Self-Regulation in Finance: Standards, Culture, and Ethics

Introduction

The pitfalls of self-regulation are not unknown: object lessons abound in Tyco, WorldCom, Enron, Arthur Andersen, and several others (Pritchard, 2003). What to make, then, of a proposal for the implementation of self-regulation that would decrease regulatory oversight of a company? On the one hand, few firms are going to reject such a proposal, as it means less red tape; on the other hand, compliance is culture, and a culture without it can quickly become a slippery slope down the same path taken by the companies already mentioned. Yet, as Omarova (2011) points out, an industry without self-regulation is unlikely to address the problems that plague it: at some point, accountability and firm responsibility are needed to address issues that largely elude regulators.

The problem of relying solely on regulators and external compliance has been seen again and again—particularly in the global context. Regulators depend on political accountability, civil support, and competitive marketplaces, and when any of those are lacking, regulation and enforcement become virtually impossible (Arnone & Padoan, 2008). Omarova (2011) describes the problematic nature of third-party regulation most clearly: "Given the complexity and global nature of the modern financial market, any government's attempt to regulate it in a purely unilateral command-and-control manner will inevitably encounter the fundamental problem of regulatory arbitrage, whereby financial institutions find new ways to get around government rules, thus creating a never-ending spiral of rulemaking and rule evading" (p. 416).

With that point in mind, it is worth considering whether self-regulation can answer the never-ending spiral Omarova (2011) describes. This paper argues in favor of self-regulation—on the condition that certain standards and concepts are applied to ensure that self-regulation does not become a license to act unethically.

The Case for Self-Regulation

One of the strongest reasons for self-regulation is that the existing regulatory regime is simply not an effective option (Greene & Odorski, 2015). The SEC, for example, typically fines offending firms, but in many cases these fines do not cover the losses caused by the offending firm's actions—nor do they amount to more than a financial wrist-slap (Greene & Odorski, 2015). The Fair Funds provision of the Sarbanes-Oxley Act (2002) was intended to ensure that fines were placed into a disbursement fund that would pay out to victims of fraud or abuse. Since 2007, however, those funds have been decreasing—even as the number of firms charged by the SEC has increased (Greene & Odorski, 2015). This is but one example among many indicating a need for regulation of the regulators, which is, of course, the crux of the problem. Regulation can be piled upon regulation, but unless personal accountability and ethical leadership are demonstrated, the issue of regulation can never truly be resolved. Ultimately, regulation is a culture issue: a company's culture must be firmly rooted in standards and concepts that promote accountability and ethical leadership.

In light of existing regulatory systems failing to produce desired outcomes, it is reasonable to accept self-regulation as a viable alternative. Rather than complying with external standards, codes, and rules, a company would comply with internal standards, codes, and values that drive both its culture and its performance. The firm must develop its own standards of conduct and hold itself accountable: everyone, from top-level executives to front-line staff, must be held to the same standards, the same principles guiding the company's vision, and the same behavioral expectations inherent in ethical leadership. The firm must also be able to monitor activity internally and identify potential abuses or fraudulent behavior through routine internal and external auditing. Self-regulation is not a free pass to ignore internal conduct; if anything, it is the acceptance of even greater responsibility to monitor, assess, and correct offenses and abuses without relying on an external regulatory system.

Omarova (2010) states that "any meaningful long-term regulatory reform in the financial services sector must seriously consider the potential role of industry self-regulation as a key mechanism of controlling and minimizing systemic risk" (p. 669). There are two primary reasons self-regulation is the key to controlling and minimizing such risk. First, firms alone have ultimate access to the information available internally—external regulators do not. Second, firms alone have the power to monitor and regulate their businesses across national borders—external regulators do not (Omarova, 2010). For these two important reasons, self-regulation emerges as the best available solution to the problem of financial oversight.

Is Self-Regulation Practical?

The question remains whether self-regulation is possible, practical, and pragmatic. With today's technology, the answer is yes. As Arner, Barberis, and Buckey (2016) demonstrate, FinTech and RegTech have reached a stage of development at which they can adequately assist firms in monitoring transactions, accounting, and all other internal activity. RegTech has become so advanced that it has "the potential to enable a nearly real-time and proportionate regulatory regime that identifies and addresses risk while facilitating more efficient regulatory compliance" (Arner et al., 2016, p. 371). Because the finance industry has integrated information technology throughout its operations, the need for an IT-based regulatory monitoring system is clear. Without such a system, self-regulation would not be feasible given the sheer volume of daily transactions. Using an IT-based solution solves that problem and gives the firm the option of deploying Big Data analytics to better understand what is happening within its own operations.

Without RegTech, self-regulation would be impossible from a monitoring and evaluation standpoint. Instead of an external agency performing the monitoring, the firm uses RegTech to monitor "trade reporting systems of securities exchanges to detect unusual behavior which can serve as a trigger for further analysis and potential regulatory investigation and enforcement" (Arner et al., 2016, p. 399). This is not the only digital technology imperative placed upon the firm, however. There is also the need to enhance cybersecurity to protect against hacking and digital theft.

Conclusion

Self-regulation is not only a viable alternative to external regulation by third-party agencies; it is also a necessary step toward the reduction and management of risk. Companies alone have the greatest access to records, numbers, personnel, and activities that may warrant investigation—access that external regulators generally lack, and which can take substantial time and resources for them to acquire. Companies alone also have the power to monitor their own actions on the international stage, where third-party regulators typically cannot reach. Companies have the technological means to do so as well: RegTech has advanced to a point where information can be monitored, collected, analyzed, and evaluated nearly instantaneously through Big Data analytics. Finally, the company itself has the capacity to cultivate the internal culture of compliance—through ethical leadership—that makes self-regulation sustainable. For all of these reasons, self-regulation is recommended.

References

Arner, D. W., Barberis, J., & Buckey, R. P. (2016). FinTech, RegTech, and the reconceptualization of financial regulation. Nw. J. Int'l L. & Bus., 37, 371.

Arnone, M., & Padoan, P. C. (2008). Anti-money laundering by international institutions: A preliminary assessment. European Journal of Law and Economics, 26(3), 361–386.

Greene, E., & Odorski, C. (2015). SEC enforcement in the financial sector: Addressing post-crisis criticism. Bus. L. Int'l, 16, 5.

Omarova, S. T. (2010). Rethinking the future of self-regulation in the financial industry. Brook. J. Int'l L., 35, 665.

Omarova, S. T. (2011). Wall Street as community of fate: Toward financial industry self-regulation. University of Pennsylvania Law Review, 159(2), 411–492.

Pritchard, A. C. (2003). Self-regulation and securities markets. Regulation, 26, 32.