Pyramid v Sparrow: the key to enforcing effective regulation

By Mark Pearson

Tuesday January 15, 2019

Commissioner Kenneth Hayne makes his opening statements during the Round 5 hearing of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry at the Commonwealth Law Courts building in Melbourne, Monday, August 6, 2018. The $2.6 trillion superannuation industry will be taken to task by a royal commission over whether funds act in the best interests of Australians when managing their retirement savings. Australia?s largest super funds head a long list of players called before a two-week financial services royal commission hearing that begins in Melbourne on Monday. (AAP Image/The Australian Pool, David Geraghty) NO ARCHIVING

Two classic regulatory approaches. But where does the biggest bang for the regulatory buck lie? Is it in education or in punishment?

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry recently submitted its interim report to government. Commissioner Kenneth Hayne found service providers motivated by greed were largely to blame for the misconduct, but regulators ‘were also at fault.’

Unsurprisingly, the report has stimulated considerable discussion about regulation and the effectiveness of the regulatory bodies that oversee the industry — the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA).

In some quarters, discussions have revolved around how the activities of ASIC and APRA sit with John Braithwaite’s enforcement pyramid and the theories of Harvard University academic Malcolm Sparrow.

Some have asserted that Braithwaite’s enforcement pyramid and Sparrow’s harms-based regulatory approaches do not fit well together.

A hierarchy of interventions

Braithwaite modelled a hierarchy of interventions that he illustrates, using the metaphor of a pyramid. The model describes how a regulator should follow a well-designed roadmap from less interventionist and cheaper engagement options through to coercive, costly and highly interventionist options such as litigation.

Sparrow plots regulatory effort or commitment against the escalation of harm. As the potential for harm to occur increases, so the regulator’s efforts to address the impact of those harms must increase. Regulators, Sparrow advises, need a full suite of tools to address these harms along with a commitment to use them.

My experience across numerous regulatory and enforcement agencies confirms that these approaches are highly complementary.

For example, approaches to collusion or price fixing demonstrate the intersection of both models.  At one level, agencies such as the Australian Competition & Consumer Commission (ACCC) engage in a wide-ranging process of education through speeches, wide circulation of and discussions about enforcement strategies, presentations to industry groups etc.  At the particular level, for example where price fixing or collusion is identified then the agency will make an assessment of the likely harm, the nature of the conduct, history of the parties and so on.

In many of these cases, the ACCC moves directly to litigation as they already have in place a well-developed education program.  For example, the Visy cardboard manufacturing case and the Air Cargo case.

However, even with individual cases, agencies may well agree to undertakings if the conduct does not meet a high level of harm. For example, a group of bricklayers in a large country town may agree to fix prices but without a full understanding of the illegality of those actions.  In addition, through market analysis it may be obvious that the price fix is quite likely to unwind due to the nature of the industry.

Sparrow’s approach of identifying the serious harms or problems and then addressing them requires a regulatory toolkit that employs a number of differing and scalable tools to achieve a desired result. In my estimation, Braithwaite provides a framework in which an agency can undertake the harms- or risk-based approach, such as that proposed by Sparrow.

In some respects, the Braithwaite model may sit more easily under a systems-based approach.  Professor Sparrow’s harms-based approach requires a splitting or parsing of the harms and a more focused, tailor-made approach to the solutions that are undertaken. It is premised on a sophisticated organisational decision-making structure based on well-developed intelligence and analysis. However, this does not in any way lead to one approach being considered more appropriate than the other.

Decisions based on discretion

Both models require decisions based on the use of discretion. This discretion rests on highly developed analytical skills, appropriate research and data. And both approaches stand and fall on the willingness of the regulator to escalate matters sufficiently to deter the identified harmful conduct.

“Both approaches stand and fall on the willingness of the regulator to escalate matters sufficiently to deter the identified harmful conduct.”

Where Braithwaite and Sparrow may appear to differ is if one takes the view that all regulatory effort should begin with the interventions at the base of the pyramid, whereas Sparrow suggests regulatory effort increases with harm.

However, the application of the pyramid allows for interventions at any stage, based on the egregious or otherwise nature of the conduct at hand.  Both the approaches require an understanding of where the biggest bang for the regulatory buck occurs. Is it in education or in punishment?

Operationally both methods lead to interventions at the stage identified as the most likely to achieve the desired enforcement or regulatory outcomes.

In the interim report, Commissioner Hayne expresses his concern that the regulators have taken too complex an approach, which ‘does not always assist the regulator to impose discipline on entities.’

My experience suggests a deeper awareness of Sparrow’s and Braithwaite’s approaches — with incremental steps, matched to the size and nature of the harms to be addressed — is one way to improve the effectiveness of the regulators.

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