Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs and Professor of Insurance and Risk Management at Cass Business School.
A thriving economy needs saving and capital investment. Capital investment is inherently risky because it involves making a judgment about returns from entrepreneurial ventures when our knowledge about the future is always limited. Any saving that leads to capital investment must therefore lead to risk. While risk can be managed and reduced (for example, by diversification), in general it is only possible for a saver to bear less risk if some other party bears more. For example, when we put our money in a bank, the level of risk is very low because the shareholders of the bank take the first hit if borrowers do not repay their loans. However, the extent to which we can offload risk like this is limited and, because all savers are ultimately households, such mechanisms merely switch risk from one household to another.
Despite this, successive governments have tried to eliminate risk in financial services. Conservative governments have been particularly guilty. It was a Conservative government that hugely increased the regulation of life insurance companies though the Insurance Companies Act 1982. The current government is also going through with the implementation of “Solvency II” which is an incredibly complex method of tightly regulating insurance companies. This is being promoted by the British and will be imposed on all EU companies. Incredibly, the promoters of that agenda have boasted that it replicates the Basel approach to regulating banks (which was shown to be a huge failure). Conservatives introduced the Financial Services Act 1986 (which moved the responsibility for regulation of financial markets from institutions that developed within the market to the government) and they introduced the 1995 Pensions Act. Conservatives are also trying to make banks not only failsafe (i.e. put them in a position where they fail safely – a very good idea) but also trying to ensure that they hold so much capital that they never fail.
There are several undesirable effects of all this that governments keen on regulation tend to ignore. The tightening up of the regulation of company pension funds has not only contributed considerably to their demise, but has arguably led to individuals having to take much more risky defined contribution pension arrangements in place of defined benefit pension funds.
In the insurance sector, regulation quickly became fossilised and encouraged insurance companies to use antiquated risk-management techniques – a major cause of the Equitable collapse. In contrast, between 1870 and 1970 (when there was minimal regulation), there were only two failures of life insurance companies and neither of them affected policyholders.
In the world of product sales, consumers are drowned in paperwork, much of which is ignored because it cannot easily be determined which aspects are important and which are not.
All increases in regulation tend to restrict competition because regulation tends to be a fixed cost that bears more heavily on new entrants and small companies – this should be a particular concern in the banking market.
Of course, the ultimate irony is that, when households are prevented from taking financial risk, the taxpayer tends to bear the risks instead. The taxpayer is every bit as vulnerable as the consumer of financial products and does not, of course, choose to bear the risk. This has most obviously manifested itself in the banking crisis where the US government tried to eliminate financial risk from the banking system through deposit insurance, weak personal bankruptcy law, the operation of Fannie and Freddie and the continual bailing out of financial institutions over several decades. These actions did not reduce risks – indeed, in anything, they increased risks and transferred them to the innocent taxpayer.
In the UK, the taxpayer has borne part of the cost of The Equitable scandal – due to a specific decision of the Conservative government – on the ground that the losses were partly due to regulatory failure. This is deeply problematic and it was, in fact, partly because people anticipated that this would happen that, in 1870, it was decided not to have state regulation and certification of insurance companies. If the state certified, the state would be responsible, it was argued.
Of course, the market – though never perfect and never able to eliminate risk – does develop its own mechanisms to manage risk if left unregulated. Mutual insurance companies and building societies where a method of ensuring that conflicts of interest between customers and owners were managed. It was regulation that put paid to this institutional variety. Stock exchanges, trustee mechanisms and the voluntary restriction of commissions payments by insurance companies to salesmen (outlawed by government) all developed as a way of controlling risk for unsophisticated consumers. The government – largely Conservative governments – have driven out these market mechanisms and this institutional variety and replaced them by millions of paragraphs of regulation managed by a regulatory bureau.
Telling the population that they do not have to be prudent and that they can delegate responsibility for managing financial risk to regulators is never a good idea. Preventing market mechanisms from developing that can help consumers take sensible decisions is also not helpful. However, removing risk from savers and passing it to taxpayers is both economically disastrous and immoral.