Science-Based Regulation in Financial Services: From Deterrence to Culture

Abstract

Recent regulatory responses to major adverse events have produced a range of responses, encompassing either retrospective reactions or attempts to control future behaviour. This paper juxtaposes the extremes of such responses in two models of how to regulate, which are almost diametrically opposed in their theoretical justifications. The two approaches are the legal model, based on the theory of deterrence, and the cultural model, based on behavioural science. We summarise some major examples of these models from different sectors, notably the Australian response to misconduct by banks (wholly based on deterrence) and the cultural approach to civil aviation safety (involving an open, ‘no blame’ culture that leads to necessary consequences in a ‘just’ culture). Traditional legal and economics-based theories of regulation (especially the theory of deterrence) have been re-thought in some industries and can now be based on the scientific findings from behavioural psychology and how humans behave in groups or organisations. With a focus primarily on financial services, we then discuss developments that are influenced by one or other model, illustrated by increased regulation of financial services managers, increased enforcement, changes to corporate governance, a focus on the purpose of organisations, and attempts by regulators and firms to change the cultures of the latter. We conclude that many recent initiatives conflict because they are unclear whether their underlying model is to blame, sanction, and deter or to support doing the right thing in an open and just culture. This is clear from confusion about the meaning, objectives and effects of terminology around responsibility and accountability. The evidence indicates that the legal model will have limited success in avoiding major disasters, but that the cultural model may be more effective as long as it is pursued under the right conditions. This includes understanding the meaning of accountability and responsibility in new ways. There is a need for detailed analysis of the causes of recurrent problems and of the responses that science indicates would reduce future risk.