Financial markets should be left to regulate themselves

New research from the IEA looks at statutory regulation, private regulation and financial markets

In a new research paper released today, the Institute of Economic Affairs argues the coalition’s proposals on financial reform will do little to improve the quality of financial regulation in the UK.

The coalition is proposing to abolish the FSA and reallocate its functions between a series of new quangos and the Bank of England. Instead “Does Britain need a financial regulator?” (authored by Philip Booth and Terry Arthur) suggests the regulation of investment markets, financial products, insurance companies and other financial institutions, currently carried out by the FSA and the Pensions’ Regulator, should be stopped and these sectors should instead be allowed to self-regulate within a framework of limited primary legislation.

Only banks linked to the payments system should be regulated and this should be done by the Bank of England. Instead of the coalition’s levy on banks, banks should provide the capital needed for the central bank to run a risk-based deposit insurance scheme.

In summary, the paper argues that a central regulator is the wrong model to generate appropriate rules and regulations for the financial sector. The FSA should be abolished, along with almost all its functions.

Philip Booth, Editorial Director at the IEA and author of the report, “Does Britain need a financial regulator?” said:

“The market mechanism is enough to guarantee effective regulation: the number of financial scandals has not reduced in the era of statutory, bureaucratic regulation. Other than in the case of banks dependent on the Bank of England for deposit insurance and lender of last resort facilities, the financial system should be left to self-regulate.”

“If the coalition genuinely wants to create better regulation in the financial sector, along with more competition and cheaper capital for companies, they should scrap the FSA and the vast majority of its functions and leave the financial sector to itself as far as possible.”

Investment markets

Statutory regulation of the stock exchange and other investment markets is a recent development, only introduced in 1986. Self-regulation of exchanges works better, as exchanges have a strong incentive to develop the best regulatory systems possible in ways that reduce the cost of capital to companies. Exchanges need to attract both companies that wish to raise capital through them and investors. They therefore need efficient but effective systems of regulation. Investment markets should therefore be allowed to regulate themselves.
Both history and economic theory show that the statutory regulation of investment markets leads to bureaucratic rule-writing attitude instead of effective regulation.

Investment markets are now regulated by an incomprehensible combination of EU and UK statutory regulation which is unnecessary and costly.

The paper proposes:

• To abolish statutory regulation of investment markets and exchanges. As a first step towards this, this paper supports the recent Treasury Green Paper’s proposal to allow regional stock exchanges to be set up exempt from financial regulation.

• That, as an extension of this model, the Alternative Investment Market (AIM) should be allowed to establish a sub-market where companies that are quoted only on AIM could be traded according to rules developed by the exchange itself with no other statutory regulation.

Regulation of banks

The focus of regulation of banks should be the protection of the payments system, while individual banks should be allowed to fail in an orderly fashion.

The paper proposes:

• As per the coalition’s proposals, the central bank should be the regulator of those banks connected directly to the payments system and, in return, the central bank would be the provider of lender-of-last-resort facilities, to those banks as at present.

• However, in stark contrast to the coalition’s proposals the research’s authors argue that the central bank should have its capital provided by the banks that it regulates, rather than the government and that other banks should not be regulated.

Regulation of investment banks and other financial institutions

Hedge funds, investment banks and other private investment funds should not face statutory regulation. Instead the regulator of commercial banks – the Bank of England – should ensure that banks are appropriately regulated where they have risky counterparties. Thus, if a bank connected to the payments system has significant exposure to an investment bank and the investment bank, in turn, is exposed to the failure of one or more hedge funds, then this may be a reason for the Bank of England to take appropriate action in relation to the narrow range of banks it regulates.