In this article Marcus Johnson calls for a radical simplification of the regulatory regime for financial services and draconian changes to Banking Regulation.
In 1981 the Trade Secretary, John Biffen, commissioned Professor Jim Gower to produce a report on how the Financial Services Industry might be regulated. He did this because there had been a spate of newspaper articles detailing how cricketer Colin Cowdrey and the pop group Pink Floyd had been fooled into parting with part of their (large) earnings by unscrupulous financial advisers.
The structure of Regulation introduced by the Financial Services Act in 1986 has failed the test of time in line with a rather prescient paper given to Margaret Thatcher by John Redwood recently released under the 30 year rule. He said, and I quote “there is a possible danger that the wide powers given to vary or revoke the self-regulatory framework could be used later by less sensible politicians to usher in a much more heavy handed approach without new law”. He was right and every five years or so since 1986 the number of regulators has doubled, the number of regulations has doubled and the cost of running the system has doubled. At the same time it has become steadily more remote from reality, the relationship with the regulated has become steadily more restrictive and the overall availability of advice has reduced substantially.
What Norman Tebbit and Margaret Thatcher missed was that by establishing a profession of regulators and an industry of regulation they would inevitably create a machine to lobby for more regulation and more regulators to enforce it. Clearly Financial Services will always need a legal framework in which it should operate and when expressed as ‘effective regulation’ everyone can agree the prescription. Recent history suggests over-regulation is worse than light regulation, and in particular the banking crisis of 2007/8 can be put down to excessive and detailed over-regulation. The FSA was not effective and there is little sign that the FCA will be any more effective. The biggest single problem is that the regulator tries to apply the same detailed rules (and there are thousands of pages of them) to everyone from an insurance company to a mortgage adviser as they apply to Barclays Bank. They try to have a prescription for every activity and to say exactly how every firm should relate to every client. This is not only foolish and costly, it is impossible.
It is logically impossible for a regulator to know more about the industry he regulates than those engaged in it, because if they knew how to do the job better the people concerned would be more valuable doing it than regulating it. Therefore effective regulation has to work with the knowledge that the regulated will always be smarter, have better advisers and receive high rewards for arbitrage and evasion around the regulatory structure. The banking crisis was the result of off balance sheet structures created to get around regulations which turned into bad assets on the balance sheet. Although the off balance sheet structures were created to arbitrage regulatory systems a by-product was such complexity and opacity that the boards of the banks lost control. The depth of the 2008 recession was wholly the result of the application of stricter capital controls by regulators. It was a problem created by regulators and was turned into a crisis by regulators. The worst aspect was that regulators subsequently concluded that if only they had more regulation and more regulators they could stop such problems recurring. They were and are wrong. What is required is effective regulation and this means specialised sectoral regulators, it means structures and principles, it means monitoring and controlling who is allowed to practice but it does not mean laying down exactly who does what to whom and how they do it.
The secret of effective control of the financial services industry is structural, but today the FCA attempts to codify and control every aspect of behaviour. It cannot. The lesson learned in the early 1930’s after the Wall Street crash, was then successful for 60 years. The SEC in the USA and the Prevention of Fraud Act in the UK introduced a regulatory regime and industry structure which worked well for 60 years. It depended on authorising individuals and controlling structures but otherwise letting the private sector and voluntary associations do most of the work in controlling professional standards. In the UK the banks were effectively regulated by the Bank of England for most of the last 200 years, but the way in which it was done is partly responsible for today’s impasse. Every time there was a crisis the Bank would get a profitable bank to take over the problem firm so as time went by we had fewer and fewer banks. The answer is not to have more controls, it is to have more banks. If we can solve the problem of how to regulate the banking sector once and for all then it will become much easier to address the less significant problems of other financial services where misconduct does not pose a systemic threat.
What we require in the UK (and EU and USA as well) is a structure of banking which ensures we have no repetition of the 2008 crisis for the next 60 years at least. The reason for legal controls on industry structure are simply that because the banks have the power to create money and the state is the source and sole guarantor of the value of money it must control the action of private sector agents who create it. This is particularly so where it underwrites the solvency of retail banks by guaranteeing deposits.
It is essential to have a division between banks which accept retail deposits (say <£100,000) and wholesale banks. Retail banks should be prohibited from investment underwriting, broking or securities dealing and from owning a stake in excess of 10% in any company performing such activities or from having a controller who performs such activities. A retail bank with a market share (defined as the total deposits of all retail banks in the UK) up to 5% should have deposits with the Bank of England of 1% and a liquidity ratio (bank and highly liquid securities) of 10%. If its total deposits (including any non-UK) exceed 5% then for each 1% above 5% it will have an extra 1% deposit with the Bank. There should be no other capital controls, but every retail bank should be required to have a rating of at least “A” to have its deposits guaranteed.
Wholesale Banks, Investment Banks and International Trade Banks with their head office in the UK should have similar liquidity and deposits requirements but no market share test and it will be made very explicit that they will never benefit from a government guarantee. There should be no state imposed rating requirement, although one might expect the market to impose an effective “BB” or better floor on any banks seeking financing.
All banks should be required to follow sound and prudent practice in their business. The Bank of England (or its successors) should be solely responsible for bank supervision. Each Chief Executive should be expected to meet with the Governor collectively once a week and to present a rolling comprehensive 5 year plan annually which will have been approved by the board and will be subject to public scrutiny within 6 months of presentation to the Bank. No other regulation will apply to a retail bank.
Once regulation of banks is removed from the equation a radical reform of how we deal with insurers, investment firms and other financial intermediaries becomes much easier. The ever more detailed prescriptive approach has not spectacularly failed here in the same way as it has with banks. It has spectacularly failed in a different way. In 1984 Professor Gower estimated the structure he was proposing might cost £8m a year to run. Today a reasonable estimate (based on industry spending £2 for every £1 the regulator spends) might be that the cost to investors is £20m per working day and it is almost certainly the case that fraud losses and opportunity costs mean the general population is paying through the nose for a system which has made sensible financial advice unavailable to huge numbers of people, has severely restricted availability of advice to middle income earners and made sophisticated financial advice the preserve of the wealthy and well connected.