Arnold Schilder: The boundaries of the Civil Society?
The example offered by financial supervision
Speech given by Professor A Schilder, Executive Director of the Nederlandsche Bank, in the context
of the Second European Social Week held in Bad Honnef, Germany, on 7 April 2000.
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Introduction
The main theme of this Second European Social Week is the establishment of a Civil Society in
Europe. This Week is intended to generate initiatives which could contribute towards this goal. At the
same time, we need to ask ourselves where the boundaries of a Civil Society lie. Put differently, does
the model for the Civil Society meet the requirements of the European Society that we envisage? I am
sure that you have no need of an explanation of the concept of a Civil Society. Put briefly, a Civil
Society is a society built on a large measure of self-control. If you favour a Civil Society you expect
individuals to engage in responsible behaviour. In our societies, freedom is a great good. But freedom
goes hand in hand with responsibility. One man's freedom may be another's lack of it. That is why
freedom is curtailed by standards and values. At the end of the day, it is these standards and values
that protect our freedom. These days we are increasingly asking ourselves to what extent individuals
are capable of taking responsibility for their actions. This question arises from our growing interest in
moral values. There is an increasing call for control and supervision of compliance with standards.
Why? Well, we are living in highly democratized times, where the need for transparency and openness
is growing daily. This is not least because of the development of a wide variety of new media, such as
the Internet. Whether this call for more supervision and control spells the end of the Civil Society is
something I will be going into later. Let me first say something about the boundaries of the Civil
Society. Why do we need to see to it that individuals shoulder their responsibilities? I shall illustrate
my point by taking a look at supervision as it is exercised on the financial sector.
Financial supervision in summary
Before discussing the boundaries of the Civil Society, I would like to provide you with a brief
overview of financial supervision. The emphasis will be on how that supervision is organised in the
Netherlands. However, keep in mind that the issues confronting the Dutch financial system are no
different from those in other European countries or other parts of the world. In this context, the fact
that supervision is organised differently from one country to the next is irrelevant. Supervision on the
Dutch financial sector is segmented. The supervision on banks (credit institutions), investment
institutions and exchange offices has been delegated to the Nederlandsche Bank. The Bank is also
responsible for the stability of the financial system as a whole. Insurance companies are supervised by
the Dutch Insurance Supervision Board, while the Dutch Securities Board supervises the stock
exchange, securities firms and securities business in general. Regulatory issues which involve all three
supervisory authorities are dealt with by the Council of Financial Regulators, without detracting from
their individual responsibilities. This model is receiving increasing attention internationally. It forms a
good alternative to the supervisory model whereby all regulators are united in a single agency. The
supervision of the Dutch financial sector is laid down in a number of statutory instruments. The
statutory objectives of banking supervision in particular may be summarised as follows: safeguarding
a stable financial system, protecting creditors and, within the near future, maintaining the integrity of
the financial sector, objectives which I will be looking at extensively later on. Let us now return to the
Civil Society: what are key issues here? There are three, which I will be discussing in detail. First,
externalities, i.e. the benefit for and cost to society of individual action. Second, reprehensible
behaviour on the part of individuals. Third, the need to protect the interests of weaker groups in
society. In each case, I will be drawing parallels with supervision of the financial sector and pointing
out what lessons could be drawn from this for the Civil Society.
Key issues of Civil Society: externalities
A Civil Society is no free-for-all; it is a society of individuals engaging in responsible behaviour. As
the Chairman of the Van Ede Foundation, Mr Leeuwens, put it very aptly not long ago: acting
responsibly is acting appropriately on the common ground between self-interest and the greater good.
This is not a novel idea, and has always held its place in economic science, as Mr Leeuwens so rightly
pointed out. Adam Smith was a fervent advocate of free enterprise. He argued that when individuals
are free to choose how to use scarce goods and capital, the resources available to an economy are put
to their best use. Adam Smith was not thinking in terms of mere self-interest. He spoke of an invisible
hand, providing guidance to the market mechanism. He too assumed that, individuals are guided by
the common good consciously or unconsciously. The question arises whether this invisible hand
always works properly. Most individuals base their behaviour on a cost/benefit analysis of their own.
Even an individual who tries to take the general interest into account has no inkling of the true costs
and benefits of his decisions for society as a whole. In addition, individuals often base their decisions
on less rational considerations as well. Take, for instance, investor behaviour, such as the herd instinct
on the stock exchanges. This can be explained by the theory of cognitive dissonance: investors filter
information to justify earlier investment decisions. Economic textbooks often cite environmental
pollution as an example of an area where the invisible hand does not work as it should. Industrialists
undoubtedly take the consequences of their production process for the environment into account.
Nevertheless, they are incapable of making an optimum assessment of the costs of pollution for
society. In cases such as this, we need to seek ways of internalising the externalities into the market
mechanism. One way of dealing with this problem is to impose statutory requirements on the release
of pollutants and to set up an agency which checks compliance with these requirements. A Civil
Society will also have externalities to deal with. Even if the participants in a Civil Society behave
responsibly, the outcome of their actions may not be optimal to society. To what extent do
externalities figure in the functioning of the financial sector? A good example is the Nederlandsche
Bank's responsibility for the stability of the financial system. Through their behaviour, financial
institutions may jeopardize their own continuity. Take, for instance, a bank which exposes itself to
considerable risk by granting vast, high-risk loans. If the borrower defaults on these loans, the bank
could founder. That in itself would be a disaster, but the ultimate outcome could be worse still. If the
bank in question has borrowed heavily from another bank, the latter may also find itself in trouble.
This is known as the domino effect. In order to prevent such situations from arising, the legislator has
set up a banking supervisory authority. The first task entrusted to this supervisor was to watch over the
continuity of banks. This is where prudential supervision came in. It made it possible for regulators to
issue rules and guidelines for the way banks manage their balance sheets. The best known
internationally-agreed - rule is the Basel Capital Accord. It compels banks to maintain a buffer of own
funds, of at least 8% of all loans outstanding. Should a bank fail, something that cannot be wholly
precluded by supervision, the supervisory authorities can resort to other ways and means to keep it
going. In the early-1990s, the Swedish government made vast amounts of funds available to the
Swedish banking system when a major financial crisis threatened to paralyse the entire financial sector
there. If and when a central bank will actually act as lender of last resort is known only to that central
bank. This is to prevent banks from engaging in "moral hazard" behaviour. If banks knew under what
conditions liquidity support is given to the banking system, they might anticipate such action, rather
than shoulder their own responsibility for the continuity of their business. This brings us back to the
Civil Society. Even though there may be an authority which supervises the functioning of the financial
sector, at the end of the day it is up to banks themselves to bear responsibility at the very least for their
own continuity. Supervisors do not act for bankers. In other words, rules and standards - and the
establishment of an agency which ensures compliance - may help to internalise externalities in the
Civil Society; ultimately, the participants of the Civil Society must shoulder their own responsibilities.
Key elements of the Civil Society: reprehensible behaviour
The second constraint on the Civil Society is reprehensible behaviour on the part of individual
participants in respect of certain standards and values. Those who advocate a Civil Society assume that
everyone is more or less concerned with the common good. Everyone operates on the common ground
between self-interest and the greater good. There are, however, always people who have only their
own best interests at heart, and who have no qualms about sacrificing others in the process. This is
considered reprehensible behaviour. In this sphere, too, there is a need for an agency to demarcate the
boundaries between acceptable and unacceptable behaviour, as well as to ensure that these boundaries
are not transgressed. Reprehensible behaviour is completely out of the question in the financial sector.
Individuals entrust their money to financial institutions. Abuse of that trust will damage the reputation
of the bank in question, and with it possibly its continuity. That is why financial supervisors are
paying increasing attention to the integrity of financial institutions. This brings us to an area of great
activity. In the past, supervisors focussed notably on the prudential aspects of banks' operations. Over
the years, however, their attention has shifted to the integrity aspects of banking. First of all, it turned
out that reprehensible behaviour can also threaten the continued existence of a financial institution.
Secondly, the requirements to be met by the integrity of the financial sector have been sharpened over
the years. Insider trading, never questioned several decades ago, is now considered totally
unacceptable in most countries. The Nederlandsche Bank has also come to pay increasing attention to
financial integrity. In July 1997, the Bank decided to set up an integrity unit. The unit offers
specialised support in the sphere of regular integrity supervision. It also takes part in policymaking in
this field. Financial integrity has since come to figure prominently on the Dutch political agenda. As
things now stand, integrity supervision is becoming a separate, statutory aim of Dutch banking
supervision. In anticipation of this development, an integrity audit has been drawn up under the
auspices of the integrity unit. This is in fact a computerised methodology that allows supervisors to
assess banks systematically in terms of integrity. Back to the Civil Society again. Tackling
reprehensible behaviour does not mean distrusting every participant in the Civil Society in advance.
That is in any case not how financial supervisors see their task. Financial institutions, and certainly the
overwhelming majority of banks, are not out to engage in reprehensible behaviour. After all, if they
did, they could be jeopardising their continuity. However, there is always the chance that an individual
employed at an institution cannot resist the temptation to put his own interests above those of others.
Supervisors must therefore be on the lookout at all times. However, if distrust were to get the upper
hand, the open relationship between the supervisor and the bank would be undermined. The Civil
Society, too, cannot function on the basis of distrust. The measure of trust among people determines
the measure of cohesion within society.
Key elements of the Civil Society: protecting the weak
Let us take a look at the third element of the Civil Society. The participants of the Civil Society are
basically assumed to be equal. They allegedly have the same information at their disposal and are
considered capable of looking after their own interests. In practice, however, that is not always the
case. Society also encompasses weaker groups, which are insufficiently able to defend their interests
in a Civil Society. There are several solutions to this problem. Notably in a well-functioning Civil
Society, the obvious thing would be for vulnerable groups of individuals to organise themselves. If
this option proves ineffective, they should be able to resort to an agency which looks after their
interests for them. From the point of view of the financial system, the weaker party is clearly
discernible, viz. consumers, the individual customers of a financial institution. Their interests are
protected by supervision in several ways, in the Netherlands, too. To begin with, the Dutch Act on the
Supervision of the Credit System explicitly seeks to protect banks' creditors. Not only do the
supervisory authorities watch over the continuity of financial institutions with a view to overall
financial stability, they also seek to protect those who have entrusted their money to banks. In the
event of a bank failure, its creditors can resort to a deposit guarantee scheme, which ensures that their
deposits are guaranteed - subject to certain conditions - to an amount of EUR 20,000. Supervisors
furthermore seek to ensure that financial institutions provide their customers with proper information.
The supervisory authorities do not intermediate between banks and their customers, on the contrary.
They - increasingly - require banks to provide consumers with adequate information. Consumers must
have sufficient information at their disposal to make a well-founded choice. In the Netherlands, a
package of minimum information requirements is currently being drawn up. Last year, the
Nederlandsche Bank set up a consumer affairs unit. The unit's staff contribute to the rules being drawn
up with regard to the information being supplied to consumers. They also answer questions put by
consumers about financial services, and inform consumers on what to do when they have concrete
complaints about a financial institution. In this respect, the Netherlands is in the vanguard in
Continental Europe. In the United States and the United Kingdom, consumer interests figure even
more prominently in supervision. The conclusion is therefore that even in a Civil Society, it may be
necessary to protect the interests of vulnerable groups by formulating standards and values.
Is the Civil Society infeasible?
So much for key elements of the Civil Society. Does this mean that the Civil Society is infeasible? Far
from it. As I noted earlier, the proponents of the Civil Society are well aware of the bounds of societal
responsibility. The Civil Society has nothing to do with unbridled liberalism. On the contrary, the
protagonists of the Civil Society are continuously seeking to improve and supplement its model. This
serves to internalise the constraints which I outlined earlier. In the Netherlands, supervision is, on the
one hand, enforced by a statutory framework, providing for rules and obligations for financial
institutions and sanctions for non-compliance. On the other, it was set up in a "partnership" with the
financial sector. The financial system helped to shape supervision as we know it. In other words, the
currently much-acclaimed Dutch polder model concerns not just the cooperation between government
and social partners, but in a sense also the supervision exercised on the financial sector, with all parties
involved acknowledging that proper supervision serves a common purpose. Obviously institutions
have commercial goals, but they are also aware that the public's confidence in the financial system is
conditional upon sound supervision. An open relationship has consequently grown up between the
Bank and the institutions subject to its supervision. Yet the Bank maintains a sufficient distance
vis-àvis the institutions, to safeguard objectivity and the authority to act when and where necessary. It is
this mix of cooperation, efficacy and forceful action which makes the supervision exercised by the
Bank so potent. I would like to point out that a partnership does not equal self-regulation where the
supervision of the financial sector is concerned. The experience gained by the financial sector with
self-regulation has not always been positive. Though widely sustained by the sector, financial
supervision also clearly stands above it. As the Civil Society will not be able to function properly
without impartial supervisory bodies, it will need to delegate part of its competencies and
responsibilities to them.
Conclusion
I am nearing the end of my address. I am all for striving for a Civil Society in Europe. It means,
however, that we need to analyse the obstacles that we find on our way to that goal. The model of the
Civil Society is up against several constraints. First, the externalities of the behaviour evinced by those
taking part in the Civil Society. Second, possible reprehensible behaviour by individuals - to the
detriment of others. Third, the tendency to lose sight of the interests of weaker groups in society. I
have attempted to show that the limitations that the Civil Society is up against also constrain the
financial sector; there the remedy has been found in the establishment of a supervisory authority which
sets standards and ensures compliance. Ideally, financial supervision is a partnership between the
supervisory authority and the financial sector. At the same time, the supervisor should stand above the
sector, and be capable of intervening forcefully and effectively. What does all this mean for the Civil
Society? Though the constraints on the Civil Society can be remedied in part by society itself, some
form of supervision is ultimately indispensable. The best illustration I can think of is street violence.
Violence cannot be curbed by simply putting more police on the street. Maintaining standards within
society calls for the active participation of all. A good example is the neighbourhood watch. On the
other hand, it would be unacceptable if people were to take the law into their own hands, or if safety
on the street were to become only their own responsibility. An impartial supervisory authority - in this
case the police and other instruments of the constitutional state - may not be the ultimate remedy. It
certainly is an indispensable tool in ensuring a well-functioning society. Finally, how does the Civil
society achieve a state of supervision which is effective? This should develop through public debate as
well as initiatives from participants. Recently in the Netherlands we noted some cases of so-called
meaningless violence: youngsters killed by mindless people for no reason. This raised storms of
protest, demonstrations, silent procession. Now we see this developing into a mix of officially backed
arrangements and joint private efforts to fight violence and the lack of solidarity. That is the right
balance between organized supervision and self-regulation. So, there is no excuse for awaiting others'
actions. That is why this conference may prove meaningful.