Conduct regulation: Helpmate or distraction?

The lure of misconduct

Conduct regulators have a distinct staff profile and occupational culture, drawing upon lawyers, investigators with knowledge of markets, auditors and other gatekeepers, in contrast to the economists and quant types who make up much of the staffing for prudential regulation. They inhabit different worlds (with something of a status differential). Although the prudential side of regulation carries the responsibility for the technocratic networking, introspection, herding and convergence that facilitated financial markets' tendencies towards Too Similar To Fail and Too Big To Fail, it is impossible to ignore conduct regulation for two reasons.

Firstly, in the wake of multiple scandals, conduct regulation has risen to the top of the political agenda. Many citizens are now aware of the undue risk-taking undertaken by mainstream financial firms in the runup to the crisis; are aware of the frauds that were uncovered and the high-level conflicts of interest that continue to be exposed; and are agog at the continuing stream of revelations, allegations and fines (LIBOR, insider trading, conflicts of interest, product mis-selling and so forth; see Table 10.1, last column). The perception has arisen that enforcement was a tad too lax in the pre-crisis years.

Secondly, however, there is a question over whether more vigorous enforcement of conduct regulation - such as we are seeing as the crisis develops - might help to make financial markets sounder. Put crudely, a few bankers metaphorically hung from street lights could divert attention from issues that are more fundamental (systemic vulnerabilities, public impacts and how to reduce them). Thus, we ask the following question: does the current heightened state of the debate over market misconduct offer opportunities to strengthen prudential regulation - or is it a populist distraction?

Some history may be helpful. Looking back to the period before the emergence of the crisis, a variety of approaches were taken to the regulation of market misconduct. For example, commentators commonly drew attention to the contrast between a quite passive approach to enforcement in Europe and the UK in particular, and a heavier hand in some states in the US. Notwithstanding New York state attorney Elliot Spitzer's moral lapses and his subsequent reputational destruction, vigorous enforcement continues under his successors and indeed has to some extent been taken up at federal level. Today, regulators are to some extent overcoming their previous ambivalence over enforcement actions, even against high-level people and top global firms. This is not simply a change of mood; it also has potentially positive legal aspects, as seen, for example, in the Spector judgment from the European Court of Justice on insider trading (for a dissenting view, see Klohn 2010).

However, it is by no means apparent that such changes - a more wakeful and serious approach on the part of conduct regulators, and subsequently more attention to the rules on the part of market participants - have any bearing on prudential concerns about systemic risk, Too Connected To Fail, or bailouts at public expense. Conversely, it is well established that totally legal market behaviour can inculcate very serious systemic risks. Consider, for example, the well-worn example of Bear Stearns, whose demise in 2008 'put the writing on the wall' for Lehman Brothers because of the similarity of their business models. That, and the wider trajectory of failures from 2007 to the present day,

Table 10.1 Governing financial market regulation: Technocratic autonomy versus democratic direction, with diffuse accountabilities being a middle category

•<- Technocratic Autonomy versus Democratic Direction ->?

Technocratic autonomy

Diffuse accountabilities

Democratic direction



Technocratic agencies with high autonomy. Role model: independent central banks (ICBs). Result: strong networking with peers, effectively neutralizing external, formal accountabilities.

Regulators with a mix of upward-facing, horizontal and downward-facing accountabilities. Complex bargaining between regulators (national, regional, international), regulatees, ministries and parliaments, post hoc.

Either: party political agenda setting, then parliamentary endorsement or amendment of proposed rules (strong version). Or: directly elected heads of agencies (weaker version). Depassement of both independence and accountability.

As illustrated in



Technical legitimization ('science-based') and stronger peer networking ->? greater international convergence of standards. For example, Basel group; European Central Bank; Financial Stability Forum.

Complex bargaining between regulators (national, regional, international), regulatees, ministries and (sometimes) parliaments. Contingent outcomes, between autonomous and democratic.

Greater possibilities for jurisdictional competition. Within EU, UK tendency to 'gold plate' some standards, for example on bank capital. Diversity of prudential regimes ->? less connected markets, resulting in less instability at a global level.

As illustrated in conduct regulation

Independence in the ICB tradition poorly theorizes misconduct: it is 'market failure', but theory on its rectification is vague and low status rectification. For ICBs, enforcement is rather distasteful - in cultural terms, a bit dirty.

Low enforcement (pre-crisis), due to regulatory tendency to dialogue with industry. The US was more active than EU, but still 'stalled' in the face of high status (for example, Madoff). On Canada, see Williams 2012. Post-crisis, regulators have been shamed into more vigorous enforcement.

More active parliamentary enquiries into misconduct, not simply targeting individuals but 'naming and shaming' and reshaping market cultures (Parliamentary Commission 2013). Alternatively (in US): activist (elected) state attorneys.

illustrate that not just single firms but also the whole financial sector can combine boneheaded leadership and a determination to maintain unsustainably high levels of risk without running foul of conduct regulation. Hyper-connectedness and systemic risk seem, in principle, to be unrelated to the presence or absence of market misconduct in the legal sense.

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