How to Regulate the Regulators: Applying Principles of Good Corporate Governance to Financial Regulatory Institutions

Financial regulatory institutions are at the centre of intensive debates surrounding the regulatory tools to supervise financial firms and markets. There is also an important and growing body of literature focusing on the financial regulatory institutions themselves. Here, following Juvenal’s famous phrase ‘quis custodiet ipsos custodes?’, the literature has mainly been concerned with the question of ‘who should regulate the regulators’. This goes back to problems of monitoring and accountability. In practice, financial regulatory institutions are usually audited incidentally as part of a country-review by international organizations, such as the International Monetary Fund, the World Bank or the OECD. There is therefore a risk that the structure of financial regulatory institutions and the conduct of financial regulators are not regularly and consistently monitored.

The main idea of the paper on which this blog post is based is that we should extend the debate and ask not just who should regulate the regulators, but also how they should be regulated. In order to do so, this paper proposes to examine the lessons that were learned and tools that were developed in the world of corporate governance in order to solve conflicts of interests between shareholders and other stakeholders within the corporate entity, and apply these lessons and tools to financial regulatory institutions, subject to the necessary changes. We believe that this would put an end to many of the accountability and monitoring problems associated with financial regulatory institutions.

While private-sector companies differ from financial regulatory institutions, some relevant analogies can nevertheless be made. The reasoning in this paper is therefore as follows: first, it discusses the general differences between private- and public-sector institutions; second, it presents theoretical arguments supporting the existence of similarities; and third, it shows which standards of good corporate governance should also be applied to financial regulatory institutions.

One of the main points identified by this paper concerns the independence of regulatory authorities. Such independence is critical for regulators to be able to make professional decisions that serve the public interest, free of political influence. In particular, dependence on politicians for budgetary approval or any other need, might interfere with the regulators’ strategic, long-term thinking, and force them to work according to short-term political constraints. To this end, one of our recommendations is to make the regulator financially independent, namely, to detach the regulatory authority’s budget from that of the state and instead have it collected from fees levied on the regulated firms.

Another important point concerns the monitoring of the regulatory authority and its work. To start with, we recommend introducing an audit committee to the financial regulatory authority. In addition, and as far as our recommendation regarding budget independence is accepted, we also recommend to introduce a remuneration (compensation) committee to decide on the remuneration scheme for the top executives of the financial regulatory institution. Other recommendations include peer review of the work of the regulatory institution by counterparts from other jurisdictions, and a duty of care for members of the board of directors.

Our main normative suggestions can be summarized as follows: (i) to reduce the number of financial regulatory institutions in any single jurisdiction; (ii) to free the board of the regulatory body from political intervention, for example, by prohibiting nomination of politicians to the board; (ii) to make the budget of the regulatory body completely independent from government, both in the way it is funded and in the way it is decided upon; (iii) to adopt early retirement mechanisms for regulators, in order to incentivize regulators to regulate in times of crisis; (iv) to diversify the board of directors of the regulatory institution, by including mandatory public representatives and experts; (v) to impose a statutory duty of loyalty and care on both the directors of the regulatory institution and the regulator itself; (vi) to appoint audit and remuneration committees; (vii) to institute mandatory peer review by counterparts from other jurisdictions; (vii) to restrict service of former employees of the financial regulatory institution as external consultants to the regulatory authority, in order to avoid capture and conflict of interests; (viii) to clearly set out by law the goals of the financial regulatory authority; (ix) to impose statutory extensive public disclosure of the regulatory work.

We believe that implementing these recommendations could help solve some of the oh-so-familiar accountability and conflict-of-interest problems in the field of financial regulatory institutions, and would also increase the quality of financial supervision and regulation.

Hadar Jabotinsky is a Postdoctoral Fellow at Hebrew University of Jerusalem, Israel.

Mathias Siems is a Professor of Commercial Law at Durham University, UK.