How regulation made markets riskier

Here’s a by no means exhaustive list of financial scandals in the UK over the last 20 years: Barlow Clowes (remember that one?), BCCI, Barings, pensions misselling, endowment mortgages, the internet bubble and crash, Equitable Life, split capital investment trusts, Northern Rock. 

What do they have in common?  All have occurred since the introduction of compulsory regulation of investment business in the UK, under the Financial Services Act of 1986, a system that was brought in to improve protection for investors.

While the actors have changed, and the regulators have appeared under a veritable alphabet soup of acronyms – since 1986 financial market participants have had to deal with, amongst others, SFA, SIB, IMRO, LAUTRO, FIMBRA, the PIA, and now the FSA – it does not take a genius to reach the conclusion that our regulatory system doesn’t work.

Northern Rock exposes flaws in tripartite system 

The latest collapse – the failure and nationalisation of Northern Rock – occurred under something called the tripartite system of financial sector regulation, which was introduced by Gordon Brown in 1997. This divided responsibility for the functioning of the markets between the Bank of England, the Treasury, and the FSA. When the bank got into trouble it very quickly became clear that there was noone in charge. The Bank of England governor was forced into a rapid U-turn on intervention, and the Chancellor was panicked into guaranteeing all Northern Rock’s deposits, committing the taxpayer to enormous liabilities.  The FSA, in turn, had clearly failed in its duty as bank supervisor.

The regulatory system will no doubt be changed yet again as a result of the Northern Rock affair – perhaps with another shuffle of initials and more work for the brass plate makers.  But a fundamental question begs to be asked.  What is the point of all these organisations and their rulebooks?

Maximising return, minimising risk?

When I started work as a fund manager in 1987, our contract with clients was a one-page letter committing us to “maximise return while minimising risk”, or something along those lines. And that was pretty much it – clients handed over their money and we looked after it. Within months of my arrival, the new regulatory framework had forced us to replace these letters with multi-page management agreements, going into great detail about where we could and could not invest. A compliance officer or two appeared at the firm, whose job it was to ensure that the regulators’ rules were kept.

Over the years the investment management agreements grew in size and complexity, and the compliance officers became large compliance departments. The new employee who wants to work in the markets now has to sit one of a variety of FSA-sponsored exams, a large part of which is devoted, in mind-boggling detail, to the regulatory system.

If it were simply a question of a bit of excess bureaucracy, people would grumble, sit the exams, and put up with the occasional form filling at work for the compliance people. Clients would be none the wiser either way.  Yet there is ample evidence that the regulatory system is positively damaging.

Why a regulatory system may be damaging

First of all there is the old problem of moral hazard.  If people believe that the regulator will protect them or even bail them out, they are likely to behave more recklessly than otherwise. Equally, an investor may take the fact that an IFA, for example, or bank, has FSA approval as an implicit guarantee that they will not be mistreated. One doesn’t have to look very far to find plenty of examples which contradict this – all the scandals listed above occurred at regulated institutions.

But it is also clear that having an explicit rulebook can make things worse. Take the current credit ratings scandal, where hundreds of billions of bonds were rated AAA by the main rating agencies when they shouldn’t have been (to clarify, AAA is supposed to mean a practically risk-free bond, with little chance of capital loss, whereas a number of recently issued “AAA”-rated mortgage issues have lost up to 40% in price). 

This only occurred because many regulations, for example those specifying how much capital a bank must hold against its loans, or those which set minimum ratings for a whole range of investment funds, specify a minimum credit rating. Under pressure to find extra returns for clients who were constrained in this way, clever bankers devised very complicated bonds and obtained the required ratings by making highly subjective assumptions about their likely performance. The fact that the credit rating agencies – themselves a part of the regulatory framework under US law – had a monetary interest in getting new bonds approved and issued compromised their independence and removed an important safeguard for investors.

This is a classic example of “regulatory arbitrage” – where the mere existence of a rule encourages clever lawyers and bankers to find ways around it. Regulation in the USA, for example, under the SEC and the Financial Accounting Standards Board, has become almost entirely rules-driven, and an explosion of off balance sheet schemes to get round them has resulted. This has had predictable consequences – Enron, for example, was able to hide its insolvency for a long time by the use of such accounting schemes, and more recently banks have got into similar problems by using SIVs to push real economic exposures out of sight.

More importantly, the overall effect has been a significant deterioration in the transparency of the financial markets, as noone knows which skeletons are lurking in whose closet. Banks and fund managers have become reluctant to trade with one another, as noone trusts the financial health of the counterparty – who knows if the bank you want to trade with might be hiding billions of losses?

And so the increase in regulation has had precisely the opposite effect of what it was meant to achieve, making the markets more opaque and riskier for all of us. This is before even mentioning the costs that regulation imposes – costs that are all passed on to the end-user as higher fees.

Simplicity and clarity is best

Will anything change?  Under the financial leadership of Brown and Darling in the UK, this seems highly unlikely. The government has its own history of off balance sheet shenanigans through PFI schemes, and its incessant tinkering with the tax system reveals an instinct for adding, rather than reducing complexity. This is before even mentioning the whole new system of EU-wide regulation under the ugly acronym of MiFID. We now have a jungle of rules from which it will be difficult to escape.

Yet for the health of the financial markets, and the economy as a whole, it is vital that we start to move back towards simplicity and clarity. Would it not be better to teach investors the only real rule they need to know – “Caveat emptor” or “Buyer beware” – and let all the rest be done on trust? Financial scandals will continue to occur, as they have always done, but at least we will do away with the pretence that that the state and its agencies can somehow protect us from loss (or, more importantly, from the consequences of our own bad decisions).

This may seem like wishful thinking, when the knee-jerk reaction to the ongoing credit crunch is likely to be more, rather than less regulation. But a return to a simpler system based upon basic but quite adequate legal protection, such as that against fraud and breach of contract, is surely preferable to the unstable and dangerous financial market structure that we now see.

Paul Amery is an independent financial analyst based in London, formerly a fund manager and bond trader

  • Rod Murdison

    Absolutely correct in every detail. After nearly 30 years mostly spent in the non-investment side of the industry (mortgage broking) I will shortly be taking the hint and leaving the industry. How does this help the public? How does diminishing sources of advice increase competition and (supposedly) efficiency? The whole thing’s a farce.