Regulatory Capture

Recently, I and my colleague were walking out of a meeting with a CEO of a company. As we were walking out, we were discussing on Regulatory Capture which we have both learned while we were pursuing an educational qualification. What led us to the discussion was that the particular CEO of the insurance company we met was previously an officer at the regulatory body (Insurance Board of Sri Lanka) which acts as the regulator of the insurance industry in the country. Today, a discussion on the same subject matter appeared on the newspaper, which prompted me to write this piece. As pointed out in the article there and as we have encountered, there are several examples that we can point out to this fact.

The Role of the Regulators

Be it the Central Bank of Sri Lanka, Securities and Exchange Commission of Sri Lanka, Insurance Board of Sri Lanka, Consumer Affairs Authority or any other regulatory body, their main role, simply, is to look after the public interests or the interests of the individual consumers of the regulated industry’s products, i.e., Financial Products, Securities, Insurance Products, etc. In academia, this is identified as the “public interest” hypothesis which conceives that government regulation benefits consumers of goods and services. The contrary argument is the “Capture” hypothesis which theorize that producers of goods and services receive net benefits from government regulation. 

Capture Hypothesis

A theory of regulatory behavior that predicts that regulators will eventually be captured by special interests of the industry being regulated. In the Capture Hypothesis it is argued that regardless of why a regulatory agency was set up, eventually special interests of the industry it regulates will capture it. This happens when the regulators become key personnel at the firms they are entrusted with regulating or personnel from industry become regulators. 

Is this a problem found only in Sri Lanka? No. It has not been a phenomenon seen only in Sri Lanka. Across the globe there are instances of regulatory capture where questions were raised as to how effective the regulatory bodies are in protecting the interests of the public. It is also reported in media that regulatory capture was responsible even for the recent financial crisis.   

The other question is whether the prevalence of this, of regulators ending up at entities they used to regulate, is bad for the Sri Lankan markets or not?  Well this is a question that has not been answered objectively by anyone (as far as I know) and neither do I am in a position to answer this question. However, a bit of news analysis will definitely show that this has not been good for the markets either. For instance, the resigning of SEC DG Malik Cader, SECchairperson’s subsequent resignation, Tilak's resignation as SEC chairman, etc. While it is not right to say that all these things were as a result of regulatory capture alone (rather as a result of a plethora of things), I believe that a proper study will reveal that there was a certain element of regulatory capture that was responsible for some of these issues. 

Are they not supposed to work!

The other question is; are these regulators not supposed work after they complete their respective tenures with the regulators? My belief is that they shouldn’t be joining the entities that they used to regulate, at least for certain period of time. (there would be a question raised by anyone against this on the basis that they know better the industries they regulated and how are they going to work for a totally different sector which they don’t know!!!) 

The bottomline

The economic rationale for regulation is that it offers benefits; albeit not measureable. These benefits from a capital market perspective may, broadly, include efficient markets, efficient capital flow, investor protection, etc. Potential beneficiaries are investors, issuers and other market participants. However, these benefits don't come free, they incur a cost. End of the day the taxpayers finance the regulatory agencies and hence they should be benefiting from it rather than a select industry group.