24 July 2014

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 SuggestionChina 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.
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