The financial crisis has prompted us to take a hard look at how our financial institutions are regulated both locally and internationally. As policymakers debate how regulators could help prevent future crises, we have an opportunity to think about what makes good regulation.
I know what many of you are thinking: Good regulation—isn’t that an oxymoron? Since many analysts agree that the financial crisis was in part a failure of regulatory oversight, it’s worth talking about how to make regulation more effective and less burdensome.
When I was in graduate school, my economics professor argued that it was more efficient to give the poor cash than food stamps and let them decide how best to spend it. I know, I know. The argument has its flaws, but so does a system in which draconian rules stifle innovation and efficiency.
To provide some guidance on “good regulation,” the international Organization of Economic Cooperation and Development (OECD) last year developed a document called “Policy Framework for Effective and Efficient Financial Regulation.” Although the paper is directed at regulating financial institutions, the principles can be applied to any industry.
Here are a few of the OECD principles (policymakers and regulators, take heed):
First, what is the problem? Perhaps this is stating the obvious, but you would be surprised (or not) how often decision-makers plunge in without clearly understanding the problem. There should be clear evidence of the nature of the problem and its magnitude (and why it has become a problem). If the problem isn’t understood and clearly articulated, the solution will miss the mark.
Is government action justified? This is a biggie for industry and certainly should be for taxpayers. Any government action should be based on clear evidence that the action is justified, based on a realistic assessment of whether government action would be the most effective solution.
Is regulation the best form of government action? A comparison should be made of the different regulatory and non-regulatory policy mechanisms available and their costs and benefits. Regulators also need to assess the administrative costs of any options on government and industry.
Is there a legal basis for regulation? All regulations should rigorously respect the rule of law. Regulations should be authorized at a higher level (i.e., a legislative body) and should be consistent with treaty obligations and relevant legal principles, such as certainty, proportionality and applicable procedural requirements.
What is the appropriate level of government action? Should regulation take place at the highest level of government or at a lower level? When more than one government body is involved, is there a coordination plan to avoid gaps in regulation? (Can you say credit default swap?)
Do the benefits of regulation justify the costs? This is the $30 billion question, one often ignored by policymakers. Does the cost justify government regulation? The benefits of regulation should justify the action.
Is the distribution of effects across society transparent? The beneficial effects of regulation should be clear.
Is the regulation clear, consistent, comprehensible and accessible to users? The rules should be understandable to the end users.
Have all interested parties had the opportunity to present their views? Public rule-making is essential in ensuring a transparent process. All interested parties must have ample time and opportunity to comment on any proposed new rule.
To that list I am adding a few other principles, some of which are raised in the OECD paper.
Regulators should be proactive, not reactionary. Rarely are we hit by a man-made crisis that someone didn’t anticipate. By assessing emerging risks, regulators might prevent the next crisis.
Regulation should be based on principles, not rules. Set the principles and then let the industry decide how best to achieve the goal. This encourages innovation and efficiency.
Regulation should support a level playing field and a competitive market. The rules should not stifle competition or erect barriers to entry.
Rules should be periodically reviewed. Regular reviews will help determine whether the rules are still effective and efficient.
Regulation should include clear recourse provisions to challenge charges of non-compliance. Confidence in the regulatory process is undermined when enforcement is arbitrary. A mechanism for challenging allegations is essential for ensuring respect for the regulatory system.
In the ideal world, all regulation would be weighed against these basic principles. Realistically, we know policymaking is like making sausage—everything goes in it. It’s up to us to remind our policy-makers what good regulation should look like.