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Henry Thornton - Economics: A discussion of economic, social and political issues Financial regulation and moral suasion Date 01/07/1994
Member rating 4.3/5
Should society rely on black letter law or morality? The more we use the former, the more moral values will decline.
By PD Jonson and Elizabeth Prior Jonson Email / Print

Regulation is most generally a form of control, and control of actions may be achieved in any number of ways.

Writing on walls is an activity many young children enjoy. It is (usually) an activity parents wish to discourage.

The parent may use a number of means to achieve his (the parent's) desired end, scribble-free walls. He may threaten the child with some punishment (no ice-cream or dinner) if he continues to write on walls. He may smack the child in the hope that the avoidance of future pain will curb the child's inclination to decorate further walls. Or he may lock the child in his room. Or he may remove pencils, pens or crayons from the child's reach.

All of these are different ways of attempting to regulate an undesirable behaviour. Adult behaviour may also be regulated in a range of ways. At one extreme the regulation may be of the most personal and individual kind. This is where individuals regulate their own behaviour in accord with strongly held ethical principles. This is the action of conscience, if you like, and conscience has become a deeply unfashionable word.

At the other extreme adult behaviour may be regulated by the threat of punishment by the law. In between we have such things as regulation of behaviour via taxation (either as an incentive or a disincentive), and/or moral suasion by co-professionals, or by some official agency with the ultimate right to remove a licence.

Modern pluralistic societies are not incompatible with systems of ethical belief. However, the very existence of the complex secular society serves to undermine adherence to simple ethical systems, especially in cases where there is divergence of opinion as to the rightness or wrongness of a particular matter. The ethical complexity and diversity of modem pluralistic societies means that less reliance can be placed upon ethical beliefs as regulators of human behaviour.

We all believe that there is a need to regulate formally certain kinds of behaviour (for example, through the provision of criminal sanctions for murder and rape). However, there is a wide difference of opinion with respect to where the boundaries should be drawn and what mechanisms are most appropriate to control or modify other less dramatic negative behaviours, if only because any interference with the freedom of individuals has costs.

Law and morality are connected but not in the simplest of ways. There are many aspects of life where we rely upon individual restraint to uphold civilised noms, and this may work more or less well. There are good reasons to suppose that ethical principles alone cannot always be expected to achieve the desired regulation of undesirable business behaviour.

Some have argued that, since ethical principles alone are not sufficient, the criminal law should involve itself more in the area of business activity. In general we believe this view to be mistaken. In the first place we know that it is both difficult and costly to achieve a prosecution, as the examples of the NCSC and the ASC show so clearly. Second, when dealing with rich companies or individuals, an unfavourable judgment (from their perspective) can be expected to initiate protracted and expensive appeals. Third, the introduction of new criminal legislation in the business area causes wealthy companies to invest more of their resources in circumventing that new legislation, at the cost of investing in more productive activities. Fourth, since for the reasons stated above such legislation would from the start be crippled, there would be a fall in the general level of community respect for the criminal law.

In addition to these serious practical weaknesses, we believe that there exists a crucial moral weakness in a strictly legalistic approach. That legalistic approach may generate solutions contrary to what is reasonable given all of the circumstances. It is, for instance, more reasonable (when suitably provoked) to punch a strong man than a weak one, or to drive a hard bargain with a man of the world than with a little old lady, or to drive a hard bargain at an auction rather than within a personal transaction.

Finally, and in our view most importantly, reliance upon black-letter law (except in cases where there is no alternative) may actually contribute to the erosion of ethical standards. This is because many people, having expended great energy in negotiating their way through a complex minefield of black-letter law, will then believe that they have done all that can reasonably be required of them.

Some such people will prosper at the expense of those who act to satisfy a higher ethical standard. Over time more will be tempted to join the first group, and over time ethical standards will decline even further. So we have the possibility of a vicious circle. Moral standards begin to decline. Black-letter law is introduced to limit undesirable behaviour, and itself encourages a further decline in moral standards.

We believe that such a process is now in train and needs to be reversed. If reliance on ethical principles is ineffective and the costs associated with criminal sanctions too high, are there other ways of bringing about higher ethical standards? We consider three possible mechanisms: moral suasion, information, incentives.


A major part of Australia's financial regulation has involved supervision by central agencies, intended to prevent loss by the customers of selected financial institutions. Existing measures have conspicuously failed to prevent financial failure - eg the State Bank of Victoria. There is room for debate about precisely what the law required of the supervisors. But the average citizen is certainly entitled to ask whether the official agencies did their job well in the 1980s, when, as the chairman of the latest banking enquiry put it, 'the Reserve Bank was in the pavilion polishing its whistle'. The Reserve Bank's traditional approach to supervision was rather informal, even quaint: 'Would you care to come into the Bank for a cup of tea and a chat?'

In the wake of the debacle of the 1980s there have been calls for greater formality, even to the use of intrusive and expensive audit procedures. Some increased formality of official supervisory practices may well be a sensible response to the financial failures of the 1980s. But it should not be the sole response.

Extra official supervision uses scarce resources, some of which might be better deployed increasing efficiency in private business. It should also be noted that the tradition of official supervision is one way of seeking to create a climate in which common ethical standards can be agreed upon and enforced. Good supervisory practice, involving moral suasion of one sort or another, enhances and reinforces ethical standards.

There is a further point. In the wake of the financial failures of the 1980s, private financial institutions have already conspicuously adopted tougher internal controls. A company which has lost large amounts of money due to lax controls is forced by market reaction to get its own house in order.

More generally, a reputation for ethical behaviour is in a crucial sense part of a company's or an individual's capital. In this context there is a point that is often missed. As the financial world becomes more sophisticated, a host of private rating agencies grow up. Such institutions make money by analysing and publicising the strengths and weaknesses of major financial institutions. Perhaps a small part of the Reserve Bank's supervisory budget should be set aside for enhancing dialogue with Australia's leading banking analysts.


Information is a powerful commercial antiseptic. Much of the work of existing official regulatory agencies is of necessity secret, but perhaps more information should be provided. Publishing the 'capital adequacy' ratios of Australia's leading banks is an example of sensible progress, and there are other ways in which fuller information could usefully be provided. At present it is left to private agencies (the broker's banking analysts) to publicise the extra information made available when banks choose to list on the US market. Why our regulatory agencies do not simply insist that such information also be made readily available in Australia is puzzling.

 Methods of supervision can also be made less intrusive and costly, especially for companies whose reputation and strength are beyond reproach. At present misguided attempts to be fair impose the same costs on all. An example recently implemented for the supervision of banking in the United States is of interest. By the end of 1992 the US federal banking agencies were required to implement a 'capital-based policy of prompt corrective action'.

Under this system each depository institution must be placed in one of five groups based on its capital: well capitalised; adequately capitallsed; undercapitallsed; significantly undercapitallsed; or critically undercapitalised. For each of the latter three categories of undercapitallsed banks specific corrective action must be taken, including rapid movement toward receivership if a bank remains in the last category. This offers no panacea - checks must be made on capital ratios, information systems may be inadequate and so on. But at least it offers a sensible spectrum of regulatory interference which channels most regulatory resources into the most urgent cases.

We wish to suggest a further line of action: official agencies could go back to basics in the provision of information. Australia has been outstandingly successful in controlling the spread of the AIDS virus, primarily through well targeted educative programs. It has cost relatively little, yet has been exceedingly effective. What might have been the impact on financial behaviour in the 1980s of a similar campaign with its focus the simple dictum 'High returns imply high risks'? Simple television advertisements or leaflets explaining the risks which often go with unusually high returns might well have prevented some people from chasing those high returns in the 1980s. And even if the campaign had not been highly effective, governments would then have felt less justified later in taxing the prudent to compensate the imprudent.

In the same vein, if Australia's central bank had been conducting a publicity campaign over the last decade based on the theme 'Inflation is theft', the climate for control of inflation in Australia would now be far more favourable.

We are not here advocating the widespread use of taxpayer-funded official propaganda; there would need to be a system of checks and balances to prevent such an outcome. The obvious sanction Is the ballot box. Oppositions will be free to claim that particular campaigns are a waste of money or worse. Private agencies might publicly evaluate aspects of official regulatory practices. There are a number of ways in which greater provision of information would promote welfare.

The concern to keep secret what must be kept secret in the work of the regulatory bodies has biased them against the provision of information. Even more costly has been a bias against entering public debate, not on the specifics of public policy, but rather on the eternal verities.


The discussion so far has concerned methods of persuasion. It Is also our view that higher standards of conduct could be achieved in business matters if tax breaks were given to companies that allowed greater public scrutiny of their activities. Such a system would be voluntary. Companies could go on paying the same rate of tax they now pay without subjecting their financial transactions to increased public scrutiny. But if they wanted the new tax break they would have to subject their dealings to that higher level of scrutiny.

Not every company that did not opt for the tax break would have something to hide, bu t one would suppose that in general this would be true. (Why give up additional profit if one has nothing to hide?) Law enforcement agencies like the ASC could therefore operate more cheaply since they could then legitimately focus their attention on those companies that had not opted for the higher-scrutiny-lower-tax scheme. If the administrators believed that prosecutable infringements of the law had occurred then the matter could be turned over to the ASC or the public prosecutor. If they believed that merely non-prosecutable misdemeanours had occurred then there would be no tax break and everyone would know that that particular business had applied and failed.

It may be objected that corporations would still have an incentive to cheat, since if they are able to appear squeaky clean they will qualify for the tax break even if in fact they are undertaking ethically dubious practices. Undoubtedly there is an element of truth in this. But then no system is perfect. Importantly, it is not simply a question of missing out on a tax break. There would also be harm done to the reputation of companies that fall to make the grade, which could be expected to produce longer-term problems for those companies.

We must also concern ourselves with the possibility of official corruption. This undoubtedly always exists, and the only antidote is the most rigorous imposition of those principles applied to Caesar's wife. In particular, when official agencies seek to avoid scrutiny (ATO audit delayed?) or seek to have different rules apply to them (eg unfunded superannuation for politicians and officials) tough questions need to be asked. There could well be a greater role for private agencies investigating aspects of the official regulatory regime.

 This is just a thumbnail sketch of some means which might be employed to provide incentives for higher ethical standards. Whether such mechamisms would deliver the desired results is of considerably less importance than our more general claim that the appropriate way to achieve more ethical business practices is through appropriate incentive schemes.

Simple reliance on personal. ethical standards will be ineffective, while the introduction of more black-letter law will be both ineffective and costly, and may make the problem worse. The first question a prospective regulator should ask himself is whether the practice under consideration is genuinely undesirable. The second question is whether interference will improve things, or make them worse. We consider a set of examples regulating behaviour within the finance sector. There are many others.

Life Insurance and Investment Management

Life Insurance and investment management companies find themselves enmeshed in a complex web of regulation. The situation is made much more complicated by turf battles among regulators and by the current tendency toward government by press release. Consider the following points:

    - The ISC regulates insurance operations. Its philosophy is akin to that of the Reserve Bank's supervision of the banks - based on suasion and mutual education but with an understandable tendency toward codification.

    - The ASC regulates unit trust business. Here there is a stated desire to impose a regime of onerous black-letter law, in which (in our view) the costs are likely to be well in excess of the benefits.

    - Investment management operations are impacted on by both ISC and ASC as well as private ratings agencies and the companies' own actuarial and general financial controls. It is here that the battle for turf is strongest, and attempts to drive out the unscrupulous and incompetent will prove very costly for the honest and competent majority.

In practice it is all pretty complex.


    “The Goverment has taken notice of complaints and by dint of a great deal of simplifying legislation has made things much, much worse. Fur ther simplifying legislation is threatened.”


The life insurance industry is governed by the Insurance (Agents and Brokers) Act, the Insurance Contracts Act and the Life Insurance Act 1947. All are under review and it is understood that amendments will be extensive. There is no reason to believe that the myriad of forms and returns already required of companies will be simplified.

A major part of this industry concerns superannuation. A few years ago the Government's approach to superannuation regulation was comparable to that of a drunken duck shooter. The regulation of superannuation is hopelessly complex and beyond the grasp of all consumers and most professional advisers. The Government has taken notice of these complaints and by dint of a great deal of simplifying legislation has made things much, much worse. Further simplifying legislation is threatened by politicians on both sides of the political fence.

When trying to describe today's superannuation legislation, words like morass, impenetrable maze and legislative disaster spring to mind. One has almost to assume that the aim of those responsible is to discourage and confuse anyone who wishes to make some rational and informed decision about providing for his or her retirement. Income tax legislation is another minefield.

The life insurance industry has its own Division in the Income Tax Assessment Act. To a certain extent the provisions of the Act which relate to life insurance favour policy-holders, as the result of longstanding government policy to encourage people to protect their own financial interests and to engage in long-term saving. However, this industry, like all other corporations and individuals, is also subject to the whole of the Act.

In this context we could comment at some length on the body of the Income Tax Assessment Act - its unbelievably tortuous drafting, its unintelligible provisions, its myriad of unintended consequences, and the mass of uncertainty surrounding many aspects of its interpretation.

These matters are common knowledge and need no elaboration in this context, except for one further point. The current administrative practice is to rely upon self-assessment by taxpayers. With the Act so complex that experts frequently disagree, it seems to us morally objectionable that if the taxpayer is deemed to have got it wrong he can be subject to fines and other penalties.

It is also worth commenting on the recent amendments to the Act in relation to overseas investments. Australia's major fund managers are in the business of trying to maximise the returns on the long-term savings of Australians. Because security is of paramount importance to many, and because the industry is by nature and experience prudent, investment involves spreading the risks over as wide a range of investments as possible.

Naturally, a substantial proportion of funds are managed offshore, essentially to make sure that clients are not unduly exposed to the vagaries of the relatively small and volatile Australian market. There is no element of tax avoidance or tax minimisation in this activity, and no such allegation has ever been made about any major investment manager. Yet, apparently as the result of the use of foreign tax havens by a few 1980s entrepreneurs, fairly draconian legislation – the FIF (Foreign Investment Fund) Rules - has been imposed on the industry. This involves a timing detriment (prepayment of tax) and a record-keeping burden, both of which will reduce returns to policy-holders. One can also criticise the manner of the Government's implementation of these proposed new rules. The Government's intention was announced in a very long white paper, but at the time July 1992) from which the new rules were meant to apply there was still no draft legislation to examine. Ultimately the commencement date was deferred to the start of 1993 and the provisions were watered d own. And the Government entered into the consultation process with great reluctance.


It is now widely accepted that official regulation has been overdone in the second half of the twentieth century. Everywhere the role of government, broadly defined, is being questioned. Australia is one of the stronger outposts of democratic socialism, and in some areas here the regulatory tide is still running strong. Often this tide does more to retard welfare than to promote it.

The existence of an extensive explicit regulatory apparatus gives some the idea that they have done enough ethically so long as they have kept to the letter of the law. This is a powerful reason to slow down, and in some cases to reverse, the rush to regulate. Increasingly the question will be not whether to regulate, but rather what form that regulation should take.

We strongly advocate that much greater attention be given to the use of incentives and the graduated response in devising regulations which are least costly and least intrusive. The example we give of the former is the US legislation for a capital-based policy of prompt corrective action. Our example of the latter is a lower tax rate for companies which conform to higher standards of disclosure. Other 'softer' forms of regulation - including supervision by private or official agencies - need to be encouraged. At best such agencies reinforce ethical standards. In contrast, too much black-letter law can encourage the erosion of ethical standards.

We also recommend that official regulatory agencies get back to basics. Specifically we believe that much more attention should be given to the provision of information in easily digestible form; to using the cleansing properties of sunlight.


Peter D. Jonson is the Managing Director of Norwich Financial Services Group. Elizabeth Prior Jonson is Senior Lecturer in the Institute of Ethics and Public Policy at Monash University. They would like to acknowledge the encouragement and assistance of John Hyde and Ian Miller. This article was first published in Quadrant, July-August, 1994.


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