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October 28, 2009

Competition is the best financial regulator - argue Michael Mainelli & Richard D. North

Posted by Richard D. North

By Michael Mainelli and Richard D North

We should redeploy Adam Smith before we redeploy John Maynard Keynes, say Michael Mainelli and Richard D. North.

The financial industry is still gaming the state regulatory and guarantee processes. Indeed, the 2008/9 bail-outs have seemed to reassure financiers that their old business model of carefree risk-taking is even sounder now than it was before the credit crunch. There has been, as Mervyn King, governor of the Bank of England, told his Edinburgh audience last week, "little real reform".

Managers see the same situation which led them to let us down: they face the same pressure for short term profit and the same indifference to long term security. They are pressured to be crude profiteers rather than nuanced professionals. The industry may even believe the bickering amongst regulators provides them with cover whilst they make hay.

Those are the messages we get from conversations with bankers and informed observers.

So what's the answer? We beg to suggest that almost everyone is arguing for too much regulation and too much complexity of regulation. We believe competition is the key and that it could lead to a fierce and modern self-policing. In line with Nobel laureate Elinor Ostrom's thinking on the non-tragedy of the commons, whole sectors will find themselves demonstrating the rigour of community sanction.

We do not so much dispute how banks might look when they are safer as want to discuss the role of regulators in achieving the effect. We think regulators should resist the urge to design a new financial sector and instead concentrate on setting up the right tensions.

Mervyn King and Lord Turner, chairman of the Financial Services Authority, have different styles and approaches, but both seem to believe there needs to be a distinction between casino and utility banking operations. Professor King seems to be arguing that a safety wall between the two can be manufactured by regulators whilst the FSA's new discussion paper seems to argue that the regulator can achieve a virtual barrier by imposing different capital requirements on banks according to their riskiness.

We think Prof King's position resonates with ours more than Lord Turner's because the governor insists that,

The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.
He wants the minimum regulation and wants it to aim at damage limitation rather than absolute safety, except for very narrow, utility banks.

We think things can be simplified further. The obvious dilemma is that tax-payers and consumers need to know that while the state will in the final analysis stand by the financial sector, politicians are doing nothing that makes that emergency action more likely.

The only alternative to the moral hazard of cosseting and corseting the sector is to allow competition to encourage the vigour of greed and chill of fear to stalk the market.

As a precursor, it is necessary for governments to break up firms which are too big to fail and too big to regulate. That would have the merit of being in line with the fundamental, deep and old understanding that capitalism's biggest hazard is oligopoly. Let's redeploy Adam Smith before we redeploy John Maynard Keynes. Anti-trust and competition commissions need to be at the heart of reform, not just the Bank of England, the FSA or EU financial regulators.

The consequence of increased competition is that regulators could relax their direct control whilst intensifying their interrogation, challenge and exposure of firmsí risk-taking. Regulators should outlaw only the most egregious behaviour, but they could play a role in flagging up and publicising sub-optimal habits. It is easy for firms to game the absolutism of legalistic rules, and much more purifying for them to need to prove their professionalism.

More widely, government should claim that their most important role is simply to ensure that everyone insists that firms demonstrate that they are optimally safe players. Some firms will and should opt for safety-first strategies, others for more adventurous ones. They will all face scrutiny and evaluation by their own peers, savers, investors, managers, shareholders, academics, credit agencies, journalists - and regulators - all of whom will become more anxious and more active sources of discipline in the market.

Cock-ups would still happen and might happen more often. But they would have much less chance of causing contagion or a massacre of the innocents.

Michael Mainelli is co-author with Bob Giffords of The Road to Long Finance, 2009, published by the Centre for Study of Financial Innovation.

Richard D. North is the author of Mr Cameron's Makeover Politics, 2009, published by the Social Affairs Unit.


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