Perpetuation of a failed regulatory philosophy means more City crises and scandals
On 1 April 2013 the Financial Services Act 2012 came into force, creating a new framework for UK financial services regulation.
Under its reforms the Bank of England, and specifically a new Financial Policy Committee (FPC), assumed overall responsibility for monitoring and responding to threats to financial stability. Meanwhile, the Financial Services Authority (FSA) was dissolved and its responsibilities for regulating financial firms passed to two new organisations: the Prudential Regulation Authority (PRA) (a subsidiary of the Bank of England set up to oversee the prudential regulation of financial institutions managing significant risks) and the Financial Conduct Authority (FCA) (broadly responsible for supervising business conduct and ensuring consumer protection).
There must be serious doubts, however, about whether this revamped regulatory architecture can deliver a safe and stable financial system in the UK.
These latest reforms repeat the errors made in previous overhauls of UK financial services regulation in 1986 and 1997. This is because they fixate on altering the institutional structure of financial services regulation, but leave untouched a common denominator in UK financial crises since the ‘Big Bang’: namely, a misguided regulatory philosophy informed by neo-classical assumptions about the efficiency of markets and their ability to manage risks.
To be clear, this isn’t to argue that the structure of financial services regulation is unimportant. The decision by the UK to integrate prudential regulation of financial services into the FSA in 1997 was part of a wider international trend towards single national financial regulators. In addition to offering economies of scale and scope, it was widely believed that unified regulators would have a panoramic view of the financial sector and that this was an important advantage in a world where liberalisation had removed barriers between previously segmented markets and had ushered in financial conglomerates.
Nonetheless, in other ways the UK’s regulatory structure remained highly fragmented. While FSA oversaw prudential regulation, responsibility for monetary policy and making funds available to institutions whose failure could infect the wider financial system remained with the Bank of England. Finally, the Treasury was accountable to Parliament for its overall management of the financial system.
Poor coordination within this tripartite structure was heavily implicated in the 2007-8 financial crisis. There can’t be any doubt about that. Nevertheless, by nurturing a narrative of the crisis linked to poor coordination amongst regulatory institutions, the UK coalition government’s reform package has neatly deflected attention away from arguments which suggest that the crisis actually originated from a regulatory philosophy based on flawed ideas.
Since 1986 UK financial services regulation has been beholden to what is called the ‘Efficient Markets Hypothesis’ (EMH). This holds that rational investors acting on perfect information will ensure that market prices reflect their fundamental values. Under this model the role for regulators is not to limit markets or meddle in their operation, but simply to supply the conditions for their efficient operation. Market, rather than regulatory, discipline is deemed to provide the best way of ensuring that risks are managed in a way that delivers financial stability. Regulation should, in short, be light-touch and risk-based.
Official explanations for financial crises during the 1980s, 1990s and 2000s tended to suggest that they were the result of state interference that distorted incentives and the mispricing of risk. Nonetheless, a growing body of opinion felt the blame laid squarely with the nature of financial markets and, to borrow Charles Kindleberger’s phrase, their inherent propensity for ‘manias, panics and crashes’.
The financial crisis of 2008 lent further weight to the argument that EMH offered, at best, an incomplete understanding of financial markets and a poor basis on which to erect the regulatory system.
The FSA’s own assessment of the financial crisis seemed to concur. It noted that the assumptions of EMH were ‘now subject to extensive challenge on both theoretical and empirical grounds’ and that this had ‘implications for the appropriate design of regulation and for the role of regulatory authorities’.
Yet, in scouring the Treasury’s consultation documents and the documentation detailing the PRA’s proposed approach to supervision, I’m immediately struck by the fundamental continuity in thinking. The belief that market discipline will ensure that firms will conduct their business in a safe and sound manner, that financial innovations can only ever be beneficial, and that regulators should look not to limit markets but remove impediments to their efficient operation – all are prominent.
In some ways this is hardly surprising. All of the PRA’s senior management team previously worked for the FSA or the Bank in some capacity. It’s difficult, therefore, to escape the conclusion that these are the same people, following the same philosophy, just in a rebranded organisation.
Whether this will alter when Mark Carney is installed as Bank of England governor remains to be seen. He has occasionally expressed the view that regulators should play more than a residual role. Equally, he is clear about the limits to regulation.
There remain significant doubts, then, about whether the new regulatory regime will overcome the structural shortcomings of its predecessor. Even if it can, its reliance on a discredited philosophy will impair its ability to reduce financial crisis. If one believes that markets aren’t efficient (or at least are not efficient at all times), the City’s new regulatory edifice still looks to rest on shaky intellectual foundations and the future seems set for further financial malpractice, scandal and crisis.