Agencies” (2008) at http://epub.ub.uni-

muenchen.de/5169/1/Forster_CRA_Regulation.pdf.

284Erik F Gerding, “Code, Crash and Open Source” (2009) 84 Washington Law Review 127; John Braithwaite,

Regulatory Capitalism (Cheltenham: Edward Elgar 2008) at 4, 109ff.

285D Asenova, M Beck, & S Toms, “The Limits of Market-Based Governance and Accountability - PFI

Refinancing and the Resurgence of the Regulatory State” (2007) University of York Working paper number 35

argues that making the outsourcee accountable in private-public partnerships such as the Private Financing

Initiative, is one of the main challenges in making the partnership work.

286Norman S Poser, “The Stock Exchanges of the US and Europe- Automation, Globalisation and Consolidation”

(2001) Univ of Penn Journal of Int Econ Law 497; Betty Ho, “Demutualization of Organized Securities Exchanges

in Hong Kong: The Great Leap Forward” in 33 Law and Pol’y Int’l Bus 283; James D Cox, “Commentary: Brands

vs Generics: Self-regulation By Competitors” 2000 Colum Bus L Rev 15; Roberta S. Karmel, What Should Market

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governance, much less reliance is placed on exchanges in the UK and EU, and hence this Section will

not look into the potential “agency problems” that may exist where delegated governance is made

to stock exchanges. In this Section, I have decided to look at whether “gatekeepers” may provide a

form of market-based discipline in the financial services landscape. “Gatekeepers” are a broad range

of third parties who may be:

(a) Transactionally connected with firms, such as auditors and lawyers;

(b) Involved in reputational verification of firms’ disclosures or activities such as auditors,

underwriters, rating agencies and stock exchanges;

(c) Involved in evaluation but not necessarily reputational verification, of disclosures by firms,

such as research analysts, stock exchanges, credit, corporate governance and social

responsibility rating agencies.287

Gatekeepers are generally discrete groups with either professional or specialised expertise, and their

involvement with a firm may provide a form of “surrogate regulation” envisaged in the smart

regulation model, although there may be no conscious perception that gatekeepers have been

delegated or outsourced with aspects of governance. The following will not deal with (c) as has been

dealt with above. I will argue that regulators have perhaps missed perceiving that there is an

element of delegation in some aspects of gatekeepers’ governance and there are significant agency

problems in gatekeepers’ governance providing public/regulatory goods.

The following will focus on auditors and lawyers. Auditors and lawyers are regarded as gatekeepers

as they are often able to gain access to intimate firm information, and hence may be in a position to

uncover wrongdoing and disconcerting signals such as excessive risk. Gatekeepers’ potential access

to detection and their capacity to apply a critical mind are the attributes that allow us to ascribe

governance capacity to these gatekeepers. Gatekeepers could provide a form of governance over

issuers for investors through audit, assurance and professional verification, some of which may be

regulatory goods, such as the annual audit of company accounts, others may be market goods

desired by issuers such as consulting and corporate governance assurances.288

Although gatekeepers

could provide a form of governance as part of their market-based services to clients, the imposition

of this social good aspect upon gatekeepers’ market-based services may be difficult and

inappropriate. However, where the market for gatekeepers’ services or functions has been created

by regulation, then gatekeepers could arguably be made accountable to regulators for the

governance that has been delegated to them. However, this is not to suggest a bright line distinction

Infrastructure Institutions Regulate? (forthcoming); Cally Jordan and Pamela Hughes, “Which Way for Market

Institutions? The Fundamental Question of Self Regulation” (2007) 4 Berkeley Bus. L.J. 205.

287Arthur Laby, “Differentiating Gatekeepers” (2007) 1 Brooklyn Journal of Corporate and Financial Law 119;

John C Coffee, Gatekeepers (Oxford: OUP 2006).

288For example, the accounting profession is considering offering audits or assuarnces of corporate

governance statements made by companies, see Fédération des Experts Comptables Européens, DiscussionPaper for Auditor's Role Regarding Providing Assurance on Corporate Governance Statements (Nov 2009).

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in the various roles of gatekeepers undertake for their clients, and regulators and professional

bodies need to engage each other in greater exchange over gatekeepers’ roles.

Where accountants and lawyers are transactionally connected with issuers, accountants may be able

to flag up wrongdoing, and increasingly, even signs of excessive risk that could become systemically

important,289 and lawyers may also be able to detect non-compliance or creative compliance by their

clients. However, it is arguable that accountants and lawyers could provide governance for the social

good only if professional discipline or regulatory liability compels them to choose social good above

client loyalty at all times. Hamdani290

has argued that gatekeepers such as auditors and lawyers will

only be incentivised to consciously monitor their clients if some form of liability is imposed on them

to do so. As negligence liability is costly to prove, strict liability is the least costly way of co-opting

responsibility for monitoring by these gatekeepers. However, the imposition of strict liability may be

disproportionately costly291

if it is difficult for gatekeepers to screen their clients perfectly. This is

likely a sub-optimal way of enrolling gatekeepers into the regulatory space, and does not take into

account of the value added innovations gatekeepers have brought to businesses and the

development of gatekeepers as a business industry itself. It is proposed that gatekeeper functions

may be looked at in two respects: one, gatekeepers’ services as market-based services derived

according to demand, such as aspects of consultancy work unrelated to compliance, corporate

finance and acquisitions, and lawyers’ advisory and drafting services for transactions. The second

type of gatekeeper services would be based on a market created by regulatory requirements, ie

audit services provided by accountants or compliance services provided by lawyers.

For gatekeeper services of the first type, gatekeepers may gain significant proximity into corporate

and business affairs and may be able to detect wrongdoing and excessive risk. However, accountants

engaged in consulting and advisory work are often placed under duties of confidentiality, and the

professional mantra of lawyers is that they see themselves as fiduciaries of their clients and not

“trustees” of stakeholders.292

Although the capacity of these gatekeepers puts them in a position

that could be influential for governance purposes, the imposition of governance objectives upon

their work poses challenges in terms of conflict of purpose. If regulators establish a whistleblowing

regime or even impose a whistleblowing duty, professionals may find it difficult to comply with that

289Christopher Humphrey, Anne Loft and Margaret Woods, “The Global Audit Profession and the International

Financial Architecture: Understanding Regulatory Relationships at a Time of Financial Crisis” (2009) 34

Accounting Organisations and Society 810.

290Assaf Hamdani, “Gatekeeper Liability” (2003) 77 Southern California Law Rev 53.

291Frank B Cross and Robert A Prentice, “The Economic Value of Securities Regulation” (2006-7) 28 Cardozo

Law Review 333, arguing that gatekeeper monitoring is fraught with difficulties and is imperfect.

292Rutherford B Campbell Jnr and Eugene R.Gaetke, “The Ethical Obligation of Transactional Lawyers to Act as

Gatekeepers” (2003) 56 Rutgers Law Review 9; Arthur Laby, “Differentiating Gatekeepers” (2007) 1 Brooklyn

Journal of Corporate and Financial Law 119; Hugh P Gunz and Sally P Gunz, “Client Capture and the

Professional Service Firm” (2008) 45 American Business Law Journal 685. Coffee however argues that it is

possible to make lawyers more independent and more like gatekeepers by imposing extra certification

obligations subject to the threat of liability that may be enforced by regulators, see John C. Coffee, Jr., TheAttorney as Gatekeeper: An Agenda for the SEC” (2003) 103 Columbia Law Review 1293.

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as the social legitimacy of whistleblowing is still not well-established, and whistleblowing

professionals may find their lives as professionals cut short rather than enhanced.293

Further,

commentators have observed that in-house lawyers adopt the organisational identity of the

corporation over individual ethical self-regulation or professional identity.294

Even external counsel

appointed to represent corporations in specific transactions can be captured by their clients

depending on how the counsel views the relationship with the client and how important the client

may be to the firm.295

Hence, whistleblowing regimes may not be able to overcome those inherent

perceptions and biases.

Accountants and lawyers owe duties in private contract although their professional capacities and

expertise lend themselves to being seen as surrogate regulators in the regulatory space. It is

proposed that where accountants and lawyers are transactionally connected with their clients in

respect of market-based services mentioned above, the private contractual nature of those

arrangements should prima facie be preserved. Intervention by regulators in these areas would

likely entail unintended consequences such as the creative avoidance of regulatory objectives

through opaque means of rendering services. Such intervention may not enhance the monitoring

capacity of these gatekeepers and may promote collusions between gatekeepers and clients through

creative and opaque forms. However, this is an area which regulators should have dialogue and

information exchange with professional bodies in order to build up understanding into how

professionals may have a role in governance in the regulatory space. Cunningham also advocates a

model to introduce carrots to induce gatekeepers to pay attention to the social good of their

activities. This model allows rewards to be paid for gatekeepers to whistleblow on their clients.

Cunningham is of the view that firms could contract to pay gatekeepers extra if wrongdoing is

uncovered, as the lack of uncovering of such wrongdoing would boost firm reputation and hence

there is something in it for firms to enter into such bargains. Gatekeepers can be prevented fromhaving perverse incentives to earn those rewards if regulation makes it mandatory for gatekeepers

to work in teams from different firms, hence checking each other’s behaviour.296

As for gatekeeper work of the second type ie that the market for gatekeepers’ work such as audit or

compliance, has arisen because of regulatory requirements, it is proposed that gatekeepers in those

capacities should be perceived as having been delegated a role in governance in the regulatory

space, and regulators should address the agency problems this entails.

293KR Sawyer, J Jackson and M Holub, “The Necessary Illegitimacy of the Whistleblower” at SSRN, at


294Mark Sargent, “Lawyers in the Moral Maze” (2004) 49 Villanova Law Rev 867; Hugh P Gunz and Sally P

Gunz, “Hired Professional to Hired Gun: An Identity Theory Approach to Understanding the Ethical Behaviour

of Professionals In Non-Professional Organizations” (2007) 60 Human Relations 851.

295Hugh P Gunz and Sally P Gunz, “Client Capture and the Professional Service Firm” (2008) 45 American

Business Law Journal 685;

296

Lawrence A Cunningham, “Beyond Liability: Rewarding Effective Gatekeepers” (2008) 92 Minnesota LawReview 323.

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Villiers points out that the fundamental basis underlying issuers’ corporate reporting is their

accountability in exchange for the privilege of incorporation, limited liability and corporate

finance.297

Auditors are engaged in order to provide an assurance as to the accuracy of the

mandatory reporting required of corporations.298

Hence, auditors’ transactional relationship with

their clients is not merely a private market contract for services. The market for audit contracts has

arisen because of regulatory provision to co-opt the professional services of auditors to provide

inspection and verification of corporations. Viewed in that light, independent auditing is a delegated

form of regulatory administration in ensuring accuracy in corporate disclosure, and hence is

expected to assist in the delivery of public/regulatory goods. This may provide a legitimate basis for

us to regard auditors as gatekeepers whose role is to provide governance via the audit, although the

same argument may be less convincing in cases of voluntary audits or assurances299

which would be

market-based products.

However, Markham argues that auditors in the US are required to certify a sample of financial

statements produced by firms as in compliance with the Generally Accepted Accounting Principles

(US) and hence auditors are not to be taken as warranting financial soundness or policing corporate

fraud.300

This may arguably be different from the auditors’ duty to certify that a firm’s financial

statements are “true and fair” in the UK.301

But does the audit entail all of the implications of

detection of wrongdoing and policing of an issuer? Some commentators have argued that it is not

technically easy for auditors to detect wrongdoing,302

or to value complex financial assets held by

297Charlotte Villiers, Corporate Reporting and Company Law (Cambridge: Cambridge University Press 2006) at

ch1.

298Michael Power, The Audit Society: Rituals of Verification (Oxford, Oxford University Press, 1999) at chs 1

and 3.

299Such as audit or assurance services for corporate governance see Fédération des Experts Comptables

Européens, Discussion Paper for Auditor's Role Regarding Providing Assurance on Corporate Governance

Statements (Nov 2009).

300Jerry W. Markham, “Accountants make Miserable Policemen: Rethinking the Federal Securities Laws”

(2003) 28 North Carolina Journal of International Law and Commercial Regulation 725.

301Gilad Livne and Maureen McNichols., “An Empirical Investigation of True and Fair Override in the United

Kingdom”(2009) 36 Journal of Business Finance & Accounting 1; Shyam Sunder, ““True and Fair” as the Moral

Compass of Financial Reporting”, Keynote address to the American Accounting Association Ethics Symposium,

New York, 2 August 2009 at

http://www.som.yale.edu/faculty/sunder/Research/Accounting%20and%20Control/Presentations%20and%20

Working%20Papers/AAA-NYC-Aug2009/MoralCompassSept2009.pdf.

302T Bell, S Szykowny. and J Willingham, Assessing the Likelihood of Fraudulent Financial Reporting : A

Cascaded Logit Approach. KPMG Peat Marwick, Montvale, NJ. Working Paper, 1993; JV Hansen,.JB McDonald,

WF Messier and TB Bell, “A Generalized Qualitative-Response Model and the Analysis of Management Fraud”

(1996) 42 Management Science 1022–1032; -Juan Jose Ganuza and Fernando Gomez, “Should We Trust the

Gatekeepers? Auditors’ and Lawyers’ Liability -for Clients’ Misconduct” (2007) 27 International Review of Lawand Economics 96.

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firms in order to evaluate the level of financial risk.303

Empirical evidence has shown that because it

is not always easy for auditors to screen the quality of their clients, auditors rely on proxy factors

such as the corporate governance of the firm in deciding whether the audit may be complex and

hence the level of audit fees to charge.304

Empirical research by Ganuza and Gomez also shows that

it is difficult for courts and regulators to discern if gatekeepers have actually discharged diligence in

monitoring for wrongdoing or excessive risk. Gatekeepers could adduce evidence of processes and

data trails to insist that they have taken all care and it is difficult to prove otherwise.305

In such

circumstances, what is the level of public good that can be expected to be delivered by audit?

I have elsewhere argued that in a model of delegated regulatory administration, agency problems

may entail.306

Coffee and others have argued that the public interest aspect of the audit has been

lost on the auditing profession as manifested in the Enron saga. Auditors have used the auditing

opportunities as channels for non-audit business and have commodified the audit.307

Hence, there is

a role for regulators to define the social good sought to be achieved in the audit process. Power

argues that regulators should not necessarily accept the gatekeeper’s verdict as the final say.308

This

would be tantamount to forgoing any supervisory oversight upon delegation. The agency problem

could be addressed by radically subjecting the profession to account to a regulatory agency, as is the

case in the US with the Public Accounting Standards Oversight Board. In the EU, perhaps regulators

could engage with professional bodies, in defining or fostering the standards309

of accountability for

audits, besides the profession’s general adherence to professional and technical standards.

In relation to lawyers, Parker suggests that where lawyers take on the role of “compliance

institution” in firms, especially in financial services firms, this role is different from being an in-house

counsel or legal advisor. The compliance institution is established by regulation310

and hence the role

of such an outfit is defined in accordance with regulatory objectives and can be fashioned to achieve

303Humphrey, Loft and Woods (2009), op cit.

304El’fred Boo and Divesh Sharma, “Effect of Regulatory Oversight on the Association Between Internal

Governance Characteristics and Audit Fees” (2008) 48 Accounting and Finance 51.

305Juan Jose Ganuza and Fernando Gomez, “Should We Trust the Gatekeepers? Auditors’ and Lawyers’ Liability

-for Clients’ Misconduct” (2007) 27 International Review of Law and Economics 96; John C. Coffee Jnr.,

“Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms” (2004) 84 Boston University

Law Rev 301; Frank Partnoy, “Strict Liability for Gatekeepers: A Reply to Professor Coffee” (2004) 84 Boston

University Law Rev 365, both championing strict liability for auditors.306

For example, see Iris H-Y Chiu “Delegated Regulatory Administration in EU Securities Regulation” (2007) 40

International Lawyer 737.

307John C.Coffee Jnr, “Understanding Enron: "It's About the Gatekeepers, Stupid" (2002) 57 Business Lawyer

1403, Gatekeepers (2006), op cit; Gary Fooks, “Auditors and the Permissive Society: Market Failure,

Globalisation and Financial Regulation in the US” (2003) 5 Risk Management 17.

308Ch6, The Audit Society (1999), op cit.

309Ganuza and Gomez, “Should we Trust the Gatekeepers?” (2007), op cit.

310Article 6, MiFID Commission Directive.

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public good.311

The compliance professional may thus be regarded as a delegate in monitoring

compliance and wrong-doing, supplying the governance envisaged in the smart regulation model.

However, although the compliance function envisaged in the MiFID312

is to be independent, it is

framed as an outfit to support senior management, not as intelligence provider to regulators. This

issue will be addressed in detail under “Meta-regulation” shortly, as to the potential of compliance

units to act as internal monitors in the regulatory space.

The US Sarbanes-Oxley Act 2002 has moved towards enrolling auditors and lawyers as gatekeepers

by subjecting them to regulatory oversight in place of self-regulatory discipline by professional

bodies. Lawyers are required to report up the ladder to audit committees of companies if

wrongdoing is suspected.313

These legal duties compel gatekeepers to provide governance over

issuers. As a result, empirical evidence shows that the Big 4 audit firms tend to decline riskier

business so that the gatekeepers with the most capacity avoid having to encounter governance

challenges of detecting wrongdoing or fraud.314

Hence, gatekeepers may shy away from a

governance role if the threat of regulatory liability looms. It is proposed that although the audit and

compliance markets have arisen due to regulatory requirements and hence they could be regarded

as delegated forms of governance, the harnessing of governance potential by auditors and lawyers

needs to be more fully developed. Regulators need to engage with professional bodies, developing

common understandings and standards in achieving public goods, instead of a model of delegated

governance supported only by penalties. O’Connor also suggests that stakeholder involvement

should be enrolled in order to monitor auditors in achieving the social good of the audit. In

particular, shareholders may be given the right to appoint and remove auditors and determine the

remit of the audit.315

Regulators have a continuing role to engage with and monitor their delegate gatekeepers, but it is

submitted that such monitoring should not be based on a system of strict liability as this may in fact

chill gatekeepers from taking on the governance role. The relational paradigm between regulators

311Christine Parker, “The Ethics of Advising on Regulatory Compliance: Autonomy or Independence?” (2000)

28 Journal of Business Ethics 339, arguing that the independence of such outfits is key to enhancing the

embrace of ethical values and social good.

312Art 8, MiFID Commission Directive.

313Sections 101-108, 202-203, 206 and 307. Also see Larry Cata Backer, “The Duty to Monitor: Emerging

Obligations of Outside Lawyers and Auditors to Detect and Report Corporate Wrongdoing Beyond the Federal

Securities Laws” (2003) 77 St John’s Law Rev 919; Karl A.Groskaufmanis, “Climbing "Up the Ladder": Corporate

Counsel and the SEC's Reporting Requirement for Lawyers” (2004) 89 Cornell Law Rev 511.

314Jason Schloetzer, “Arthur Andersen, SOX Section 404 and Auditor Turnover: Theory and Evidence” (2006) at


315

Sean M O’Connor, “Strengthening Auditor Independence by Reducing the Need for It: Reestablishing Auditsas Control and Premium Signaling Mechanisms” (2006) 81 Washington Law Review 525.

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and gatekeepers is arguably a continuous learning process so that gatekeepers’ market and business

roles and their governance roles may co-evolve.316

Soft Law

In this section, I will examine the nature and efficacy of soft law as external standards that mayprovide governance but are not legally binding. Soft law has become increasingly important not only

in international financial governance but in global governance generally.317

Soft law represents a

range of measures, instruments and standards that may not have the attributes of traditional law

made under the auspices of a state, and in Abbott and Snidal’s conceptualisation, is “soft” as it lacks

one or more of the characteristics of hard law. Hard law obligations are defined as obligations which

have been fashioned with precision and whose interpretation and adjudication is delegated to a

third party, using defined processes.318

However Meyer does not strictly agree with Abbott and

Snidal’s conceptualisation of soft law and prefers to view soft law as distinguished from mere policy

or politics as it intends to secure a binding effect although there is more flexibility in dealing with

deviations. Soft law is different from hard law as it essentially accommodates negotiation, especially

at an international level, as well as modification and evolution.319

Soft law is an essential feature of the decentered realities of the regulatory space. The location of

power, expertise, capacity and influence in different entities within the “regulatory space” means

that much policy making would occur through the processes of negotiation and dialogue.320

This is

especially augmented at the international level where policy-making is increasingly eclipsing merely

domestic regulatory solutions in the financial services landscape.321

As domestic regulatory solutions

could be undermined by regulatory arbitrage in this age of easy migration of economic and financial

activities, policy makers recognise the importance of engaging in negotiation, dialogue and


(2009) 31 Law and Policy 192. John Braithwaite also considers dialogue, information exchange and learning to

be key to the regulatory capitalism of today, see Braithwaite, Regulatory Capitalism (2008), op cit at 59.

317Christine Chinkin, “The Challenge of Soft law”(1989) 38 ICLQ 850; F Snyder, “Global Economic Networks and

Global Legal Pluralism” EUI Working Paper No. 99/6 (Florence: European University Institute, 1999).

318Kenneth W Abbott and Duncan Snidal, “Hard and Soft law in International Governance” (2000) 54

International Organisation 421.

319Timothy Meyer, “Soft Law as Delegation” (2009) 32 Fordham International Law Journal 888.


(2009) 31 Law and Policy 192; Sol Piccioto and Jason Haines, “Regulating International Financial

Markets”(1999) 26 Journal of Law and Society 351.

321Mario Giovanoli, “Reflections on International Financial Standards as Soft Law” (Essays in International

Financial & Economic Law ; No. 37, London : London Institute of International Banking, Finance and

Development 2002); Caroline S Bradley, “Private International Law Making for the Financial Markets” (2005)

29 Fordham International Law Journal 127; Kern Alexander, “Global Financial Standard Setting the G10Committees and International Economic Law” (2009) 34 Brooklyn International Law Journal 861.

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coordination on an international level.322

Soft law offers a platform for such engagement to take

place as it represents any commitment made to policies or decisions as being reflexive,323

although

the workability of such solutions could become convincing and legalised in states.324

Soft law is

undeniably important in the present landscape of international financial regulation, but a few key

challenges remain.

As argued earlier, the two dominant locations of influence in the decentred regulatory space of

financial services are regulatory agencies and the industry. The industry wields great power in

influencing the soft law outcomes. This is especially so where the industry has technocratic expertise

and form epistemic communities325

to take leadership in the framing of standards and soft law

governing themselves.326

Technocratic actors have been especially successful in standard and policy

setting. Zaring327

and Redak comment328

that international networks such as the Basel Committee is

based on a high respect for technocracy and is therefore very successful in taking leadership over

establishing the standards of international prudential regulation. Tsingou also comments on how the

OTC derivatives industry has made a case for self-regulation for a long time by producing

322Apostolos Gkoutzinis, “How Far is Basel from Geneva? International Regulatory Convergence and the

Elimination of Barriers to International Financial Integration” (2005) at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=699781; also see Chris Brummer, “Post American

Securities Regulation” (2010) California Law Review, forthcoming at http://ssrn.com/abstract=1441508,

arguing that networks have become attractive for both coordination, convergence and systemic risk issues.

323Andrew T Guzman and Timothy L Meyer, “Explaining Soft Law” (2009) at

http://ssrn.com/abstract=1353444; Walter Mattli and Tim Büthe, “Setting International Standards:

Technological Rationality or Primacy of Power” (2003) 56 World Politics 1 arguing that soft law allows states to

balance the needs of international coordination to find optimal solutions as well as to behave in a realist

manner to achieve the maximisation of the state’s own interest.

324Timothy Meyer, “Soft Law as Delegation” (2009) 32 Fordham International Law Journal 888; Gralf-Peter

Calliess & Moritz Renner, “From Soft Law to Hard Core: The Juridification of Global Governance” (2006) at

http://ssrn.com/abstract=1030526; Douglas Arner and Michael Taylor, “The Global Financial Crisis and the

Financial Stability Board: Hardening the Soft Law of International Financial Regulation?” (2009), Asian Institute

of International Financial Law Working Paper, University of Hong Kong; Roberta S Karmel and Claire R Kelly,

“The Hardening of Soft Law in Securities Regulation” (2009) 34 Brooklyn Journal of Inernational Law 883.

325Tony Porter, “The Significance of Changes in Private-Sector Associational Activity in Global Finance for the

Problem of Inclusion and Exclusion” in Peter Mooschlechner, Helene Schuberth and Beat Weber eds, The

Political Economy of Financial Market Regulation (Cheltenham: Edward Elgar 2006) at 89.

326Caroline S Bradley, “Private International Law Making for the Financial Markets” (2005) 29 Fordham

International Law Journal 127; Edward J Kane, “Connecting National Safety Nets: The Dialectics of the Basel II

Contracting Process” (2007) 35 Atlanta Economic Journal 399; David Zaring, “Three Challenges for Regulatory

Networks” (2009) 43 International Lawyer 211; Jost Delbruck, “Prospects for a World Internal Law? Legal

Developments for a Changing International System” (2002) 9 Indiana Journal of Global Studies 401,

327David Zaring, “Three Challenges for Regulatory Networks” (2009) 43 International Lawyer 211.

328

Vanessa Redak, “Risks, Ratings and Regulation: Towards a Reorganization of Credit via Basel II?” inMooschlechner et al eds, The Political Economy (2006), op cit at 208.

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technocratic blueprints for self-regulation although policy-makers are now concerned about the size

of the market and the social risks of losses and fallouts from the market.329

Zaring however sees

IOSCO (the International Organisation of Securities Commissions) as relatively weaker in influence in

the setting of international standards as it is a network of state regulators and argues that the IOSCO

is too concerned with political considerations and diplomatic niceties, and hence it has not been that

effective in leading international standard setting.330

An example would be the lack of enthusiastic

acceptance or legalistion of IOSCO’s Code of Fundamental Practices for Credit Rating Agencies issued

in 2004, which has only now become a useful benchmark in the EU Regulation for credit rating

agencies. In terms of industry-led technocratic networks, the International Accounting Standards

Board, a network representing the industry has become very successful in taking leadership over

technocratic standard setting, not to mention other industry-led international networks such as the

International Chamber of Commerce which has led in producing standards such as the ICC

Arbitration Rules and the Uniform Customs and Practice for Documentary Credits, and the

International Capital Markets Association which has issued a definitive set of rules dealing with

Eurobonds.

The decentreed locations of influence in the regulatory space are not equal in power. Much

deference is given to technocratic expertise and such expertise is often regarded as legitimate in

leading international standard setting.331

This may be the reason why there has been extensive

acceptance332

by states of the prudential regulation established in Basel II Capital Accord, albeit

giving elite banks much autonomy in managing their own risks,333

such autonomy now questioned

and compelled to be limited after the onset of the global financial crisis.334

Although many

329Eleni Tsingou, “The Governance of OTC Derivatives Markets” in Peter Mooschlechner, Helene Schuberth

and Beat Weber eds, The Political Economy of Financial Market Regulation (Cheltenham: Edward Elgar 2006)

at 168, 184.

330Zaring, “Three Challenges” (2009), above, arguing that IOSCO has only established a few sets of standards

such as prospectus requirements for cross-border listings, but the influence of IOSCO is not as great as the

Basel Committee for example.

331Dieter Kerwer, “Rules that Many Use: Standards and Global Regulation” (2005) 18 Governance 611, arguing

that although technocratic expertise is a strong indication of legitimacy in influence and the exercise of power,

the standards set are often done in an opaque and non-inclusive manner, and there is no thought given as to

how the standards may be enforced. See also Walter Mattli and Tim Büthe, “Global Private Governance:

Lessons from a National Model of Setting Standards in Accounting” (2004-5) 68 Law and Contemporary

Problems 225.

332John C Pattison, “International Financial Cooperation and the Number of Adherents: The Basel Committee

and Capital Regulation” (2006) 17 Open Economies Rev 433.

333Joseph J Norton, “A Perceived Trend in Modern International Financial Regulation- A Reliance on a Public-

Private Partnership” (2003) 37 International Lawyer 43.

334FSA, The Turner Review: A Regulatory Response to the Global Banking Crisis (March 2009); FSA Policy

Statement on Strengthening Liquidity Standards, at http://www.fsa.gov.uk/pubs/policy/ps09_16.pdf ; Basel

Committee, “Comprehensive Response to the Global Banking Crisis” (7 Sep 2009) athttp://www.bis.org/press/p090907.htm.

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technocratic standards appear credible and enjoy widespread support, there is a risk that

technocratic centres of influence may be disproportionately powerful in the regulatory space. An

issue that needs to be addressed is that the regulatory space may have become too inclusive of

technocratic experts and industry interests, and exclusive of stakeholder participation to bring to the

table concerns of a more social or redistributive nature.335

The dominance of the industry has led to

the type of unaccountable outsourcing of governance discussed earlier in relation to credit rating

agencies. This may be largely attributable to a form of “technocratic capture” of regulators by the

industry, regulators relying on the industry’s governance as legitimated by superior levels of

technical expertise.

It has been argued that labour and consumer representation in the Basel II process are non-

existent.336

Fransen and Kolks call for greater access and participation to be available to stakeholder

networks so that stakeholder networks could be put in a position to monitor standard setting at the

international level.337

Seidl describes international standard setting in soft law as a platform of

“observeability”, a platform that allows many interested entities to observe the dynamics of other

entities, and to move in to fill in gaps or create gaps as the dynamics unfolds.338

However, the

dynamics of these entities depend largely on their bargaining power, rights of access, participation

and critical scrutiny. Decentred locations of influence may behave as self-interested entities in a

game, focussing on the appropriation of power, or entities may take a neoliberalist view that

cooperation and coordination would secure optimal results.339

Perhaps in reality both sets of driving

forces exist to shape the dynamics amongst decentred locations of influence in the regulatory

space.340

Turnbull is of the view that it is necessary to empower the different centres of influence in

the regulatory space so that all entities can check and monitor each other and can communicate and

335Peter Mooschlechner, Helene Schuberth and Beat Weber , “Financial Market Regulation and the Dynamics

of Inclusion and Exclusion” in the same authors eds, The Political Economy of Financial Market Regulation

(Cheltenham: Edward Elgar 2006) at xii.

336Vanessa Redak, “Risks, Ratings and Regulation: Towards a Reorganization of Credit via Basel II?” in

Mooschlechner et al eds, The Political Economy (2006), op cit at 208.

337Luc W Fransen and Ans Kolk, “Global Rule-Setting for Business: A Critical Analysis of Multi-Stakeholder

Standards” (2007) 14 Organisation 667.

338David Seidl, “Standard Setting and Following in Corporate Governance: An Observation- Theoretical Study

of the Effectiveness of Governance Codes” (2007) 14 Organisation 705.

339A succinct discussion of the theories of cooperation and opposition in international relations is found in

Linda Cornett and James A Caparaso, “And Still It Moves! State Interests and Social Forces in the European

Community” in J Rosenau (ed), Governance Without Government (Cambridge: Cambridge University Press

1992, rep 2000) at 219.

340Susanne Lütz, “Political Economy Approach to Financial Reform” in Peter Mooschlechner, Helene Schuberth

and Beat Weber eds, The Political Economy of Financial Market Regulation (Cheltenham: Edward Elgar 2006)

at 34, arguing that political relations and concerns drive regulatory reform, and regulatory reform is not merelypremised on economic and rational analyses.

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negotiate on an even level in order to generate decision-making that fully takes into account of the

complexities and needs of the regulatory space.341

Stakeholder access and participation may also enhance the quality and process of problem

solving.342

In this respect, this paper submits that it is important to empower diverse representation,

such as stakeholder representation in the decentred regulatory space at the international level so

that standard setting and the development of soft law at the international level may be carried out

under more critical scrutiny and in an environment allowing for more meaningful participation,

approximating a more democratic framework. Many technocratic standards issued at the

international level have become legalised in states, such as the Basel Capital II Accord standards and

the International Accounting Standards, both adopted as law in the EU. However, commentators

warn that the legalisation of these standards may mean a wholesale endorsement of technocratic or

elite governance without requiring the same level of accountability that would be required of

governments and state bodies.343

Government representation and stakeholder representation

should be given at least observer status in industry-led international networks which produce soft

law. Perhaps the Basel Committee should also be subject to some scrutiny outside of the narrow

circle of central bankers that constitute its membership. It is noted that in January 2009 the IASB has

voluntarily subjected itself to a Monitoring Board consisting of IOSCO and the US Securities Exchange

Commission.

The above has discussed the key challenge of expanding the relational paradigm between regulators

and industry to include more diverse participation by stakeholders. This may improve the input

aspect of standard setting and the quality of the standards themselves at the international level. The

next key challenge for soft law is the output aspect- how the standards are used and applied, and

the efficacy of the standards. Standards such as Corporate Governance codes, are subject to a

comply or explain regime and not formally legalised. There are some commonly accepted reasons

for adopting a comply-or-explain regime for various pieces of soft law.344

The voluntary nature of the

standards may make them adaptable to specific needs, and avoids burdensome prescription for

corporations. Further, the soft law status of the standards may mean that amendments to these

standards can be made quickly and easily to reflect the changing times and needs. The comply or

explain regime is also intended to provide a testing ground for how standards may work in practice.

These benefits of the reflexive nature of the comply-or-explain regime may be harnessed if the

market is able to evaluate the application of these standards. If the voluntary nature of the

341 Shaan Turnbull, “Governing the Management of Complexity” (2003), paper presented at 19th EGOS

Colloquium, European Group for Organisational Studies, Copenhagen;

342Daniel Durrant, “Burying Globally, Acting Locally: Control and Co-Option In Nuclear Waste Management”

(2007) 34 Science and Public Policy 515 on an example of how stakeholder competition, co-option,

communication and coalition can provide solutions to nuclear waste management.

343Walter Mattli and Tim Büthe, “Global Private Governance: Lessons from a National Model of Setting

Standards in Accounting” (2004-5) 68 Law and Contemporary Problems 225.

344Antoine Faure-Grimaud, Sridhar Arcot and Valentina Bruno, “Corporate Governance in the UK: Is the

Comply or Explain Approach Working?” (2005) at“http://eprints.lse.ac.uk/24673/1/dp581_Corporate_Governance_at_LSE_001.pdf.

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standards results in shirking, or the lack of market discipline, then the comply-or-explain regime may

only serve to expose and perpetuate a market failure.

The comply-or-explain regime faces two key problems. One is market failure, ie shirking by the

industry to which the standards are meant to apply, and that the shirking is not addressed by market

discipline; and secondly, the issue of whether comply-or-explain is appropriate if the application of

the standards is meant to deliver a public good.

In terms of market failure, empirical evidence shows that shirking is rather prevalent. For example,

Andres and Thiessen surveyed German corporations subject to the comply-or-explain regime in

respect of the Corporate Governance code and found that firms may comply more or less depending

on their financial performance and explanations are hardly given for non-compliance as firms prefer

to fall outside of the radar.345

Faure-Grimaud et al also found that in the UK, where a comply-or-

explain regime applies to the Combined Code of Corporate Governance, non-compliant firms are

appalling in their explanations for deviation if explanations are given at all, although the rate of

compliance has increased over the years.346 Have shareholders exerted any market discipline? The

Report of the Cadbury Committee347

in 1992 stated that:

Shareholders have delegated many of their responsibilities as owners to the directors who

act as their stewards. It is for the shareholders to call the directors to book if they appear to be

failing in their stewardship and they should use this power. While they cannot be involved in the

direction and management of their company, they can insist on a high standard of corporate

governance and good governance. (at para 6.6, Cadbury Report)

The market discipline from shareholders has been arguably slow and not quite effective. Market

discipline could exist in the form of exit, ie where shareholders sell shares in response to poorgovernance and hence the price of company shares may provide an indication of market discipline.

MacNeil and Li, in surveying the market response in the form of share price changes to non-

compliance with the UK Combined Code of Corporate Governance, reports that market participants

and shareholders do not exert any market discipline on firms that do not comply or explain

adequately.348

This may be due to a lack of conviction that corporate governance affects investment

value at least in the short term349

although the evidence of correlation seems stronger in the

345Christian Andres and Erik Thiessen, “Setting a Fox to Keep the Geese — Does the Comply-or-Explain

Principle Work?” (2008) 14 Journal of Corporate Finance 289. See also John G Parkinson and Gamble Kelly,

“The Combined Code on Corporate Governance” (1999) The Political Quarterly 101.

346Faure-Grimaud et al (2005), op cit.

347Adrian Cadbury, Financial Aspects of Corporate Governance (1992).

348Ian MacNeil and Xiao Li, ““Comply or Explain”: market discipline and non-compliance with the Combined

Code” (2006) 14 Corporate Governance 286.

349Lucian Bebchuk, Alma Cohen and Allen Ferrell, “What Matters in Corporate Governance?” (2009) 22 Review

of Financial Studies 783; Sridhar R. Arcot & Valentina G. Bruno, “One Size Does Not Fit After All: Evidence from

Corporate Governance” (2006) (unpublished manuscript), available at http://ssrn.com/abstract=887947; N. K.

Chidambaran et al., Corporate Governance and Firm Performance: Evidence from Large Governance Changes

(2008) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108497.

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medium to long term.350

This uncertainty in perceiving the value of adherence to corporate

governance codes may account for the weak market discipline in “enforcing” the codes. Market

discipline can also exist in the form of “voice” ie by engagement or voting in order to make

shareholder views on poor governance known to the company. Institutional shareholders are

assisted by the proxy voting industry in making voting decisions and have engaged in some

activism.351

However, it remains to be seen if such engagement is effective in “spirit” and not merely

a box-ticking and narrow-minded application of the Combined Code.

I have argued elsewhere that there is insistent policy leadership in the UK calling upon institutional

shareholders to ask management to account and to ensure that sound governance is in place.352

This

arguably goes beyond exhorting institutional shareholders to exert market discipline. If the

Combined Code is a platform upon which market practices and discipline should develop, then it

should be shaped by market forces, including the lukewarm market reactions documented in

empirical research mentioned above. It is arguable that policy-makers do not see the comply-or-

explain regime for best practices in corporate governance in the UK as merely a platform for the

market to shape its wishes. There is arguably an aspect of a desirable social good or public good that

may be delivered from compliance with the Code. For example, empirical evidence suggests that

sound corporate governance may be key to averting corporate disasters and losses in shareholder

value. A number of commentators suggest, albeit with hindsight, that corporate disasters such as

Enron and Royal Ahold could have been averted if better corporate governance were earlier in

place.353

Although such ex post analyses do not positively prove that sound corporate governance

would likely contribute to corporate survival, these studies contribute towards the perspective that

sound corporate governance could be advocated for the possible prevention of corporate disasters,

which not only lead to losses in shareholder value but also social losses for stakeholders such as

employees, suppliers and the wider community. Further, in the recent global financial crisis, manypolicy-makers view remuneration structures in firms that encourage excessive risk taking in

350Mariano Selvaggi and James Upton, Governance and Performance in Corporate Britain: Evidence from the

IVIS Colour-coding System (ABI Research Paper 7, 2008). Earlier empirical evidence applicable to other

countries may be found in Carlos Alves and Victor Mendes, “Corporate Governance Policy and Company

Performance: The Portuguese Case”(2004) 12(3) Corporate Governance 290; Carol Padgett and Ammana

Shabir, “The UK Code of Corporate Governance: Link between Compliance and Performance” (ICMA Centre

Discussion Paper 2005). For the correlation between investment value in the short term and corporate

governance improvements, see David F Larcker, Scott A Richardson and Irem Tuna, “How Important is

Corporate Governance” (Wharton Working Paper, May 2005).

351Institutional investors face policy exhortation to take ownership seriously, but many actions in engagement

may be superficial and overly based on the letter of the Code. See ch2, Iris H-Y Chiu, The Foundations and

Anatomy of Shareholder Activism (Oxford: Hart, forthcoming).

352Ch2, Iris H-Y Chiu, The Foundations and Anatomy of Shareholder Activism (Oxford: Hart forthcoming).

353Abe De Jong, Douglas V De Jong, Peter Roosenboom and Gerard Mertens, “Royal Ahold: A Failure of

Corporate Governance” (Feb 2005) at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=663504; Robert

Rosen, “Risk Management and Corporate Governance: The Case of Enron” (2003) 35 University of ConnecticutLaw Review 1157.

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investment activities to be important in contributing to bank failure and systemic risk.354

However,

on the other hand, it can be argued that preventing the occasional social loss from bad apples does

not necessarily mean the governance structure of every corporation should now be subject to

accountability to the public or community at large.

Certain limited corporate governance issues such as remuneration policies at banks may be issues of

public interest, as failed governance may result in externalities of a scale that exceed those from

corporate collapses in other industries.355

This is now increasingly being accepted by policy-makers.

For example, the French government has tightened bonuses that could be paid to bank executives

where the bank is receiving government support,356

and the UK Financial Services Authority has

published A Code of Remuneration Practices for banks and financial institutions.357

However,

corporate governance straddles the internal-external and public-private paradigms. It is on the one

hand concerned with internal policies, culture, risk management and accountability to shareholders,

but on the other hand, failures of governance may contribute to corporate failures having wide

social effects.358

If corporate governance or aspects of it may be public goods, then the comply-or-explain regime is

arguably inappropriate and inadequate to ensure the supply of the public good. This is because

“comply-or-explain” does not represent to companies that public good is relevant to its corporate

governance arrangements. The relational paradigm in a comply-or-explain regime is between the

company and its shareholders. “Comply-or-explain” may favour individualised approaches as long as

they can be well explained and accountability is prima facie to shareholders. But if the adherence to

the Combined Code is intended to deliver a public good that entails from well-governed companies,

then “comply-or-explain” should be accountable to the regulator as well. But if the quality of

explanations is not monitored and there is no prescription as to the quality of explanations, then

there is no mechanism to oversee that alternative supplies of corporate governance by deviating

firms will maintain the level of public good. This would mean that some firms for some reason can

opt not to supply the public good, or affect the overall level of supply of the public good. Comply-or-

354Turner Review (2009), op cit, M Brunnermeier, A Crockett, C Goodhart, A.D. Persaud and Hyun Shin, “The

Fundamental Principles of Financial Regulation”, Geneva Reports on the World Economy (2009); Jacques de

Larosière, Report from the High Level Group on Financial Supervision in the EU (25 Feb 2009) at

http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf .

355Ch7, Second Banking Supervision and Regulation Report , Economic Affairs Committee, House of Lords (19

May 2009); Marco Becht, “Corporate Governance and the Credit Crisis, Financial Regulation and

Macroeconomic Stability – Key issues for the G20” (2009) Centre for Economic Policy Research; Lucian A

Bebchuk and Jesse M Fried, “Pay Without Performance: An Overview of the Issues” (2005) 30 Journal of

Corporation Law 647.

London, 31 January 2009

356“Sarkozy Tightens Bank Bonus Rules”, The Financial Times (25 May 2009).

357March 2009, at http://www.fsa.gov.uk/pubs/other/remuneration.pdf.

358

Lutgart Van den Berghe, “To What Extent is the Financial Crisis a Governance Crisis? From Diagnosis toPossible Remedies” (2009) at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1410455.

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explain arguably entails an ambivalent character that is not ideal in making it unequivocal if a public

good is sought to be delivered.

However, it remains an open question as to whether corporate governance or aspects of which

would deliver any public good. The Walker Review of Corporate Governance in UK Banks359

states

that

“There is nonetheless an important concentricity between public policy objectives and the interests

of shareholders. This relates respectively to the “downside” protection of shareholders as a

responsibility of their boards and, in the case of the financial regulator, the central bank and the

Treasury, their attentiveness to the public interest more widely, including the potentially unlimited

liability of taxpayers.”

This articulation of the social importance of corporate governance may underlie the approach in the

Walker Review as inching closer to regarding more aspects of corporate governance as capable of

delivering public goods. However, there is still a difficult balance and the Walker Review is unwillingto depart from the comply-or-explain regime of the Code which premises accountability primarily to

shareholders. The Review however expects that the quality of explanations should be improved and

that shareholders should engage actively in monitoring the comply-or-explain regime.360

The co-

option of shareholders, particularly institutional shareholders in the regulatory space has been

persistent in policy.361

This is in nature a form of delegated governance towards public/social good if

the link is made between corporate governance and public good. Walker has argued that the limited

liability of shareholders is a privilege whose social legitimacy also depends on the exercise of

stewardship by shareholders.362

Hence, it now seems that accountability will now be asked of

shareholders to show how they have managed the accountability of their investee companies. Are

shareholders now delegated with the governance of ensuring that the public good of sound

corporate governance is delivered? Even if they are, to whom are they accountable? Would it be the

accountability of the investment manager to the engaging pension fund, or the accountability of the

pension fund to its diffuse beneficiaries? Who would be able to judge the measure of public good in

shareholder activism for sound corporate governance?

In respect of one particular issue, that of bankers’ remuneration, the Walker review however

proposes that bankers’ remuneration issues be legislated.363

The FSA Code of Remuneration

Practices has also taken a first step to address this issue, defining the remuneration structures of

financial institutions as affecting public interest since social losses following from financial institution

failure may be massive. These steps arguably move us toward accepting that remuneration

structures in financial institutions affect the level of public good, and hence increased regulatory

359Final report (26 Nov 2009), at para 1.5.

360Para 5.7.

361As discussed in Iris H-Y Chiu, The Foundations and Anatomy of Shareholder Activism (Hart 2010,

forthcoming).

362Para 5.7, Walker Review Final Report.

363Para 7.17.

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ownership over this aspect of corporate governance may be developed. The FSA is further bolstered

by enforcement powers to intervene and invalidate remuneration clauses in banks’ transactions that

may pose excessive risk.364

Signs and signals relating to the growing public nature of corporate governance may ultimately mean

that certain comply-or-explain structures may have to give way to meta-regulatory structures where

accountability to the regulator would be directly established (although the difficulties in this

approach will be detailed shortly).

Meta-Regulation and the “Audit” Model

In this part, discussion will be made as to the two models represented as “Meta-regulation” and

“audit”. Meta-regulation is firm-centric in nature as it is a regulatory approach that levers on firm

capacity and resources to provide permeability and accountability to external stakeholders and to

meet the requirements of “compliance”.365

In financial regulation, this approach is seen in the

MiFID

366

and FSA’s SYSC Handbook

367

in dealing with the risk management of financial institutionsincluding instituting internal audit and independent compliance functions. As for the “audit” aspect,

this is defined widely as including any evaluative or monitoring process undertaken by a third party

to assist the regulator,368

such as the delegated governance to auditors discussed earlier. This

Section will suggest how the audit model can assist regulators in meta-regulation.

Risk management has always been part of corporate management anyway, and hence, how would

the meta-regulation of risk management in financial institutions differ from self-regulation by firms?

The risk management of firms in general depends very much on the needs of particular firms, for

example in order to reduce the cost of capital.369

The approach to risk management and even

Enterprise-wide Risk Management (thereafter “ERM”) is documented in practice to be very muchbased on the particular needs of each business, or even each business line in a firm.

370Hence, risk

management by a firm has always been self-regulatory in nature as rooted in a firm’s own incentives

to survive and succeed. Meta-regulation of firms’ risk management should therefore be

distinguished from self-regulation by firms, or otherwise it would be devoid of meaning. As Parker

has earlier mentioned, meta-regulation is for achieving a wider purpose of accountability to external

364“FSA Given Extra Clout to Punish City Crime”, The Financial Times (16 Nov 2009).

365Parker, The Open Corporation (2000), op cit.

366 Arts 6 and 7, MiFID Commission Directive.

367FSA Handbook SYSC 3.1, 6.1 and 7.1.

368Power, The Audit Society (1999), op cit.

369André P Liebenberg and Robert E Hoyt, “The Determinants of Enterprise Risk Management: Evidence from

the Appointment of Chief Risk Officers” (2003) 6 Risk Management and Insurance Review 37; Tom Aabo, “The

Rise and Evolution of the Chief Risk Officer- Enterprise Risk Management at HydroOne” (2005) 17 Journal of

Applied Corporate Finance 62.

370

Brian W Nocco and Rene M Stultz, “Enterprise Risk Management: Theory and Practice” (2006) 18 Journal of Applied Corporate Finance 8.

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stakeholders, such accountability being in part manifested as compliance with legal rules. Hence,

regulators’ interest in the meta-regulation of risk management should be for the purpose of

achieving regulatory/public goods, such as requiring firms to take measures to mitigate systemic

type risks. As argued earlier, individual firms are not likely to take ownership of systemic risk and in

fact banks often have the tendency to behave in a manner that exacerbates systemic risk in the

name of individual risk management.371

Meta-regulation in the MiFID and the FSA’s SYSC Handbook is in the form of prescribing that firms

put in place adequate risk management policies and procedures to “identify, manage, monitor and

report” risks.372

Such policies, procedures and systems are dependent on the nature, scale and

complexity of the business, the diversity of its operations, the volume and size of its transactions and

the degree of risk associated with each area of operation.373

Some minimum standards prescribed in

the MiFID are that risks associated with confidentiality and storage of information and data, risks

associated with business continuity where electronic systems may malfunction, and risks associated

with financial data integrity such as accounting policies and procedures, must be managed. The FSA

SYSC Handbook provides a further list of areas where risk management must occur: delegation and

supervision systems between senior personnel and employees in the firm, the identification of

money laundering activities, legal compliance, corporate governance, the assessment of employee

suitability, remuneration policies.374

Banks, building societies and investment firms are further asked

to manage specific risks such as counterparty risk, market risk, interest rate risk, operational risk and

residual risk,375

liquidity risk376

and group risk.377

Risk management also includes regular periodic

reviews of the effectiveness and adequacy of the arrangements, policies, systems and procedures in

place.378

There is some discretion as to the design of the risk management systems and procedures in each

firm but both the MiFID and the FSA Handbook provide guidelines for the types of systems or

procedures that are desirable or optional: internal audit,379

corporate governance including

institution of an audit committee,380

independent risk assessment function,381

and incorporation of

371Viral V. Acharya, “A Theory of Systemic Risk and Design of Prudential Bank Regulation” (2009) 5 Journal of

Financial Stability 224; Schwarz, “Systemic Risk” (2008), op cit.

372Article 7, MiFID Commission Directive and SYSC 7.1.

373Art 5, MiFID Commission Directive, FSA SYSC 3.1.

374SYSC 3.2.

375SYSC 7.1.

376SYSC 11.

377SYSC 12.

378Art 5(5), MiFID Commission Directive, FSA SYSC 7.1.

379Art 8, MiFID Commission Directive, FSA Handbook SYSC 3.2.

380SYSC 3.2.15, 3.1.3.

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risk management into business strategy.382

However, an independent compliance function,383

the

accountability of senior management384

and systems for ensuring the suitability, honesty and

competence of employees385

are mandatory and must be put in place. There therefore seems to be a

minimal tier of prescribed risk processes and a second tier of optional risk processes depending on

the nature, size and complexity of the business. In the UK, the Walker Review is likely to add to the

mandatory list for listed banks and major insurers: the institution of a separate Risk Committee at

Board level and the institution of a Chief Risk Officer having independence and equivalent status

with senior management.386

The audit and compliance functions are accountable to senior

management,387

although the proposed Chief Risk Officer would have a direct line to the chairman of

the Board’s Risk Committee.

Regulators who adopt meta-regulation should arguably avoid relying solely on the internal

“gatekeepers” such as the internal audit, compliance or risk evaluation functions to discharge the

satisfactory evaluation of a firm’s risk management. The “internal regulatory space” is likely subject

to issues of organisational identity,388

conflict or collusion of goals and other incentives and cultures

that affect individual and departmental motivations.389

Spira and Page390

argue that internal risk

management involves a wide array of concerns and techniques, and hence, different departments in

a firm could develop pockets of power in relation to particular risk management issues and

techniques, and produce a competing environment in the “internal regulatory space”.391

Further, as

internal gatekeepers are intended to support senior management, it would be rather incompatible

with their organisational and legal role to see them as being accountable to regulators or the wider

community. Moreover, to frame their accountability outside of the organisation would require

regulators to first set standards as to their eligibility and qualifications so that they may be in a

position to have some independent expertise to make substantive evaluations of risk management

381SYSC 3.2.10.

382SYSC 3.2.17.

383Article 6, MiFID Commission Directive, FSA Handbook SYSC 6.

384Article 9, MiFID Commission Directive and SYSC 3.2.2-3.2.5, 3.2.11-3.2.12 support this by requiring effective

supervision and delegation systems, and reporting to senior management.

385Art 5(1), MiFID Commission Directive, SYSC 3.2.13-3.2.14.

386

Recommendations 23-27, Walker Review Final Report.387

Art 6, 8 and 9, MiFID, SYSC 6.1, 6.2.

388Such as Sargent, “Lawyers in the Moral Maze” (2004), op cit.

389James Weber and Julie E Seger, “Influences upon Organizational Ethical Subclimates: A Replication Study of

a Single Firm at Two Points in Time” (2002) 41 Journal of Business Ethics 69.

390Laura Spira and Michael Page, “Risk Management: The Reinvention of Internal Control and the Changing

Role of Internal Audit” (2003) 16 Accounting Auditing and Accountability Journal 640.

391

Supported by Stephen Ward, “Exploring the Role of the Corporate Risk Manager”(2001) 3 Risk Management7, arguing that the role of corporate risk management is highly susceptible to various interpretations.

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systems and processes. The compliance function for example, is arguably only concerned with legal

compliance.392

Although Parker argues that the compliance units of many firms see themselves not

merely as monitors of legal compliance but as auditors of the firm’s ethical and social responsibility

behaviour, there is potential but no mandate to develop the compliance function in firms to be an

independent auditing unit that goes beyond legal compliance.393

Firms designing the compliance

function could take the least costly and complex approach to its institution and structure.

As for the optional “internal audit” function, an internal audit department could provide substantive

evaluation of a firm’s processes and systems as envisaged in the MiFID and SYSC.394

The internal

audit function is currently framed to support Board evaluation of internal controls, systems and

processes under the Turnbull guidance.395

Hence, it is not required to be independent and is chiefly

responsible for reporting to the Board. Further, Spira and Page396

warn that if the internal audit

function is in fact outsourced, then the incentives of the “internal audit” may be skewed towards

value adding and maintaining continuity of business from the client instead of gatekeeping the

client.

The Chief Risk Officer proposed in the UK Walker Review is to be an independent function with

direct accountability to the Chairman of the Board’s Risk Committee. This function is intended to

have a more general overview of business strategy and risks and should focus on prudential

management of the listed bank’s risks. The Risk Committee supported by the Chief Risk Officer

would have to report annually in a separate document in the annual report, and hence these

internal gatekeepers may be perceived to have some form of accountability to shareholders.397

These proposals may supersede the FSA SYSC’s provision for an optional independent risk evaluation

function,398

although the latter may remain optional for smaller financial institutions where the

institution of the CRO may not apply. The “independent risk evaluation function” in SYSC again

defines such a function to assist the senior management, although it is meant to be independently

staffed and resourced. By and large, the range of internal gatekeepers as part of risk management,

are intended to enhance firm capacity and assist senior management. As internal gatekeepers are

392SYSC 6.1.

393Christine Parker, “The Ethics of Advising on Regulatory Compliance: Autonomy or Independence?” (2000)

28 Journal of Business Ethics 339.394

Art 8, MiFID, SYSC 6.2.

395Financial Reporting Council, Internal Control: Revised Guidance for Directors (2005); Dominic Elliott, Steve

Letza, Martina McGuinness, Clive Smallman, “Governance, Control and Operational Risk: The Turnbull Effect”

(2000) 2 Risk Management 47.

396Laura Spira and Michael Page, “Risk Management: The Reinvention of Internal Control and the Changing

Role of Internal Audit” (2003) 16 Accounting Auditing and Accountability Journal 640.

397Recommendations 23, 24, Walker Review Final Report.

398SYSC 3.2.10.

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not subject to a duty to report, whistleblow399

or otherwise be accountable to regulators, regulators

should be prepared to evaluate the performance of internal risk management functions rather than

to accept the discharge of these processes as sufficient to demonstrate sound risk management.

As meta-regulation levers on firms’ capacity and resources to deliver regulatory/public goods, the

firm should be co-opted in a proportionate manner to meet certain benchmarks for the delivery of

the regulatory/public goods. The challenge for regulators is to be able to define the public goods to

be delivered in the meta-regulatory process so that firms may not perceive meta-regulation as

allowing creative compliance that regulators cannot evaluate or as allowing firms to provide

evidence of compliance just by having a list of processes and policies in place- i.e. “ritualism”.400

The

FSA Handbook has identified a list of risks that banks, building societies and investment firms must

manage, and the Walker Review has specifically identified that risk management focuses on

prudential risk management.401

The identification of the particular risks that regulators are

concerned about has not been particularly evident in the MiFID and its supporting legislation. It is

arguably imperative that regulators need to identify the objectives and goals of the meta-regulatory

approach as this is what distinguishes meta-regulation as having a “regulatory” and not self-

regulatory effect. Regulators may also need to move away from identifying firm-specific risks which

are no different from the risk management a firm would carry out for itself anyway, to identifying

those risks that firms have to manage in order to add to regulatory/public good. In addition to

prudential risk management, perhaps risk to consumer loss, stakeholder risk and even social

responsibility risk402

could be added. Further, systemic risk beyond microscopic prudential risk could

also be identified as a specific regulatory goal in this meta-regulatory approach. Ideally this should

also be done at the EU level so that the meta-regulatory approaches may be consistent and do not

encourage regulatory arbitrage.

Meta-regulation should pertain to the identification of risks that need to be managed as a matter for

delivering regulatory/public goods beyond the risk management specific to the business, success or

survival of the firm. Firms should also understand that the risk management required of them under

the meta-regulatory approach goes beyond mere firm needs. Levy and Kaplan argue that “[t]he

embrace of corporate capacity has been fuelled by a growing concern at an international

“governance” deficit.... [d]espite the need for more global coordination, states have tended to

399 SYSC 18 specifically provides for protection from retaliation for any worker in a financial institution, if

whistleblowing is done with respect to risk management issues, SYSC 18 is of general application and does not

specifically relate to any connection between the regulator and internal gatekeepers nor does it impose a duty

on anyone to whistleblow.

400John Braithwaite, Regulatory Capitalism (Cheltenham: Edward Elgar 2008) at 140-156.

401Paras 6.5, 6.10, above.

402Beth Kytle and John Gerard Ruggie, “Corporate Social Responsibility as Risk Management- A Model for

Multinationals” (2005), Corporate Social Responsibility Initiative Working Paper No 10, John F Kennedy School

of Government, Harvard University, arguing that CSR risks and stakeholder risks are social losses uponmaterialisation.

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restrict their roles”.403

If the embrace of corporate capacity in meta-regulation becomes

unquestioning, then regulators may forget to assess the outcomes of meta-regulation. Firms are co-

opted in designing appropriate processes and systems for themselves and may be tempted to

provide the least costly systems in order to achieve “compliance”. This may not always be sufficient

to meet the needs of the regulatory/public goods.404

Further, what is “compliance”? Is it the

existence of processes and systems evidenced by the adequacy of thought addressed to them, or is

it an assessment by the regulator of substantive adequacy and the likelihood to achieve the

regulatory/public goods desired? Levy and Kaplan warn that delegation to private governance

focussing on the documentation of processes is likely to risk forgetting the assessment of

outcomes.405

The approach to the regulatory implementation of the Basel II Capital Accord has

shown that regulators have not satisfied themselves as to the sufficiency and effectiveness of

flexible prudential management by financial institutions. This would allow processes to become a

proxy for delivery of the public goods, and therefore an end in themselves to be achieved. Further,

the perception by firms that they would be evaluated based on the existence of processes rather

than by the performance of the processes would lead to incentives for least costly design andcosmetic institutions.

406

Meta-regulators should ideally engage in own evaluations of the performance of processes, but as

Coglianese and Kagan suggest, this requires knowledge and capacity building on the part of

regulators,407

and the more diverse the industry may be, the more challenging it would be for

regulators to identify what may be substantively adequate. The FSA, in line with the Financial

Stability Board’s recommendations have included stress-testing408

as part of firm risk management.

Such stress testing would be both carried out by the firm and regulator in selected firms. Where

stress-testing is internally managed, this is arguably another layer of meta-regulation. But where

regulator stress-testing may be carried out, there is potential for this to become evaluative of performance rather than of processes. However, the issue with meta-regulation is that it is not easy

for regulators to test and predict the performance of risk management under hypothetical

situations, and hence there may be a temptation to be captured by firm expertise.

It is suggested that regulators may enhance their capacity in knowledge and expertise in 2 ways.

Regulators may complement the meta-regulation model with an “audit” model of regulation, viz co-

403David Levy and Rami Kaplan, “Corporate Social Responsibility and the Theories of Global Governance” in

Andrew Crane et al eds, The Oxford Handbook of Social Responsibility (2009), op cit at 434.

404 Although Braithwaite argues that the regulators must ascertain that firm resources are sufficient to design

processes and systems to deliver the regulatory/public goods, see John Braithwaite, “Meta Risk Management

and Responsive Regulation for Tax System Integrity” (2003) 25 Law & Policy 1.

405Levy and Kaplan, “Corporate Social Responsibility” in Andrew Crane et al eds, The Oxford Handbook (2009),

op cit at 438.

406Cary Coglianese and Robert A Kagan, “Regulation and Regulatory Processes” (2007)

http://papers.ssrn.com/abstract=1297410.

407above.

408FSA, Stress and Scenario Testing PS20/09, Dec 2009.

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opting third party certifiers to engage in vetting, auditing and recommending on the adequacy of the

regulated firm’s designs and systems.409

Such third party certifiers could be private entities or

agencies involved in Board evaluation, remuneration solutions, and advisory services for risk

management and enterprise-wide risk management. Standards such as the balanced scorecard has

been developed for enhancing the effectiveness of Boards,410

and board evaluators could be in a

position to assess the adequacy of the balanced scorecard adopted by Boards and their

effectiveness. In the alternative, there are other standards recommended for board evaluation,

pertaining to the Board dynamics, teamwork, accountability, quality of decision-making and

leadership and visionary steering.411

Remuneration consultants are perhaps less reliable as their

methodologies are based on surveys in the peer group in similar industries and often act for an

executive appointee in contractual negotiations.412

However, the Walker Review has identified the

possibility that remuneration consultants could act as third party certifiers on the basis of their

voluntary submission to a Code of Best Practice.413

On risk management, especially enterprise risk

management, standards are being developed both in industry and academia in order to assess what

the benchmarks of appropriate systems and processes for firms may be.414

It is submitted that regulators can learn from third party certifiers, although co-opting them may be

a form of delegated governance, and regulators would need to address potential agency problems in

409Edward J Balleisen and Marc Eisner, “The Promise and Pitfalls of Co-Regulation: How Governments Can

Draw on Private Governance for Public Purpose” in David Moss and John Cisternino eds, New Perspectives in

Regulation (The Tobin Project 2009).

410See SR Kaplan and DP Norton, Translating Strategy into Action: The Balanced Scorecard (Boston: Harvard

University Press 1996) and recommendations from commentators to go beyond some of the items on thescorecard, eg Mohsen Souissi, “Going Beyond Compliance: The Role of the Balanced Scorecard” (2006) 17

Journal of Corporate Accounting and Finance 75. The balanced scorecard approach can be further modified to

include sustainability evaluation, see Graham Hubbard, “Measuring Organisational Performance: Beyond the

Triple Bottom Line” (2009) 18 Business Strategy and Environment 177.

411Geoffrey C Kiel and Gavin J Nicholson, “Evaluating Boards and Directors” (2005) 13 Corporate Governance

63.

412Eg http://www.independentremuneration.co.uk/independent-remuneration-solutions.html.

413Paras 7.53, 7.54, Walker Review Final Report.

414Sebastian Francis and Bob Paladino, “Enterprise Risk Management: A Best Practice Approach” (2008)

Journal of Corporate Accounting and Finance 19; Stephen Gates, “Incorporating Strategic Risk into Enterprise

Risk Management: A Survey of Current Corporate Practice” (2006) 18 Journal of Applied Corporate Finance 81

on how risk management may be systemically incorporated into business strategy; Bernard L Erven, “The Role

of Human Resource Management in Risk Management” (2003) at

http://agecon.uwyo.edu/riskmgt/humanrisk/TheRoleofHRMinRMpdf.pdf on processes and systems Human

Resources departments could put into place to address personnel related risks in the ERM framework. Egs of

specific application of procedures of systems especially in respect of human resource risk may be found in

Heinz Fischer and Klaus D Mittorp, “How HR Measures Support Risk Management: The Deutsche Bank” (2002)

41 Human Resource Management 477; Christopher Paul and Lars Mitlacher, “Expanding risk managementsystems: human resources and German banks” (2008) 17 Strategic Change 21.

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this “delegation” of governance.415

It has also been suggested earlier that the learning process for

regulators may be enhanced by allowing diverse stakeholder input into the regulatory policy process

in order to introduce alternative and critical views. Regulatory networks at the international level

could also facilitate and promote the development of open procedural and technical standards for

risk management.416

Meta-regulation is very much at the heart of the decentred landscape of governance, and there is

great potential albeit difficulties in navigating this complex landscape.417

Regulators need to

constantly review the achievements of the regulatory/public goods in this complex regulatory space

and ensure the accountability of the industry even if the industry has superior technical expertise .418

In this process, regulators and the industry may both be engaged in learning and experimentation of

technical and processual standards, and Greenstone refers to this as “persistent regulatory

experimentation”, allowing the governance process to become evolutionary through

experimentation, learning and review.419

For example, the FSA has recently enhanced its

prescriptions for managing liquidity risk,420

and personnel incentives risk stemming from

remuneration arrangements,421

although such changes were triggered by the global financial crisis.

The new liquidity requirements now encourage more recourse to be made to the Bank of England or

European Central Bank for liquidity turnover in order to reduce the stigma of approaching the lender

of last resort.422

This encourages constant internal review of the liquidity buffers and positions in a

bank, a form of meta-regulation, as well as co-opting the lender of last resort into transactional

scrutiny of the banks’ liquidity positions, a form of smart regulation.

415If third party audit becomes itself a ritual of comfort and not intended to uncover any discomfort, then

there is no ownership of the evaluation of regulatory outcomes, see Power, The Audit Society (1999), and

Braithwaite, Regulatory Capitalism (2009) at 140.

416The possibility of greater coordination and convergence in international networks notably government led

“clubs” such as the G-20 has been augmented since the global financial crisis and the rise of the importance of

systemic risk as a regulatory concern. See Chris Brummer, “Post-American Securities Regulation” (2010)

California Law Rev forthcoming, at http://ssrn.com/abstract=1441508

417D.McCaffrey, S. Faerman and D. Hart, “ The Appeal and Difficulties of Participative Systems”(1995).6

Organisation Science 603-627; John SF Wright and Brian Head, “Reconsidering Regulation and Governance

Theory: A Learning Approach” (2009) 31 Law and Policy 192; Orly Lobel, “The Renew Deal: The Fall of

Regulation and the Rise of Governance in Contemporary Legal Thought” (2004-5) 89 Minnesota Law Rev 342.

418James Fanto, “The “Going Private” of US Capital Markets” (2008) 3 Brooklyn Journal of Corp Fin and Com

Law 29, arguing that the lack of regulatory evaluation after “delegation” to private governance is a major issue

of concern.

419Michael Greenstone, “Toward a Culture of Persistent Regulatory Experimentation and Evaluation” in David

Moss and John Cisternino eds, New Perspectives in Regulation (The Tobin Project 2009).

420FSA Policy Statement on Strengthening Liquidity Standards, at

http://www.fsa.gov.uk/pubs/policy/ps09_16.pdf.

421FSA Code of Remuneration Practices (wef Jan 2010).

422Para 8.16, 8.17, FSA Policy Statement on Strengthening Liquidity Standards (2009).

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Regulation

The final two models are regulator-centred models, where the source, interpretation, supervision

and enforcement of laws or regulations are in the regulators’ hands.423

However, even in regulator-

centred models, there may be significant industry input in any one of the four aspects of regulation

mentioned above. The FSA consults its Consumer and Practitioner Panels424 and also publicly for

changes proposed to its policies and rules, and the ESMA is now required to consult its Stakeholders

Group.425

Hence, diverse input feeds into policy and rule making. On the interpretation of rules,

Black argues that the community of regulated firms is an interpretive community whose

engagement in dialogue and exchange with regulators entails a process of interpretive development

of rules.426

Where regulation is subject to litigation and adjudication, lawyers, experts, judges and

tribunals may also be co-opted to provide interpretive governance of rules.

Regulators also need industry input to secure supervision or compliance. Financial regulators often

rely on imposing duties upon markets to report and monitor suspicious activities so that the

regulator may take action against market abuse.427 The risk-based regulation model also means that

public-private negotiations, dialogue and exchanges in the supervisory process would likely precede

any enforcement, and models in responsive regulation428

may be used to encourage compliance

without polarising the regulator-regulated relationship.

There are also regulatory regimes which are designed in such a way that bright lines for compliance

or enforcement are more easily ascertained and where liability is often strict liability for ease of

proof and enforcement. This is represented by the last model along the spectrum. An example

would be the mandatory disclosure regimes administered by the regulator in relation to investment

products,429

market and trade transparency.430

Further, traditional command-and-control regimes

423On a systemic analysis of “regulation”, see ch3-4, Iris H-Y Chiu, Regulatory Convergence in EU Securities

Regulation (The Hague: Kluwer Law International, 2008).

424Section 9, 10, FSMA 2000.

425Article 22, Regulation for a European Securities Markets Authority 2009.

426Black, Rules and Regulators (1998), op cit.

427

For eg Arts 26 and 43 of the MiFID require electronic trading platforms and stock exchanges to monitor thattheir users comply with laws relating to market abuse. Further, Jackson and Roe argue that in policing and

enforcing against insider trading, public enforcement relying on market detection and surveillance is

undoubtedly superior to any private monitoring of the market, see Howell E Jackson and Mark J Roe, “Public

and Private Enforcement of Securities Laws: Resource-based Evidence” (2009) at

http://www.law.harvard.edu/programs/olin_center/.

428Cristie L Ford, “Towards a New Model for Securities Law Enforcement” (2005) 57 Administrative Law

Review 757.

429For example, the Prospectus Directive 2003, Units in Collective Investment Schemes Directive 1985 with

subsequent amendments in 2002, FSA Handbook on Prospectus Rules “PR” and Disclosure and TransparencyRules “dtr”, FSA Handbook COLL.

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exist where there is perceived to be public interest in fairness and justice, such as market abuse.431

This paper will not revisit the well-trodden literature explaining or exploring the rationales for

mandatory disclosure and for regulating market abuse. The characteristic of regulator-centred

governance that this paper focuses on is the extent and efficacy of “regulatory control” in this

decentred landscape of financial regulation.

The EU has moved in the direction of recommending most enforcement by regulators to be in the

form of administrative penalties.432

This may be in the interest of harmonising enforcement

approaches in EU securities and financial regulation,433

but would concentrate the power of

prosecutor and judge in the hands of the regulator.434

This in turn shapes the nature of the relational

paradigm between the regulator and industry as mainly a regulator-regulated relationship, and as

involving less of other entities such as civil litigants and their lawyers. I argue that the potential

marginalisation of other stakeholders such as criminal and civil enforcement is not ideal, as this

allows the regulated to become an excessively significant entity in the regulator’s perceived

regulatory space.435

In the FSA’s example, prior to the global financial crisis, the FSA maintained a high degree of public-

private partnership in all aspects of regulation discussed above. This is arguably a response to the

fears articulated with respect to the powers and accountability of the FSA at its establishment in

2000.436

The FSA has adopted a risk-based approach to regulation, targeting intensive supervision to

430MiFID Arts 27-30, 44-45 and Articles 17-20, 27-32, MiFID Commission Regulation (EC) No. 1286/2006, FSA

Handbook MAR 5.6-5.9, 6 and 7.

431 Market Abuse Directive 2003, FSA Handbook MAR 1. See Harry McVea, “What’s Wrong with Insider

Dealing?” (1995) 15 Legal Studies 390.

432Eg Article 14, Market Abuse Directive, Article 51, MIFID, Article 25, Prospectus Directive and Article 28,

Transparency Directive.

433Ch4, Chiu, Regulatory Convergence (2008), op cit.

434Fredrich Thomforde Jr, “Controlling Administrative Sanctions” (1976) 74 Michigan Law Review 709 argues

that sanctioning is essential to the administrative functions and exercise of power of agencies but should be

subject to some judicial monitoring. K. Mann, “Punitive Civil Sanctions: the Middleground Between Criminal

and Civil Law” (1992) 101 Yale Law Journal 179; K Yeung, Securing Compliance (Oxford: Hart 2004) at ch5.

435The number of players in a game theory setting influence the behaviour of strategically motivated entities

seeking to modify behaviour according to the perceived behaviour of another. Myrna Wooders, Edward

Cartwright and Reinhard Selten argue that multiple players in a game setting often entail conformity with

majority actions although individual actions would have been different. See “Behavioural Conformity in Games

with Many Players” (2005, Dept of Economics Working Paper, Vanderbilt University). Also see the dilemmas

and conflicts between regulators and regulated in financial regulation, Fiona Haines and David Gurney, “The

Shadows of the Law: Contemporary Approaches to Regulation and the Problem of Regulatory Conflict” (2003)

25 Law and Policy 354.

436

See generally, C Goodhart and E Ferran eds, Regulating Financial Services and Markets in the 21

st

Century (Oxford: Hart 2001) at chs 11 and 12.

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only a small fraction of the financial services sector,437

and a light-touch approach to enforcement.

Rider argues that the FSA had been anxious to maintain a good relationship with the industry and

was reluctant to move away from the old self-regulatory regime.438

However, the close relationship

between regulator and regulated has caused the regulator to adopt market beliefs and values,

resulting in a light-touch approach, as acknowledged in The Turner Review.439

The recruitment of

staff from the private sector, and the overall philosophy of belief in and engagement with the

private sector may have resulted in forms of capture440

over the FSA in taking the light-touch

regulatory approach. Contrary to what the public feared regarding the power of the FSA, the

problem that has arisen in the financial crisis is its lack of exercise of powers. With the onset of the

financial crisis and the acknowledgement of supervisory inadequacy of Northern Rock,441

the FSA has

stepped up enforcement, such as for non-disclosure and for market abuse.442

However it is

submitted that although crises often have the potential to allow reframing of the exercise of powers

in a “regulatory space” and regulators could re-centre the exercise of powers,443

regulators have to

consider the implications this may now have on their relationship with the regulated. Abrupt

polarisation from the industry may also affect frank and open information exchange in thesupervisory process , or the process of input in the design of policies and rules. But can we strike a

balance between co-opting the cooperation and expertise of the regulated and maintaining the

distance and authority of the regulator?444

437As discussed under Part I “Risk Regulation”, above.

438Barry Rider, “Financial Regulation and Supervision after 11 September 2001” (2003) 10 Journal of Financial

Crime 336.

439Turner Review, op cit at 87-88, referring to the FSA’s belief in the self-correcting nature of markers, the self-

remedying effects of transparency, and senior management’s incentives and capacity to address problems

resulting in a form of light-touch regulation which is unaggressive and arguably hands-off

440Paul Sabatier, “Social Movements and Regulatory Agencies: Toward a More Adequate: And Less Pessimistic:

Theory of "Clientele Capture” (1975) 6 Policy Sciences 301.

441FSA, The Supervision of Northern Rock: A Lessons Learned Review (March 2008).

442Eg Lloyd v Financial Services Authority [2009] UKFSM FSM069 (09 July 2009), where the non-

implementation of systems to capture trade data and non-reporting of such data resulted in a £9 million fine,

the £2.54 million fine on Barclays for the same failure in transaction reporting; FSA’s prosecution against

Uberoi and Uberoi for insider dealing (4 Nov 2009), FSA’s fine on Mark Lockwood for failing to detect and

prevent a suspicious client transaction amounting to insider dealing (2 Sep 2009), the FSA’s prosecution of

directors at ISoft for overstating revenues (7 Jan 2010) and other censures and fines in relation to broker

misrepresentation or fraud.

443Alexander Cooley, “Thinking Rationally about Hierarchy and Global Governance” (2003) 10 Review of

International Political Economy 672.

444It is argued that all regulatory relationships have a social strain that encourages flexibility, experimentation,

dialogue and bonding and the achievement of meaningful controls. This is flanked by an instrumental strain

that supports the legitimacy of exercise of power. The balance is a delicate one between the social strain and

instrumental strain to encourage control and compliance, and to minimise opportunism and antagonism.

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One consistent argument advanced in this paper across the various governance models is that there

is a need to mitigate the dominance of the industry in the relational paradigm between the regulator

and industry across the 8 governance models. One way this may be done is by enrolling expertise

beyond the regulator, such as market participants445

and stakeholders,446

and international

networks.447

Regulator-centred models of governance that are underlined by administrative

enforcement often place too much emphasis on the relationship between the regulator and

regulated, and changes in the relational paradigm could affect regulatory outcomes greatly.448

Further, the emphasis on administrative sanctions may place excessive reliance on regulator

enforcement to provide the public goods of investor protection and financial stability. This would

likely put strain on the regulator’s capacity and resources, create issues of accountability and create

a regulatory governance that may not be best informed.449

It is submitted that regulator-centred

governance should be complemented by stakeholder and wider community involvement

surrounding regulatory governance. This involves greater stakeholder participation and access to

provide input, as discussed earlier in relation to the development of knowledge and standards with

David I Gilliland and Kenneth C Manning, “When Do Firms Conform to Regulatory Control? The Effect of

Control Processes on Compliance and Opportunism” (2002) 21 Journal of Public Policy and Marketing 319.

445“External Experts Help FSA Probe Banks”, The Financial Times (3 Jan 2010). In particular, Deloitte &

Touche’s review of companies flagged up breaches of financial reporting by ISoft, whose directors now face

criminal prosecution for making misleading financial statements to perpetuate market abuse.

446Edward J Balleisen and Marc Eisner, “The Promise and Pitfalls of Co-Regulation: How Governments Can

Draw on Private Governance for Public Purpose” in David Moss and John Cisternino eds, New Perspectives in

Regulation (The Tobin Project 2009) describes this essential private-private partnership as co-regulation whichmust be based on monitoring any governance delegated to private entities and the ascertainment of

commitment to wider good and reputational values on the part of the private entities.

447Brummer, “Post-American Securities Regulation” (2010), op cit.

448Perhaps this accounts for the blame placed on the FSA for the failure of Northern Rock and the UK banking

crisis, as well as the blame placed on the US SEC for the US subprime and banking crisis and the fund

management frauds involving Madoff and Stanford, see Jill E Fisch, “Top Cop or Regulatory Flop? The SEC at

75” (2009) 95 Virginia Law Review 785; John C Coffee and Hilary A Sale, “Redesigning the SEC: Does the

Treasury have a Better Idea?” (2009) 95 Virginia Law Review 707.

449 See Elizabeth Chamblee Burch, “Securities Class Actions as Pragmatic Ex Post Regulation” (2008 ) 43 Georgia

Law Review 63 on the inherent limitations of regulators, also Howell E Jackson and Mark J Roe, “Public and

Private Enforcement of Securities Laws: Resource-based Evidence” (2009) at

http://www.law.harvard.edu/programs/olin_center/ and Rafael La Porta, Florencio Lopez De Silanes & Andrei

Shleifer, “What Works in Securities Laws?” (Tuck Sch. of Bus. at Dartmouth, Working Paper No. 03-22, 2003),

available at http://ssrn.com/abstract=425880. Amitai Aviram, “Counter-Cyclical Enforcement of Corporate

Law” (2007) at http://papers.ssrn.com/abstract=968757 argues that regulators suffer from cognitive biases in

boom times and hence enforcement is also lax, following a cyclical pattern. Stavros Gadinis, “The SEC and the

Financial Industry: Evidence From Enforcement Against Broker-Dealers” (2009) at

http://ssrn.com/abstract=1333717 argues that regulatory agency personnel have a favourable bias towards

large investment firms and are reluctant to levy aggressive enforcement as they see these firms as potentialfuture employers.

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respect to regulating credit rating agencies and the meta-regulation of risk management. Further

widening stakeholder participation also refers to civil enforcement by investors and consumers, and

perhaps even stakeholders.450

I have earlier argued that as investment intermediaries’ duties to their

clients become increasingly framed by regulatory rules and accountability to the regulator, there is a

corresponding lack in defining how these developments may relate to accountability and

responsibility to the individual aggrieved investor.451

I argued452

that:

“The principles-based approach to governing financial investment intermediaries may

arguably provide a dynamic environment where net risks may be assessed at an ongoing level, and

the governance input by the regulator may be adjusted. This will allow regulation to move away

from a static environment... Both the regulator and regulated may benefit from this dynamic

framework..., and the regulated may be allowed to carry out a discourse with the regulator in

delivering the regulatory outcomes collaboratively with regulatory oversight and/or intervention.”453

The standard of care investment intermediaries may owe to individual clients would be

“contextualised” in the supervisory process. But this should not completely substitute any civil

enforcement by investors as a form of governance. As Ayres and Braithwaite have suggested,

agencies could often be checked by “Third Party Interest Groups.”454

Third Party Interest Groups are

public interest groups that can monitor the regulator-regulated relationship where such relationship

involves frequent dialogue and exposure, entailing the risk of corruption and regulatory capture.

Ayres and Braithwaite argue that regulatory relationships that are ongoing and involve regular

contact could give rise to corruption and capture within the regulatory outfit. PIGs then play a role to

monitor the regulated and the regulator, and should have a role in calling both to account, hence

preventing corruption and capture. The closest we have is possibly the movement of corporate

social responsibility, allowing public interest groups and the media to expose and expressly discuss

the corporate practices in financial institutions. However, corporate social responsibility does not

have the same status as envisaged in Ayres and Braithwaites’ model, ie giving the social

responsibility advocates a place at the table with the regulated and regulator and being able to

monitor both.455

It remains outside the legal realm, arguably in the realm of best practice, for the

purposes of reputational enhancement or the business case.456

450John Braithwaite, Regulatory Capitalism (2009) at 79, in particular, p82 where it is stated that “qui tam

[which means people who sue for both individual and communal interests] in effect networks whistleblowers,

with law firms, state regulators and prosecutors, extending the intelligence, evidence gathering and litigation

capabilities of the state in big, difficult cases.”

451Chiu, “The Nature of” (2008), op cit.

452Iris H-Y Chiu, “The Nature of an Investment Intermediary’s Duty to His Client” (2008) Legal Studies 254.

453A theory of regulatory collaboration is discussed in Jody Freeman, “Collaborative Governance in the

Administrative State” (1997) 45 UCLA Law Rev 1.

454Discussed earlier under Part 2 “Responsive Regulation”.

455We are still at the stage of debating the theoretical justifications for corporate social responsibility, and

relying on firms to take initiatives in being socially responsible or sustainable. The development of guidelines

to measure social performance is still work in progress, see generally Andrew Crane, Abigail McWilliams, Dirk

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Sabel and Dorf also suggest that the role of administrative agencies in modern democratic

constitutionalism is to facilitate learning and exchange and joint problem solving for citizens and

markets, and hence agencies provide standards as benchmarks to facilitate and incentivise learning

and rolling of best practices, and enforcement against obstructive behaviour against the

participative and open process.457

Salamon has also proposed that modern regulation is

collaborative and co-opting in nature.458

I therefore suggest not only that civil enforcement be

necessary to complement regulator-centred governance459

but that the regulator also be involved in

the civil enforcement so that a platform of mutual exchange and learning can exist for

complementary governance in the regulatory space.

The co-option of civil enforcement has been significant in the US. Investors could start class

proceedings (largely against issuers) and are assisted by an attorney under a contingency-funded

arrangement. This model of civil enforcement arguably allows an ex-post form of regulation by

looking at actual consequences of the ex ante regulation and firm behaviour.460

It allows individuals

to be compensated,461

and empirical literature has documented a corresponding decrease in the

cost of equity and increase in market liquidity as a result of civil enforcement that exists alongside

regulators’ public enforcement.462

However, commentators warn against the proliferation of

frivolous suits, the tendency to target large firms for bounty-hunter enforcement,463

the incentives

Matten, Jeremy Moon and Donald S Siegel, The Oxford Handbook of Corporate Social Responsibility (Oxford:

OUP 2009).

456David Monsma and John Buckley, “Non-Financial Corporate Performance: The Material Edges of Social and

Environmental Disclosure” (2004) 11 University of Baltimore Journal of Environmental Law 15; Judy Brown and

Michael Fraser, “Approaches and Perspectives in Social and Environmental Accounting: an Overview of the

Conceptual Landscape” (2006) 15 Business Strategy and the Environment 103, arguing that reporting for socialresponsibility is motivated by a range of concerns including business case and normative reasons, and the

“critical school” would not think that social reporting truly reflects a more responsible or ethical stance taken

by the corporation.

457Michael Dorf and Charles Sabel, “A Constitution of Democratic Experimentalism” (1998) 98 Columbia Law

Review 267 at 345-356.

458Lester M Salamon, “The New Governance and the Tools of Public Action” in Lester M Salamon and Odus V

Elliot eds, The Tools of Government (Oxford: OUP 2002).

459S18 on collective proceedings, Financial Services Bill (UK, Dec 2009).

460Elizabeth Chamblee Burch, “Securities Class Actions as Pragmatic Ex Post Regulation” (2008 ) 43 Georgia

Law Review 63.

461Howell E Jackson and Mark J Roe, “Public and Private Enforcement of Securities Laws: Resource-based

Evidence” (2009) at http://www.law.harvard.edu/programs/olin_center/; Stephen J Choi, “The Evidence on

Securities Class Actions”(2004) at http://ssrn.com/abstract=528145.

462Utpal Battacharya, “Enforcement and Its Impact on Cost of Equity and Liquidity of the Market” (2006,

Working Paper, Kelley School of Business, Indiana University).

463

Amanda Rose, “Reforming Securities Litigation Reform: Restructuring the Relationship between Public andPrivate Enforcement of Rule 10b-5” (2008) 108 Columbia Law Review 1301.

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of attorneys to profit from the litigation,464

and the danger of treating civil enforcement as being

more important than public enforcement which reinforces public goods.465

However, the

adjudication process will co-opt counsel, experts and judges to provide jurisprudence on legal duties

and obligations and the public good of investor protection.466

This provides interpretive feedback for

the regulator and policy-makers in evaluating the efficacy and design of regulation as well. To

mitigate the ills associated with civil enforcement, Rose and Coffee have argued that the regulator

can have oversight of, input into, or institute an approval machinery to control frivolous and

unmeritorious claims.467

This co-opts the regulator into the civil enforcement landscape, and could

mutually reinforce both types of enforcement.468

Moreover, Braithwaite, quoting Bucy, supports the

contingency-fee funding model as essential to empowering private litigation, as there must be

incentives to co-opt lawyers into acting for public good and not acting for wealthy corporations, and

such incentives have to relate to private gain for the lawyers’ efforts and involvement.469

Perhaps civil enforcement could be taken by institutional investors as well, where appropriate. Such

actions would allow courts to examine the efficacy of disclosure regulation of securities products,

and where securities products have been sold to sophisticated investors under exemptions from

mandatory disclosure, civil enforcement would allow courts to examine the actual quality of the

unregulated disclosure and to define the duties of providers of investment products in common law.

Empirical literature has documented way before the global financial crisis of a paradox in the market

for complex securities products such as collateralised debt obligations frequently sold among

financial institutions and to sophisticated investors such as pension funds. These securities products

were often accompanied by opacity and paucity in disclosure but the market was oblivious and

liquidity remained in spite of poor disclosure.470

Although it could be explained that the hedging of

these products against credit default swaps and the high ratings given by rating agencies served as

proxies for disclosure and risk management, academic literature has long highlighted that investorshave been overly optimistic about the bundling of diverse obligations into the CDO, believing that

such diversity inherently reduces risk. Transactional governance between sophisticated parties in

464Choi, “The Evidence” (2004), op cit,

465Jackson and Roe, “Public and Private Enforcement” (2009), op cit.

466Burch “Securities Class Actions” (2008), op cit.

467 Rose “Reforming Securities Litigation” (2008), op cit, John C Coffee Jnr, “Reforming the Securities Class

Action: An Essay On Deterrence and Its Implementation” (2006) at http://ssrn.com/abstract=893833.

468James D Cox and Randall S Thomas, “Public and Private Enforcement of the Securities Laws: Have Things

Changed Since Enron?” (2004) 80 Notre Dame Law Review 893, also at http://ssrn.com/abstract=655201;

Guido Ferranini and Paolo Guidici, “Financial Scandals and the Role of Private Enforcement: The Parmalat

Case” ECGI Working Paper 2005.

469Braithwaite, Regulatory Capitalism (2008) at 65.

470Peter D Marzo, “The Pooling and Tranching of Securities: A Model of Informed Intermediation” (2005) 18

Review of Financial Studies 1; Edward L Glaeser, “Thin Markets, Asymmetric Information, and Mortgage-Backed Securities” (1997) 6 Journal of Financial Intermediation 64.

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this context has been weak or non-existent.471

As these transactions have been exempted from

prospectus disclosure, being offered to sophisticated investors, there cannot be ex post regulator

enforcement. However, there is significant public interest in the investment activities of

sophisticated institutions as many of these manage savings of the common people. If easier and

cost-effective access to civil enforcement is provided, an opportunity to examine the transactional

defects and issues could arise in adjudication and any jurisprudence provided can inform regulators

as to whether any rethinking needs to be done in respect of the nature of disclosure regulation for

investment products in the wholesale market.

4. General Observations and Conclusions

The regulatory space in financial regulation has become decentred, and the importance of the

relational paradigm between regulators and industry is likely to remain a staple phenomenon. In this

decentred landscape, some key challenges going forward would be how the relational paradigm,

which has become dominated by the industry should be adjusted so that the regulator may be able

to address the issues of agency and capture. In particular, as regulator reliance, delegation and

capture is largely attributed to the technical expertise claimed by the industry, the relational

paradigm should arguably expand to include other gatekeepers, certifiers, professionals and

stakeholders in order to mitigate the relational sub-optimalities.

(a) Regulators and policy-makers need to focus on the articulation and achievement of

regulatory goals and public goods.

In the decentred landscape, it is important for regulators to ascertain how self-regulatory and

market-based initiatives work in relation to the delivery of regulatory goals and public goods.

Regulators need to address the needs of public goods and regulatory goals in the financial serviceslandscape, and critically determine if the governance of the industry contributes to, undermines or is

contrary to them. As Underhill argues, “[g]overnance is also about objectives concerning the norms

underpinning the broader social and political stability without which markets are unable to

function,”472

and hence, the performance of governance assumed by the regulated should be

evaluated, and regulators have a role in ensuring that there is output legitimacy for the self-

regulatory and market-based governance.

Some governance assumed by the regulated has to date allowed the regulated to develop sub-

optimal standards, as well as opaque and proprietary systems which have been inaccessible and

hence un-evaluable by regulators, for example in relation to credit rating agencies, the riskmanagement of hedge funds, and the risks in the OTC derivatives trading market. The paper also

warns of potential tendencies in the meta-regulation of risk management in financial institutions in

general. Where governance led by the regulated may result in opacity and practical

471Richard E Mendales, “Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent The CDO

Meltdown, and How to Fix It” (2008) at http://ssrn.com/abstract = 1354062, (2009) University of Illinois Law

Review 1359.

472Geoffrey RD Underhill, “Theorizing Governance in a Global Financial System” in Peter Mooschlechner,

Helene Schuberth and Beat Weber eds, The Political Economy of Financial Market Regulation (Cheltenham:Edward Elgar 2006) at 4.

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unaccountability, regulators should arguably be able to challenge those with the values and

objectives of regulatory governance, or else, the public character of regulatory governance would be

subsumed, and how the industry governs itself would dominate the “governance” of the industry.

The relational paradigm between regulators and regulated going forward, should arguably include

enhanced evaluation and supervision by the regulator in aspects of industry governance that is

intended to deliver regulatory/public goods. As Levi-Faur and Braithwaite have pointed out,

regulatory capitalism exists because markets are essentially out of control,473

hence, regulators

remain responsible for the articulation of regulatory goals and public goods such as the mitigation of

systemic risk and to develop the evaluative ability to determine if these are delivered.474

Section 3

has discussed how regulator evaluation should be enhanced in respect of the role of central

counterparties in OTC derivatives trading, the regulation of credit rating agencies, and of

gatekeepers such as the audit and compliance functions.

In order to develop regulators’ ability to supervise and evaluate the performance of industry

governance, the EU is taking the right step forward in demanding more transparency from the

industry, for example, from alternative investment funds in terms of risk management, and from

credit rating agencies in terms of methodologies and assumptions. Transparency and access to the

regulated’s processes and systems is the first step to informational and knowledge building for the

regulator. But the regulator must still develop critical and evaluative expertise, as will be discussed

below.

(b) Where the decentred landscape presents opportunities for aspects of governance to be

supplied by the firm itself or by the regulated, regulators should remain aware as to what

extent reliance on such governance to deliver public/regulatory goods may be warranted,

and regulators should arguably be responsible for overseeing the delivery of

public/regulatory goods.

As mentioned, increased transparency and reporting to the regulator is a first step to allowing the

regulator to learn and understand the actual workings of the regulated’s expertise. Further, other

actors, such as stakeholders and gatekeepers in the regulatory space may be involved to add to an

“information revolution” in order for all participants in the regulatory space to coordinate, contest

and navigate towards comprehensive and meaningful governance.475

Regulators need to enrol and

maintain dialogue with gatekeepers, certifiers, and stakeholders in the regulatory space, through

regulatory supervision, informal dialogue or information exchange and learning in general. Widening

participation in governance is generally agreed by governance theorists to be the way forward, to

take into account of the various interests and roles in governance- the public and stakeholders as

473David Levi-Faur, “The Global Diffusion of Regulatory Capitalism” (2005) 598 The ANNALS of the American

Academy of Political and Social Science 12-32; Braithwaite, Regulatory Capitalism (2008) at 40.

474Kevin Morrell, “Governance and the Public Good” (2009) 87 Public Administration 538.

475ME Keck and K Sikkink, “Transnational Advocacy Networks in International Politics” in Keck and Sikkink eds,

Activists Beyond Borders (Ithaca: Cornell University Press 1998); AM Florini, “Who Does What: Collective

Action and the Changing Nature of Authority” in R Higgott, G Underhill and A Bieler eds, Non-state Actors and Authority in the Global System (London: Routledge 2000).

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consumer, taxpayer, client, citizen and interest champions, for example.476

The diversity in input

from other actors in the regulatory space besides the regulated would assist in developing more

critical perspectives and evaluative ability on the part of regulators. As da Cunha and Junho Pena

suggest, “[participation] is an instrument for negotiating divergent interests; it does not eliminate

losses but makes them transparent and acceptable.”477

Further, more international coordination and networking, perhaps led by regulators,478

could

generate more open standards of governance and compliance. Compelling the industry to open up

more technical systems and standards may start a platform for the fashioning of more robust

blueprints and standards. General open-ness also compels all other participants including regulators,

to become observed and challenged, and this may mitigate particular interest groups becoming too

powerful, and may provide more compromised balances towards the delivery of common good and

values.479

The movement towards greater participation and open-ness may however likely face

challenges from entities whose interests may lie in rent-seeking behaviour for their proprietary and

technical expertise, or aggressive interest groups.

It may be argued that enhancing the evaluative or critical ability on the part of regulators may allow

them to make quick and pre-emptive judgments that could damage the innovations in the financial

services industry.480

As argued in this paper, regulators need to step out of the hitherto “capture by

technocracy” and are only starting to bridge the informational gap between them and the industry.

Fears by the industry that regulators would become risk-averse and extreme are not entirely

unfounded, but it is suggested, not entirely imminent. The enrolment of diversity in stakeholder

participation in the regulatory space may bring a balanced slate of views to assist regulators. This will

make the regulatory space more dynamic and various interest representations may become invited.

This is probably inevitable but the dynamics of diverse representation could unfold in a variety of

476Lisa Blomgren Bingham, Rosemary O’Leary and Tina Nabatchi, “The New Governance: Practices and

Processes for Stakeholder and Citizen Participation in the Work of Government” (2005) 65 Public

Administration Review 547.

477Paulo Vieira da Cunha and Maria Valeria Junho Pena, “The Limits and Merits of Participation” World Bank

Research Paper 1996. However, the authors argue that participation is likely to lead to problem solving if it is

based on already shared common values. “Questions about participation cannot avoid the issue of political

power, local power,populism, and representation. They cannot avoid issues of moral pluralism (the variety of

ways in which people could value their lives) or cultural diversity. They cannot dismiss the ways in which

people can be blocked from better lives by the beliefs of their cultures. They cannot avoid the pressure that a

dominant group may exert to forge solutions that are morally unacceptable.”

478Brummer “Post-American” (2010), op cit, argues that regulatory coordination at the international level is

fraught with incentive problems and political dilemmas, but systemic risk may refocus regulators onto

cooperation.

479Erik F Gerding, “Code, Crash and Open Source” (2009) 84 Washington Law Review 127; John Braithwaite,

Regulatory Capitalism (Cheltenham: Edward Elgar 2008) at 4, 109ff. Tony Porter, “Why International

Institutions Matter” (2009) 15 Global Governance 3, Gerding, “Crash, Code and Open Source”, (2009), op cit.

480

William K Sjostrom Jr, “The AIG Bailout” (2009) 66 Washington and Lee Review 943, also athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1346552&rec=1&srcabs=1440945.

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ways as Trubek and Trubek have suggested,481

towards transformatory governance, a form of

collective problem solving with compromises in transparent minimum standards.

Regulators should also empower civil enforcement by investors against issuers and perhaps also

investment advisers. These groups are motivated by different incentives, and could be a source of

intelligence for regulators, and also exercise some monitoring over the activities of the regulated.

Unger also argues that as financialisation has moved the governance of financial markets from

domestic governments to international governance, such governance should not merely be a

platform for seizure of representative power by interest groups. The values that have evolved in

establishing the legitimacy of governments such as democracy, accountability, participation, and

checks and balances need to feed into governance frameworks as well.482

Hence, regulators should

ensure widening participation by gatekeepers, certifiers and stakeholders in order to support the

information revolution and introduce balance to the power landscape in the decentered regulatory

space.

(c) Regulators need to develop expertise in and responsibility for policies that may identify and

manage systemic risk.

As earlier mentioned, a number of commentators483

have argued that the management of systemic

risk is a public good that is not likely to be supplied by the market. Regulators are perhaps best

placed to take on the responsibility of identifying and managing systemic risk. Not all asset bubbles

or massive leverage may result in systemic risk, but it is imperative for regulators to develop

research and increased expertise in identifying the emergence of such risks and trends. The taking of

ownership of systemic risk issues is gathering pace in the EU, with the establishment of a European

Systemic Risk Bommittee which would work with the pan-European regulators and national

regulators. The Financial Stability Board is also taking the role in international coordination to frame

guidelines for the assessment of systemically risky and important matters in the financial services

landscape.484

The FSB’s guidelines may be a step forward to determine the indicators of systemic

risk, but these should be further evaluated, reviewed and developed. The financial services

landscape is not only innovative but decentred, and hence the consequences of actions taken by any

one group of actors or stakeholders may have effects that are unanticipated. Regulators have to

481“New Governance & Legal Regulation: Complementarity, Rivalry, and Transformation” (2007) 13 Columbia

Journal of European Law 1, arguing that stakeholder democracy can led to co-existence of public and private

forms of governance that complement each other, meaning that different strands of governance have

different objectives and do not merge, or rivalry between the strands of governance, but these dynamics may

lead to transformatory evolution, for example, procedural coherence in governance coordination,

development of minimum standards and collective problem solving.

482Brigitte Unger, “Who Governs? Economic Governance Mechanisms and Financial Market Regulation” in

Peter Mooschlechner, Helene Schuberth and Beat Weber eds, The Political Economy of Financial Market

Regulation (Cheltenham: Edward Elgar 2006) at 59, 78ff.

483Schwartz, “Systemic Risk” (2008), op cit; Acharya (2009), op cit.

484Financial Stability Board, Report to G20 Finance Ministers and Governors: Guidance to Assess the Systemic

Importance of Financial Institutions, Markets and Instruments: Initial Considerations (Nov 2009) athttp://www.financialstabilityboard.org/publications/r_091107c.pdf.

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develop expertise in seeking out relevant information not only from the regulated, but also from

other actors in the financial services landscape such as gatekeepers, certifiers, professionals and

stakeholders, and in applying the indicators of systemic risk to such information. This likely requires

enhanced capacity, learning and coordination on the part of regulators worldwide.

(d) Regulators must be prepared to countenance the much more complex job of regulation in a

decentred and globally-connected landscape. As Jackson and Roe argue, there is great value

in public enforcement in the achievement of regulatory goals and public goods,485

regulators

should be more and better resourced to develop standard setting, supervisory and

enforcement capabilities.

The variety of governance models discussed in Section 3 shows that the concept of governance in

the financial services landscape has been evolving to match up with the contemporary complexities

of the decentred landscape and the sophistication of the financial services industry. However, as

mentioned above in (a), regulators need to reaffirm the importance of public goods such as the

oversight of systemic risk, and to re-orient the relational sub-optimalities in public-private

governance, and to assert certain forms of appropriate control in the regulatory space, whether via

standard setting, supervision or enforcement. Regulatory standard setting may be directed not only

to the regulated industry, but to transactional parties to hedge funds, to the delegates and

outsourcees of governance, and to third party certifiers such as rating agencies. Supervision may

involve communication and experimentation, as well as evaluation and exercise of authority.486

Enforcement may include not only deterrence, but a more comprehensive sense of justice that

restores to optimal behaviour and wider social good.487

The future of governance in the financial services landscape would lie in changes to the chemistry of

the relational paradigm between the regulator and industry. In particular regulators should have a

unique role to uphold public good and regulatory governance and should assume greater critical

evaluation of the governance provided by the industry. This paper argues that this is not tantamount

to a form of simplistic re-regulation as the regulator is not assuming all forms of control over the

industry where it is impractical to do so. Rather, regulators should enhance their responsibility

through informational enhancement, knowledge and capacity building, learning and evaluation, and

co-opt a variety of participation in the financial services landscape particularly from stakeholders

and investors in civil enforcement. Enhancing the responsibility of the regulator, may be the

fundamental change in governance that is required.

485Jackson and Roe, “Public and Private Enforcement” (2009), op cit.

486John C Coffee, “Law and the Markets- The Impact of Enforcement” (2007) 156 University of Pennsylvania

Law Review 229 arguing that public enforcement is key to investor confidence and the strength of a financial

market.

487Braithwaite, explaining “restorative justice” in Regulatory Capitalism (2008) at 157ff.

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