The Argument for Less Regulation and More Pre-Regulation

I came across a post on ResPublica from Adam Wildman which argues for regulators to consider shifting the regulatory debate away from the more/less paradigm to a debate about pre/post regulatory frameworks.

Chart Source: JP Morgan
Chart Source: JP Morgan

Basically, Wildman argues that in most situations trying to create regulations ex-post facto is a loosing proposition. He feels that the best regulatory framework is not one that sets rules and legal boundaries but one that tries to root out the cause of unwanted behavior and tries to eliminate those phenomenon.

Writes Wildman:

In almost every area of social science, research conclusively demonstrates that prioritising prevention strategies over dealing with the effects of any given problem is a much more effective means of tackling an underlying problem. When assessing the suitability of regulation practices for any given industry, we need to first consider seriously whether regulation is absolutely necessary. We would argue that in most cases it is not, and instead would argue for practices that comprise what we would call “pre-regulation”.

Pre-regulation describes those practices and incentives that foster responsible behaviour from individuals or corporate bodies without the need to result to external regulation. As the Parliamentary Commission on Banking Standards recently pointed out in its Final Report, real change in industry-wide behaviour can only originate from initiatives promoted by the industry itself. It is not enough for a regulator to simply impose rules of interaction or principles of ethical behaviour from afar.

Wildman is, I think, correct to argue that a regulatory body that tries to think through the legal limits of something like today’s sophisticated financial markets is doomed to failure. The best finance experts are on analytical/methodical and yet creative/risk-taking (an interesting combination, by the way). Give these people almost unlimited resources and incentives, and one gets what we have today: a financial system that operates at the edge of legality in many ways. Trying to create a legal code for this sort of hyper-dyamimic ecosystem is never going to work. What will help, argues Wildman, is a “pre-regulatory” model that roots out the structural and behavioral drivers of corruption and tries get the market agents to change them directly (through the right incentives) in return for a lower regulatory burden, which, presumably, would lower the cost of doing business in those areas that are not on the legal margin.

Though Wildman does not go into a lot of detail on just how a pre-regulatory framework would handle today’s City or Wall Street, I think he is on to something in this line of thought. To his model I would add only that as a society we should consistently and rigorously apply the most severe legal sanctions to those to do break the laws that govern financial markets. In sum, the quid pro quo to traders would be the following:  society will dismantle a great part of the ridiculous and mostly ineffective regulatory structures that govern financial markets in return for (a) an effective pre-regulatory model that roots out the worst sources of corruption and (b) rapid and severe punishment of anyone who ignores the regulations that are left in place.

Perhaps this kind of hybrid pre-regulation/penalty model might improve what we have today, which is a world where the financial markets are as much frontier casinos as they are the repositories of fiduciary trust and responsible investment.

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Carlos Alvarenga

Founder and CEO at KatalystNet and Adjunct Professor in the Logistics, Business and Public Policy Department at the University of Maryland’s Robert E. Smith School of Business.

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