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It's time to investigate regulators around the world for the quality of their governance

By Professor Didier Cossin - October 2012

The quality of corporate governance has been deeply questioned around the world, with large reputational hits such as the BP Macondo field explosion and SanLu's milk scandal in China and New Zealand, among many others. But there has been less attention until now on the governance of the markets themselves and that of their regulatory bodies. Market dysfunctions attract attention, but little is said about the governance that leads to these dysfunctions.  

Good governance entails the separation of executive and supervisory power. This should apply to regulatory bodies too. Indeed, deficient governance of regulators is the main driver of regulatory distrust today. Who regulates the regulator? Regulatory governance should be improved swiftly.  

Hubris warnings abound – the mergers and acquisitions of exchanges across the world and their high valuations, the explosion of high frequency trades, dark pools and other ways to circumvent exchanges – such as contracts for difference. Or the growth of poorly regulated, poorly informed over-the-counter markets. Or the impact of poorly regulated rating agencies. Or the slow reaction to the problems inherent in the determination of the Libor rate. These trends lead to bad information, poor price discovery and impede liquidity, damaging some of the key attributes of well-functioning markets. Naturally, the financial industry tends to profit from regulatory weaknesses and gains a disproportionate advantage. Swift regulatory action should mean markets operate successfully without these distortions.  

There are obvious cases to learn from: the May 6 2010 flash crash, the Knight Capital failure, the Buffett 2011 IBM investment. What are the lessons? The Securities and Exchange Commission/ Commodity Futures Trading Commission response to the flash crash was slow and evasive with a weak report issued on September 30 2010. In the Knight Capital case, many suspect that the regulator's arm cannot extend to internal IT errors, a limitation that can be compared to an airline regulator's inability to clamp down on an airline with operational problems.  

Can we trust market regulation is enacted at its best? Financial issues have been somehow less strongly enforced than life and death issues as in the aviation industry. And the SEC does not always have a history of benchmarking positively to the Federal Aviation Administration, nor is the evaluation process of commissioners clear. It is not obvious that financial issues matter less to people's well-being and should be less well regulated than life and death issues in airlines.  

So, what can be done?  

Some voices, often linked to those advantaged by weaker regulation, claim there is little that can be done: regulators are always lagging, unsophisticated and poorly equipped. That was the case in the oil industry, when the Macondo field was excluded from traditional regulatory requirements and the Minerals Management Service of the US Interior Department had grown close to oil players it was supposed to supervise.  

In weak regulatory regimes such as markets (when the OTC sector is included), what we need first and foremost is better regulatory governance.  

Better governance requires the same basic qualities everywhere: strength and independence, with hard-working, dedicated, diverse, expert and focused individuals that supervise the executives themselves. Strong group dynamics at board level are vital to achieve conflicted consensus (ie a diversity of opinions that richly merge into a group position). So are adequate structures (eg, committees) and processes (including nomination and evaluation processes).  

Many regulators today do not have a board, or do not have clear supervision. There is no clear distinction between decision makers, meaning those we would call executives, and those overseeing these executives. The SEC is an example of this blurring of roles. But many market authorities and central banks are not much different. How can we then ensure strong governance, which relies on a simple process of supervision and support?  

It is time to investigate regulators around the world for the quality of their governance.

Didier Cossin is professor of finance and governance at IMD, director of the IMD Global Board Center and program director for High Performance Boards.

This article first appeared in the Financial Times on September 24, 2012.

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