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Oliver Letwin: The right kind of regulation

Arguably, the biggest failures of the last eleven years have been failures of regulation. Some of these failures have been failures of under-regulation.

Notoriously, bank lending has been under-regulated. Equitable Life was under-regulated. Haringey children's services department has been under-regulated.

But other failures have been failures of over-regulation.

Doctors, nurses, teachers and police officers all complain about being over-regulated.

Small businesses and voluntary groups are screaming about being over-regulated.

And farmers are being driven mad by over regulation.

How come there is both over-regulation of some things and under-regulation of others?

Superficial answers abound. 'The Government has its eye on the wrong balls'. 'It all depends on the tabloid headlines'. 'Some things are more difficult to regulate than others'. 'Some things are easier to over-regulate than others'.

But all of these superficial answers miss a deeper point ...

... Labour's failures of under-regulation stem from exactly the same conceptual mistake as Labour's failures of over-regulation.

Indeed, in many cases, over-regulation of Type A has actually caused under-regulation of Type B.

What are these two types of regulation?

And what is the conceptual mistake that has led both to over-regulation of Type A and to under-regulation of Type B?

First, the two types of regulation:

Type A regulation is RULE-BASED. It has the form (often also the legal character) of law.

Like any other rule-based system, Type A regulation prohibits certain actions and mandates others.

So, for example, the Type A regulation of money-laundering forces every bank and building society to do certain things when a new client seeks to open an account. Passports are to be inspected, the addresses of grandmothers written down, and so forth. In the absence of such procedures, the Type A regulation prohibits a new account being established.

Whether the things that are commanded actually have any effect on the amount of money-laundering is not a concern for the clerks and managers who are compelled to keep these records. As long as the records are amassed, dutifully stored and available for inspection, the call of duty (which is the stern daughter of the voice of God) has been heard and obeyed.

This is, of course, what happened - mutatis mutandis - in the case of Haringey children's services.

They received, just after the horrific death of Baby P, a commendable Ofsted report. Processes were in order. Everything requiring to be done under regulation of Type A had been done.

The baby was dead - ah yes, a tragic error. But the REGULATION had been observed.

Much the same applies in the case of the over-lending and complex derivatives which are one of the main causes of Labour's current debt crisis. The FSA - bless its cotton socks - had been studiously applying rule-based regulation. And the rules had been observed.  The procedures had been followed.

The entire financial system was put at severe risk? Well, yes. But that was a mere lacuna. The REGULATION had been complied with.

Proponents of Type A regulation have a touching faith that following the processes mandated in the rules will somehow guarantee the results which the rules are designed to deliver. But, of course, there is no such guarantee in practice. Following a given set of rules will produce the expected results if, but only if, the activity in question is very simple and the rules are very well judged.

In general, the activities we most want to regulate - banking, looking after children at risk, flying airplanes, cutting people up on the operating table and so forth - are not simple at all, and devising rules that will guarantee results in these complex activities is well-nigh impossible.

Hence, the need for regulation of Type B.

In Type B regulation, the regulator supervises the activity in question on the basis not of rules but of professional competence. Type B regulation is not rules-based but JUDGMENT-BASED.

A classic case of Type B regulation was Victorian school inspection. The school inspectors in those days did not require large volumes of paperwork to be produced by the schools they visited. They did not inspect the processes employed by the teachers. Instead, they inspected the children, hearing them say their lessons. If the inspector thought the children knew what they ought to know, given their abilities and ages, then all was well. If not, not.

No rules. No processes. Just a judgment of the outcomes.

It was much the same in the good old days before 1997, when Mr Brown hadn't yet deprived the Bank of England of the power to supervise the banks. The main instrument of regulation was the Governor's eyebrow. If, in his judgment (based on the judgment of his colleagues who were respected banking professionals) a given commercial bank was taking excessive risk, the Governor's eyebrow would be raised - and the risky practice would be discontinued.

No rules. No processes. Just a professional judgment of the risk.

In Type B (judgment-based) regulation, what counts is the ability of the professionals engaged in the regulated activity to satisfy the fellow-professionals doing the regulating that they are properly living up to their professional responsibilities.

By contrast, in Type A (rule-based) regulation, what counts is the ability of the professionals engaged in the regulated activity to tick all the boxes on the questionnaire sent out by the computers of the regulator.

This is what helps to explain both the conceptual mistake that Labour has made about regulation and the reason why that mistake has generated, at one and the same time, over-regulation and under-regulation.

The conceptual mistake is very simple. It consists of confusing Type A regulation with Type B regulation.

Every time there is a call for something to be regulated, the Labour Government leaps into the fray - with new rule-based (Type A) regulation that specifies more processes that must or must not be followed.

And, every time, Labour ministers imagine that they are thereby somehow going to affect, in some determinate way, whether the professionals engaged in the regulated activity are properly fulfilling their professional responsibilities.

But, of course, there is in practice no particular reason why mandating processes in a complex activity should generally be expected to produce results similar to Type B regulation - where suitably qualified professionals in the regulatory bodies make judgments about whether the professionals in the field are living up to their professional responsibilities in an effective way.

Neither form of regulation can produce the innovation or pressure for excellence that come only from contest and competition.

Nor can either form of regulation create the sense of duty, the sense of professional ethics, which are the only true and sustainable basis for connecting professional responsibility with social responsibility.

And, of course, there is no guarantee that any form of regulation will be perfect even in its own terms. Rule-based regulation will not produce 100 per cent compliance with the rules; and judgement-based regulation is only as good as the judgment of the regulators.

But, for all that, there is a decisive difference between Type A regulation which dwells on rules and processes, and Type B regulation which dwells on judgment.

Judging professional performance can help to draw attention to poor professional performance, and can thereby help to prevent continuing disasters.

The last eleven years in Britain have provided ample evidence that mandating processes, by contrast, will generally do nothing more than make people follow those processes - often with little or no beneficial effect on outcomes.

But we must add one rider.

Process-based (Type A) regulation may well make things substantially worse.

Indeed, the howls of protest now emanating from all those doctors and nurses, teachers and police officers, business people, charity trustees and farmers, are essentially howls of protest about the distorting effects of excessive Type A regulation.

When processes are mandated, the scope for professional responsibility is diminished - because the time and energy that the professional might otherwise devote to fulfilling his or her professional responsibilities is reduced by the amount of time and effort that has to go into adhering to the mandated processes.

Public choice theory teaches us what common sense in any case indicates - that people in important positions do what the system gives them incentives to do. If the system of regulation gives them incentives to adhere to processes, they will adhere to processes - even if that means suspending their professional judgment.

And this is how the present Government has created the miracle of too much regulation becoming, at one and the same time, too little regulation.

As the amount of Type A, rule-based regulation expands, the amount of process-following and box-ticking rises and the amount of professional responsibility exercised by the professionals in the field diminishes. In the absence of much Type B, judgment-based regulation, no-one notices that decline in professional responsibility - until, all of a sudden, there is a crisis and you wake up to find that (despite all the burdens of following mandatory processes) the activity in question displays the classic symptoms of under-regulation.

Let me end with a little morality tale drawn from real life.

It concerns farmers.

More particularly, it concerns farmers near rivers and streams that are vulnerable to nitrates pollution.

Those (many) farmers who combine high professional standards with a high conception of their social and environmental responsibilities know very well that they should not distribute slurry on land near to rivers on wet days.

But our dearly beloved European Commission and our dearly beloved Department of Environment, Food and Rural Affairs decided that regulation must be introduced to protect these nitrate-vulnerable zones.

What was the reaction?

Search out old hands who could go and use their professional judgment to come down like a ton of bricks on farmers who were recklessly polluting rivers on wet days?

Heaven forfend! That, after all, would be judgment-based Type B regulation.

No, this was a serious matter requiring serious measures from serious men.

Call for the Type A regulators.

Make rules.

And lo, rules were made. Processes designated. No tipping of slurry in certain (wet) months. All tipping of slurry to take place in other (dry) months.

But, cried the farmers, some days in dry months are wet and some days in wet months are dry. Let us take professional responsibility, and we will avoid tipping the slurry when it would pollute the rivers. Come down on us like a ton of bricks if we do pollute the rivers, but let us choose the dates for the slurry.

Alas, the farmers were unaware that they were facing a Government in the grip of a theory.

Only rules and processes were on the menu. Judgments were off.

So there are now, by decree (and largely unnoticed by the almighty), wet months and dry months. And the slurry is being stored in great stores every day in the wet months (including the dry days) and it is being distributed over the fields in huge quantities every day in the dry months (including the wet days); and the process is being adhered to; and the boxes are being ticked; but the farmers are bearing huge new costs of storing slurry and I'll bet you anything you like that the pollution is not being much reduced, or even - in some cases - that it is being made worse.

And that's what happens when you get in a muddle about the difference between different types of regulation.

You end up with too much regulation of the wrong kind and too little regulation of the right kind."

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