Regulatory capture theory

Regulatory capture theory

 by Doris Luya Xiao

dorisluyaxiao at gmail dot com

Capture theory was introduced by George Strigler (1971) that says a firm or an industry can benefit from the legislation if it captures the related regulatory body. In Public interest theory government find some firms or industries have issues that may harm the society. To protect social interest from those harms, government set regulatory body to regulate thebehaviour of those firms and industries. The regulatory body could be officers, legislations or guiding principles. They monitor organizations to act good for the public. Capture theory agrees that regulations are introduced aim to benefit the public at first. But the aim will eventually fail because as time flews regulator are controlled by regulated party (firms or industries), and then regulator will protect the 'regulated party'. Industries are unhappy about being monitored. They could have more benefits or profits without regulation. Those greedy industries will do whatever they can to capture or we could say control the regulatory body. Once industries succeed in controlling, regulators can no longer perform their roles to regulate. Furthermore, regulators being captured will make new decisions in favor of industries rather than the public.

Capture theory was developed while the decline of [[Public interest theory]] during the period of 1967 to 1983(Merrill 1997). Rather than describe the reason to introduce regulation, it emphasis on the development of regulation. In reality there are many cases all around the world support this theory. In Australia the former ARSB was captured by accounting professions; Tobacco industry in China had captured the State Tobacco Monopoly Administration; American had the Federal Reserve Bank of New York captured. In spite of this, the capture theory is not perfect. There are criticisms of this theory.

Illustration of Capture Theory

Structure of theory

Assumption

The regulatory capture theory was build based on following assumptions:

1. The regulator agency, regulated party and customers are all greedy and seeking to maximise their own interest.
2. All interest related party have a rational expectation for another party.
3. It might take a long period of time and huge effort for industries (regulated party) capture the regulator. To get though this theory the impact of cost of capture to efficiency should be ignored.

Arguments

One of the arguments is that the interest of a regulated party was harmed by a regulation; the regulated party want to get its interest back, and then it seeks opportunity to control the regulator. Also regulated party expects that by controlling the regulator, legislating will be in favour of parties subject to regulation. Considering the perspective for the regulator agency, its survival depends on satisfying the expectations of regulated party. If the regulated party does not exist anymore, the regulators are no longer needed.

Conclusion

All of the above concludes that regulators cannot keep their independence; and regulation will eventually lose its basic aim to regulate.

Capture of accounting standard setting in Australia

Background

Before ASRB (Australian Accounting Standards Review Board, later replaced by AASB) was established in 1984, according to Walker (1987), it is the accounting profession who is in charge of accounting standard-setting process. Only members of profession will be sanctioned for non-compliance. That is, accounting profession acts on both regulator and the objective of regulation. At that time, over 40% of company were found fail to comply with the accounting standards. Public confidence in capital market was reduced. ASRB was then established for public good to increase the level of compliance.

Regulatory capture evidence

Here are some evidences on ASRB were captured:

• While discussing the establishment of ASRB, accounting profession lobbied to ensure that the board would have no independent capability, no academic as chairperson, and would receive administrative officer instead of a research director.
• In 1985, ASRB update its procedures to ensure priorities would only be set after consultation with AARF (directly controlled by accounting profession). Its priority was previous set on the basis of public submission.
• The board initially put AARF and other interests group in the same ground. Later, it changed to offer a fast track procedure only for dealing with submission from AARF.
• Most members of ARSB were professional accountants and financial directors. The regulator lacked independence.

Capture of China cigarettes

The Economist (2014) published an article about the monopoly tobacco industry in china and the government’s control in this area. It seems that tobacco industry have captured the tobacco regulator.
The problem tobacco bring to health have become more aware in global. Below is a table of what World Health Organsation suggests on prevention of tobacco and China's action.

WHO Suggestion	China Performance
Departments issue reliable data on tobacco use.	China lacks disclosure on tobacco use.
Government sweeping imposition of smoking bans.	This issue is still on discussion.
Government set well-funded accessible scheme to help people quite smoking.	Little funds were set in China.
Broadcast on the harms of tobacco.	Not many people know the harm.
Complete ban on marketing.	Cigarette brands are seeking chances to survive.
Impose high tax on tobacco.	Cigarette in China is quite cheap, everyone can afford it.

Obstacles

In fact China agreed that WHO was right on banning cigarette. There are numerous policies on forbidden smoking in public area. First lady of China is the official anti-smoking ambassador. But there are obstacles on dying out smoking in China.
First, the tobacco business and the government are entwined with each other. This relationship prevents the efforts of smoking ban. This could be seen from the above table. The largest part of government revenue is from tobacco industry.
Second, the tobacco industry is almost monopolized by China National Tobacco Corporation. The State Tobacco Monopoly Administration plays the role on monitor. However, these two organisations have intertwined structure and they share managers and use the same website. The situation is that the tobacco industry regulates itself.
It’s clear that there are many ways china could adopt to prevent smoking. But as the regulation setting process is controlled by the Tobacco Co, the law cannot be so persuasive on regulate tobacco in China.

Capture of Federal Reserve Bank of New York

In this case the Federal Reserve Bank of New York (New York Fed) regulate Wall Street banks though the Federal Reserve Banking System. The New York Fed should be independent from the Wall Street banks considering its role as a regulator. However, the president of NY Fed is selected by a board formed with some of the Wall Street banks. Timothy Geithner who was the president of NY Fed from 2003 to 2009 always had a closer relationship with Wall Street while in position (Becker & Morgenson 2009).
During the 2008 financial crisis, Geithner made NY Fed purchase credit default swaps from AIG. In return banks received full value payment. Usually when a company wind up, creditors may be court ordered to accept payment at a discount value, otherwise taxpayers will suffer. Thus the full payment on the AIG debts was unusual; and Geithner argue that this was to save the banks from their own mistakes. He also refused to disclose the hidden parties benefit from this activity (Reilly 2010).

Criticisms of capture theory

According to Posner (1974) this theory has some weakness in its theoretical foundation. There are questions cannot be answered. Though the theory describes that the deal between regulatory agency and the regulated party affect regulatory process, it does not suggest what process the regulated party did to capture the regulator. Customer’s interest will also be affected by the new set up rules. The theory did not explain why customers cannot capture the regulatory agency to protect their interest. Now that the regulated party have the ability to capture the regulator, why don't they prevent the creation of regulatory agency in the first place?

Reference

‘Government coughers’ 2014, The Economist, 1 March, viewed 1 April 2014, http://www.economist.com/news/china/21597958-smoking-course-kill-100m-chinese-people-century-will-latest-anti-smoking.

Becker, J & Morgenson 2009, ‘Geithner, member and overseer of financial club’, The New York Times, 26 April, viewed 7 April 2014, http://www.nytimes.com/2009/04/27/business/27geithner.html?_r=0.

Merrill, TW 1997, ‘Capture theory and the courts: 1967-1983’, Chicago-Kent Law Review, vol. 72, viewed 1 April 2014, http://scholarship.kentlaw.iit.edu/cklawreview/vol72/iss4/6.

Peltzman, S 1976, 'Toward a more general theory of regulation', Journal of Law & Economics, vol. 19, no. 2, pp. 211-240, viewed 1 April 2014, http://www.nber.org/papers/w0133.

Posner, RA 1974, 'Theories of economic regulation', Bell Journal Of Economics & Management Science, vol. 5, no. 2, p. 335, viewed 1 April 2014, http://www.nber.org/papers/w0041.

Reilly, D 2010, ‘Secret banking cabal emerges from AIG shadows’, Bloomberg, 29 Jane, viewed 7 April 2014, http://www.bloomberg.com/news/2010-01-28/secret-banking-cabal-emerges-from-aig-shadows-david-reilly.html.

Strigler, GJ 1971, 'The theory of economic regulation', Bell Journal of Economics and Management Science, pp. 2-21.

Walker, RG 1987, ‘Australia’s ASRB: a case study of political activity and regulatory capture’, Accounting and Business Research, vol.17, no. 67, pp. 269-86.

What is a Theory?

What is a Theory?

By Kelly Stallard 

kelly dot stallard at bigpond dot com

A theory can be defined as:

‘A coherent set of hypothetical conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’- Hendriksen, 1970 p.1

In other words, a theory is much more than a 'hunch' or a 'gut feeling'. It is based on logical reasoning and used to help make sense of real world phenomena, providing explanations as to why some things work the way they do (Deegan, 2009 p.4).

Logic is the valid reasoning behind the theory, to show that it makes sense.  A theory also requires proof and evidence, but we must be careful not to confuse proof with evidence. Evidence is something that you show or present to support your argument, whereas proof is that one ‘thing’, be it evidence, an argument, or something else that convinces you the theory is the truth.

The following elements must be present in order to construct a theory: It must be structured, form a framework which leads to other things, be a conceptual model (show relationships) explaining what the 'real world' is and ultimately help us make decisions.

It is also beneficial, but not necessary, if the theory is useful (helpful in the real world), prescriptive (whether good or bad), able to criticise current methods, fits with existing ideas, is true in all circumstances, is exact and realistic.

Critical Thinking and Theory

It is important when evaluating a theory to think carefully about what has been presented to you and not just accept it as truth. In other words, are the supporting arguments logical, do you agree with the assumptions of the theory and is there acceptable evidence to support the theory. This is where critical thinking comes into play, enabling people to think ‘outside the box’ and to look at things in different ways. Critical thinking is governed by things such as clarity, precision, accuracy, relevance and consistency (Bassham et al, 2009 p.2)
Clarity is required to make sure we understand what we are being told both through language and through thoughts or ideas. Critical thinkers also value precision, looking for precise (or exact) answers to precise questions. Accuracy and relevance are also important as decisions that are based on bad information will lead to bad decisions. Staying focused on what is relevant will help ensure accuracy (Bassham et al, 2013 p.2).

Finally, there is a need for consistency in critical thinking. If a person holds inconsistent beliefs, how can they both be true? Inconsistencies can be logical – saying or believing inconsistent things or; practical - saying one thing yet doing another. Critical thinkers consider all these aspects when assessing a theory, in order to avoid fallacies.

Fallacies are misleading arguments or theories that are seductive and easy to believe. The two main types of fallacies to be aware of are fallacies of relevance and fallacies of evidence. Fallacies of relevance are statements whose purpose is to draw attention away from the subject matter. Fallacies of evidence relate to arguments that do not provide the required factual evidence for their conclusions (Bassham et al, 2013 p.4).

Perspectives of Accounting

There are theories can be divided into roughly two categories; Positive and Normative. Although there are additional types, these are the most common. Both are constructed in different ways and have their own objectives so users have to be careful not judge a normative theory as being "bad" if it is approached from a positive perspective.

Positive theories describe and predict. They aim to explain how things work by using a more scientific approach, so as to understand ‘why’. These theories tell us what 'is' and are based on facts.
Normative theories are prescriptive and tell us what 'should' be, more like providing instructions. These theories tend to start with morals and are based on judgements of what is good and bad or right and wrong.
Theories are constructed from a number of arguments. Each argument can then be proved (or disproved) by using either inductive or deductive reasoning.

Image by Kelly Stallard

Inductive reasoning is generally associated with positive theories that have been developed using empirical evidence - evidence based on past observations. Inductive reasoning begins with specific observations and uses these to detect patterns thus enabling a hypothesis to be formed. This hypothesis offers explanations as to why things are done in a certain way and this in turn leads to the creation of a general theory.



Deductive reasoning however often starts with a normative idea. It begins with a tentative theory that is used to form a hypothesis, explaining what should be done. These hypotheses provide evidence through testing and observations, leading to a confirmed theory. 

Image by Kelly Stallard

Deductive reasoning is often considered the stronger of the two methods. This is because from each argument, the following inference must be true to confirm the theory, whereas inductive reasoning only implies the truth. Reasoning, Logic and Proof are all required when evaluating the strength of a theory.

Parts of a Theory

A theory can essentially be broken down into four main parts: Evidence, Inference (or conclusion), Assumptions and Arguments.

Evidence can be facts, other theories, observations, and so on that you present to support your argument.
Inference / Conclusions are the resulting explanations based on an argument and supported by evidence.
Assumptions can be explicit or implicit. Explicit assumptions are clearly and precisely stated, leaving no room for implication. The assumption may include arguments based on a persons unconscious thoughts, which could affect the conclusion. For example, this is what I believe so this is my argument supporting that belief.
Implicit assumptions include the underlying agreements or statements made in the development of an argument, which are not explicitly voiced nor necessarily understood. That is, they are implied but not directly stated.

Arguments are the fragments (pieces) that build to the conclusion. Arguments are ALWAYS statements. To test whether some thing is a statement, put "it is true that" at the beginning of the sentence. If it still makes sense, then it is a statement.  A simple example of an argument could be:

1. All people are selfish (Explicit assumption)
2. Managers are paid bonuses on profits made (Argument)
3. Therefore old managers will not spend money on research and development (Conclusion)

Another way of understanding how a theory is constructed, is by looking at it from a different perspective. Imagine building a house and picture each part of the theory as one aspect of the build. For example, we start with assumptions – the foundation on which we want to build. Next, the theory itself forms the solid structure on which to base our arguments. The arguments and evidence are the parts and materials used to build on the structure. Finally, the finished product of a house is the conclusion to the theory – what it was designed to do. The below link shows this process in pictures as a visual aid to help understand how the process all fits together.

References

Bassham, G Irwin, W Nardone, H Wallace, JM 2013, Critical Thinking: A student's Introduction, 5th Edition, McGraw-Hill, New YorkDeegan, C 2009, Financial Accounting Theory, 3rd Edition, McGraw-HIll Australia Pty Ltd, NSW

Hendriksen, E 1970, Accounting Theory, Illinois, Richard D Irwin

What makes up an argument?

What is an Argument? 

By Kellie Rosenfield
kellie -dot- rosenfield -at- gmail  -dot- com

Pronounced [ahr-gyuh-muhnt] as per Dictionary.com noun: 
For the purpose of this Wiki page, the term argument does not mean ‘fight’ or ‘dispute’ but is the name given to reasoning in order to establish a conclusion.

 An argument is where you try to convince someone of something by giving reasons as evidence in the hope that they will accept the conclusion you are trying to make.  The construction of an argument has to provide reasoning and rational thought.  Arguments are the fragments (or statements) used to build up to your conclusion. An easy way to check if something is a statement you insert it into the following..
"It is true that...."

For example. A mother yells to her child, "Son! Close the door! It is cold in here!"

To break down the dialogue, we can see three distinct parts.  When trying to ascertain which one is the statement, we will insert each into the text "It is true that..." and the one that remains logical is deemed the statement.

1. It is true that Son. - This makes no sense whatsoever. This is NOT a statement.
2. It is true that close the door! - This also makes no sense. THis is NOT a statement.
3. It is true that it is cold in here. - This DOES make sense and therefore it is deemed the statement. It is

logical and brings reasoning to the original statement made by the mother. It is deemed a valid argument.
A solid argument needs a good foundation, much like building a house.  If the foundation is not solid, whatever we choose to build on it, will become weakened as we progress.  We can consider the foundation our premise. This is an idea that we consider to be true and on which we will use to then build our argument.
 What is NOT an argument? This is where the statement is void of logic and reasoning. Please see Fallacies for further information.

Reasoning

We can build arguments through two different methods. These are through Inductive reasoning or Deductive reasoning.

Inductive Reasoning

Inductive reasoning begins with data or an observation (hard facts). From this data, we look to see patterns forming (this is usually based on the average over time). This can strengthen our belief or confidence in the data or the observation.  From these patterns, we can provide a tentative explanation as to why this is occurring (in line with our argument). Once proven, this becomes an accepted theory. When using inductive reasoning, it is only necessary that each step implies the truth and it is not necessary for it to be the absolute truth. Inductive reasoning aims to provide reasons supporting the conclusion's probable truth.  In inductive reasoning, we begin with an observation or data. From this information, we look to see any patterns emerging in the data. We then hypothesize why these patterns occur and from this we draw out theory (conclusion).  In each step along this process, it implies the truth but it is NOT absolute.

Deductive Reasoning

Deductive reasoning begins with a concept or idea.  From this idea we can build a hypothesis. A hypothesis is a tentative assumption in order to draw out and test your idea’s logic or empirical consequences (which means that it can be proven).  The evidence could be logical arguments. Evidence is considered the one piece of information that makes you believe in the idea/concept/assumption. This now becomes a confirmed solid theory. For a theory to be confirmed under deductive reasoning, each inference and argument MUST be true.

Examples

Example 1 

 This general example was drawn from Deegan (2009)

1. All surfers over the age of 35 ride longboards (premise)
2. Jack is a surfer over the age of 35 (evidence)
3. Jack therefore rides a longboard (conclusion)

Acceptance of the above premise means we are more likely to accept the conclusion due to its logical deduction.

Example 2 - Accounting

Assumption: The key objective of financial accounting is to provide useful information to decision makers.
Decision Usefulness Theory

1. If investors had better information, they could make better decisions
2. Historical cost is a bad method, illogical and probably misleading
3. Therefore, we SHOULD fix this problem (historical cost) and replace with information that WOULD be more useful.

Let’s examine each line of the above argument.
1.       If investors had better information, they could make better decisions.
Is this true? Well, it’s not not true.  Consider this example. If you have bricks, mortar mixed to the perfect consistency and expert tools and you’re asked to build a house. Will you be expected to build a brick house to an acceptable standard? Probably not. What you’re lacking is not the best materials and best tools; it is the ability to successfully construct. This is as true for wall construction as it is for argument construction. Just because people have the correct information does not mean they will always make the right decisions.
 2.       Historical cost is a bad method, illogical and probably misleading.
Historical cost method is bad. It IS illogical and it is definitely misleading.
This argument is true.
 3.       Therefore, we SHOULD fix this problem (historical cost) and replace with information that WOULD be more useful.
This is a normative statement as it is stating what SHOULD happen. This raises another question. What or how much information is considered enough? This is simple. There only needs to be sufficient information for it to be useful and this will vary for each individual user of the information.

Where do Arguments fit into Theory?

Below are the elements that go into creating a theory with a brief explanation of each.
For consistency, the example of building a house will be used to keep things in context.

Assumptions (Foundation)

This is the foundation on which you build everything else.
Assumptions can fall into two categories.

1. Explicit – where your assumption about something is very clear and there is no doubt about its meaning.
2. Implicit – where your assumption is not very clear or possibly not understood. It is defined as being “unexpressed”. This is different from being unstated as it infers a level of consciousness.

House example – The house’s foundation (the concrete slab)

Arguments (Parts)

Parts which are used to construct the whole structure (these are statements made using evidence)

House example – Walls, roof, etc.

Evidence (Materials)

Materials used in the parts (Arguments) – The stronger the evidence, the higher quality the material is = Better parts and thus creates a stronger structure.
Evidence is something you or present to support your argument. These can be facts, other theories or abservations (data).

House example – bricks, wood, glass, etc

Theory (Structure)

The structure in its totality. It gives meaning to your arguments, the evidence and your underlying assumption.

House example – The house

Conclusion (Function)

Function = what you plan on doing with the structure (theory)?

This raises two very important points.

1. The conclusion indicates how people behave
2. Now you know:  what do you do with the information?

House example – What we plan on doing with the house upon completion.

 Reference List

Allen, Matthew (2004) Smart Thinking: Skills for Critical Understanding and Writing, 2nd Edition, Oxford University Press, South Melbourne, Victoria, Australia.

Deegan, Craig 2009, Financial Accounting Theory, Third Edition, McGraw-Hill Australia Pty Ltd, North Rude, NSW, Australia

Dictionary.com - accessed 27th April 2014
http://dictionary.reference.com/browse/argument?s=t

Leyden, D (2011) Critical thinking in economics, Kono Publishing and Media Group, Charlotte, North Carolina, USA

 Mohan, T McGregor, H Saunders, S Archee, R (2008) Communicating as Professionals, 2nd Edition, Cengage Learning Australia, South Melbourne, Victori, Australia, Chapter 2.