The Value of Regulation
Background
In the UK we have been at the forefront of the development of regulatory structures and with the Financial Services Authority we have already one of the broadest regulatory structures existing in the developed world. Maintaining such a regime is extremely expensive, not only due to the costs of the regulator itself, but rather due to the enormous costs incurred by the regulated. Since these costs are ultimately passed on to the relevant investor, this article seeks to consider whether investors are actually getting value for money and whether the regime is likely to achieve its objectives.
What is the Purpose of Regulation?
Regulation could either:
- Protect the public
- Protect the institutions
- Protect the regulator
- Protect the market
Let us consider each of these in turn
Does Regulation Protect the Public?
Normally when there has been a financial disaster from BCCI through Maxwell and LTCM to Barings and Enron, there is always the call for more regulation. This has the feel of “shutting the door after the horse has bolted” and yet the regulation that is subsequently implemented generally would not in itself have prevented the initial problem.
Consider the Maxwell affair. Here an unregulated business had the ability to inappropriately extract funds from pension funds to support the business. The point is that it was the unscrupulous that undertook this action – not someone trying to take advantage of a failure in regulation.
As such the rules and regulations enacted would in future apply to the scrupulous, for it is the scrupulous that will always comply with regulation and incur the costs that go with it. The unscrupulous will just ignore the new rules just as they ignored the old rules and general business ethics. Consequently the public cannot be any better protected by the legislation, rather they will by paying more to buy products from those firms that would not have got into a problem in the first place. The best way of protecting the public is probably by some form of compulsory insurance scheme, but that will also incur additional costs.
So if regulation cannot protect the public, what is it for?
Does Regulation Protect the Institution?
Well if that is the intention, it certainly does not make a good job of it. When an institution has a regulatory breach, the regulator publicizes this and there is a significant impact on the reputation of the institution. In some cases the reputational damage has been terminal and the institution has disappeared.
The argument goes that the regulator is implementing best practice rules for the good of all firms that it regulates, to pass out best practice and reduce failures. Yet in calculating capital requirements when taking percentages and dealing with conservatism, the regulator is only taking an average view. They are not saying that no firm that they regulate will go out of business; rather they are saying that in total they believe there is sufficient capital in the system.
Given that good institutions comply with rules and regulations and bad ones do not, there can be little protection in making new rules. Indeed some of the failures I have already referred to involve institutions that were heavily regulated, but for one reason or another decided to flout accepted standards of management.
So clearly regulation cannot protect the institution.
Does Regulation Protect the Regulator?
This is a harder question to answer. Clearly it is in the interests of a regulator to be able to say that there was a rule which, had it been complied with, would have prevented the problem from occurring.
But there is a natural consequence to this, which is over regulation. Recognising that any form of regulation results in a firm incurring costs, the regulator is in a difficult position being damned if they do and damned if they don’t. If they put on too much regulation the investors complain at the level of costs. If they put on too little regulation they get blamed for every failure that occurs.
So they are in a no win situation. Consequently whilst regulation could protect a regulator, in practice it rarely succeeds in this.
Does Regulation Protect the Market?
Well this appears to be our only choice. Regulation tends to attempt to ensure that there is on average adequate capital in the system and sufficient good guys around to so that in turbulent times sufficient firms will survive to enable the market to continue to function.
Therefore regulation does protect the market, but at the expense of both firms and investors.
Is Regulation Cost Effective?
If the purpose of regulation is to protect the market, then perhaps it is cost effective in that even in the most difficult of times the markets have continued to operate. However, the most commonly stated aim of regulation is to protect the public, yet it rarely achieves any real form of protection. Consider what happens when you buy an investment product in the UK. Due to the regulatory regime you are bombarded by a series of set criteria on which the investment is likely to be selected by your advisor. Currently the advisor will be a tied agent or an independent intermediary – soon he may be a multi tied agent. I tell you in truth, the average customer has no idea what the difference is and mostly buy products on the basis of what they think of the advisor, rather than the quality of his advice.
I was interviewed recently by a newspaper on the subject of increased regulation for new products. I asked the interviewer whether he had recently bought a product. He indicated that he had. I then asked him if he read the product particulars presented to him and he started to laugh and said of course not. I then asked him if he would read them if they were longer or included more detail and he indicated he would not. Regulation requires us to produce more and more information that less and less people are likely to read – yet they will pay the cost of this regulation in their product prices.
As I indicated before, the best way to protect the public is some form of national insurance scheme, but I am sure that this would be difficult to administer. The current regulatory structure is expensive and fails to protect the public adequately. At all times we should judge regulation in terms if its likelihood of achieving its objectives and if there is little to show that it will be successful, we should avoid it at all costs. I am not saying we should have no regulation, rather that we should operate on broader principles allowing most firms to comply easily and yet trying to identify the rogues where action and protection are required. We must always recognise that most firms would treat their customers fairly without additional regulation because they want repeat business – and the rogues will still ignore even more complex rules.
And finally remember that one man’s regulation is another man’s business opportunity….
