Can Soft Regulation Prevent Financial Crises?: The Dutch Central Bank's Supervision of Behavior and Culture.

Abstract

Financial regulation has traditionally been “hard”: national legislatures and regulators (and sometimes international bodies) require certain kinds of behavior and forbid others, on pain of business sanctions, fines, or even criminal penalties. When a financial crisis happens, the usual after-the-fact response is more hard regulation. That pattern goes back at least to the 1929 market crash that precipitated the Great Depression. But financial crises still occur, leading many observers to wonder if what the financial world needs is a way to identify those pathological risk-takers in advance and, perhaps more importantly, to make sure that the financial institutions that employ them discover and control them. Such an approach to financial governance might be characterized as “soft” regulation: rather than relying on prescribing, proscribing, and punishing specific actions, it would focus on education and persuasion (still backed up by the threat of sanctions) to encourage financial institutions to head off excessive risk-taking before it occurs. This Article presents in-depth study of the first major effort to put this theory into practice: De Nederlansche Bank’s (DNB; the central bank of the Netherlands) novel initiative to promote a healthy corporate culture in the large banks that is supervises. Despite its radical originality, this initiative has been almost entirely unreported in the U.S. legal and business literatures. DNB’s traditional mandate has been to ensure the stability and integrity of the national financial system by promulgating and enforcing regulations and supervising individual banks. In response to the 2007-08 financial crisis, of 2007-2008 DNB has expanded its supervision to include the evaluation of both individual behavior and group-level culture — “Behaviour & Culture” (B&C) supervision. We have investigated the history and theoretical roots of B&C supervision; interviewed both the regulators and the regulated about their practical perspectives; explored relevant themes in law and the social sciences; and considered the implications of B&C supervision for banking regulation elsewhere. We conclude that, while the response to B&C supervision has been generally positive, its tangible effect remains unproven. Moreover, its relatively positive reception may depend on the specific business culture of the Netherlands, which casts doubt on whether it can be exported to larger banking systems.