Self regulation and statutory regulation.

With reference to both theoretical and empirical examples, this article discusses the advantages and disadvantages of various mixtures of statutory and self regulation. It seeks to define circumstances where statutory regulation works better than self regulation, and vice-versa. the author concludes that ideally both forms of regulation work best when they co-exist and that, whatever the mix, the regulatory system must be able to respond to unforeseen events.

Many economic transactions are regulated by contracts enforceable by the courts. Such contracts are usually legally binding documents that specify the terms under which a transaction takes place. If the terms of a contract are violated, one or more of the injured parties can appeal to the courts seeking compensation. Most private individuals encounter written contracts only rarely, for example when buying or selling property in the housing market, whereas transactions among corporate bodies rely extensively on them. Nevertheless, even where transactions are accompanied by carefully phrased contracts, it is unlikely that all contingencies will be fully specified and in many cases written contracts are absent. In these circumstances the parties in a transaction more often rely on trust. In other words, the parties in a transaction place their trust in one another in the expectation that mutually beneficial gains will arise.

Because the drafting and enforcement of contracts to cover every economic transaction would be prohibitively costly, their presence not surprisingly arises usually when the value of a transaction is relatively high. Where a transaction involves few resources -- say when a bag of tomatoes is bought in a market -- it seems reasonable that contracts are missing or highly incomplete. Indeed, in this case, the market itself is likely to provide the necessary regulation. If the tomatoes purchased in a market are damaged, the seller may, for reputational (ie profitable) reasons, be happy to replace them with good tomatoes. In this case, the absence of a complete or explicit contract is of little concern: competitive pressures in the market are a sufficient disciplinary mechanism. However, in circumstances where a market is subject to monopolistic influences and where information is not readily available, incomplete or non-verifiable, economic transactions, to a greater or lesser extent, may be forced to rely on trust. In this climate efficiency and opportunities can be compromised and there may be a useful role for regulatory intervention.

Broadly speaking there are two institutional forms of regulation: it can be imposed by statute (statutory regulation) or it may arise through voluntary agreements (so-called self regulation).

Like self regulation, statutory regulation, where government implements and courts enforce rules, is designed primarily to protect the interests of those engaged in, or affected by, certain transactions. For example, it may be a statutory obligation to hold a licence if one is seeking to sell occupational pension schemes, and to obtain a licence various criteria may need to be satisfied. In the case of occupational pensions this might require of a prospective licensee that he or she does not have any history of financial malpractice. Without adequate statutory regulation, the costly nature of writing and enforcing contracts may provide a window of opportunity for the misselling of pensions, as happened in the UK in the late 1980s and early 1990s.

In a regime of self regulation, representatives in an industry or sector may act co-operatively to achieve amongst other things, the protection of consumers and firms from such things as bad sales practices, to provide consumers with better and consistent product information, and to initiate standards. Where self regulation works, it can lead to obvious benefits, and, like statutory regulation, it reduces the need for detailed contracts to accompany transactions. But self regulation, unlike statutory regulation, is undertaken by industry participants (firms, consumers and sometimes interested third parties like environmental groups) and is therefore more likely to be better informed and responsive to innovations.

On the other hand, self regulation can, if insufficiently checked, open the door to collusive practices and furthermore, if it is to be credible it should be more than window dressing. For example, suppose that a group of hotels in a region form an association and state that its members adhere to a strict code of conduct governing the quality of accommodation and services provided to guests. If the association announces that its hotels are superior to all other hotels in the region, this will be credible only if the code of conduct is published and available for inspection and if breaches of the code are seen to be penalised. In the absence of adequate sanctions or appropriate information, claims made by the association are likely to lack credibility.

In practice, many industries and economic activities are governed by a mix of self and statutory regulation, so-called two-tiered regulation. This is especially so in those industries which are complex and transnational in character, like financial services. Typically, statutory regulation oversees the broad framework governing an industry and self regulation concerns itself with detailed issues of …