The Governance Trap and the future of regulation, an introduction

Mike Power, LSE[/caption] [caption id="attachment_1586407" align="alignleft" width="150"]GB MP – Version 2 Gideon Benari, Solvency II Wire[/caption] Mike Power, professor of accounting, Centre for Analysis of Risk and Regulation (CARR) at the London School of Economics and Gideon Benari, editor, Solvency II Wire, co-chairs of The Governance Trap, outline some of the emerging themes from the discussion.

Principles of good governance have acquired growing prominence in regulatory debates.

Whether in response to complex events like the financial crisis or to specific ones such as the VW emissions testing scandal, regulators and rule makers are increasingly emphasising principles of good governance and placing them at the heart of regulatory frameworks. And rightly so. The advantage of focusing on governance, or so its proponents argue, is that it transcends restrictive rules-based regulation and tick-box compliance cultures. The flexibility it affords in managing and regulating highly complex organisations is alluring.

Most importantly, an emphasis on governance principles shifts the onus of compliance and ultimately of good corporate behaviour onto the regulated entities. They are responsible for implementing governance frameworks that deliver specific outcomes – whatever the specific business model or underlying corporate culture.

But while the prospect of creating responsible organisations may be attractive on paper, in practice there are limits to the efficacy of governance as a regulatory tool.

These limits to the reliance on governance in regulation were explored in ‘The Governance Trap and the future of regulation’, a collaboration between Solvency II Wire and the Centre for Analysis of Risk and Regulation (CARR) at the London School of Economics that brought together ten regulators from a diverse range of sectors.

The main themes that emerged in the discussion are explored in this introduction to a volume of articles published by a number of the participants who took part in the event on 3 March 2016, hosted by law firm DWF LLP.

List of participants at the event

Nathalie Berger, head of unit, Insurance and Pensions, European Commission

Martin Crouch, senior partner, improving regulation, Office of Gas and Electricity Markets

Michael Guthrie, director of policy and standards, Health and Care Professions Council

Elspeth Macdonald, deputy chief executive, Food Standards Scotland

Kathryn Morgan, director of regulatory operations, Gibraltar Financial Services Commission

Chris Moulder, director of general insurance supervision, Prudential Regulation Authority, Bank of England

Jan Parner, deputy director general, Danish Financial Supervisory Authority

Amanda Spielman, chair, Office of Qualifications and Examinations Regulation

Philip White, head of operational strategy, Health and Safety Executive

Manuela Zweimueller, head of regulations, EIOPA

Co-chairs

Gideon Benari, editor, Solvency II Wire

Mike Power, professor of accounting, Centre for Analysis of Risk and Regulation, LSE

Observers

Martin Lodge, professor of political science and public policy, director, Centre for Analysis of Risk and Regulation

Emerging themes in governance and regulation

Based on early contributions by participants, Gideon Benari and Michael Power, co-chairs of the event, identified four key themes associated with the challenges of governance in regulation: behaviour change, complexity, flexibility and legitimacy (see The Governance Trap, G Benari & M Power).

Behaviour change

The emphasis on governance in regulation is closely linked to the assumption that appropriate governance arrangements can moderate behaviour to align it with wider regulatory purpose (e.g. responsible behaviour or promoting competition). This is in turn linked to questions of individual accountability.

The governace trap 2Governance is also regarded as an effective preventative strategy, focusing on the capacity of the regulated organisation to self-discover problems before they materialise.

Participants in the discussion agreed that an emphasis on governance as a panacea for behaviour change was unlikely to generate intended effects on its own. Rather, behaviour change related to questions of organisational culture and design choices in how governance principles were being applied within and across regulated entities.

For example, one regulator noted that a growing interest in governance principles as a regulatory tool reflected increasing concern that regulated companies regarded fines as part of the cost of doing business.

In other areas, such as health and safety, governance principles had already witnessed widespread recognition and acceptance. There, governance had been used to introduce a culture of responsibility that included a focus on risk and communicating the benefits of having a robust approach to health and safety.

Flexibility

Perhaps one of the greatest advantages of promoting governance as a regulatory approach is the supposed flexibility it affords regulators to adapt to changing business practices and environments.

The legislative process is said to be too slow to adapt to changing conditions (an argument witnessed in the context of ‘disruptors’ such as Uber or AirBnB). By applying general governance principles, regulators can modify rules to adapt to fast-changing markets and emerging risks without the need to wait for the legal process to catch up.

Complexity

The flexibility that governance enables is also appealing for the regulation of large complex organisations and cross-border groups. Setting generally desired best-practice principles can reduce the need to draft over-prescriptive rules that seek, and inevitably fail, to take into account all possible scenarios and setups.

Even so, regulators noted the difficulty, if not impossibility, of defining a uniform governance framework that can be applied effectively across all the entities of a complex organisation.

[pullquote class =”left”]Perhaps one of the greatest advantages of promoting governance as a regulatory approach is the supposed flexibility it affords regulators to adapt to changing business practices and environments.[/pullquote]The discussion suggested that governance did not represent a one-size-fits-all solution. Governance frameworks had to be adapted to fit individual entities’ business models, geographical spread, and the tone and culture set by senior management.

Financial regulators appear to have acknowledged this constraint and are in favour of allowing firms, and especially cross-border groups, to design and own their governance frameworks.

Other industries, too, are characterised by considerable differences in terms of size and type of activity. Again, for regulators this highlighted the difficulty of devising a model that could be applied to organisations at large.

In sum, therefore, the potential advantages of enhanced flexibility and responsiveness to regulated entities’ specific characteristics had to be carefully balanced with the regulatory need to establish some uniform benchmarks to ensure acceptable standards across the entire industry.

Unpacking the governance black box

A major problem associated with governance is how to measure, evaluate and document its application and quality.

During the discussion, regulators and industry stakeholders reflected on the challenges associated with verification. In general, there was a focus on the activities of the board. It was suggested that any positive outcomes from governance principles were usually a result of the ‘tone from the top’.

One effective evaluation technique was to assess responses to questions about governance. One regulator used what they called a ‘Muppet test’– a series of questions aimed at testing a board member’s ability to stand up to pressure. Others suggested questions related to practice. For example, one question was to enquire into the frequency in which the risk function was involved with product design.GT_Audience_001

In some cases the way an organisation responded to requests by the regulator to put controls in place was also regarded as a good indicator for proper governance. If the request was met with a lot of resistance, it could suggest insufficient attention to a governance framework or approach.

A further complication was that enthusiasm for endorsing governance principles was not uniform within organisations. Often there were significant discrepancies between the attitude of the board and the organisation as a whole.

This could perhaps be exemplified best in a number of major organisational failings, where ex-post investigations revealed that the paperwork was completed as required and bore little relation to the underlying problems. These experiences by regulators were echoed by some industry participants who noted that similar challenges of evaluating the quality of governance frameworks occurred when trying to conduct due diligence for M&A transactions.

Legitimacy

The limitations of ‘measuring’ governance were also problematic for the nature of the interaction between some regulators and the respective regulated industry. Many regulators operate as government appointed agencies and so had to establish their legitimacy vis-à-vis their regulated entities. However, relying on good governance as part of a proportionate regulatory approach, might also enhance that legitimacy.

The industrialisation of governance

An almost inevitable consequence of the rise in prominence of governance has been the ‘industrialisation’ of the governance process.

[pullquote]A trend towards the industrialisation of governance runs the risk of being entirely counter-productive as regulated entities focus on compliance with governance handbooks, rather than promoting a culture of challenge.[/pullquote]A number of participants reflected on the similarities with audit culture, where a standardised audit book had been created and the focus had turned to ‘complying’ with the rules set in the book. This compliance had in fact given a false sense of comfort, as the underlying sense of organisational responsibility had been lost.

Indeed, it was suggested that the widespread boom in governance as a favoured regulatory strategy, and its subsequent industrialisation, may already contain the seeds for its demise as an effective approach, leading to exactly the type of tick-box compliance pattern that it was trying to avoid.

The future of governance and the governance trap

The Governance Trap set out to explore the limitations of governance as an approach in regulation. The discussion (and the accompanying volume of articles) highlighted some of the challenges, and participants acknowledged that governance does not present a one-size-fits-all solution and that there are difficulties in monitoring and affecting behaviour change.

More worryingly, a trend towards the industrialisation of governance runs the risk of being entirely counter-productive as regulated entities focus on compliance with governance handbooks, rather than promoting a culture of challenge.

What then might be the role for governance in regulation in a decade’s time? Opinion here was divided. On the one hand, governance faces the challenge of maintaining its relevance at a time where technological and societal changes are questioning key relationships. On the other hand, the openness of what governance means offers the promise of continued relevance. The challenge then is how to develop a more nuanced understanding of governance to make it a more effective regulatory approach.

Articles in this series

Manuela Zweimueller, head of regulations, EIOPA on the potential for misinterpreting dialogue with the regulator as a ‘soft approach’ in the Solvency II insurance regulation framework and a call to include more behavioural scientist in drafting regulation. Michael Guthrie, director of policy and standards, Health and Care Professions Council on the role of governance in regulating healthcare professionals and meeting the challenges of creating a joined up and flexible framework across the sector’s nine regulators, which cover sixteen professions. Kathryn Morgan, director of regulatory operations, Gibraltar Financial Services Commission on managing for good governance in a diverse sector as reflected in the experience of the financial services industry in Gibraltar. Jan Parner, deputy director general, Danish Financial Supervisory Authority on the perils of overreliance on governance as a kneejerk reaction to organisational failings in the financial sector. Elspeth Macdonald, deputy chief executive, Food Standards Scotland on the importance of governance for creating trust with consumers, the problem of a unified approach for the food supply chain and what “good” looks like.  

‘The Governance Trap and the Future of Regulation’ is a collaboration between Solvency II Wire and the Centre for Analysis of Risk and Regulation (CARR) at the London School of Economics.

The event was held in London on 03 March 2016 and hosted by DWF LLP.   dwf To receive the next article in the series directly to your inbox and subscribe to the Solvency II Wire mailing list for free, click here. [widget id=”mp_featured_posts-18″] [adsanity_group num_ads=1 num_columns=1 group_ids=233 /]]]>

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