Discovering the Known Unknowns? Assessing if UK Financial Regulation has Improved since the Great Financial Crisis
Since the great financial crisis of 2007, there have been widespread calls to strengthen the regulation of financial markets. Since this crisis, the level of fines levied on firms has sharply escalated and remediation for misconduct such as financial mis-selling has soared. The crisis also engendered widespread criticism of financial regulation with some nations, including the UK making substantial and costly changes to their regulatory frameworks.
Despite the scale and importance of these changes there is paucity of metrics by which we may measure how well financial actually works and if financial regulation has improved or otherwise. This lack of metrics arises from the partial observability problem whereby we only know of the financial firms and individuals which are actually caught for offending by the financial regulator. Subsequently much financial offending maybe occur and never be brought to book as this is not discovered. Recent research from Bangor University has addressed this problem to assess the effectiveness of financial regulation in the UK since the financial crisis. This research examines if fewer firms commit misconduct offences and if future offending has been deterred. This work produced jointly with academics from the University of East Anglia, the University of Otago and Aston University is accepted for publication and forthcoming in the Journal of Financial Markets Institutions and Money.
This evaluation is not as easy to make as one would think. While the proportion of firms brought to book by the regulator has been dropping since 2010 and it is unclear if this represents a decline in the number of firms offending or the regulator just catching fewer firms for aberrant behaviours. Either the regulators’ past actions has deterred future offending and there are few transgressing firms to catch or alternatively this is a sign of weakening enforcement and a diminishing proportion of offenders are caught? Both explanations are plausible, but whereas the former outcome would attract wide-ranging praise, the latter would be highly undesirable. Our work untangles these two effects of detection and deterrence. This is a non-trivial exercise, as we are trying to measure something that is partially unobserved – the level of offending which is not observed or caught by the regulator.
To do this, we used a simple logic. We observe that the proportion of offenders is declining. If we can establish that the rate of detection has not dropped, this would be a sign of increased deterrence. As a simple example, if you know that you always detain at least 20% of the offenders, but the numbers you catch drop from 30 to 20, then it must mean fewer offenders exist. Estimating how the rate of detection changed, however, is not an obvious undertaking.
To do this, we summon an unorthodox capture-recapture method. This technique is frequently used and well established in ecology to estimate population parameters of various species. When wildlife researchers want to estimate the population size of a given species, they don’t need to capture all the animals which exist. It is sufficient to tag a proportion of this animal population and release them back into the wild. This process is repeated, with a second, third and fourth sample of captured animals tagged and released. In this recurring process the proportion of tagged animals which are recaptured provides an estimator from which the proportion of all tagged animals within the whole population can be derived.
Although this is an extreme simplification of what is performed in our study, we analogously apply a variation of capture-recapture methods for financial firms. The regulator catching offending financial firms is the equivalent of trapping animals with each year considered to be a new trapping event. The proportion of firms caught repeatedly is akin to animals captured and tagged, providing a basis to estimate the overall proportion of firms breaching financial regulations. From this we can infer on the probability of catching offenders in each year.
Of course financial firms might be expected to be even more cunning than wildlife species when it comes to avoiding traps. Subsequently these sampling procedures are unlikely to be random and the samples taken each year will probably not be independent. We also account for these issues by using multiple variations of capture-recapture methods to show that detection rates have not dropped, implying (because the number of cases declined) that there are relatively fewer offences committed.Turning to the results- we can report regulation appears to have improved. While the number of firms and individuals caught for breaching regulations and laws by the UK financial regulator has been declining in recent years, the proportion of financial offenders caught appears to be increasing. From this we can surmise the level of regulatory deterrence has increased. Despite this, the actual proportion of offending firms and individuals caught still remains low, increasing from around a tenth of offenders being caught before 2010 to approximately a quarter of offenders being caught by the regulator after this year.
This evidence is useful for many reasons. Due to the high costs of regulation, the evaluation of regulatory performance is an increasingly important task. By providing evidence that the UK financial regulatory system is improving and regulatory deterrence is rising, we may determine that at least some of the many policy changes seen in the last decade have had a positive influence. These changes have been numerous including the increasing severity of regulatory sanctions, the reputational damage driven by the increased media exposure of financial misconduct, or even a cultural change in the financial industries since the 2008 crisis.
Ashton, J.K., Burnett, T., Diaz Rainey I. and Ormosi, P, (Accepted and Forthcoming). “Known unknowns: How much financial misconduct is detected and deterred?”, International Journal Of Financial Markets Institutions and Money.