Governance Not Regulation

Il conseguimento del pubblico interesse in ogni organizzazione non comporta necessariamente l’imposizione di regole prescrittive di comportamento (regulation), ma piuttosto la definizione di corretti incentivi diretti a chi la gestisce (governance). Tali incentivi dovrebbero indurre quest’ultimo a operare in un modo che, salvaguardando il suo miglior interesse, sia anche conforme all’interesse generale.

Questa tesi viene verificata su due casi: sull’adeguatezza dei coefficienti di capitale nel settore bancario, e sugli standard della contabilità aziendale. Nel primo caso, l’interesse generale è connesso all’importanza delle banche per l’economia, quello privato al conseguimento di un profitto. Questi interessi sono diversi ma non in opposizione: entrambi tendono a prevenire il fallimento della banca. Le regole di Basilea sull’adeguatezza del capitale bancario intendono raggiungere questo obiettivo ma, caratterizzate da complessità crescente e da alcune criticità che gli eventi recenti hanno mostrato, non comportano necessariamente un uso efficiente del capitale. E’ preferibile che i gestori della banca abbiano una serie di incentivi che consentano una gestione efficiente, senza sacrificare il pubblico interesse alla stabilità della banca stessa. Gli scopi della contabilità aziendale – è questo il secondo caso  considerato – cambiano nel corso del tempo, da controllo dell’azienda da parte degli azionisti, a base per l’assunzione di decisioni. Col cambiamento degli scopi cambiano le regole; in certi paesi, come negli SU, esse sono molto prescrittive, frustrando l’indipendenza di giudizio di chi è preposto alla contabilità, riducendone la discrezionalità, restringendo la concorrenza delle idee e l’innovazione, e la visione dei conti aziendali che ne risulta è spesso fuorviante.

Occorre, seguendo un approccio finora trascurato, chiedersi quali siano i comportamenti desiderabili, e prevedere incentivi per attuarli attraverso il “disegno di contratti” che permettano l’allineamento dell’interesse dei “regolati” a quello dei “regolatori”. Al riguardo, il centro dell’attenzione deve essere sui risultati (outcomes), piuttosto che sulle procedure (processes) per raggiungerli. La questione è discussa con riferimenti alla letteratura economica e giuridica. Nel campo bancario (il primo caso sopra accennato) viene ritenuto che un impegno finanziario diretto dei gestori delle banca, proporzionale alle loro responsabilità, costituisca un adeguato incentivo a operare nel rispetto di entrambi gli interessi.

Governance Not Regulation
di Geoffrey Wood, Professor of Economics, Cass Business School, London

There are two ways for governments to get organisations to do what they think is in the public interest. One is telling them what to do. This can mean prescribing the outcome, prescribing the process, or even both together. These are forms of regulation. The other is explicitly to recognise that organisations are run by people, not by automata waiting passively to be told what to do. Such recognition suggests that rather than simply issuing instructions one should organise incentive structures such that these rational individuals, out of their own self interest, do what the government wishes. The latter course can best be described as governance. The aim of this paper is to contrast regulation and governance. First, brief definitions of regulation and of governance are proposed. Then two examples, from different areas of life, are briefly considered, and it is suggested on the basis of these that in general governance is better than regulation in two ways. First, it is more likely to achieve the desired result. Second, it is likely to be effective for longer.

Having set out examples which suggest this conclusion, an analytical framework is sketched out which suggests that claim, based on examples, is likely to hold in general.

A clear definition of regulation was provided by that most eminent of scholars of it, George Stigler, in 1975. Regulation, he wrote, is “… the exercise of coercive government power”. It is, in other words, telling people what to do and punishing them in some way if they do not perform as instructed.
There is a problem with this definition. Stated baldly it is somewhat too wide. It seems to imply that any legal rule is regulation, so that a libertarian who wants state enforcement of contracts would be said to be in favour of regulation. But it does help capture the difference which is at the heart of the argument of this paper. Regulation tells people what to do, while governance involves setting up structures, inside or outside organisations, so as to make it desirable for the organisations in the best service of their own interests to do what is thought also to be in the public interest.
Illustrations are helpful. The setting of speed limits on roads, enforced by supervision and punished by one of a range of penalties, is regulation. The repeal of the Bubble Act in 1825 is an example of governance from English financial history – it provided a framework to facilitate large scale investment in risky projects, and thus to facilitate a faster stage of industrialisation.

The two examples by use of which regulation and governance will be contrasted are as follows.
1. The regulation of capital ratios for banks under the Basle accord.
2. The regulation of accounting standards.
These are taken in turn.

Capital Ratios
When a bank fails (using the term “fail” loosely for the moment) there is an immediate and adverse effect on its competitors. This comes through three channels. If the bank is large, there is turmoil in financial markets. To the extent that other banks had contracts with the failed bank, these contracts are at the least frozen. Even if most of the money eventually comes back, it may come back slowly. And third, confidence in banks generally is weakened, and this loss of confidence can lead to a “flight to quality” which in the last resort can become a flight to liquidity requiring central bank assistance.

Now, that of itself does not justify interest in them by government. But what does justify that interest is the important role of banks in the economy.

This has led, surprisingly recently in the case of some countries, to governments (or central banks) imposing regulations on how much capital banks should hold. This is currently set by the Basel committee of central banks and supervisors, so the current set of regulations are known as Basel II .

The fundamental difference between Basel II and its predecessor, Basel I, is that required capital ratios are related to risk in a much more complicated way. Thus, the more risky a bank’s portfolio (of assets) the higher is the capital required. This seems sensible. It is what prudent banks would do without prompting. This is no doubt exactly the viewpoint that led to such widespread support for the principle of Basel II. But supporting Basel II because it produces what prudent banks would choose to do involves a misconception.

First, assessing relative risks in a continually changing market, with rapid financial innovation, is not easy. Assessments are likely to be wrong, and to change frequently. Second, the attempt at greater accuracy inevitably involves greater complexity. Third, although there is reliance on banks’ internal risk assessments, Basel II actually suggests quite strongly how such assessments be made. This has two difficulties. First, we can certainly not be sure we know the right model; and second, it may encourage herding, all banks responding to the same stimulus in the same way.

And fourth, there is widespread agreement that Basel II will produce “pro-cyclicality” – increased bank lending in booms and reduced in slumps – since risks in general fall in booms and rise in slumps. The disagreement that exists over this issue is only over how big the effect will be.

Now, all these criticisms were generally accepted at least to some degree and after recent events have been proven fully justified. There is however a more fundamental point. Banks hold capital to use: they run it down as a result of negative shocks and build it up as a result of positive ones. In contrast, regulatory capital sets a floor below which capital is not allowed to fall. Regulatory capital is not for using.

Does this mean that banks should be left to choose their own capital, as they choose their usable capital?

They certainly were in the past; and some systems, notably the UK, proved singularly robust.[1] It is undoubtedly correct that regulators are concerned primarily about the above-discussed “external effects” of bank failures, while banks are concerned to survive to earn future profits. But despite this apparent difference of interest, (note that it is difference not conflict: both regulators and banks want banks to survive) in the past banks, it seems highly likely, took heed of both issues. One cannot of course infer this from the ratios they held (even if one can get the data). But one can infer it from actions banks took to monitor other banks, and to protect themselves from failures by others. See in evidence clearing houses, the famous Suffolk Banking System in the USA, and banknote return arrangements in Scotland under free banking. Why can we not rely on self interest now? The answer, it may be argued, is that the governance structure within banks has changed. In the periods just considered banks, although sometimes quite large, were smaller than now and, very important, in much more concentrated ownership. Further, those who managed the banks usually had a large amount of their wealth in the bank.

So why not reform “governance”? Why not require bank management to hold their wealth, in increasing proportions as they become more senior, in the Bank’s equity? This would start to produce the alliance of desired outcome with incentive that we saw in the past. This would not produce perfection, but it would surely improve behaviour.

Accountants and Accountancy
Our second example comes from accounting. British (and North American) accounting both derive from the same tradition. The original purpose – and still probably the primary purpose – of company accounts is as follows:
“…in law the object of annual accounts is to assist shareholders in exercising control of the company by enabling them to judge how its affairs have been conducted” (Caparo Industries plc. V Dickman and others: House of Lords, 8th February 1980; Lord Jaunay.)
Such accounting originated from the practice of ‘accounting for ventures’ – for discrete operations, such as a voyage to the Indies – and evolved into accounting for the stewardship of going concerns. In the first, the returns, if any, were divided among the shareholders at the conclusion of the venture. Going concern accounting required regular measurement of profit to determine how much a company could distribute to the ‘shareholders’ without diminishing its capital.
In 1966 there was in the USA a proposal (from the American Accounting Association) to move away from stewardship accounting to accounting for decision making (Myddleton, p36). This was followed up by the US Financial Accounting Standards Board:
“Financial Accounting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions.” (p37).
There is thus disagreement about the purpose of accounts, and invariably, as we shall see, disagreement about what kind of regulation of them might be sensible.[2]

For over 50 years British law has required that company accounts provide a ‘true and fair view’ of the state of a company’s affairs and of its profit or loss for the financial year. Thus, so long as the procedure is revealed, different companies can depending on the nature of the business do different things – for writing down old or damaged stock, for allowing for bad debts, for depreciating capital. It is a requirement over outputs rather than over inputs or processes.
Formal accounting standards, restricting the use of judgment, started to be discussed in the UK after the 1967 takeover of Associated Electrical Industries by the General Electric Company. (Before then, there had been “Recommendations on Accounting Principles” – voluntary guidelines on best practice which often described several possible approaches.) After the takeover, AEI’s projected profit of £10mn for the year turned out to be a loss of £4.5 mn. (In fact, two thirds of the turn round was the result of a different judgment about the prospective outcome of long-term contracts.)

But what was laid down was still not a set of standards; rather it was a basic framework from which departures were expected to be disclosed and explained. They were not a code of rigid rules. The over-riding requirement remained to give a ‘true and fair view’.

International accounting standards have emerged in the last 30 years. There are two basic templates: International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).

The differences can be summarised as follows. IFRS is more principle based standards than detailed prescriptions. Under it, ‘true and fair’ is the over-riding rule. Alternative treatments are allowed rather than a single one being prescribed.

US accounting is more authoritarian. This, Myddleton (2004) suggests, is a result of the much greater influence there of government agencies over the subject.
“In the USA ‘presenting fairly’ requires absolute compliance with US GAAP even if it might lead to a misleading view. There is no provision in law or practice for any equivalent of the UK’s ‘true or fair ‘override’.”

What can be said about the positions? What are the arguments for and against imposing a common set of rules?

First the ‘for’. Six arguments for accounting standards are as follows.

They prevent dishonesty by preparers of accounts. Auditors can lack independence. Investors may be damaged without standards. Accounting decisions can be complex. Uniformity in words and layout is helpful. Standards will facilitate cross company comparisons.

Now, how strong are these arguments? All have encountered criticism. It pays insiders to provide information to outsiders. Auditors’ incomes depend in the long run on their honesty. So long as accounts provide a clear account of stewardship they can give no further guidance. Complex tasks can often differ from one another; this can require different solutions. As to uniformity, a sufficient degree tends to evolve. To quote in example a development in a related area, “Prospectuses in the UK (fell) voluntarily into a reasonably uniform format because users liked it that way.” (Myddleton, op. cit. p91)

As well as these “negative” arguments against imposed standards, there are “positive ones.
They can stifle or even forbid independent judgment. They can reduce competition in ideas, and restrict evolution. They may legitimize bad accounting; and they can mislead by raising expectations unduly. On the first, they can lead to “… an approach [which] implies that unless the rules explicitly forbid it, anything goes.” (Myddleton, op. cit. p99). In a voluntary regime, views on the treatment of difficult issues can evolve slowly; disclosure of the method is what matters. As for compelling bad accounting, many argue (for example) that the treatment of research expenditure under SSAP requires just that (Myddleton, op. cit. p104). And finally, people can be confused by the clear implication that the presentation of accounts has no grey areas. Everything is not black or white; but compulsory standards imply that it is.

As with the previous example, capital standards in banking, it is clear that governance had for a long time done a good job – governance in this present context being a situation where auditors who prepare and check company accounts prosper by being independent, honest, and providing information helpful to the users of the accounts.

At least in those areas, governance appears to trump regulation. Now, one cannot generalize simply from two cases. But there is a well developed body of analysis, neglected in this area, which is helpful in exploring the issues further and considering whether the argument is generalisable.

A neglected approach
So far it has been maintained in two cases that detailed prescription of processes will not necessarily produce desired outcomes.
The alternative implied by the above discussion is to consider what kind of behaviour is desired, and then put in place the appropriate “governance” within the firm so as to promote that behaviour.
We can specify the objective. Can we design contracts to deliver these objectives?
Contract design has over the years received a good deal of attention from economists. It is usually handled under the heading of “The Principal-Agent Problem”, the nomenclature invented by Steve Ross in 1973. The “principal” is the person who wants something done, the “agent” is the person employed to do it.

The “problem” can arise for a variety of reasons.

Adam Smith touched on the subject in some detail. This he did at several points. His most detailed, and best known, discussion arises in the context of his explanation for the decline of agriculture in Europe after the fall of the Roman Empire. The system was one where the land was worked by “metayers”:

“The Landlord furnished them with the seed, cattle, and instruments of husbandry. The produce was divided equally between the proprietor and the farmer”. (Book 3 chapter 2)

Now, what was the problem?
“It could never, however, be the interest even of this last species of cultivators (the metayers) to lay out, in the further improvement of the land, any part of the little stock they might save from their own share of the produce, because the lord, who laid out nothing, was to get one-half of whatever it produced …… It might be the interest of metayer to make the land produce as much as could be brought out of it by means of the stock furnished by the proprietor; but it could never be in his interest to mix any part of his own with it.” Smith (1776, bk. 3, chap 2. p 367) There would be underinvestment.

Hume (1740) seems to have been the first to state the “free rider” problem.
“Two neighbours may agree to drain a meadow, which they possess in common; because it is easy for them to know each other’s mind; …But it is very difficult, and indeed impossible, that a thousand persons shou’d agree in any such action; it being difficult for them to concert so complicated a design, and still more difficult for them to execute it; while each seeks a pretext to free himself of the trouble and expence, ….”
-Hume (1740, p 538)

This was followed up in 19th century discussions of public finance – on the “benefit approach” and the “ability to pay approach” to taxation. Various writers, notably Pantaleoni and de Viti de Marco, advocated the benefit approach. Wicksell (1896) pointed out what became known subsequently as the free rider problem with this approach.

“If the individual is to spend his money for private and public uses so that his satisfaction is maximized he will obviously pay nothing whatsoever for public purposes. … Whether he pays much or little will affect the scope of public service so slightly, that for all practical purposes, he himself will not notice it at all. Of course, if everyone were to do the same, the State will soon cease to function.”
-Wicksell (1896, p 81)

In other words, it can be advantageous to the individual to conceal preference. That, too, is a problem for contract design.

The problem of monopoly regulation has also been recognised as essentially one of contract design. This is due to Loeb and Marget (1979) who recognised that (as with the voting problem above) the difficulty is lack of information. The regulator, in advance of setting the regulation, knows less about costs (and possibly demand) than does the regulated firm.
The problem of concealment (or non-disclosure) of course also lies behind the problem of moral hazard that has been recognised for centuries in insurance. A number of economists have grappled with how to design contracts for this – see, for example, Arrow (1963) Pauly (1974) and Grossman and Hart (1983).

If we now stand back to see the problems of contract design that economists have grappled with since Hume and Smith what do we find?
We see first why the subject temporarily (for at least a hundred years) vanished from view. In a large economy, with many buyers and many sellers and no entry barriers (such as natural monopoly) to a particular activity, the problems vanish. Rational individual behaviour translates into profit maximisation for firms’ owners. This leads to cost minimisation, and hence to productive efficiency. Similarly, consumers facing exogenous prices have the appropriate incentives for utility maximisation.

But of course that treated the firm as a “black box”. How did the owners of firms align the interests of the various members of the firm (workers, managers) with profit maximisation? The moment that question returned to view, we came to the issue of contract design. The extensive and often complex literature touched on above, which has examined contract design problems, faces such difficulties and sometimes reaches impasses because of three main types of information problem – adverse selection, moral hazard and non-verifiability. Do these three issues arise in the examples with which this paper opens?

Relevance in the Examples
Consider the examples – banking system stability, and accountants and auditors producing “accounts of stewardship” which are fit for that purpose.

Banking sector instability is all too visible. The results of faulty audits reveal themselves, not necessarily immediately, but in due course. In both cases there is ex post visibility which can be verified by a third party. So one of our problems is not present. What about adverse selection and moral hazard?

Neither of these is relevant . For in the cases under review we are concerned only with observable outcomes after the event, and not at all with what goes on inside the firms; and we can observe the outcomes.

Now, what goes on inside these firms is of course of concern for their owners, but it is no concern of ours. We need specify only that the contracts have characteristics which regardless of their other features will provide what the authorities regard as desirable

An example shows how this might be done.

My friend and colleague Charles Goodhart has proposed (I think partly in jest but am not sure) that the Chairman of any bank which gets into difficulties should be put in the stocks outside the Bank of England, and then, as was traditional with those placed in the stocks, be pelted with rotten fruit. This, he suggests would sharpen their attention to their respective bank’s stability. He is I am sure right. But I am not persuaded that even today any prospective British government would adopt that measure.

Another course, much more plausible, is however prompted by the proposal. The proposal was designed to make senior management focus on stability. This could also be done by insisting that contracts do not grant options with no risk of loss; that management have to place its wealth, the more senior they are the higher the proportion, in the bank’s stock, and that stock be held, untradeable, by trustees until, say, five years after retirement of the respective manager (and that any contract designed to offset the risk be unenforceable at law); and, if it were so wished, to sharpen incentives also for the owners double or even triple liability for each shareholder could be reintroduced.

Where does that lead in general? What general lessons can be drawn?

General Conclusion
Regulation has invariably led to attempts to circumvent it. Accordingly, it is surely worth considering an approach which aligns the interests of the regulated with the regulators, rather than the latter simply telling the former what to do. There is extensive work by economists on contract design. It is worth attempting to draw on that. This claim is surely reinforced by the work of lawyers – notably Richard Posner – showing how judicial interpretations under common law tend to evolve towards economically efficient outcomes. Law, a form of governance, has worked. Why not try it again?
As the economic literature discussed above has shown, there can sometimes be substantial problems with attempting to do so. But so long as there is public concern only with observable outcomes, governance can replace regulation. It will be more durable in its effects, and relying on it, and thus focussing on outcomes rather than processes, will ensure that the regulated firms seek the most economically efficient way of doing what the government wants. We would thus be exploiting the most fundamental of all economic insights, one stated by Adam Smith and reiterated by Hayek in his famous “The Use of Knowledge in Society”. Each individual knows more about his own situation, interests, and desires than any outside observer can. This insight has been neglected in the field of regulation. Ending this neglect might well prove productive.


Defining “Fail

Sometimes when economists use the word “fail” a definition of exactly what is meant is unnecessary. An example of this would be the phrase “…a wave of bank failures swept the southern states of the USA”. That phrase, from the discussion of the consequences of the failure of Cauldwell and Co. of Nashville, is taken from Friedman and Schwartz’s “A Monetary History of the United States”. In that context further definition is unnecessary, for what was relevant was that such a wave followed from a surge in the demand for cash (instead of bank deposits) following the closure of an important bank and unchecked could have continued still further, because of that same surge in demand. In the context it was immaterial how much capital bank shareholders eventually got back, for the concern was not with them but with depositors.
But for shareholders, and creditors other than depositors, the meaning of fail is crucial. Several issues have to be clarified. How much of their funds did they eventually get back? When did they get it? When did they know they would get something back? When did they know how much they would get back? The answers to these questions are surely likely to affect their behaviour.
But answers are seldom provided. Rather it is simply assumed that the word “fail” has an unambiguous meaning, and subsequent behaviour then deduced.

There is also discussion of the consequences of a big bank failing, and what the monetary and perhaps fiscal authorities should do about this failure. This, aside from neglecting the above issues, also ignores an important fact. Banks the overnight failure of which would disturb the whole banking system, and perhaps the financial system more generally, rarely fail overnight. Indeed, no example exists in British banking history, and in the USA the case of LTCM (not a bank in any case) is arguable. Rather they decline slowly. From Britain consider the now defunct Midland Bank. In the 1930s (just after it opened its magnificent head office in Poultry, just across the road from the Bank of England), it was the biggest bank in the world. It steadily declined, suffered the ignominy of receiving a takeover bid from its advertising agency, and was eventually taken over by HSBC. That process took some 50 years. In the USA the failure of Continental Illinois, though often described as an overnight collapse, actually was not. Many of its counterparty banks and other financial institutions had noticed the increased riskiness of its lending, and had reduced or eliminated their exposure to it before the collapse came.
To summarise, the word “Fail” should be used carefully.


Benston, G. J. (1969) The Effectiveness and Effects of the SEC’s Accounting Disclosure Requirements, in H. Manne (ed) Economic Policy and the Regulation of Corporate Securities AEI, Washington, DC

Dupui, J. (1844) De la Mesure de L’utilité des Travaux Publics, Annales des Ponts et Chaussées, Paris. Scientifiques et Medicales Elsevier

Grossman, S and Hart, O. (1983) An Analysis of the Principal-Agent Problem, Econometrica 51: 7-45

Hume, D. (1740) Treatise of Human Nature, Oxford: Oxford University Press

Loeb, M. and Marget, W. (1979) A Decentralised Method of Utility Regulation, Journal of Law and Economics 22: 399-404

Myddleton, D. (2004) Unshackling Accounts IEA, London

Pauly, M.V. (1974) Over insurance and Public Provision of Insurance: The Roles of Moral Hazard and Adverse Selection, Quarterly Journal of Economics 88: 44-62

Ross, S. (1973) The Economic Theory of Agency; the Principle’s Problem, American Economic Review, G3, 134-139

Smith, A. (1776) The Wealth of Nations, New York, The Modern History

Stigler, G. J. (1975) The Citizen and the State, University of Chicago Press, Chicago

Vickrey, W. (1960) Utility, Strategy and Social Decision Rules, Quarterly Journal of Economics, 74: 507-535

Wicksell, K. (1896) see p. 412


1.  This was the case even before the mid 20th Century, by when UK banks were a well capitalised and well diversified cartel

2.  As an aside, it is worth observing that there appears to be little evidence that company accounts are good at predicting future profits – except of course when they provide evidence of fraudulent or incompetent stewardship. (Benston, 1969)