Regulation is a necessary evil. Without it, people would be reluctant to trade, markets would fail and economic efficiency would be severely crimped. But necessary or not, there is growing pressure to minimize the evil and make the regulatory regime smarter and more efficient.

Businesses are acutely aware of the costs of complying with the many levels of regulation in Canada. They are well aware that, rather than ensuring well-functioning markets, excessive or clumsy regulation imposes wasteful, frictional costs, deters trade, stifles innovation and hampers competitiveness.

Now, policy-makers are coming to that realization as well — and they are making noise about a need to smarten up the system.

When federal Finance Minister Jim Flaherty delivered his latest economic update at the end of November, the focus was on the government’s plan to reduce taxes and eliminate the national debt. But reducing the regulatory burden was also part of the package.

Flaherty has pledged to improve competitiveness by cutting red tape and reducing “unnecessary” regulation. The update also states an intention to enhance economic efficiency by reducing interprovincial trade barriers, improving labour mobility, harmonizing provincial sales taxes with the federal GST and, last but not least, creating a common securities regulator.

The government’s plans are echoed by the House of Commons standing committee on finance in its pre-budget report, which was tabled in early December. The report also calls for the federal government to reach an agreement with the provinces on establishing a single securities regulator by March 31 and having it up and running by June 30.

“We feel that there is a particular and urgent need to ensure smart regulation in the area of securities,” the report says. “In our view, a commitment among the federal and provincial/territorial governments to a single securities regulator is needed.”

The position was effectively reiterated by David Dodge, governor of the Bank of Canada, in a speech to the Economic Club of Toronto in mid-December. Dodge stressed the importance of a more efficient regulatory system, and called for reforms toward that goal in a number of areas. “If we want our financial institutions to remain a major economic driver in Canada, then we need to make sure that the regulatory framework under which they operate encourages competition and innovation, and does not prevent them from maximizing efficiency,” he said.

Dodge suggested that the government should be more open to bank mergers. He also called for a uniform system of tiered securities regulation that takes into account the size and complexity of companies, tougher enforcement and more flexible pension regulation.

Noting Britain’s move toward more principles-based regulation and recent efforts to improve U.S. regulation, Dodge said, “Against this backdrop, we in Canada increasingly look as if we are stuck in the middle of the 20th century, and are not positioning ourselves well to compete in the 21st century. For the sake of efficiency, we need a single, uniform framework for securities regulation. Rules need to be applied in a uniform way across the country, and tailored to be appropriate for firms of all sizes, while providing appropriate protection for investors.”

As Dodge noted, the challenge of improving securities regulation and the general operating environment for capital markets has also become a hot topic in the U.S. In mid-December, the Securities and Exchange Com-mission proposed new guidance for the implementation of its controversial internal-control reporting requirements. It also proposed a new method of allowing foreign firms to withdraw their securities from the U.S. market — which may make firms more willing to explore a U.S. listing without fear they’ll be locked into complying with U.S. rules if turns out that they don’t benefit much from the listing.

The SEC measures follow an early December report from the Committee on Capital Markets Regulation, a bipartisan group convened last September to study competitiveness issues. It calls for a host of changes designed to improve the competitiveness of the U.S. markets. They boil down to two ideas: enhancing shareholder rights and reducing the burden of litigation and regulation.

“The shift of regulatory intensity balance has been lost to the competitive disadvantage of U.S. financial markets,” the committee wrote.

It doesn’t, however, call for a wholesale relaxation of regulations: “To make a reduction of regulatory intensity an end in itself would be self-defeating. A regulatory ‘race to the bottom’ will serve no useful competitive purpose.”

@page_break@Instead, it argues, a better balance is needed between all the mechanisms of investor protection — regulations, laws, and public and private enforcement. To that end, it calls for, among other things, more attention to cost/benefit analysis, a more risk-based approach to rule-making and a more principles-based approach to regulation.

The recommendations are meeting with mixed reviews. The Securities Industry and Financial Mar-kets Association, a U.S. trade association applauded the report, calling it a “constructive contribution.” However, the Council of Institutional Investors said it disagrees strongly with the committee’s assertion that overzealous regulation is stifling competitiveness. “We also believe,” it adds, “that many of the panel’s recommendations, if adopted, would undermine the effectiveness of market watchdogs and weaken critical investor protections.”

The challenge of reforming securities regulation is receiving plenty of lip service, but efforts to improve regulation go well beyond this narrow slice of inefficiency. Indeed, in Canada, the House finance committee’s report recommends that Ottawa undertake “a comprehensive cost/benefit analysis” of all federal regulations to ensure that the benefits outweigh the costs. It says such a review should be completed by the end of 2007.

Until a study takes place, it’s not clear just how much cost savings that rationalizing regulation can wring out of the system. One study released in 2005 suggested that annual compliance costs for businesses in Canada total $33 billion, with those costs falling disproportionately on small firms.

In mid-December, Statistics Canada released the results of its first-ever effort to measure regulatory compliance costs. The survey is hardly comprehensive, looking at just five sectors, and measures only the cost of complying with 11 obligations, such as filing income tax forms, provincial licensing and corporate registration. Nevertheless, it estimates that small and medium-sized business spent $1.5 billion complying with the obligations in 2005. Income tax filing was found to be the biggest expense, accounting for 41% of the costs.

Indeed, the tax regime is one area in which Canada doesn’t rate very well when compared with the rest of the world. According to the Organization for Economic Co-operation and Development’s Doing Business index — which looks at the ease with which companies can be launched and operated in 175 jurisdictions around the world — Canada ranks fourth overall. It is just behind the U.S. and two spots ahead of Britain in the rankings. Despite all the heat that securities regulators take, the OECD ranks Canada fifth, tied with the U.S. and others, for investor protection. In terms of the ease of paying taxes, we rank 22nd, one of our weaker spots, along with registering property and dealing with licences.

Such broader cost issues have been more high-profile in Britain, which has already spent a good deal of time trying to improve regulation throughout its economy. In 2005, Philip Hampton, chairman of British supermarket chain J. Sainsbury PLC, published a report calling for a wholesale shift toward more risk-based regulation.

“The risk-based approach of the future that Britain is now pioneering is founded on a different view of the world — trust in the responsible company, the educated consumer and the informed employee; adopting a risk basis, with only a fraction of forms, a fraction of information requirements and a fraction of inspections needed,” explained Gordon Brown, Britain’s Chancellor of the Exchequer, in a speech to the Confederation of British Industry in late November.

To ensure adoption of the risk-based approach, a number of regulators are being merged to create fewer “cops on the beat,” and the rest are receiving greater scrutiny. In 2007, the British government is slated to establish the Local Better Regulation Office, which is supposed to ensure that regulators are adhering to the risk-based approach and address inconsistencies in enforcement among different local authorities. Regulators will have their performance assessed by its National Audit Office.

The Financial Services Authority, Britain’s integrated financial regulator, has been at the forefront of many of the changes. Comprising a merger of many regulatory agencies, the FSA has pioneered a shift to risk-based and principles-based regulation and focused on reducing the administrative burden.

In December, the FSA released a report detailing its most recent streamlining efforts, including: replacing 57 pages of detailed anti-money-laundering rules with two pages of high-level principles; deleting requirements that it estimates cost firms around £15 million annually; and proposing a new risk-based capital system for non-profit businesses, which, it estimates, will free up £4 billion of regulatory capital in the life insurance industry.

Regulators must accept that they are never going to be popular. When they fail, they are sure to be roundly criticized; when they are doing their job, they are seen to be a burden. Still, there’s much to be done to improve their efficacy and efficiency.

It’s now up to policy-makers to buckle down to see if they can, in fact, make regulation smarter. IE