Complex Regulation - Corporate Governance and Business Ethics

Regulation may be more or less complex.1 intuitively complexity is costly, but the costs of complexity are difficult to understand using standard economic theory which assumes rational agents and zero information costs. Recognizing the existence of information costs seems to be a step ahead, but is not very helpful unless we can understand what information costs are and what determines them.

Unfortunately, mathematical information theory does not seem very useful in this respect. A logical theorem may be very simple to a computer, but complicated to human beings. A detailed piece of legislation may contain many pages, but be very easy to deal with because it specifies exactly what you have to do. Nor do information costs appear to capture all costs of complexity. It may be relatively easy to read and understand a piece of legislation, but difficult to implement the rules if they are to be applied to many different activities in different ways. The costs of enforcement, decision making, implementation and monitoring could all increase with complexity. Moreover, information problems can interact with incentive problems, for example if many different parties have to cooperate to comply with a piece of legislation.

Some of this is captured by transaction costs economics (Williamson 2005), which has however tended to focus on analyzing other issues related to dependence (asset specificity) in recent years. The concept of “bounded rationality” (Simon 1955), which transaction cost theory has adopted, appears to be closely related to complexity. But even bounded rationality is not very helpful if we do not understand how rationality is bounded. To do so we probably have to draw on psychology which is exactly what is attempted in behavioral economics (Kahneman 2003).

In this paper I therefore examine the psychological origins of regulation complexity. As a test case to avoid blackboard or armchair economics I use the regulation of corporate governance which I argue has become highly complex in recent years with the Sarbanes Oxley Act, corporate governance codes, self reporting and other regulation. The US Committee on Capital Markets Regulation has recently concluded that regulation has seriously damaged the competitiveness of US capital markets (Committee on Capital Markets Regulation 2006).

I go on to examine the economics and psychology of complexity. Reviewing relevant research in psychology I find that complexity introduces error in perception, memory, cognition and learning depending on personality, emotional and social context. I identify alternative strategies to deal with complex regulation including non-compliance and avoidance, but find that they are all costly. There are many straightforward implications. Laws should be simple and intuitive. They should rely on an underlying logic (principles) which people can understand. Self regulation (e.g., codes of best practice) is less costly than top-down legislation. Complex regulations should preferably be handled by professionals (lawyers, auditors, tax advisors, companies and organizations) rather than ordinary citizens.

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