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BoothPhilip Booth is Editorial and Programme Director at the Institute of Economic Affairs and Professor of Insurance and Risk Management at Cass Business School.

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.

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