normal science and paradigmatic shifts: political and regulatory strategies to develop investor...

Normal science and paradigmatic shifts: political andregulatory strategies to develop investor protection in the

aftermath of crisis*

Justin O’Brien

Centre for Law, Markets and Regulation, Faculty of Law, The University of New South Wales,Kensington, NSW, Australia

Abstract

The scale of the Global Financial Crisis prompted initial systematic reflection byleading politicians from Anglo-Saxon countries. One commonality linked theanalyses put forward by Gordon Brown (UK), Barack Obama (USA) and KevinRudd (Australia): the crisis had roots in ethical failure. The interlinked failure ofstructure and agency necessitated fundamental change in the theory and practiceof the regulation of capital markets. The international regulatory reform agendahas, however, focused on the technical requirements of the former and largelyignored the latter. The paper argues that this is not only a mistake. It reflects theongoing strength of the financial services industry to determine the ideational,ideological and institutional battleground.

Key words: Financial regulation; Institutional theory; Corporate governance;Ethics

JEL classification: K22

doi: 10.1111/j.1467-629X.2012.00483.x

1. Introduction

TheGlobalFinancialCrisis,which continues tometastasize, has its roots inwide-spread if not systematic ethical failure. The collapse in authority and legitimacy ofthe conceptual underpinnings of financial regulation has profound implications forthe theory and practice. Critical to any evaluation of the trajectory of reform is the

* Address to the Accounting and Finance Association of Australia and New Zealand,Darwin. The financial support of the Australian Research Council is gratefully acknowl-edged (‘The Future of Financial Regulation’ (LP100100713) and ‘The Limits of Disclo-sure’ (LP100200573).

Received 3 July 2011; accepted 4 April 2012 by Steven Cahan (Editor).

� 2012 The AuthorsAccounting and Finance � 2012 AFAANZ

Accounting and Finance

extent to which it addresses the factors that contributed to ethical erosion. Thiscomplex mapping exercise reveals not simply the dynamics of financial regulationbut also shifting power relations within it. This paper contributes to this process byexcavating the ideational roots of the crisis. It unearths howandwhy abelief systemwas inculcated that compartmentalized responsibility and downplayed societalobligation. It assesses the extent to which this belief system has been impacted bythe scale of the externalities nowborneby society becauseof institutionalized specu-lative activity. It argues that unless accompanied by effective mechanisms to inte-grate ethics and accountability in regulatory design, reform is likely to fail becausethe belief system that facilitated the crisis remains remarkably resilient.Contrary to the rhetoric of the invisible hand much loved by contemporary

economists, markets are exceptionally complex social constructs. They are boundtogether by formal and informal mechanisms. These require reliance on andrespect for rules and principles to operate effectively. Crucially, they also necessi-tate shared adherence to or at least non-deviance from social norms. Thesemechanisms simultaneously inform and justify institutional arrangements. Effi-ciency criteria alone are an insufficient bulwark for authority and legitimacy.The latter two are determined by the extent to which these procedures to achievethe former gain, retain or loose broad-based societal support. The alchemy ofauthority pivots on how the artificial is transformed into what approximates anatural order within a specific regulatory setting. Legitimacy, on the other hand,is determined by success in embedding these preferences within the broader polit-ical culture, preferably in a bi-partisan manner.Theprivileging ofmarket governance – limiting the roleof the state to thatof ena-

bler of freedom to contract – is the result of a very specific normative ordering. Fail-ure to understand and map that process and its implications has caused untolddamage to the social fabric within the Anglo-Saxonmodel of capitalism. Paradoxi-cally, the political steps taken to resolve the banking crisis are likely to rent that fab-ric further. This is largely through the interlinked power of neo-liberalism to shapethe ideational, ideological and institutional discourse (see Peck 2010). This is mademanifest in the re-institutionalizing of the rhetoric and practice of economic auster-ity. This process is not, however, monolithic. At the regulatory level, for example,international coordination, particularly in the market conduct arena, remainsfocused on what should constitute the appropriate balance between private rightsandpublicduties in the search for accountable governance. It is by nomeans certainwhichworldviewwill dominate.A structural fissure is, however, inevitable.The combination of endogenous and exogenous shocks is likely to fundamen-

tally impact on the dynamics and outcome of the process. Ongoing discontent inGreece, the fear of contagion passing to Ireland, Portugal and (potentially) Spainraise fears in the periphery as well as the core over the future of the Euro as wellas the European project itself. A jobless recovery in the United States and theUnited Kingdom, as well as the vagaries of minority government and the timingof the political cycle within and between each country, is equally likely to impacton the legitimacy and authority dimensions of power. The protection of social

2 J. O’Brien/Accounting and Finance


capital, central to societal well-being in times of crisis, is unlikely to survivematerial reductions in public financing. The effective management of these com-plex interactions between law and policy requires a normative narrative moresophisticated that the triumph of hope. Unfortunately, there is little evidence (todate) that this normative agenda has been developed at a political level. Tounderstand how and why this process occurred, necessitates evaluating the inter-stice between politics, regulation and policy.

2. Technical solutions to normative problems

The deficiencies in shared commitments to rules, principles or norms were par-ticularly apparent in the design, marketing, sale and regulation of complex finan-cial products. The myopia has demonstrated conclusively the limits of disclosure,the principal regulatory tool for safeguarding the integrity of capital markets.Yet, in the United States, the United Kingdom and Australia, the stated politicalpreference is to enhance disclosure requirements. In addition, significantresources are to be made available to improve retail financial literacy. At onelevel, this is puzzling. Most initial direct losses associated with investments incomplex financial products (with the partial exception of Australia) accrued tothe wholesale market. The unresolved policy problem is that professional and/orsophisticated investors trading as individual or institutional actors were awareof, but transacted around the risks. The search for yield trumped reason.If defective disclosure was not the cause of the myopia and the primary prob-

lems operated in the sophisticated sector, a more granular ex ante articulation ofrisk is unlikely, in itself, to be sufficient. Is the regulatory response, therefore,misguided or is a more complex recalibration emerging? Satisfactory answersrequire an evaluation of how the reform agenda (and its representation throughmedia discourse) addresses not just efficiency (i.e. lower transaction costs). Threeadditional distinct but overlapping subjective normative criteria must be applied.First, permissibility (i.e. whether a particular product can be sold, and if so, towhom and on what basis); second, responsibility (i.e. who carries the risk if theinvestment sours and on what terms); and third, legitimacy (i.e. does the productserve a legitimate purpose and who should determine it).All of these additional criteria suggest a reduction in the freedom to contract.

They necessarily imply a more interventionist role for the state. As such, it necessi-tates a normative repositioning. Change of this nature featured in the rhetoric ofpolicymakers in the early part of the crisis (e.g. Obama, 2009; Rudd, 2009; Brown,2009; Sarkozy 2009). It periodically resurfaced in calls for a new ‘social compact’(Osbourne, 2011) – itself a reframing of Gordon Brown’s call for a renewed socialcontract (seeO’Brien, 2010). Public discourse since, however, been largely confinedto the implementation of budget reductions in much of the West, including theUnited Kingdom itself. This is most unfortunate, not least because the crisis wasand remains essentially an ethical one. The breakdown in trust cannot be resolvedby reference to technical measures alone within the banking or shadow-banking

J. O’Brien/Accounting and Finance 3


sectors; nor can the deficit be addressed by disproportionately transferring the costto the most vulnerable in society given the reckless endangerment that manysophisticated investors wilfully engaged in. Undoubtedly, any successful proposalto extend responsibility and accountability to those involved in financial productdesign rather than clarifying the enabling conditions that govern marketing andsale would constitute a seismic shift in the structure of the financial services indus-try. The integration of more interventionist normative objectives with enablingones may also significantly change the ethical boundaries of global finance. None-theless, this possibility is precisely what is deeply embedded in recent speeches andpolicy consultation papers in each jurisdiction under review. As will be exploredbelow, it is also one that once raised has been conspicuously ignored in media rep-resentations of the crisis, which focus instead on the ‘need’ to institutionalize publicsector spending cuts (see The Economist, 2010a,b). Not surprisingly, regulatoryauthorities use public law imperatives to justify the intervention and withinbroader society, such claims have received public support. Moreover, it is publicunease that elite support is lacking that drives protest marches from Athens toDublin and underpinned the OccupyWall Street protests.The ‘duty to protect’, however, inexorably raises the question of political inter-

ference. It also heightens legal and policy uncertainty associated with the exerciseof subjective judgment (i.e. not simply how to regulate, but why, for what ultimatepurpose and under what limitations). This is anathema to many in financial ser-vices. Equally unsurprisingly, the industry continues to privilege the efficiencyarguments embedded in the freedom to contract model. Lest we forget, this toohas an explicit (if restricted) normative dimension (Hayek, 1944; see also Appleby,2010). It compartmentalizes and, in so doing, limits debates on what constitutesor should constitute broader responsibility to maintain the social fabric. The dis-closure debate masks, therefore, a much more profound ideational dispute.Definitive resolution will determine whether the reforms herald substantive

change or mark yet another exercise in the triumph of the politics of symbolism(Edelman, 1964; O’Brien, 2003, 2007a,b, 2009). The need for substantive changeis amplified by the failure of private litigation in both the United States and theUnited Kingdom in cases concerning alleged deceptive and misleading conductin the operation of the Collateralized Debt Obligation (CDO) market.1

1 SNS Bank, N.V. v Citigroup, N.A. et al. (SDNY) holding no breach of contract and nobreach of fiduciary duty, with limitations on liability in the portfolio management agree-ment enforceable; Banco Espirito Santo de Investimento S.A. v Citibank, Na (SDNY) limi-tations imposed by contract upheld; Daniel Boone School District v Lehman Brothers(W.D., Pa) holding that Lehman may be liable only if it knew that product was explicitlyprohibited and still sold to school district. In the United Kingdom, plaintiffs had similarproblems attaching liability if deemed sophisticated, see IFE v Goldman Sachs (2007)ALL ER (D) 476 (July) holding no duty of care in cases in which the arranger adequatelydisclaims responsibility; see also Titan Steel Wheels v Royal Bank of Scotland [2010]EWHC 211 (Contractual disclaimers, exclusion clauses and nonreliance clauses precludean advisory duty of care from being owed to sophisticated investors).



Moreover, as with the United Kingdom and the United States, in Australia aninfluential 2006 federal court ruling held that the specific duties owed by invest-ment banks are determined solely by the terms of the contract.2 Taken together,these judicial roadblocks demonstrate the need for legislative change. This, how-ever, is unlikely to be sufficient, after all if the crisis demonstrated anything, itwas the capacity of legal advisers to transact around rules and principles withease. Sustainable reform requires that we place sustained attention on findingways to achieve ongoing substantive and warranted changes in corporate prac-tice and in the culture of capitalism more generally at either state or supra-national level (see Appleby, 2010; Marquand, 2011). This, in turn, cannot beaddressed without paying attention to what constitutes or should constitute theappropriate boundaries of the culture of capitalism and whether disclosure is suf-ficient restraint. The rise and fall of securitization provides confirming evidenceof its limitations.

3. The rise and fall of securitization

The ability to contract out of investor protection mechanisms is central to therationale behind the bifurcation between sophisticated (i.e. wholesale or profes-sional) and unsophisticated (i.e. retail) investors. In most developed markets,much greater disclosure is required when products or financial advice are offeredto retail clients. These restraints are designed to protect the naıve and the unwaryfrom unscrupulous action by those with asymmetrical advantage. Sophisticatedinvestors, by contrast, have traditionally been (wrongly) assumed to have theresources to make informed decisions.3 The bifurcation has been justified, inpart, on the need to facilitate financial services innovation and generate eco-nomic prosperity. These objectives can and often have positive effects on thebroader economy. Securitization, for example, was once lauded as the primarymechanism for expanding home ownership.The dispersal of risk did, in fact, facilitate the advancement of credit to those

imperfect credit histories (Schwartz, 1994). This was and remains, however, anunintended (and questionable) by-product. Apparent success was measured byshort-term objective efficiency criteria (e.g. lower transaction costs, expansion ofcorporate profits, increased shareholder returns). These retrospectively justifiedand legitimated the innovation. The potential negative externalities, includingexcessive leverage, deteriorating quality of loan books, inflating asset bubbles,

2 ASIC v Citigroup [2007] FCA 963.

3 See Securities and Exchange Commission v Capital Gains Research Bureau 375 US 180(Goldberg J) (1963) (‘A fundamental purpose common to these statues, was to substitutea philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve ahigh standard of business ethics in the securities industry’: at 186). This necessitates, how-ever, balancing valid and spurious claims (see O’Brien, 2007a,b, 66–67).



were glossed over or, more accurately ignored, largely self-consciously (seeBorio, 2009; Rajan, 2010). In much the same way, the ‘asset-lite’ strategypioneered by Enron at the turn of the millennium suggested a new paradigm forfinancial reporting. Similarly, the rise of private equity in the period 2004–2007reprised claims that the leveraged buy-out governance model heralded the demiseof the public corporation. Both offered woefully incomplete accounts of thebalance between innovation and security or what should be the duty of the state.In large measure, the failure to learn from either made the securitization crisismuch more problematic.Following the implosion of the securitization market, the individual corporate

and societal consequences of this myopia became clear. The fallout impactednegatively the responsibility and legitimacy as well as long-termer efficiencydimensions. Investment losses triggered an enormous erosion of private wealth.Housing and capital markets across much of the United States, Ireland and theUnited Kingdom went into a downward spiral and credit stopped flowing acrossthe economy. Emergency funding to the banking and financial services sectorsolved neither the underlying liquidity nor solvency problems in either jurisdic-tion. It merely transferred the risk. Sloganeering about the inherent unfairnessof ‘privatized profits and socialized losses’ became more than a worn-out cliche.Throughout the crisis and beyond, as we moved from the great moderation tothe institutionalization of the politics of austerity, senior bankers expressed care-fully couched regret. At no stage did they accept responsibility. Instead a narrowtechnical defence was proffered. As the immediate crisis facing the banksreceded (largely through public injection of capital), the strategies used by thefinancial services sector were framed even more aggressively. To preserve thesanctity of contract, there was a stated need to uphold terms entered into freely(if misguidedly). Moreover, a similar rationale justified the payments of market-determined bonuses to executives then working in de facto nationalized institu-tions. Second, the privileging of caveat emptor facilitated the transference ofresponsibility. Equally understandably, both sets of strategies fuelled publicresentment.The moral tone of this broader debate was particularly apparent in the United

States. The explicit re-framing of the issue in constitutive terms by PresidentObama was a critical (if short-lived) intervention. The president highlighted thenormative problems associated with the privileging of short-term transactionsover longer-term relations.

In many ways, our financial system reflects us. In the aggregate of countless indepen-dent decisions, we see the potential for creativity — and the potential for abuse. We see

the capacity for innovations that make our economy stronger — and for innovationsthat exploit our economy’s weaknesses. We are called upon to put in place thosereforms that allow our best qualities to flourish — while keeping those worst traits incheck. We’re called upon to recognize that the free market is the most powerful genera-

tive force for our prosperity — but it is not a free license to ignore the consequences ofour actions (Obama, 2009).



This leaves unresolved, how and why the financial regulatory system became sodetached from societal obligation. Equally, it leaves unanswered why it is prov-ing so problematic to address the core governance and regulatory deficiencies?As will be explored below, the rise of financialization was the result of a deliber-ate strategy to privilege the ideational as rational. The paucity of institutionalmemory of past crises both within the banks and crucially, the financial media,helped frame the initial dislocation. It also stymies the debate on what consti-tutes effective resolution (i.e. the privileging of austerity rather than attemptingto reconfigure the balance of power) either within or through the dismantling ofthe structured action field.

4. The social construction of markets

The recognition of the political calculation required to construct the economi-cally rational has long featured in social science research (e.g. Schumpeter, 1942,137; Hayek, 1944, 29; Polanyi, 1944, 171; Granovetter, 1985, 484). The legitimat-ing effect of the interaction between market norms and economic and regulatorypolicy within a mediated discourse has also been recognized (e.g. Giddens, 1985,25) as has the cultural roots of capitalism more generally (see Appleby, 2010;Marquand, 2011). This has been lost, however, by the privileging of homo eco-nomicus as both a metaphor and, at times, deification of the individual that onlyaccelerated following the demise of communism. The duality of agency andstructure helps to create and sustain powerful networks. In finance, these becameincreasingly powerful, particularly given the relative decline of manufacturingacross much of the Anglo-Saxon World (Lord Turner, 2010). As Fligstein (1998,8) has argued these networks, by no means limited to finance but none quite aspowerful, create and operate within a ‘strategic action field’. This determinesboth access and the range of acceptable strategies. The strength of such a field isdetermined by its ideational terms of reference and the coherence of underpin-ning vision, values and norms (see Ruggie, 1998, 879; see also Hood et al., 2001).Power to limit the agenda is largely determined by the creation and maintenanceof barriers to entry, including, for example, the possession of specific technicalcompetencies (e.g. Gutierrez, 2010; Finnemore and Sikkink, 1998, 888). The fieldalso provides iterative processes for defining goals and how rules and recalibra-tions are constructed, interpreted, evaluated and, ultimately, legitimated (seeEdelman, 2007; Milhaupt and Pistor, 2008). Unless accompanied by a broadersense of societal obligation, the danger is that suboptimal modes of behaviournot only become dominant; they are deified. This is precisely what happened asfinance globalized, impervious to national restraint.Within the financial services industry, efficiency and effectiveness are inevitably

predominantly privileged. Ostensible improvements to both, measured largelythrough short-term financial performance, have traditionally been used to pro-vide a proxy for societal progress. As we have seen in the sketch of the securitiza-tion industry provided above, these short-term profits provide a (deluded) metric



for managerial performance and broader political legitimacy. However, this doesnot mean that the debate takes place in a normative vacuum. As Miller (2007,342) points out, ‘even the staunchest supporters of the free market have under-pinning normative or ethical commitments. They are committed, in particular, tothe ethical value of the social institution of private property, the moral force ofcontractual obligations, and the human right of individual freedom’. The prob-lem is that the cloak of rationality obfuscated these essentially normative consid-erations, which were the result of political choices rather than pre-ordainedrationality.Ineffective or inefficient markets do not necessarily result in a crisis of manage-

rial position or political legitimacy. A lack of confidence is not the same as a lackof support for the underpinning system (Lehman, 1988). Indeed the structure ofthe field can be and often is remarkably resilient, as the recent history of financialregulation demonstrates. Past inefficiencies (or indeed illegalities) can be – andoften are – redressed by the passage of further ostensibly more stringent rules orthe more granular articulation of overarching principles. This dynamic is particu-larly apparent in corporate governance and financial regulation reform, in boththe United Kingdom and the United States. As with the grandiosely titled Euro-pean Union Directive on Market Integrity, these initiatives are often presentedas evidence of increased accountability. More often that not, however, thesesame initiatives tend to privilege the politics of symbolism (Edelman, 1964;O’Brien, 2003, 2007a,b, 2009). The problem is that we do not stop to examinehow, if at all, the move from governing to governance, from responsibility toaccountability to integrity impacts, if at all, on the formal and informal networksthat make up the structured action field that is financial regulation.The passage and subsequent failure of the Sarbanes-Oxley Act (2002) in the

United States is a notable example (see O’Brien, 2007a,b, 27-55). Enacted in theaftermath of the Enron and WorldCom accounting scandals at the turn of themillenium, the legislation was presented as a template for more accountable gov-ernance. The technical reforms introduced suggested that decisive action hadbeen taken. Accountability was, we were informed, achieved by significantlyincreasing the investigation of and penalties for white-collar crime. Moreover,initial business quiescence suggested if not culpability then certainly humility.The accounting and conflict of interest scandals, while detrimental to sophisti-cated and unsophisticated investors alike, did not, however, have a demonstrableongoing effect on broader society beyond understandable irritation. The passageof Sarbanes–Oxley then cauterized the issue. As a consequence, initial publicanger quickly subsided. Where, one might ask, were the efficacy of the internalcontrols mandated by the act’s most controversial section (s. 404) in the currentcrisis?The structural separation of economic and political spheres continued largely

unchallenged, notwithstanding the fact that the legislation prompted a Securitiesand Exchange Commissioner to warn that it represented an ‘almost unimagin-able incursion of the US federal government into the corporate governance



arena’ (Atkins, 2003). As O’Brien (2003, 29) argued at the time, however, the‘effectiveness [of Sarbanes-Oxley] depends on the degree to which business inter-nalizes its internal logic, or, alternatively, transacts its way around the substan-tive provisions by engaging it technical compliance’. Unfortunately, the latterwas privileged demonstrating both the strength and hubris of the structuredaction field. Moreover, negative media reporting of the costs associated withcompliance with Sarbanes–Oxley and the enhanced regulatory burden were criti-cal factors in undermining regulatory authority just as the securitization marketwas heating up (O’Brien, 2007a,b, 2009). Unfortunately, the public debateremains fixated on reducing the cost of intervention. Given the societal costs ofthe Global Financial Crisis, this is no longer sustainable.While efficiency and effectiveness are largely internally evaluated within a stra-

tegic action field, legitimacy, however, requires broader external acceptance orquiescence of the compromises made through elite bargaining. The enormity ofthe current crisis has demonstrated just how misplaced confidence in marketordering was and remains. As such, the GFC represents a fin de siecle momentin which the material and ideational certainties associated with the privileging offinancial capitalism have evaporated. This opens a space for contestation notonly within elites but also between elites and mass opinion, most of which is con-veniently excised from contemporary media coverage, which decries the paucityof debate, disappointment at the defeat of hope and frustration at the vacuity ofelectoral contestation without necessarily connecting the travails of Americanpolitics to a seismic legitimacy crisis occasioned by demonstrable market failure.It does, however, help illuminate why the structured action fields once cementedare so difficult to dislodge.The elevation of short-term transactional imperatives, without external restric-

tions imposed by regulatory authorities, provided essential behavioural cues toindividual traders who operated, reasonably enough, within a system ofcompartmentalized responsibility (MacIntyre, 1982, 358; 1999, 322). More prob-lematically, power to effect change was rendered even more difficult preciselybecause the underpinning system appeared superficially successful on botheffectiveness and efficiency grounds (Borio, 2009, 13). As such, the ideationalstructure had not only become merely embedded but almost impervious tochallenge, even within communities of elites (see Rajan, 2010, 1). The academiccommunity itself became part of the problem.In a legendary debate with Thomas Kuhn at the LSE, Karl Popper famously

argued that theory remains relevant only insofar as it is not falsified. Kuhn, bycontrast, argued that most academics work within the confines of normal science(i.e. the prevailing fashions of the time and the prejudices of conventional aca-demic wisdom). There are, of course, many reasons for this. Comprehensiverejection of a deeply embedded thesis is difficult to achieve. The power of under-lying terms of reference to colour academic debate through measures such ascitation indexing is a powerful incentive to work within accepted boundaries.Ironically, it is Kuhn, the author of The Structure of Scientific Revolutions, who



is regarded (wrongly) as the champion of innovative thinking. This has not goneunrecognized. As Lord Turner argued in 2010, the crisis demonstrated the dan-ger associated with the inculcation of ‘an entire philosophy of market regulationwhich failed to identify and address the dangers of excessive leverage, and whichtoo confidently relied on supposedly efficient and rational markets always to pro-duce good results’. Turner’s critique suggests the need for a comprehensive refra-ming of the purpose as well as the conduct of regulation. It is one that most ofhis contemporaries are loathe to follow. If we are to design and implementsystems of governance that redress the perceived ‘responsibility deficit’ in corpo-rate and public policy, however, it is essential to more precisely map the verycontours of a process that privileged the illusion of accountability over itssubstance (Stiglitz, 2010). This requires not simply examining but, where neces-sary, changing the governance and mission of regulatory agencies.

5. Challenging the narrative

The failure of financial markets to internalize ethical restraint necessitates wepay much more attention to how rules are structured and why. More impor-tantly, it suggests the need to evaluate the critical power played by cultural termsof reference. Evidence from the United Kingdom suggests this has begun (if onlyin the retail environment). On 12 March 2010, the chief executive of the Finan-cial Services Authority, Hector Sants, used an address at the University ofOxford to outline a new consumer protection strategy. The strategy had threeinterlocking components: (i) to make the retail market work better for consum-ers; (ii) avoid systemic problems by preventing what the FSA terms the ‘crystalli-zation of conduct risks that exceed risk tolerance; and (iii) ensure that credibledeterrence systems are put in place within firms and the FSA itself to provideeffective redress. As with his speech the previous year on the failure of principles-based regulation, the FSA official emphasized that changed societal preferenceshad altered the risk–security calculation. This, he argued, required a radical shiftfrom principles-based regulation towards an outcomes-based approach. Cru-cially, he accepted that past reliance on disclosure and financial literacy was notonly insufficient; it was deleterious to consumer welfare. The regulator went onto emphasize the importance of ‘culture, behaviour – dare I say it, ethics?’It was most unfortunate that one of the most influential regulators in the

world was cautious about re-framing the debate towards the substantive issue(i.e. ethical erosion). He accepted, however, that the FSA’s renewed emphasis onthe importance of evaluating business models necessitates moving inexorably inthis direction, crucially, in partnership with industry.

We need to answer the question of whether a regulator has a legitimate focus to inter-vene on the question of culture. This arguably requires both a view on the right cultureand a mechanism for intervention. Answering yes to this question would undoubtedlysignificantly extend the FSA’s engagement with industry.



My personal view is that if we really do wish to learn lessons from the past, we need tochange not just the regulatory rules and supervisory approach, but also the culture and

attitudes of both society as a whole, and the management of major financial firms. Thiswill not be easy. A cultural trend can be very widespread and resilient – as has beenseen by a return to a ‘business as usual’ mentality.

Nevertheless, no culture is inevitable. But changing it is a task that cannot be achievedby policymakers alone - we need to collectively address these issues. From the regula-

tors’ perspective it is probably the case that seeking to set ourselves up as a judge ofethics and culture would not be feasible or acceptable. More realistic would be to relatethe consequences of culture to regulatory outcomes. However, developing this line of

thinking requires much further debate, which I would welcome (Sants, 2010).

A number of critical issues stem from this repositioning. First, there is the expli-cit, if timid, recognition that one of the central problems facing regulators andbusiness and indeed society is the inculcation among market participants of cul-tural terms of reference that allow for technical compliance with legal obligationbut derogation from the underpinning spirit. Second, there is an acknowledge-ment that reliance on ex post regulation is no longer either appropriate or sus-tainable. Earlier intervention in the product cycle is likely to have a much betterconsumer impact. Third, there is recognition that policymakers cannot solve thisproblem on their own. Fourth, there is an explicit invitation to industry to jointhe debate. Fifth, a framework is proposed that ‘links the consequences ofculture to regulatory outcomes’.Unfortunately, no specific design on how to render this operational was or has

been forthcoming. What is clear, however, is that the continued emphasis onmore intense pro-active supervision is likely to further exacerbate the tensionbetween product design and distribution. It has become increasingly apparentthat some way of adjudicating these disputes on responsibility and legitimacy cri-teria is required. These conflicts can be ameliorated through the development ofmeta-regulatory strategies in which there is integrated monitoring of compliancewith and deviance from codes of conduct. This requires, in turn, the capacity todifferentiate between warranted and unwarranted reputation. This requires theactive engagement of the professions, including financial journalism. From aprofessional perspective, it requires willingness to transcend conceiving obliga-tion in terms of a ‘hired gun’ and conceives of it rather as one designed to protectthe public interest. Jeremy Carver (2005, 229), the former head of internationallaw at Clifford Chance, puts it in a legal context ‘the lawyer cannot escape thecommitments inherent in the lawyer-client relationship. It is a contractual one,placing mutual obligations and expectations on both. But the obligation to servethe interests of the client is not unqualified. It is conditioned by a set of publicduties, including the duty not to misinform’.Seen in this context, professional obligation is an essential constitutive compo-

nent of effective capital market governance recommended by Adam Smith inThe Theory of Moral Sentiments (1759). It acts as a further mechanism to assess



the efficacy of existing trust boundaries, police deviance from agreed institutionalcommitments and reinforce stated adherence to values and integrity.

6. Creating an alternative structure

As with the social and political systems in which they are nested, effective andefficient financial markets depend on integrity. Disclosure, transparency andaccountability means little if understood in formal mechanistic fashion. Identify-ing and repositioning the precise intersection between law and ethics requires thedesign and implementation of an integrated set of carefully nuanced strategies.This holistic approach extends the determination of the value of interventionbeyond reduction of a financial compliance burden, the primary metric associ-ated with cost–benefit analysis. It places equal focus on the normative dimen-sions of regulatory design. Specifically, performance must be measured andevaluated to determine effectiveness not only on efficiency grounds. Of equalimportance is the incorporation of permissibility, responsibility and legitimacycriteria (i.e. the articulation of regulatory purpose and the assessment of perfor-mance against it). This privileging of an integrated approach to integrity is thensustained through an interlocking dissemination network, comprising and rein-forcing formal and informal nodes. It has the potential to lead to more substan-tive compliance, warranted commitment to ethical behaviour, more effectivedeterrence, enhanced accountability and reduced risk.As it happens, an embryonic model for this form of engagement already exists.

Created in the aftermath of previous scandal, it is the one robust component ofSarbanes–Oxley remaining. The Public Company Accounting Oversight Board(PCAOB) has fundamentally changed the governance of the audit profession.Crucially, it has not displaced professional membership bodies. Rather, its role isto monitor the extent to which professional values inform actual practice. ThePCAOB is an independent private sector regulator. Although the Securities andExchange Commission selects its board, it is neither government-sponsored nortaxpayer-funded. Operating expenses are collected from public firms with contri-butions based on market capitalization. The success of the PCAOB comes fromits monopoly power. No public company can submit a financial report unlessthe audit firm is registered with the agency. Second, the board conducts regularinspection audits that go well beyond technical peer review to examine auditfirm’s systems of compensation, promotion and internal oversight (MacDon-ough, 2005). What really differentiates the PCAOB, however, is its emphasis onactual practice. It delineates the duties and responsibilities as well as the rights ofeach participant in the regulatory conversation. It does so within an integratedframework. It focuses less on formal structure and more on how ongoing dia-logue can and should be linked to definable agreed objectives and measurableoutcomes. The drawback with the PCAOB model is that these conversationstake place behind closed doors, largely because of congressional restrictions inrelease of negative reports. Clearly, in the aftermath of the GFC, public trust in



technical expertise is understandably unforthcoming. The creation of a PublicFinancial Services Integrity Board would do much to restore faith in capital mar-kets. It is an opportunity that cannot be wasted. Unless reform of this magnitudeis bedded down, there is a risk that the ideational terms of reference inferred inHector Sants’ Oxford address will remain undeterred. This may represent atriumph for normal science. It would a tragedy for the capital market, itsparticipants and the communities they allegedly serve.

7. Conclusion

Unlike previous crises, which started or were contained within specific coun-tries or discrete regulatory systems, the global dislocation caused by the implo-sion of the securitization markets revealed the spurious nature of the rules vprinciples bifurcation as the primary distinguishing feature in regulatory design.Both systems of oversight were incapable of embedding the ethical restraintrequired for effective market integrity. Irrespective of the jurisdiction, therefore,the interlinked corporate, legal and broader political pressures highlight a singleexistential dispute. This dispute is predicated on the potential incommensurabil-ity between the enabling basis of private law and the public law imperatives ofsecurities regulation. Past reliance on bifurcation between sophisticated andunsophisticated investors masked but did not resolve this core problem.While efficiency and effectiveness are largely internally evaluated within a stra-

tegic action field, legitimacy requires broader external acceptance or quiescenceof the compromises made through elite bargaining. The enormity of the globalfinancial crisis has demonstrated just how misplaced confidence in marketordering was. As such, it represents a fin de siecle moment. The material andideational certainties associated with the privileging of financial capitalism haveevaporated. This has opened the space for contestation not only within elites butalso between elites and mass opinion. This is to be welcomed. The critical issue ishow to respond. As we have seen too often in the past, rules are too easily trans-acted around, and principles lack the granularity to be enforceable. Tacklingethical deficiencies require us to pay much more attention to the moral dimen-sion of market conduct, in other words, how lives are led professionally. It is atask we resile from at our peril.

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