25/07: Capital Markets - Regulatory Design Issues
Category: Regulation
Posted by: Admin
I wrote the following summary of problems with present approaches in N.Z.......
Regulatory Design Failure in Capital Market Reform in New Zealand
1. The contention of this submission is that attempts to improve the performance of the regulatory regimes for capital markets in New Zealand suffer from an inadequate consideration of regulatory design options and thus new initiatives, as they are currently conceived, are likely to prove costly and ineffective if reform efforts do not address this flaw.
2. Specifically, reforms being examined do not start with a consideration of the critical difference between before the fact, or ex ante, regimes and after the fact (ex post) regimes. New Zealand, in line with most jurisdictions bequeathed British regimes, relies almost exclusively on ex ante approaches such as licensing and compulsory disclosure. The performance of such regimes has, to date, proven inadequate.
3. While cries from the media and various interest groups have adopted emotive and sometimes melodramatic criticisms of the framework, the agencies charged with enforcing it and other factors such as “political will”, these charges largely miss the fundamental weaknesses in ex ante regulation and inevitably end up calling for “stricter versions” of the same approach. Such regimes are therefore doomed to the same fate as their predecessors.
4. A more adequate analysis is required as a point of departure .
5. Attempts to regulate ex ante or before the fact in a preventative fashion, for example through licensing, imposing “educational requirements” and imposing disclosure, involve two major difficulties:
5.1. Information problems – ex ante regulation requires regulators to attempt to conceive of all circumstances under which investors might be unreasonably harmed (i.e. harmed beyond bearing risks associated with a specific investment). They therefore depend upon regulators “guessing” the nature and content of the essentially private knowledge held by issuers and promoters of investment. This is a demanding task which by definition can never be complete, and,
5.2. High costs – the process of establishing high standards for licensing, disclosure and other before the fact information revealing processes inevitably raises barriers to entry and thus lowers the very competitive processes which might protect investors. The more stringent the call for reform and regulation, inevitably the higher the barriers and thus the cost incurred through lack of competition.
6. Neither do regulatory barriers necessarily operate in investors’ interests. Under presently proposed schemes it is unlikely that Warren Buffet could operate as a financial advisor in N.Z. while at the same time certain incumbents of dubious qualification may well remain in the industry.
7. It is critical to note that these deficiencies exist because of design issues and the incentives created by adopting a heavy reliance on ex ante regimes rather than anything to do enforcement resource, motivation or the politics of interest group activity.
8. After the fact or ex post regimes focus on specific outcomes and seek to provide remedies and sanctions where adverse outcomes arise for investors. Such regimes seek to facilitate tort actions, suing of issuers and promoters, provision of guarantee mechanisms and the use of bonds and insurance instruments which compensate investors for damage incurred. They might or might not involve criminal remedies and sanctions.
9. The possibility and likelihood of ex post actions arising acts to create before the fact incentives which operate on all (not just regulated) participants in capital markets. Insurance sought by issuers and promoters to cover that likelihood in turn generates supply side scrutiny and monitoring as well as private regulatory activity amongst insurers who underwrite issuers and promoters.
10. These characteristics address the fundamental flaws of ex ante regulation.
10.1. Issuers and promoters generally have greater knowledge of the risks and potential problems associated with a given investment than regulators since this is essentially private rather than public knowledge, it is dynamic (rather than static as schedules of acceptable and unacceptable behaviour are for example) and changes from investment to investment, and those taking ex post action have specific and particular knowledge of unacceptable outcomes as well as direct incentives to take enforcement action, and,
10.2. Because ex post regimes focus on remedies for particular outcomes rather than blanket attempts to filter certain kinds of behaviour or persons, they do not impose unnecessary costs on legitimate activity. Like any regulation ex post regulatory regimes raise costs but not at the expense of competition to the extent associated with ex ante regimes.
11. An additional benefit is that the compensatory element of ex post regimes has the potential to increase the perception of “fairness” which adds credibility to the perceived integrity of markets.
12. The most frequent objection to ex post regimes as opposed to ex ante regimes is that are not preventative and that action occurs “too late”. This “common sense” position is to a large extent flawed. The knowledge that ex post action is likely operates as an incentive to all existing and would be issuers and promoters to exercise care and diligence regardless of licensing, education and other so called preventative measures.
13. The possibility of loss also creates incentives for issuers and promoters to provide comfort to investors through underwriting mechanisms, posting of bonds and use of insurance mechanisms. Providers of such instruments in turn generate significant scrutiny of issuers and promoters – before the fact.
14. No regulatory regime is perfect. Moreover the cost of pursuing perfection is high. A better balance of ex post and ex ante mechanisms would serve N.Z. capital markets better than the current dominance of ex ante approaches.
15. Some useful attention might therefore be applied to institutional arrangements which facilitate class actions, encourage contingent enforcement of ex post remedies, promote the posting of bonds and allow insurance mechanisms to develop. Such arrangements, coupled with more appropriate levels of low barrier ex ante regulation could be of benefit.
16. Examples might include filtering ony for criminal records, not seeking to “second guess” what investors need in prospectuses, abandoning costly and blurred distinctions such as the “public versus the habitual investor” along with declarations of the limits of government regulatory action).
17. The reform of N.Z. capital market regulation is a prime focus at present. The approaches taken to date have not, at least publically, been characterised by a comprehensive assessment of the options suggested by the last two decades research in law and economics but have instead focussed on the same ex ante regulatory mechanisms which produced the failures which led to calls for reform.
18. A more balanced approach with the provision of significant ex post mechanisms would get much closer to the heart of the problem while providing low costs mechanisms capable of delivering better outcomes for investors at lower costs to taxpayers.
Regulatory Design Failure in Capital Market Reform in New Zealand
1. The contention of this submission is that attempts to improve the performance of the regulatory regimes for capital markets in New Zealand suffer from an inadequate consideration of regulatory design options and thus new initiatives, as they are currently conceived, are likely to prove costly and ineffective if reform efforts do not address this flaw.
2. Specifically, reforms being examined do not start with a consideration of the critical difference between before the fact, or ex ante, regimes and after the fact (ex post) regimes. New Zealand, in line with most jurisdictions bequeathed British regimes, relies almost exclusively on ex ante approaches such as licensing and compulsory disclosure. The performance of such regimes has, to date, proven inadequate.
3. While cries from the media and various interest groups have adopted emotive and sometimes melodramatic criticisms of the framework, the agencies charged with enforcing it and other factors such as “political will”, these charges largely miss the fundamental weaknesses in ex ante regulation and inevitably end up calling for “stricter versions” of the same approach. Such regimes are therefore doomed to the same fate as their predecessors.
4. A more adequate analysis is required as a point of departure .
5. Attempts to regulate ex ante or before the fact in a preventative fashion, for example through licensing, imposing “educational requirements” and imposing disclosure, involve two major difficulties:
5.1. Information problems – ex ante regulation requires regulators to attempt to conceive of all circumstances under which investors might be unreasonably harmed (i.e. harmed beyond bearing risks associated with a specific investment). They therefore depend upon regulators “guessing” the nature and content of the essentially private knowledge held by issuers and promoters of investment. This is a demanding task which by definition can never be complete, and,
5.2. High costs – the process of establishing high standards for licensing, disclosure and other before the fact information revealing processes inevitably raises barriers to entry and thus lowers the very competitive processes which might protect investors. The more stringent the call for reform and regulation, inevitably the higher the barriers and thus the cost incurred through lack of competition.
6. Neither do regulatory barriers necessarily operate in investors’ interests. Under presently proposed schemes it is unlikely that Warren Buffet could operate as a financial advisor in N.Z. while at the same time certain incumbents of dubious qualification may well remain in the industry.
7. It is critical to note that these deficiencies exist because of design issues and the incentives created by adopting a heavy reliance on ex ante regimes rather than anything to do enforcement resource, motivation or the politics of interest group activity.
8. After the fact or ex post regimes focus on specific outcomes and seek to provide remedies and sanctions where adverse outcomes arise for investors. Such regimes seek to facilitate tort actions, suing of issuers and promoters, provision of guarantee mechanisms and the use of bonds and insurance instruments which compensate investors for damage incurred. They might or might not involve criminal remedies and sanctions.
9. The possibility and likelihood of ex post actions arising acts to create before the fact incentives which operate on all (not just regulated) participants in capital markets. Insurance sought by issuers and promoters to cover that likelihood in turn generates supply side scrutiny and monitoring as well as private regulatory activity amongst insurers who underwrite issuers and promoters.
10. These characteristics address the fundamental flaws of ex ante regulation.
10.1. Issuers and promoters generally have greater knowledge of the risks and potential problems associated with a given investment than regulators since this is essentially private rather than public knowledge, it is dynamic (rather than static as schedules of acceptable and unacceptable behaviour are for example) and changes from investment to investment, and those taking ex post action have specific and particular knowledge of unacceptable outcomes as well as direct incentives to take enforcement action, and,
10.2. Because ex post regimes focus on remedies for particular outcomes rather than blanket attempts to filter certain kinds of behaviour or persons, they do not impose unnecessary costs on legitimate activity. Like any regulation ex post regulatory regimes raise costs but not at the expense of competition to the extent associated with ex ante regimes.
11. An additional benefit is that the compensatory element of ex post regimes has the potential to increase the perception of “fairness” which adds credibility to the perceived integrity of markets.
12. The most frequent objection to ex post regimes as opposed to ex ante regimes is that are not preventative and that action occurs “too late”. This “common sense” position is to a large extent flawed. The knowledge that ex post action is likely operates as an incentive to all existing and would be issuers and promoters to exercise care and diligence regardless of licensing, education and other so called preventative measures.
13. The possibility of loss also creates incentives for issuers and promoters to provide comfort to investors through underwriting mechanisms, posting of bonds and use of insurance mechanisms. Providers of such instruments in turn generate significant scrutiny of issuers and promoters – before the fact.
14. No regulatory regime is perfect. Moreover the cost of pursuing perfection is high. A better balance of ex post and ex ante mechanisms would serve N.Z. capital markets better than the current dominance of ex ante approaches.
15. Some useful attention might therefore be applied to institutional arrangements which facilitate class actions, encourage contingent enforcement of ex post remedies, promote the posting of bonds and allow insurance mechanisms to develop. Such arrangements, coupled with more appropriate levels of low barrier ex ante regulation could be of benefit.
16. Examples might include filtering ony for criminal records, not seeking to “second guess” what investors need in prospectuses, abandoning costly and blurred distinctions such as the “public versus the habitual investor” along with declarations of the limits of government regulatory action).
17. The reform of N.Z. capital market regulation is a prime focus at present. The approaches taken to date have not, at least publically, been characterised by a comprehensive assessment of the options suggested by the last two decades research in law and economics but have instead focussed on the same ex ante regulatory mechanisms which produced the failures which led to calls for reform.
18. A more balanced approach with the provision of significant ex post mechanisms would get much closer to the heart of the problem while providing low costs mechanisms capable of delivering better outcomes for investors at lower costs to taxpayers.
