«Colin Mayer Saïd Business School, University of Oxford 10 October 2000 This paper was prepared for a conference on “The Challenges Facing ...»
Regulatory Principles and the Financial Services and Markets Act
Saïd Business School, University of Oxford
10 October 2000
This paper was prepared for a conference on “The Challenges Facing Financial
Regulation”, 6-7 July 2000, organized by the Centre for Corporate and Commercial
Law at the University of Cambridge. It is forthcoming in E. Ferran and C. Goodhart
(eds), Regulating Financial Services and Markets in the Twenty First Century,
Oxford: Hart Publishing. I am grateful to Julian Franks, to my discussant Colin Brown and to participants at the conference for comments on the paper.
1 Introduction Regulation in the UK is undergoing fundamental change. Dissatisfaction with selfregulation and the self-regulatory organizations intensified steadily during the 1990’s.
The failure of regulation to avert the Maxwell pension collapse and the widespread selling of inappropriate pension policies were viewed as serious deficiencies of what many people had already come to regard as inadequate and expensive regulation. The Labour administration came to office with the clear intention of overhauling and strengthening the system.
The Financial Services and Markets Act (FSMA) suffered a tortuous process through the Houses of Parliament. Most concern focused on questions of governance of the Financial Services Authority (FSA): how accountable should it be and to whom, should it have immunity from actions for damages, should it have an independent complaints procedure, should the roles of chairman and chief executive be separated.
These are critically important questions, which several of the papers in this volume address. Notwithstanding the concerns, the FSMA has been broadly welcomed for enhancing investor protection and eliminating the complex system of overlapping self-regulatory organizations that previously existed.
The objectives of the FSMA are to maintain market confidence in the financial system, to promote public awareness of the financial system, to secure the appropriate degree of protection of consumers and to reduce financial crime. These objectives have their basis in the market failures that afflict financial markets: market manipulation, systemic problems, asymmetries in information, incomplete contracts and problems in the enforcement of contracts. To meet the need for a more effective system of regulation, the government proposed the creation of a new statutory body, the Financial Services Authority (FSA), to replace its predecessors, the Securities and Investments Board (SIB) and its accompanying self-regulatory organizations. Selfregulation was deemed to have failed to live up to the requirements of effective investor protection.
But in the rush to bring in new legislation, there has been remarkably little academic debate about one of themost fundamental changes to financial regulation in the post WW2 period. The questions of governance, referred to in a previous paragraph, are important but may not prove in the long-term to be the most significant. Instead, this paper will suggest that there are more fundamental questions that the debate about the FSMA leave unanswered.
The primary issue that regulation is supposed to address, and many people might feel is the only relevant issue, is investor protection. The FSMA has been welcomed for strengthening this. But the financial sector does not stand in isolation. It plays a key function in linking individuals on the one hand with the corporate sector on the other.
The financial sector facilitates the transfer of funds between savers and borrowers and oversees the allocation of resources in the corporate sector through a variety of governance mechanisms. The financial sector is therefore a critical determinant of economic performance. In designing financial regulation, it is therefore important to be aware of its repercussion on the wider economy. It is this aspect of financial regulation that the paper will argue has received inadequate attention to date.
The paper will begin by considering how financial regulation impacts on the structure of the financial system. It will distinguish between financial institutions that are prone to systemic risks, most notably commercial banking, in section 2 from those that are not, for example asset management, in section 3. Where there are systemic risks then there is an inevitable trade-off between protection of the financial system and competition. A critical issue that has received little attention to date is how an appropriate point on the trade-off should be determined. In other parts of the financial sector where systemic risks do not arise, the paper will argue that regulation should promote competition through disclosure, auditing and enforcement. Sections 2 and 3 will discuss these issues in the domestic UK context, which is clearly the main focus of the FSMA. The paper will then consider international aspects in section 4, in particular in relation to the European Commission.
Having considered how regulation impacts on the structure of financial systems, the paper will then turn to how financial systems affect the real economy. There is a growing body of literature that points to the importance of the design of financial systems for economic activity. Section 5 will briefly review this literature.
Section 6 will bring the two strands of the argument together in a consideration of the criteria that should guide the formulation of financial regulation and an assessment of current legislation.
An interim report on UK banking in 1998 co-ordinated by the UK Treasury and headed by Don Cruickshank raised a question which until then had received little debate: what is the appropriate balance between regulation and competition?1 In banking, the nature of the trade-off is clear. Charter values are the most significant incentives that can be provided for depositor protection. Charter values offer a cushion against poor performance and discourage the excessive risk taking that otherwise afflicts banking. But the creation of charter values requires limitations to be imposed on competition and entry into banking. Depositor protection can be provided but at a cost of limiting competition in banking. What is the appropriate balance between competition and investor protection?
Since the 1840s, Britain has opted progressively for protection of depositors over competition. In the first half of the 19th century, Britain was populated with a large number of local banks. Local banks were important in the funding of manufacturing.
Many bankers were originally engaged in a business for which banking was a sideline. They launched banks as a way of funding their activities.2 They were therefore knowledgeable about both borrowers and the trades in which they were engaged.3 However, the existence of 800 small, private banks, empowered to engage in note issuance, caused serious stability problems. Over the period 1809 to 1830 there were 311 bankruptcies of country banks. The Bank Charter Act of 1844 which created the supremacy of the Bank of England did not eliminate banking crises: there were further crises in 1847, 1857 and 1866.
Large banks are less exposed to local disturbances and have more resources available to them than small, local banks. In response, banks withdrew from the illiquid Cruickshank (1999) Cottrell (1980), p14.
Deane (1965) investments in which they had been engaged and began to spread their activities geographically. In 1850, the average English joint-stock bank operated five branches;
by 1913 they operated on average 156 branches. As a consequence, concentration increased dramatically: in 1850 there were 459 banks in the UK; by 1913 there were 88 and in 1920 the “Big Five” banks (Barclays, Lloyds, Midland, National Provincial and Westminster) accounted for 80% of English bank deposits.4 A convenient relation between the Bank of England and the banks therefore gradually emerged by which the clearing banks faced little competition and the Bank of England faced little failure. As a consequence, British banking became a club of a small number of large members. The cosy relation was disturbed by the arrival of foreign banks during the 1960’s and the diversification of the secondary banks from their traditional retail lending activities into more speculative asset investments, prompting the secondary banking crisis in the 1970’s. Nevertheless, the UK has endured less failure than, for example, the US. The critical question that this raises and has not been adequately addressed is how should an appropriate point on the trade-off be determined.
Inadequate competition is thought to create problems of excessive pricing and cost inefficiencies. In fact, UK banking is not for the most part characterized by static inefficiency. On the contrary, it is quite efficient in comparison with most of its Continental European counterparts.5 Furthermore, it is unclear whether it is excessively profitable. Traditional measures of profitability do not take adequate account of the fact that banking involves relationships and risk sharing between lender and borrower. If banks support firms during periods of financial difficulty then it is reasonable to expect them to earn high rates of return during periods of economic boom. One cannot therefore draw inferences from observations on the profitability of banks during a period in which the UK economy has enjoyed an exceptionally long period of sustained growth.
The real cost of excessive regulation is probably neither static inefficiency nor excessive pricing but its impact on diversity and innovation of services. The failure Collins (1991), p 37.
See, for example, Sarkis (1999) of financial institutions to finance activities and investments that would have been funded under a more lax regulatory regime is difficult to measure and hard to observe.
In contrast, bank failures are major events that create political storms. Unless considerable care is taken, there is therefore a natural inclination for the political process to introduce an inherent bias in favour of depositor protection over competition.
3 Non-bank domestic regulation
It is not just in relation to banks and depositors that there has been extensive regulation in the UK. Ever since the South Sea Bubble, investor abuse been a highly charged political issue. In response, minority investor protection has become more extensive in the UK than in virtually any other country. Recent international comparisons6 suggest that both the UK and the US offer investors high levels of protection and that the UK and US are not dissimilar in the degree of protection that they offer shareholders. However, the UK provides more protection to its creditors through its insolvency code than the US Chapter 11.
One area in which shareholder protection differs between the UK and US is in relation to takeovers. The takeover code was introduced in the UK to achieve fair play in takeovers and to ensure that minority investors were not disadvantaged. Unlike the UK, the US has no 30% equal price rule requiring a bid for all shares in a company once 30% of shares have been acquired. There is no equal price rule in the US as there is in the UK requiring all shareholders to receive the same price as the highest price offered to any shareholder. Instead, the US relies on fair price rules to protect investors.
While the regulation of banking is primarily concerned with systemic failures, the regulation of non-banks is not. The main market failures that afflict non-bank institutions are market manipulation, imperfect information and contract failure through poor enforcement.
See La Porta et al (1997)
Market manipulation: The efficient functioning of markets requires the avoidance of market manipulation through private information and dominant positions. Individuals are deterred from participating in financial markets in which they believe there is a risk of manipulation and abuse. This requires the active policing of market transactions and the prosecution of market abuse.
Information: Evaluating information of financial products and institutions is complex and expensive. Investors are discouraged from participating in markets in which they believe that they are at an information disadvantage. In particular, they avoid institutions and markets that they believe are afflicted by risks of losses from bad management or fraud. Disclosure rules and auditing of information are fundamental to the operation of and competition in these markets.
Contract failure: Contract failure is primarily associated with fraud. Risks of fraud can be diminished through rules requiring assets and monies to be held by separate custodians. Active auditing by private as well as public auditors assists in the identification of fraud. It is widely recognized that financial fraud has been difficult to prosecue in the UK in the past. The strengthening of powers of the regulator in this regard is clearly welcome, though questions of accountability have been raised. Other papers in this volume consider whether proposed appeals and compensation mechanisms offer adequate safeguards but the UK is clearly starting from a position in which powers to prosecute have been weak.
The regulation of non-bank financial institutions therefore hinges on information disclosure, monitoring and auditing and enforcement through the courts.
Intermediaries that evaluate the quality of management and systems employed by financial institutions can help inform investors. Such institutions perform a function similar to that of credit rating agencies in bond markets but instead of rating risks of bond defaults they assess investor exposure to losses from fraud and operating failures. Investors can be further protected through private insurance markets.
Indemnity and fiduciary insurance are widespread in the US but comparatively underdeveloped in Europe. In the absence of systemic risks, private insurance markets can enhance investor protection.