Earlier this week, a group of leading academics called for a revolution in financial regulation. This call came after the publication of a group of papers examining regulation across every field of financial services. A revolution - in the proper sense of the word - takes you back to where you should be. This is what should happen with regard to financial regulation.
It is commonly thought that we have seen a huge liberalisation in financial regulation in recent years and that this was responsible for the financial crash. Across most sectors, this really is not true – certainly in the UK. Until we entered the EU, there was virtually no specific regulation of insurance companies. There was, however, in the case of life insurance, an excellent but simple law that facilitated the orderly winding up of insurance companies and which required disclosure. We have now moved to very prescriptive regulation of both the sales of financial products and of insurance companies themselves. This regulation is about to get tighter through the introduction of Solvency II in the EU. The UK often blames the EU for over-regulating our businesses, yet this dreadful piece of regulation is British born and bred. In its present form, the academics who signed the statement argue that Solvency II will damage insurance companies and may well lead to financial contagion and sow the seeds of future crises. The reason for this is that it will strongly encourage all insurance companies across Europe to invest in similar assets and strongly encourage investment in government bonds – hardly a safe haven.
The same problems are evident in the development of the regulation of company pensions. Until the Maxwell crisis, pensions were regulated by common law, trust law and a few pieces of primary legislation. We did not need the dreadful regulatory reaction to the Maxwell crisis – that crisis was caused by theft. Theft was already illegal. We just needed better disclosure and less opacity. As the group of academics signing the statement explain, the regulation of company pension schemes has contributed significantly to their widespread closure as well as to short-termism and herding behaviour amongst investors. Indeed, perversely, regulation designed to protect members has led to the replacement of relatively safe defined-benefit schemes by much more risky arrangements. Regulation was the chosen way of dealing with risks to members, and there are now virtually no schemes left to regulate.
This blossoming of regulation has also infected what were previously free and independent professions. Accountants are now technicians applying rules and not professionals making judgements. The imposition of centralised regulation of accounting standards has not only created much complexity, but it had very damaging consequences during the financial crash. Accounting standards led to profits being exaggerated in the boom and losses being exaggerated after the crash.
It may surprise many that, until recently, banks did not have their capital regulated. Of course, before 1979, neither banks nor their customers had any expectation of being bailed out – market discipline prevailed. The history of banks’ capital positions is interesting. During the post-war period, banks were pressurising the Bank of England to allow them to hold more capital – they were prevented from doing so because the government and the Bank of England believed that, if the banks raised more capital, there would be less capital available for the non-financial industries. Banks exposed to market discipline were conservative institutions. I wonder if the post-1988 regulatory binge has really achieved anything positive.
Regulation has run riot and so did the banks. Last year alone there were 14,200 new banking regulations worldwide and the US Dodd Frank Act will contain around 30,000 pages of regulations. Furthermore, there is a real danger, when regulation becomes as complex as it is today, that it is only understood by a clique both in government and in the industry. That is a recipe for regulatory capture – in other words, the controlling of the regulatory system by the companies that are being regulated. The approach of the UK government which is trying to create a legal framework so that banks can be wound up safely is to be applauded, but this should replace and not be added to existing regulation.
The one area where it can be argued that deregulation has taken place is in securities markets. But, even here, things are not as simple as they may seem. In 1986, Big Bang did introduce a wave of deregulation. However, this was not the most important feature of Big Bang. This event marked the passing of regulation from the markets themselves – who chose to regulate participants heavily whilst always being open to the threat of competition from those operating outside the London Stock Exchange – to the government. This has been a disaster. Regulation based on simple principles has been replaced by the development of huge bureaucratic rule books. It is, indeed, ironic that FSA and EU regulation of securities markets prevented the Bank of England acting covertly as lender of last resort to Northern Rock and thus precipitated the early events of the crash in the UK.
The academics that signed the statement on financial regulation do not disagree that the public want a sustainable financial services industry. It is important to point out that episodes such as the LIBOR scandal and the Maxwell scandal can, and must, be dealt with using tough primary legal frameworks that prevent fraud, theft, misrepresentation and so on. However, there is little evidence that massive regulatory intervention and bureaucratic rule-writing is the only or the best way to achieve this objective. There are other routes that have historically been more successful in nurturing a thriving financial industry that is not captured by the cliques who understand the millions of paragraphs of bureaucratic regulation that are a mystery even to educated outsiders.