Self vs. public discipline in the financial field - Tommaso Padoa-Schioppa
Central bank: ecb | Type: speech | Date: 2002-05-20

Self vs. public discipline in the financial field

Lecture by Tommaso Padoa-Schioppa,Member of the Executive Board of the European Central Bank

TABLE OF CONTENTS

I.

Introduction

II.

Conceptual map

III.

Standards as a tool for governance

IV.

Process-oriented regulation

V.

Role of public discipline 12

VI.

Conclusion 16

References 18

I.

INTRODUCTION

1.

This is the third lecture on financial regulation and supervision which I am privileged to deliver, here, at the London School of Economics, thanks to the generous invitation of Professor Charles Goodhart.

In February 1999 I dealt with the issue of co-operation among European supervisors in the banking field, a topic which is currently in the forefront of EU policy-makers' discussions.

In January this year, I explored emerging cross-sectoral links between banking and securities activities and the appropriate regulatory responses to this development.

Today, I will be discussing self versus public discipline in the financial field.

2.

Broadly speaking, one could say that on the first two occasions I examined the issues of "Who (whether a national or a European authority) should regulate?" and "What should be regulated?" in light of the changes in the financial industry.

Today, I shall focus on the perhaps less frequently raised question of "How should we regulate?" I feel that the "how" issue, i.e. the mode of regulation - and its consequences for achieving the objectives of systemic stability and investor protection - has not attracted all the attention it deserves.

I have used the word "regulation" but, to be precise, I should talk of regulation and supervision.

Regulation refers to rule making whereas supervision deals with the implementation and the enforcement of the rules.

In my remarks, I will address the simultaneous development of financial regulation along two key dimensions.

First, the use of financial standards, rather than law-based prescriptions; and second, the development of "process- oriented" regulation, drawing on financial institutions' internal control mechanisms, rather than the traditional simple and easily verifiable rules.

In both dimensions, we are witnessing a development that has many desirable properties, as it is "industry-friendly" and allows the regulatory framework to adjust quickly and flexibly to financial innovation.

However, one must be aware that this twofold development also implies a substantial outsourcing of de facto self-disciplinary functions to financial institutions.

Public authorities need to be alert to the potential pitfalls associated with this delegation of power and be careful not to hand over functions which are in fact public.

They should retain the possibility of "call-backing" the outsourcing contract whenever needed to maintain effective public control.

The case of Enron was a painful, but perhaps healthy, remainder of the dangers in placing too much trust on the self-corrective features of the market mechanism.

3.

My remarks are organised as follows: I will start by setting out the conceptual road map I shall use to explore the complex landscape of controls in the financial industry.

Subsequently, I will review the evolution of the methods of financial regulation (along the two dimensions of this map) towards the use of standards and process-oriented regulation.

Finally, I will turn to the policy issue of how to maintain effective control when significant self-regulatory powers are delegated to financial institutions.

II.

CONCEPTUAL MAP

4.

Let me begin by defining the conceptual road map.

To this end I will use two pairs of opposite concepts, which in my view provide the essential

dimensions for analysing how the methods of financial regulation have evolved.

The first dimension is the contrast between standards and law-based regulations as the basic tool for exercising discipline.

Standards constitute an informal mode of governance; they are formulated under a consensus principle by those to whom they are addressed; and compliance with them is voluntary.

By contrast, law-based provisions represent formal public regulations which are stipulated in the law or issued by the competent public authorities.

While law-based provisions are binding "by construction", i.e. because of their legal status, standards are voluntary by construction, but can also be binding in practice.

For instance, complying with standards can be strictly required to be active in a specific market due to peer or market pressure.

Hence, one should not associate strictness with public rules and laxity with standards; in some circumstances, standards can be even more compelling than public rules if, for instance, the latter are enforced by a weak public authority.

To make this point clear, think about the changes in traffic behaviour in different countries, even though the public rules are pretty much the same.

In Rome, people (including, I must confess, myself) park their car without inhibition in the second row, even if this is prohibited, and there is hardly a policeman, let alone any one else, who will bring it to their attention.

In Frankfurt , however, no policeman is fast enough to correct the undisciplined driver before his peer group of fellow drivers, or the multitude of attentive pedestrians, does so.

What ultimately differentiates standards from law-based provisions is that they emerge endogenously from the prevailing industry practices, while law-based provisions stem from exogenous public intervention.

In the financial field, several self-regulatory standards have been established by the industry itself, possibly with a degree of public sector contribution.

Interestingly, we also find the use of standards in the international arena, as a tool to co-ordinate the regulatory policies of national authorities because there is no formal legal structure in place at world level.

5.

The second dimension of the road map is the distinction between rule- based and process-oriented regulation.

In the rule-based approach, the requirements consist of simple and often mechanical formulas, which are objective and applied in a uniform manner.

This approach ensures consistency across financial institutions, but it disregards substantial diversity in their risks and business activities.

In addition, a simple rule easily becomes outdated by market developments and arbitrage opportunities.

While this has always been true, technological advances and financial innovation have made it increasingly difficult to determine a single set of rules.

By contrast, the process-oriented approach rejects the idea of "one-size-fits-all" rules, as it puts the onus on financial institutions' own internal control processes.

Process-oriented regulation is not readily comparable across firms, as it does not impose a uniform framework for every institution.

It is also rather difficult to implement and verify in practice.

However, it has the major benefit of being readily adaptable to dynamic developments in the financial industry, provided that internal procedures are kept in line with market developments.

To quote Alan Greenspan: "the use of new technology and instruments in

rapidly changing financial markets means that the supervisor must rely on his evaluation of risk management procedures as a supplement to - and in extreme cases, a substitute for - balance sheet facts".

6.

Now, when locating regulatory innovations on the conceptual map, it is not a coincidence that nowadays we see the emergence of standards and process-oriented regulation at the same time.

Both are flexible, industry- friendly forms of governance.

Both can emulate market developments and adjust to them more easily than law-based requirements and explicit mechanical rules.

Both place the emphasis on the self-disciplining mechanisms in the financial industry.

In going forward, I will first review the relevance of financial standards and address the evolution towards process-orientation in financial regulation.

In terms of both dimensions, I will refer to developments and examples on both a national and an international level.

As you are aware, the international stage has gained much in importance in recent times, as there is an ever-greater need for international co-ordination due to the integration of financial markets and extensive cross-border operations by financial institutions and investors.

III.

STANDARDS AS A TOOL FOR GOVERNANCE

7.

I now turn to the development of financial standards, starting from the field where it originally gained strength, i.e. the national field.

Standards have been an instrument of industry self-discipline almost since the beginning of time.

Their function was to define the terms of supply and marketability of products, thus facilitating trade.

Indeed, when we think of standards, we probably first visualise the kind of industrial and technical

standards to which we are subject to in our everyday life - like the plane ticket I used to get here.

In some cases, they appear as a natural (if not always fully logical) outcome of technical evolution, such as the normal computer keyboard.

In other cases they are the result of careful preparation and agreement among industry participants and associations.

Of course, this function of lowering obstacles to trade has also applied in the financial industry - think about the standardisation of bank accounts and bank transfer instruments, for instance.

8.

While removing obstacles to trade, standards can also develop into an effective form of governance, possibly serving as a substitute for public regulation.

In political science, standards and public regulations are actually viewed as alternatives, and the availability and strength of the different options are used to explain the choice of one over the other.

Accordingly, we have seen standards emerging as the primary means of governance where there has been no strong central legal authority, or where the balance of power has tilted on the side of the industry.

The use of standards in the function of governance is also very old.

This occurred, for example, in the Middle Ages, when a centralised state authority

had not yet taken shape.

Businessmen spontaneously produced "merchant law" - or lex mercatoria - whose principles and rules were enforced by the merchants themselves.

What kept people united under the same set of rules was the shared conviction of belonging to the same community - the key sanction being a rejection from that community.

This is often still the case with modern standards.

In the financial field, standards have played an important role, in the past, as a form of governance to contain risk-taking of financial intermediaries.

Subsequently, they have been replaced by public prudential regulation, which addresses mainly banks, but increasingly also other financial institutions, with the objective of safeguarding financial stability.

The period of free banking in the United States is the case in point.

In the United States , towards the end of the nineteenth century, thousands of different bank notes were in circulation, which constituted the currency for settling all sorts of transactions. "Free- banking States" did not require a license to enter the banking industry.

So- called "wildcat banks", which assumed greater risk and inflated their currency to the point where it could no longer be continuously redeemed, were constrained only by private associations acting as standard-setters.

The respective associations maintained a "club-type" control over the members of the industry, but they were not successful in imposing effective restrictions on risk-taking behaviour and in preventing banking panics.

On account of this negative experience, self-regulation was practically abandoned and was replaced by the public prudential regulation of banks, for the most part after the Great Depression.

By contrast with the prudential field, private standards have grown in importance in securities markets, in the area of conduct of business.

This other class of financial regulation aims at protecting investors and addresses banks and other financial institutions, and sometimes also non-financial institutions.

Trading in stock markets has been historically governed to quite a large extent by self-regulatory organisations.

This self-regulatory tradition has been wide- ranging in Anglo-Saxon countries; less so in continental Europe , where legal centralism, strong public authorities and public ownership have left little room to self-regulation.

In the United States , for example, the New York Stock Exchange and the National Association of Securities Dealers and Clearing

Agencies have retained important self-regulatory competencies.

Even in Europe , however, the very recent proposal to reform the Investment Services Directive contains an express clause allowing the delegation of regulatory and supervisory responsibilities to regulated markets.

In general, the importance of self-regulation in this field could increase further, as many exchanges have been transformed into private companies.

As securities markets are very important for the smooth functioning of the financial system, public authorities have had a legitimate interest in this field.

In this context, free competition has been a major public concern, since the "private club" nature of stock markets and their monopolistic dominance in national financial systems may have led to artificially high costs for firms and investors.

Possibilities for international listing and cross-border investment, however, are now eroding monopolistic practices, thus making self-regulation more compatible with free competition.

The official sector can play a major role in fostering effective competition; for instance, the current revision of the Investment Service Directive places much emphasis on unconstrained access to regulated markets by firms and investment service providers.

11.

Another central area in the field of conduct of business in securities markets relates to accounting and disclosure requirements.

This is a particularly topical area, if we think of the Enron case.

Traditionally, Anglo-Saxon countries and continental Europe have had different approaches to accounting: standards-based and law-based respectively.

In the United States , the predominant Accounting Principles, the US-GAAP, date from the 1930s and are now produced by the Financial Accounting Standards Board (FASB), a private sector standard-setting body staffed by professional accountants.

In continental Europe , governments have controlled accounting directly by means of company law provisions.

Accordingly, in the EU, the Company Law Directives set out the basic rules, although there are still differences in detail between countries.

Accounting and disclosure are of major importance for public confidence in financial markets, and therefore are of close public interest.

The Enron case, and other accounting scandals, have significantly weakened confidence, as they have shown that many tricks might be used to hide the truth and to prop up the stock market price until the very verge of collapse.

This included the abuses of using unconsolidated special-purpose vehicles and off-balance sheet derivatives.

Even though the coverage of the US-GAAP is comprehensive, it did not avoid loopholes.

After Enron, the debate has intensified on how to strengthen the accounting and auditing framework.

The case indeed suggests caution when discipline in this area is only exercised through private standards.

Luigi Spaventa, the Chairman of the Italian securities commission, recently argued that - thanks to the lesser reliance on industry standards and to beneficial legal provisions - such a case would be less likely in the European framework.

Specifically, the seventh EU Company Law Directive requires the production of consolidated data, which limits, to a certain extent, the possibility of using special-purpose vehicles to hide losses.

There are of course many other lessons from Enron; and I will return to them in the course of my remarks.

12.

Financial standards established by private bodies are increasingly an international phenomenon as well.

This is due to the fact that State authority has been challenged by the borderless nature of financial activities while financial industry developments are driven by financial innovation.

As on a national level, these standards relate mainly to the area of conduct of business in securities markets.

First, market participants, organised in trade associations, have been quite active in developing standards for trading activities.

For instance, the International Swaps and Derivatives Association has developed the international contractual model for swaps, while also working on best practices for derivatives markets, and the International Securities Market Association is establishing uniform best practices for trading and settlement in securities markets.

Second, there is an ever more compelling need to agree on international accounting standards.

Financial markets are increasingly global and accounts must be comparable for investors.

Take the case of Daimler-Chrysler and Mercedes-Benz, which are now one and the same company listed both in the United States and in Germany .

In spite of the fact that a distance should be the same whether it is measured in miles or kilometres, the accounts disclosed to the New York and German stock exchanges do not provide the same information.

The International Accounting Standards Board began its work back in 1973 and it will play a key role in the harmonisation efforts by developing the IAS standards.

These were recently recognised by the EU as a basis for future reporting requirements.

The United States, however, have not yet accepted them.

13.

As I mentioned before, standards are the tool used in international co­ operation among public bodies.

Here too, they have the same general pros and cons as private standards, while they are obviously not to be regarded as an alternative to public regulation.

The most visible international financial standards are those developed by the specialist groups of supervisory authorities and central banks in their capacity as overseers of financial stability and payment system safety and soundness, such as the BCBS, IOSCO, IAIS, and CPSS.

These standard-setters have, by-and-large, passed the initial stage of establishing continuity and creating mutual recognition and trust among their members.

There are, however, clear differences in the level of ambition across the standard-setters.

The least ambitious international standards represent a minimum common denominator of existing national requirements.

By contrast, the most advanced standards may go beyond some national requirements; the main example being the first Basel Capital Accord.

The main feature of international standards is that the addressees are the standard-setters themselves.

National authorities are, in principle, only advised to implement such standards as part of national regulation and practice.

This implies, in turn, that the implementation of the standards has to be assessed.

Indeed - in the absence of a formal international power - the voluntary nature of standards is a clear weakness of this mode of international governance.

Two routes have been identified as remedies to this weakness.

First, the implementation of standards may be subject to an independent assessment of compliance.

Such an assessment may even be publicised in order to strengthen the incentives for the fulfilment of the agreements on a national level.

In this regard, I would mention the work being done by the IMF and the World Bank.

The second route is "self-control" and peer pressure.

For example, the implementation of the FATF's anti-money laundering recommendations by national authorities is verified by peer review, on the basis of which the FATF assesses compliance in individual jurisdictions.

14.

To summarise, I would state - also in light of historical developments - that the private industry standards continue to play an important role as a disciplining device in the specific area of conduct of business in securities markets, whereas they have lost ground in the prudential field.

This is probably due to the ability shown by the securities industry, until recently, to discipline itself effectively and in line with public objectives.

However, this ability is being put into question by the increasing complexity of financial markets and instruments, as the Enron case shows.

Indeed, a tendency to reinforce public authorities vis-à-vis self-regulatory organisations can be observed in Anglo- Saxon countries, in response to this concern.

On an international level, an important role is also played by standards developed by the multilateral forums of public authorities.

In this context, the main challenge of how to ensure compliance across different jurisdictions, with the standards set on a voluntary basis, still remains.

IV.

PROCESS-ORIENTED REGULATION

15.

Let me now move on to address the second dimension of our road map, i.e. the axis between rule-based and process-oriented regulation.

The shift from the former to the latter is a clear trend, which has emerged in many fields of financial regulation.

In the prudential field, reliance on financial institutions' formal internal models - validated and verified by supervisory authorities - was an innovation introduced internationally by the Basel Committee on Banking Supervision in 1997, when it established capital requirements for market risks.

Now, a similar approach is being proposed for credit and operational risks in the context of the revision of the 1988 Basel Accord.

While its achievements are clearly outstanding, it is not fully appropriate to credit the Basel Committee with the invention of process-oriented regulation.

Drawing on my experience as Chairman of the Committee when the market risk amendment was launched, I can say that it has been rather incidental that the development of sufficiently mature internal modelling techniques by banks has coincided with the development of international regulatory co-ordination.

16.

Actually, the seeds of process-oriented regulation were sown on a national level before steps were taken on an international level.

Regulation and supervision have already been geared for some time towards ensuring efficient risk management by banks themselves, rather than focusing solely on compliance with legally determined rules.

The main reasons are that the

complexity of the risk profile of each institution and the high speed at which risk positions can change have made uniform and simple regulatory formulas increasingly ineffective.

In this way, the regulatory framework is becoming less intrusive and more industry-friendly as emphasis on rules-based restrictions declines.

The principles of process-orientated regulation seem to have played a greater role in the Anglo-Saxon countries than in continental Europe .

The US and the UK authorities have been the keenest supporters of the models-based approach in the international setting as well.

Indeed, looking back, the process- orientation of the United States has taken the form of strong reliance on examinations and extended supervisors' discretionary powers.

The same has applied in the United Kingdom, as confirmed by Sir Andrew Large by stating that: "we should not lose sight of the fact that so much in regulation has not

been about structure, but about attitude and management: the "how" of regulation; the way it is done".

Over time, more and more supervisors in a number of countries have been moving towards process-based supervision in order to cope with the changing risk profile of credit institutions.

This refers to developing risk analysis methods that allow a differentiated supervision, tailored to each individual institution's risk management needs, thus abandoning the "one-size-fits-all" approach of rules-based regulation.

17.

Whereas "rules vs. processes" relates to the prudential regulation, an analogous but not identical dichotomy, i.e. "rules vs. principles", can be found in the conduct of business regulation.

Both pairs of concepts share the basic feature that they contrast strict and detailed requirements (i.e. "rules") with regulations, which allow substantial involvement of individual firms and ample flexibility as regards the compliance with the set requirements (i.e. "processes" or "principles").

The aspect distinguishing principles from the process-oriented regulation can concern the degree of intrusiveness of the regulations.

While in a process-based approach authorities' main role consists in setting out requirements for internal risk assessment procedures and validating their output, in a principles-based one authorities essentially set the objectives and define the best-practice features of desired behaviour.

As a result, principles can represent as binding requirements as detailed rules in constraining the behaviour of individual financial institutions.

In the debate after the Enron case, the distinction between rules and principles has been made to characterise two alternative approaches to accounting.

This refers to relying either on specific, detailed disclosure requirements or broad principles which set out the basic objectives for disclosure, while leaving to individual firms the freedom to present their own specific activities and risks by drawing on their particular internal control systems.

Here, the positions of the United States and Europe are reversed, since the US-GAAP is based on very formal, detailed rules, while European accounting rules and the current international IAS standards rely much more on general principles.

Enron clearly took advantage of the prescriptive accounting rules in the US framework, stretching them to their limit, as the rules - even though very detailed - did not cover the specific instruments used by the business to hide its losses.

Consequently, a discussion has arisen concerning the relative merits of rules and principles for accounting as the appropriate basis for developing accounting standards and overcoming current deficiencies.

Again, the main benefit of the principles-based approach is that its basic objectives cannot be circumvented and made obsolete by financial innovation as easily as detailed accounting rules can be.

18.

We can detect a similar evolution from explicit rules to process- orientation, also at the international level.

It is increasingly acknowledged that the traditional rules-based regulation does not best suit the international financial markets.

This is due to the geographical constraints of state powers and - as on a national level - to the limitations of the rule-based approach in tackling financial innovation and the circumvention efforts of market participants.

As you know, the Basel II proposal is based on three pillars.

Pillar I is a measurement framework that refines the 1988 Accord by drawing on banks' own risk assessment systems.

It replaces the one-size-fits-all approach with more risk-sensitive options.

Pillar II is the supervisory review of banks' capital adequacy and internal assessment.

Finally, Pillar III is market discipline, i.e. encouraging safe and sound banking practices through effective disclosure.

The degree of detail of Basel II is very high.

However, the workability of this framework rests on the self-assessments of banks and on the consistency of the supervisory review across jurisdictions.

The Basel Committee is contributing to the development of a sophisticated mode of public regulation which effectively tracks industry developments.

In the EU, a similar interplay between public regulation and market developments has been established within the so-called "Lamfalussy framework", which includes broad consultation with securities market participants and the industry as a mandatory element in the regulatory process and in the convergence of supervisory practices.

19.

In summary, there is a clear tendency towards process-orientation, in particular in the area of prudential controls, controls which are in the domain of public regulation rather than industry standards.

This tendency is beneficial and does not appear to be reversible in the foreseeable future.

However, it necessarily requires strong public discipline to function properly and also effective market discipline to complement public action.

The regulations based on firms' internal practices impose a heavy verification burden on supervisory authorities and may leave room for "gaming incentives" by those being disciplined.

In concrete terms, this means that when its financial condition deteriorates, an institution may have incentives to hide problems and manipulate results.

Hence, competent authorities have to be very strict in validating internal solutions and in asking for necessary revisions.

In other words, effective supervision has to take centre stage in the overall regulatory framework, when the internal control mechanisms of financial institutions are used as a basis for regulatory requirements.

V.

ROLE OF PUBLIC DISCIPLINE

20.

Coming to the final part of my remarks, I would like to dwell further on the question of the effectiveness of public discipline.

I think this becomes a highly relevant issue when a move towards process-oriented regulation is combined with the maintenance of important self-disciplinary standards in the field of conduct of business in the securities market.

The combination of these two developments, which I have reviewed, implies a clear shift towards industry-friendly regulation, delegating increasing regulatory powers to the financial institutions themselves.

There are two crucial problems which need to be kept in mind when assessing the effectiveness of public control in such circumstances.

Self- disciplinary regimes can fail (and have failed) because of two main reasons.

The first is that only public authorities can ultimately take due account of the possible problems caused by negative externalities.

The second is that regulation may be captured for the benefit of the industry itself.

The developments in the regulatory framework described earlier in this lecture can exacerbate the two problems, as the influence of the industry on its own governance is enhanced.

This applies both in the national and international dimensions, while - as I will comment in a moment - the international dimension has its own specific concerns.

21.

Let me deal with negative externalities first.

Systemic risk is obviously the main externality requiring public control.

The inability to account for the externalities involved ultimately led to the collapse of the historical free banking arrangements based on self-regulation and to the institution of public prudential regulation.

The financial industry itself cannot duly take into account the wide impacts of a crisis which can extend well beyond the boundaries of a single institution or a segment of the industry.

I am persuaded that today, as in the past, financial strains assume systemic relevance only when the banking system is hit.

It is the special role of banks and the associated systemic risk which continue to provide the justification for the specific public control of the banking industry and the focus on the issue of externalities in the area of prudential regulation.

Another important and often underestimated externality is the implication that the behaviour of financial institutions may have for overall economic

growth.

This issue is relevant, for instance, in the area of regulatory capital.

We should be aware that the shift towards the use of internal risk measurement systems for regulatory capital purposes has the likely implication that the capital base of financial institutions will become more dependent than before on the way the management of risk adapts to changing economic conditions.

This will, of course, depend crucially on the specific nature of the internal risk assessment process.

It is widely recognised that the amount of capital required under the new Basel Accord, would significantly increase in a recession if banks continue to apply the currently most widespread "point-in-time" risk measurement methodologies.

This could hamper banks' capability to extend credit and might thus produce adverse overall economic consequences.

I do want to emphasise that the impact on the business cycle is an externality which will probably not be taken into account by individual institutions.

Banks' may not internalise this feature of the "point-in-time" risk measurement, while they appreciate its ability to adjust quickly to risk differences among borrowers.

Accordingly, this type of risk measurement may lead banks to restructure their portfolios when the economic conditions change.

This means, in fact, transferring the negative impact of a recession to the rest of the economy.

Therefore, public authorities may need to intervene in the implementation of the Basel II proposal on a national level and to encourage the adoption of the "through-the-cycle" approaches to capital allocation.

22.

Let me turn to the second problem, i.e. that of regulatory capture.

This can be defined as designing and implementing regulatory requirements for the private benefit of the firms being regulated - at worst to the detriment of the public at large.

We might immediately recall the famous sceptical attitude of George Stigler that any controls acquired by the industry are designed for its benefit.

Other scholars, with more nuanced views, have suggested that public rules established by independent authorities are least likely to suffer from regulatory capture.

Hence, financial industry standards could be captured because of the mere fact that the public influence is minimised.

In this context, I would like to take up the case of the potentially undue influence of industry lobbies by returning to the Enron case.

In the United States, it seems that the accounting rules were indeed, to an extent, captured by the powerful industrial lobby and that this capture hindered progress towards adequate transparency, preventing early and effective reaction to the problems which materialised in the Enron affair.

In particular, the FSAB is now under heavy criticism for its very sluggish and eventually inconclusive stance on consolidation accounting.

FSAB's projects on special-purpose vehicles and off-balance-sheet abuses were also apparently put on hold, under pressure from a powerful corporate lobby group, as managers had found that such vehicles could usefully deliver "flexibility".

I am convinced that if future "Enrons" are to be avoided, greater independence in setting accounting rules is needed to ensure, as well as more effective international co-operation.

Under the auspices of the IASB, work has already commenced on the priority areas identified in the Enron case: off-balance-sheet derivatives and special-purpose vehicles.

23.

These examples should be sufficient to support the view that effective public discipline is needed to address both the problem of externalities and the problem of regulatory capture.

As is increasingly recognised, public authorities could also share the burden of disciplining the industry with the equity and debt-holders of the financial institutions.

A central role for this market discipline is envisaged - for the first time - in the third Pillar of the new Capital Accord.

The actual extent to which market discipline could play a role in complementing discipline by public authorities is subject to varying views.

The strongest support can be found in those views based on neo-classical rational expectations, which regard markets as in continuous equilibrium with information-efficient prices.

Indeed, the prices of the securities issued by financial institutions need to reflect their risks if any market discipline is to work, since there has to be an impact on the cost of funds.

There is, however, some empirical evidence in support of alternative "Neo-Austrian" and other views of possible over and undershooting in prices, such as those theories which point to the impact on prices of strategic behaviour in financial markets.

This warns against basing too much explicit regulation on market prices, as would happen in a more widespread application of the Fair Value Accounting in the banking field.

Nevertheless, while there might be some friction in price-formation, there is positive empirical evidence, gathered for European banks, that the prices of bank securities do constitute an indicator of their soundness.

Similar evidence also exists for the United States .

Hence, market discipline can apparently play a useful role in complementing supervisors' monitoring activities and would be further supported by developments in the disclosure regime.

24.

Turning to the international dimension, a specific problem exists because here a strong public authority necessary to balance the focus on self- disciplinary mechanisms simply does not exist.

This authority is, in principle, available on a national level, hence a move towards industry-standards and process-orientation can be beneficial.

In the absence of an equivalent authority, however, the same developments on an international level can be more of a mixed blessing.

To be consistent, the evolution of the international regulatory framework would have to be paralleled by the developments of adequate international powers and control mechanisms.

Indeed, the achievement of a public good can refer to the national jurisdiction of the public authorities, while the overall global optimum (corresponding to the now emerging notion of global public goods) may not be achieved.

National authorities may, indeed, not take into account the externalities of their actions on an international level.

At worst, national authorities would work for the benefit of national financial institutions when implementing and interpreting commonly agreed standards, at the expense of the objectives of safety and soundness and even a level playing field.

This would be another example of captive regulators.

Considering again the example of Basel II, we will have a system where the regulatory capital requirements (Pillar I) and also, to a large extent, market discipline (Pillar III) are shared on an international level.

The necessary supervisory actions of checking and verifying the outcome of banks' internal processes (Pillar II) remain, however, on a national level.

Unless mechanisms of substantial international co-operation in the implementation of the Basel II requirements are put in place, comparable treatment of banks within different jurisdictions, in an adequately stringent way, may not be guaranteed.

Adequate safeguards, even against possible favouritism by local supervisory authorities when implementing the new requirements, need to be in place.

VI.

CONCLUSION

25.

I have now reached the stage of concluding my remarks.

In this lecture I have discussed the evolution of the methods of financial regulation towards using industry standards and process-oriented regulatory tools as alternatives to simple, unequivocal legal rules.

This evolution involves significant outsourcing of self-regulatory functions to financial institutions or industry associations.

In the light of past experiences, this development is basically to be supported as industry-friendly and innovation-adjustable.

It can, however, involve important pitfalls.

The issues of negative externalities and regulatory capture may especially generate problems when such delegation of responsibility occurs.

Thus, my main message concerns the appropriate extent to which regulatory functions ought to be entrusted to the industry itself.

As we saw, delegation is, in principle, desirable and potentially beneficial, but the appropriate role entrusted to the market is not the same as full reliance on the "invisible hand".

One must maintain the opportunity of effective public discipline whenever needed.

An industry-friendly approach to regulation needs the counterpart of a strong and "non-captive" public authority.

The fact that this counterpart is not present on an international level can be a source of problems unless bridged by effective co-operation.

In particular, in the case of Enron, I see a reminder that we need to distinguish clearly between the scope of public intervention and its effectiveness.

Where there is room for public action, a minimum scope of intervention should not be the same as weak intervention.

With Enron, the signals provided by market authorities and policy-makers were not sufficiently strong to ensure adequate transparency and avoid conflicts of interest.

While initiatives to improve the situation were proposed over a relatively long period of time prior to the incident, the prevailing pressure from the corporate sector lobbies prevented substantive achievements.

Regulators and policy makers have much in common with teachers.

A teacher should be friendly to pupils - just as regulators need to be industry-friendly - but like teachers, regulators always have to remember who they are and exercise the necessary discipline when needed.

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Previously published in 1971.

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