Regulators are rewarded for failure

I now have to admit that I was unduly optimistic about the UK response to the crash regarding the future of financial regulation. Initially, there seemed to be some humility on behalf of the government institutions. That humility was certainly justified. Loose monetary policy was an important contributor to the crash and the Bank of England’s MPC (with one or two exceptions) ignored the warning signals. A senior Bank figure suggested (albeit in a slightly qualified way – but all Bank statements are qualified) that the innovative and opaque instruments that many believe are at least partly responsible for the crash would reduce risks in the banking system just six months before the Northern Rock failure. The FSA probably has over a million paragraphs in its prudential regulation manual for banks (it is no longer possible to download the whole document to count them because it is so big) and that degree of regulation clearly did not work. International bank capital regulation also made the crash worse rather than better. Furthermore (I won’t say “finally” because there is much more I could add) the Prime Minister created a regulatory system that was not fit for the purpose of dealing with systemic risk in the banking system.  

The authorities now believe they know how they could have regulated banks to avoid the last crash. Well done them! Unfortunately, it is three years too late. Despite the failure of over-regulation, the Chief Executive of the FSA told us last week that the FSA would get tougher and that banks should be “really scared” of the FSA. We know what that means. Have you tried to open a bank account recently – or undertake any other significant financial transaction? Financial institutions are so scared of the FSA that they impose all sorts of rules (going well beyond those required by the FSA) in the name of anti-money-laundering. It took me seven weeks to pay a very small extra contribution into my pension fund because of the identification requirements of the insurance company (and this was a pension fund into which I was already paying monthly contributions and from which I could take no money for 12 years – as if somebody would be stupid enough to use such a vehicle for money laundering). The problem was that the insurance company was scared of FSA retrospective action. The financial system is already scared of the FSA and customers suffer as a result. Covering your back is more important than looking after the customer.   

The authorities made exactly the same mistakes as the banks in this crash. They under-estimated the risks of securitisation. They made many other mistakes too. Will the authorities learn more quickly than the markets so that the risk of mistakes is minimised? Of course not. RBS has lost 95% of its share value. Failure has cost it dear. Shareholders have an incentive to learn. The senior figure at the Bank of England mentioned above was promoted to Deputy Governor. Hector Sants, FSA CEO, will have his empire made bigger and more powerful. Regulators are rewarded for failure. No wonder “regulator failure” is so common.

I wonder if there is more scope for competition with respect to regulation than we currently seem to experience. Would it be possible to have an UNREGULATED bank, with which I could deal at my own risk? I would lose the benefits of having all my bank details purveyed to government officials whenever they want, of deposit insurance, and so on. Might a company choose to use UNREGULATED auditors, who would just give their own professional opinion without necessarily following all 3,000 pages of accounting ‘principles’ we currently enjoy (more on the way, no doubt)? We could call this parallel system ‘the FREE market’.
Only a thought.

I agree. The unregulated bank should state that it is so, clearly. The Bank of England might also decide that it does not want to provide such a bank with lender of last resort facilities (that is fine too as far as I am concerned). Of course, the unregulated bank will have a strong incentive to signal to the market that it is trustworthy in some way. Indeed, there could be many providers of regulation with which banks could contract with the state regulator being just one of those.

It has often been pointed out that regulation can lead to a sense of false security. And to expect everyone to ‘follow best practice’ seems self-evidently impracticable.Hayek [in 'The Meaning of Competition'] said “competition is in a large measure competition for reputation or good will”; but regulation may be anti-competitive in that it makes such competition unprofitable.We need a choice: competition versus regulation as a dynamic way to provide best value to consumers. Clearly it needs to be dynamic not static. And there surely needs to be some kind of implied cost-benefit analysis. (The ‘costs’ of regulation are far wider than just direct plus compliance costs.)

I wonder if there is more scope for competition with respect to regulation than we currently seem to experience. Would it be possible to have an UNREGULATED bank, with which I could deal at my own risk? I would lose the benefits of having all my bank details purveyed to government officials whenever they want, of deposit insurance, and so on. Might a company choose to use UNREGULATED auditors, who would just give their own professional opinion without necessarily following all 3,000 pages of accounting ‘principles’ we currently enjoy (more on the way, no doubt)? We could call this parallel system ‘the FREE market’.
Only a thought.

I agree. The unregulated bank should state that it is so, clearly. The Bank of England might also decide that it does not want to provide such a bank with lender of last resort facilities (that is fine too as far as I am concerned). Of course, the unregulated bank will have a strong incentive to signal to the market that it is trustworthy in some way. Indeed, there could be many providers of regulation with which banks could contract with the state regulator being just one of those.

It has often been pointed out that regulation can lead to a sense of false security. And to expect everyone to ‘follow best practice’ seems self-evidently impracticable.Hayek [in 'The Meaning of Competition'] said “competition is in a large measure competition for reputation or good will”; but regulation may be anti-competitive in that it makes such competition unprofitable.We need a choice: competition versus regulation as a dynamic way to provide best value to consumers. Clearly it needs to be dynamic not static. And there surely needs to be some kind of implied cost-benefit analysis. (The ‘costs’ of regulation are far wider than just direct plus compliance costs.)

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