The Future of Financial Regulation World Economy and Finance Programme London, 28 January Professor Justin O’Brien Faculty of Law University of New South.

The Future of Financial Regulation

World Economy and Finance Programme

London, 28 January

Professor Justin O’BrienFaculty of Law

University of New South Wales, Sydney

Centre for Applied Philosophy and Public Ethics The Australian National University

Research Agenda

What can we learn about accountability by examining how it is used in the discourses associated with the global financial market crisis?

Why has effective reform of capital market proved so illusive?

Mapping the parameters of what constitutes the parameters of accountability is an exceptionally complex task

The creative ambiguity of accountability highlights a potential disconnect between the rhetoric and substance of reform.

We hypothesize that the failure of effective accountability to date rests essentially on the failure to focus on the normative infrastructure.

Research Problem

Three interlinked global phenomena: flawed governance mechanisms, including

remuneration incentives skewed in favour of short-term profit-taking;

flawed models of financing, including (but not limited to) the dominant originate-and-distribute model of securitization; and

regulatory structures predicated on risk reduction which created incentives for arbitrage and paid insufficient attention to systemic credit risk.

Setting Up the Board

The New Institutional Economics Framework (Williamson, 2000)

Level Frequency Purpose

Social Norms 100-1000 years Non-calculative Societal Contract

Institutional Environment

10-100 years Overarching legal, political and bureaucratic framework

Governance Arrangements

1-10 years Aligning transactions within accepted rules of the game

Resource Allocation Continuous Incentive alignments

The Return of Depression Era Economics

1944 1942 1944

The ‘perennial gale’ of change ‘incessantly revolutionises the economic structure from within, destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism (p.84)

“No social system can work in which everyone is supposed to be guided by nothing except his short-term utilitarian ends...the stock market is a poor substitute for the Holy Grail (p. 137)

Destructive Creation

‘A self-regulating market demands nothing less than the institutional separation of society into an economic and political sphere’ (p.74)

Aim was to ‘annihilate all organic forms of existence and to replace them with a different type of organization, an atomistic and individualistic one… best served by the principle of freedom to contract…To represent this principle as one of non-interference…merely the expression of an ingrained prejudice in favour of a definite kind of interference, namely such as would destroy non-contractual relations (p.171)

Re-Embedding the Market

“Parties in the market should be free to sell and buy at any price at which they can find a partner to the transaction” (p 27).

“To create conditions in which competition will be as effective as possible, to supplement it where it cannot be made effective....provide indeed a wide and unquestioning field for state activity. In no system that could be rationally defended would the state just do nothing. An effective competitive system needs an intelligently designed and continuously adjusted legal framework as much as any other” (p, 29).

Unshackling Hayek

The End of History or the Demise of Hubris?

‘We shall not grow wiser before we learn that much that we have done was very foolish’ (p, 177)

‘Few discoveries are more irritating than those which expose the pedigree of ideas’ - Lord Acton (p, 1)

‘I found a flaw. That is precisely the reason I was shocked because I’d been going for 40 years or more with very considerable evidence that it was working exceptionally well’ – Alan Greenspan, 23 October 2008

A keyword is a “significant, binding” term that is “not only indicative of the meanings and interpretation of a particular discourse but simultaneously forms elements of the problem that the very discourse they addressed had generated” (Raymond Williams, Keywords: A Vocabulary of Culture and Society, New York: Oxford University Press, 1985, p15).

Research Design

Raymond Williams: “Keywords”

Democracy

Equality

Class

Bureaucracy

Accountability

Accountability is treated as “cause” and/or “cure” As a causal factor, it is the absence or failure of

effective accountability that provides the focus of the discourse.

In contrast, accountability is also central to many discussions about how to deal with specific failures or as a counter to the overall conditions that caused the crisis.

Observation 1:

Accountability is discussed as both “mechanism” (designed to foster accountability) and “condition” (state of “being accountable”)

Being accountable means being subject to those mechanisms that are designed to impose some form of control or guidance (answerable, liable, legally obligated, etc).

Alternatively, accountability is also treated as a manifestation of the normative condition of “being accountable” (something an agent is or ought to be).

Observation 2:

Focus on:

Perspective: Cause Cure

Accountability-as-Mechanism(i.e., control) Failure of instrument Reform, replace, repair the

instrument

Accountability-as-Setting(i.e., normative infrastructure)

Absence or collapse of norms, mores, standards

Reestablishing, rebuilding moral community based on effective

norms/standards

Figure 1: Accountability’s Discursive Roles

Power of accountability as a “keyword” is rooted in widely held “beliefs” about what accountability mechanisms can or should accomplish (e.g. control, performance, integrity)

Observation 3:

Strategic approaches to reform are related to the perceived “promises” of accountability.

Therefore, the second stage of the research examines the role played by accountability in the design of corporate and regulatory strategies in response to the crisis, using a similar framework.

In particular we test (1) for the salience of the US-based perspective on global patterns of policy responses to the crisis and (2) for a possible disconnect between the rhetoric and substance of reform traceable to the creative ambiguity at the heart of accountability’s status as a key word.

Manifestations and Testing

Does reform enhance accountability?

Rhetorically focused on improving integrity of markets

Actual proposals focused on repairing or creating mechanisms of control

Observation 4

The actions of many firms escaped scrutiny. In some cases, the dealings of these institutions were so complex and opaque that few inside or outside these companies understood what was happening. Where there were gaps in the rules, regulators lacked the authority to take action. Where there were overlaps, regulators lacked accountability for their inaction – President Obama, 17 June 2009

Change we can believe in?

Specificity of accountable activity

Low High

Autonomy of accountable agent

High

ConstitutiveCreation of “accountable space”

of internalized norms and standards

ManagerialSet “what” agent is accountable for (objective or standard), allow

agent to determine “how”

Low

RegulativeCreation and externalized

oversight of actions of agent within “accountable space”

PerformativeSet “what” agent is accountable

for and “how” to proceed

Figure 2: Accountable Strategies

Applied Ethics and the GFC Immanuel Kant’s categorical imperative, namely ‘act

only according to that maxim whereby you can at the same time will that it should become a universal law’

Utilitarian or consequential approaches apportion blame on impact

Essential to differentiate between the product and the inappropriate uses to which it was put to work

It is a deficient defence to claim ignorance of how these products were structured or how unstable the expansion of alchemistic engineering had made individual banks or the system as a whole

The failure to calculate the risks and design or recalibrate restraining mechanisms at the corporate, regulatory and political levels grossly exacerbated the externality costs

Virtue Ethics: The Promise of Integrity ‘elevation of the values of the market to a central social

place’ risks creating the circumstances in which ‘the concept of the virtues might suffer at first attrition and then perhaps something near total effacement’ (After Virtue, p 256, p.196)

‘effectiveness in organizations is often both the product and the producer of an intense focus on a narrow range of specialized tasks which has as its counterpart blindness to other aspects of one’s activity’ (1982)

Compartmentalization occurs when a ‘distinct sphere of social activity comes to have its own role structure governed by its own specific norms in relative independence of other such spheres. Within each sphere those norms dictate which kinds of consideration are to be treated as relevant to decision-making and which are to be excluded’ (1999)

The Dimensions of Integrity

Integrity is a cluster concept: consistency of actions, values, methods, measures and principles within or between biological and ecological entities

‘The condition of having no part or element wanting; unbroken state; material wholeness; completeness; entirety’ (OED);

Unimpaired or uncorrupted state Soundness of moral principle (responsibility?); the

character of uncorrupted virtue(s); honesty (self-interrogation), sincerity (self-synthesis)

Practical not a theoretical issue informed by practice: ‘Lawyers must do more than know the law and the art of

practicing it. They need as well to develop a consciousness of their moral and social responsibilities .... Merely learning and studying the Code of Professional Responsibility is insufficient to satisfy ethical duties as a lawyer’ - Justice Sandra Day O’Connor

Integrity in Practice: ASIC ASIC has completed a strategic review of its operations. a focus on outcomes; the development of initiatives to help retail investors

manage and protect wealth; the introduction of new investigative techniques to reduce

systemic problems; the reduction of red-tape in administration; and an emphasis on facilitating inward and outward investment

by differentiating the Australian marketplace by demonstrable improvements in business integrity

Success, however, will depend on ASIC’s ability to cause market participants to embrace the reform agenda including, crucially, its conception of business integrity.

Integrity in Practice and Practise The market in unrated, unlisted bonds accounts for $8 billion

and involves 92 vehicles with variable risk Benchmarked articulation of risk (e.g. credit rating, equity

capital, liquidity, lending principles, portfolio diversification, valuation of stock, related party transactions and rollovers and early redemption possibilities and penalties)

External gatekeepers should explicitly take disclosure into account when issuing valuations but also risk that enhanced levels of disclosure can obfuscate as well as illuminate

Attention must also be placed on and accountability demanded from those providing corporate advisory services and the creation and dissemination of technically legal but misleading advertising (i.e. not just trustees and auditors but also copywriters, production teams, publishers)

Requires professional groups to acknowledge their own responsibility and be accountable: acquiescing to external scrutiny of what codes of conduct mean in practice

Retrieving the Meaning of Accountability in the Causes of the Global Financial Crisis

Retrieving the Meaning of Accountability in the Policy Responses

Explaining the Gap Between Rhetoric and Substance in Capital Market Regulation

Transcending Regulatory Failure by focusing on interaction of Rules, Principles and Social Norms in Capital Markets

Integrating Integrity into Accountable Design

Strategies for Development