THE BEST DEBATES – and here, it will come as no surprise to learn, I refer not to the series of US Presidential debates – follow the Hegelian dialectic of thesis, antithesis and synthesis.
The proponent of one point of view sets out his or her case in cogent terms, supported by hard evidence, to be countered by an alternative view that is equally well founded. From this difference of opinion a degree of consensus emerges, so that impartial observers feel their understanding has been enriched.
So it proved with the Third Annual Debate of Heriot-Watt’s Centre for Finance and Investment on the question of whether financial markets should be more heavily regulated by government.
I almost missed the beginning, having been delayed by teeming rain and heavy traffic through an Edinburgh pockmarked by construction works on the ill-starred tram project – a case study in inept central planning. However, I arrived just in time to hear the opening remarks of Professor Philip Booth of the Cass Business School and IEA.
Thesis – Financial Markets should not be Regulated by Government.
“I am not against regulation,” Professor Booth emphasised, “simply Government regulation.”
Hear, hear, I almost cried as I shook out by umberella and raincoat and took my place among an audience of around 150 earnest students of varying ages.
His case was that the current financial crisis was largely caused by errors in government regulation and central banking. An ultra-loose monetary policy in the years running up to 2007 led to a dangerous escalation in bank leverage that made the subsequent crash almost inevitable.
This exactly replicates the analysis of The Golden Guinea, and I believe is now largely accepted across the political spectrum.
Professor Booth convincingly made the point that ”bank bondholders largely gave up monitoring the behaviour of the banks because they thought it was unnecessary to do so”, since Big Brother in the form of government regulators was doing it for them.
As events transpired, Big Brother had gone to sleep at the wheel – completely failing to tackle the rise in bank leverage, or even (according to a recent statement by Sir Mervyn King) to notice that it was happening.
So we – bank depositors and bondholders – should seize back responsibility for regulating the banks in which we put our money from Big Brother. This was how things worked before Big Bang, when banks were regulated by the market itself. In those days, Philip Booth commented, “the London Stock Exchange had such high standards of probity that its motto was simply – my word is my bond.”
This came to an end with Big Bang, which was followed by ever more complex goverment regulation and a litany of disasters of which the latest are the mis-selling scandals and the rigging of LIBOR. “Government regulation is a seriously deficient tool for seeking to control unethical behaviour,” concluded Professor Booth.
Antithesis – Government Regulation of Financial Markets is Essential.
The counter-argument was put by financial journalist Ian Fraser, who argued that history shows that an unregulated banking system will progressively “trustify”. An efficient competitive market will break down as banks merge to become so powerful that they are able to use their market power against the public interest if left unchecked. This threat can only be addressed by effective anti-trust legislation, supported by measures to protect depositors, and the pursuit and punishment of financial crime such as insider trading.
This point was wittily emphasised by his seconder, William Dinning, Head of Strategy at Kames Capital, who regretted the passing of the long liquid City lunches of the pre-Big Bang era. According to Mr Dinning, their principal aim was to ensure that both parties were sufficiently well lubricated to gossip more openly than if entirely sober. “With the end goal of ensuring a happy balance – with the other guy sufficiently tipsy to give you whatever inside information you wanted, while you remain just sober enough to remember it later in the afternoon!” With tongue firmly in cheek, he stated that, while in some respects the passing of those days was doubtless regrettable, there was no way that we should go back to them, and effective government regulation of the financial services industry was essential to ensure that we do not.
From these opposing views, some common ground did emerge in the Q&A. Firstly, both parties agreed that some form of regulation is necessary – the only question being who should regulate and how.
Secondly, both parties agreed that the regulatory framework as it existed in the UK between 1987 and 2007 was seriously deficient. Under the the tripartite approach “no one knew who was in charge of what”. Mr Fraser’s view was somewhat stronger – “the FSA was an utterly useless organisation from the date of its inception” – a refreshingly frank appraisal, which earned some support the following day from no less an authority than a House of Commons Select Committe, which formally criticised the FSA’s Chairman, Sir Callum McCarthy, and Chief Executive, Hector Sants, for having failed to halt RBS’s disastrous acquisition of ABN Amro in 2008 – a failure that led directly to the largest corporate collapse in British history.
Thirdly, both the Free Banking school of Philip Booth and the Regulatory school of Ian Fraser agreed that, whatever system was put in place, it was imperative that individual banks should be allowed to fail without risking the breakdown of the entire financial system.
The Free Banking school felt that bank shareholders, bondholders and ultimately depositors should bear the cost of failure – not the taxpayer.
The Regulatory school stated that bank depositors should ultimately be insured by Government, as individual depositors lack the information or expertise to assess whether the banks in which they place their money are sound.
So some fundamental principles did emerge from the debate.
Overall, my sympathies are broadly with the Free Banking school in its critique of government regulation of the financial markets. Government cannot, and should not seek to, micromanage the affairs of individual banks. On the other hand, there is a need for a regulatory framework to ensure that;
- the free market in banking works efficiently – which it has manifestly failed to do in recent years;
- those who exploit inside information are punished,
- minimum solvency standards are maintained, for example with a formal legal requirement that bank equity should represent at least 5% of bank assets, compared to 2% or less in the case of RBS and Lehman Brothers immediately before they collapsed, and
- a system is put in place to ensure the orderly liquidation of failed banks without ruining their depositors – although I am with the Free Banking school in believing that depositors of failed banks should be compensated by an insurance system funded by levies on participating banks, rather than by the taxpayer.