LLAW6093B Chap.7 New Governance Techniques and the Crisis
New Governance Techniques and the Crisis
A puzzle about praised techniques
The extra reading for the second seminar asks why regulatory techniques that had been praised for twenty years failed in the crisis. It studies four of them: regulation by principles, regulation of firms' own management systems, enlisting third parties such as rating agencies and accounting standard-setters, and risk-based supervision.
Their promise was flexibility, responsiveness and more regulatory capacity; in the crisis they proved indulgent, fixated on processes that could be audited, and in some cases sources of new risk.
Regulation that backfires
The reading starts from paradox: rules can produce the opposite of their aim.
Safety nets create moral hazard, a warning about a bank can trigger a run, and rules push activity into less regulated corners. Capital rules that were sensitive to risk fell in the boom and rose in the bust, and lower charges for mortgages and securitisation encouraged both.
One government's blanket deposit guarantee even pulled deposits out of a neighbouring country's banks.
How each technique failed
Principles became a political label and covered two very different strategies at once. Reliance on firms' systems turned into reliance on polished descriptions of those systems, with stress tests closer to fiction than evidence.
Enlisting rating agencies imported their conflicts, since issuers paid for ratings, and writing ratings into capital rules magnified the damage when they proved wrong; accounting at market prices fed a spiral of forced sales.
Risk-based supervision either was not followed or rested on the wrong model.
A better explanation than rules versus principles
The reading does not recommend going back to detailed rules, which had their own failures.
It explains the failures through three dimensions: the organisation of the regulator, including its resources, will and political licence; the logic of the techniques and how separate regimes interact; and the shared beliefs that blinded regulators and firms alike. Its prescription is learning that questions whether the regulator is doing the right tasks at all.
What this chapter covers
- 01
Why praised techniques failed
- 02
Regulatory paradox and endogenous risk
- 03
Principles as rhetoric and as practice
- 04
Regulating a representation of risk
- 05
Rating agencies, accounting and enrolment
- 06
Risk-based supervision under strain
- 07
Organisational, functional and cognitive dimensions
Worked example · free
Diagnose a supervisory failure
- 2Identify the technique relied on.
- 4Explain the failure on each dimension.
- 2State what should change.
Key terms
- Regulatory Paradox
- The tendency of a rule to produce the opposite of its intended effect, such as a safety net that encourages risk-taking.
- Endogenous Risk
- Risk created or amplified by the regulatory regime itself, or by its interaction with other regimes.
- Enrolment
- The practice of extending regulatory reach by relying on third parties such as gatekeepers and standard-setters.
- Gatekeeper
- A party not itself the target of regulation but in a position to control access for those who are, such as an auditor or rating agency.
- Cognitive Capture
- The situation in which regulators come to share the assumptions of the firms they supervise, rather than being captured by their interests.
- Double-Loop Learning
- Learning that questions whether an organisation is pursuing the right goals and tasks, not only whether it performs them well.
New Governance Techniques and the Crisis FAQ
Did the crisis show that detailed rules work better than principles?
The reading finds no evidence for that. Detailed rules were outdated, gamed and left unenforced when their enforcers did not understand the activity, and a rule-based regulator missed a long-running fraud for years. Each technique had its own weaknesses.
Why were credit ratings such a problem in the crisis?
Rating agencies were paid by the issuers whose products they rated, fees rose with the rating, and they sometimes helped structure what they rated. Regulators then wrote ratings into capital and collateral rules, so inaccurate ratings were carried into the core of the framework and downgrades produced sharp jumps in required capital.
What does the reading propose instead of a new toolkit?
It proposes looking at the organisational, functional and cognitive conditions in which any tool operates, and building in reflective learning that asks whether a regulator is doing the right tasks at all, while accepting that things will sometimes go wrong.
Exam move
For each technique, write down the one condition under which it works and the one way it failed. Then pick a current Hong Kong supervisory initiative and ask which of the four techniques it relies on and whether that condition holds today.
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