Good Regulation, Bad Regulation

The Anatomy of Financial Regulation

Imad A. Moosa

• Publisher: Palgrave Macmillan
• Year: 2016
• Print ISBN: 9781349685936, 9781137447098
• eBook ISBN: 9781137447104
• Topic: Business
• Subtopic: Business General
• Index: Business

Since the 2007 2008 global financial crisis, there has been much debate about the role of financial regulation and the causes of financial instability in the industry. Where studies commonly question the value of a regulated rather than free market, this book focuses on the differentiation of 'good regulation' and 'bad regulation'.This book highlights the need for financial regulation to combat corruption, and the integral link that exists between corruption and financial instability. The author evaluates the benefits and shortcomings of specific types of regulation, drawing on recent examples to illustrate each argument. The book presents compelling arguments for the regulation of leverage, liquidity, payday loans and securitisation; and debates the negative aspects of the regulation of short selling, and high-frequency trading, and of Basel-style banking regulation. The author argues that there is no free-market solution to financial instability, and rejects the idea of 'too big to fail'.

1

Definition and Theories of Regulation

1.1 Definition of Regulation

Before discussing the pros and cons of regulation in general and financial regulation in particular, we have to understand what regulation is all about and what forms it takes. Although there are arguments for and against regulation in general (hence against and for deregulation), some arguments are type-specific. For example, environmental regulation is motivated by the desire to protect human health from the effect of pollution (which provides an argument for regulation) whereas a primary argument for financial regulation is corruption in the financial sector. Regulation in general is a form of government intervention in economic activity and interference with the working of the free-market system. According to some views, regulation is “synonymous with government intervention in social and economic life” (Moran, 1986). Free marketeers dislike regulation because they do not like any form of government intervention and prefer to feel the full power of the market. However, those who believe that government intervention may be necessary (even a necessary evil), and that people should not be exposed to the full tyranny of the market, find regulation to be tolerable, even desirable.

Regulation can be defined in more than one way, as suggested by Mitnick (1980), who presents the most comprehensive review of competing definitions. Moran (1986) argues that “regulation is a contested concept, its essential nature being the subject of continuing argument”. However, he goes on to define regulation as “an activity in which the discretion of individuals or institutions is restricted by the imposition of rules”. Likewise, Den Hertog (2000) argues that “in the legal and economic literature, there is no fixed definition of regulation”, then he goes on to define regulation as “the employment of legal instruments for the implementation of social-economic policy objectives”, pointing out that “a characteristic of the legal instrument is that individuals or organizations can be compelled by [the] government to comply with prescribed behavior under penalty of sanctions”. Den Hertog illustrates the definition of regulation with examples, suggesting that firms can be forced to observe certain prices, to supply certain goods, to stay out of certain markets, to apply particular techniques in the production process, and to pay the legal minimum wage. Sanctions include fines, the publicising of violations, imprisonment, the imposition of specific arrangements, injunctions against withholding certain actions, and (in the extreme) closing down the business.

These definitions paint a bad picture of regulation, reflecting an ideological anti-regulation stance. This is obvious from the use of words like “restricted”, “imposition”, “compelled”, “penalty”, “sanctions” and “forced”. Moran’s definition portrays regulation as tantamount to a partial confiscation of liberty, which is true in certain cases. For example, the US Patriot Act, which is a piece of regulation, does confiscate civil liberties and so does the “regulation” of private communication by the NSA and GCHQ. However, preventing a polluter from dumping toxic waste in a river does not represent confiscation of liberty, but rather a justifiable confiscation of the profit obtained by pursuing an illegal activity. Den Hertog’s definition contains words that convey a bad image of regulation but it does not say anything about why “compelling”, “penalising” and “forcing” may be necessary—perhaps as necessary as when they are used to deal with a serial killer. Is it not a good idea that our behaviour in a court of law and interaction with other people are regulated? The animal kingdom is not regulated, and this is why lions and crocodiles are not compelled to be nice to their victims (or, in a way, the animal kingdom is regulated by the laws of nature). In the human kingdom, things are different. Traffic lights represent a form of regulation that we have to abide by. We have all experienced the chaos resulting from the failure of traffic lights, which is why the most enthusiastic free marketeer would not argue for the “deregulation” of traffic lights even though we are forced to comply under a penalty of sanctions.

Deregulation, the opposite of regulation, is the process of removing or reducing the extent of regulation. Like regulation, deregulation is typically (but not always) implemented by legislation, often by abolishing or revoking existing legislation. For example, the Gramm–Leach–Bliely Act of 1999 (which was signed into law by President Clinton) was intended to revoke the Glass–Steagall Act of 1933, to allow banks more freedom in conducting business. These two acts pertain to financial regulation, which encompasses the laws and rules that govern the operations of financial institutions and the working of financial markets. Macey (1989) argues that regulation and deregulation occur simultaneously (even in closely related areas) because both of them reflect changes in the equilibrium conditions that provide the underpinnings of the special interest groups theory of regulation. This view reflects Macey’s preference for the special interest groups theory as opposed to the public interest theory of regulation—we will examine these theories later on.

The laws and rules that prescribe financial regulation are promulgated by the government or international groups (such as the Basel Committee on Banking Supervision) to protect investors, maintain orderly markets and promote financial stability. Whether or not these novel objectives are achieved depends on whether the regulation is good or bad and whether or not it is enforced effectively. The range of financial regulatory activities may include setting minimum standards (for capital, leverage and liquidity), making regular inspections, and investigating and prosecuting misconduct. An important distinction should be made between legislation setting the rules and procedures for implementing regulation and the enforcement of such legislation. For example, it is arguable that Bernie Madoff managed to swindle his clients, not because of the absence of appropriate regulation but because the regulation was not enforced.

Some observers argue for regulation but not for rule-based regulation. In his book, The Rule of Nobody, Philip Howard argues for “broad, principle-based regulation”, whereby officials and judges are allowed to use their discretion, common sense and compassion when enforcing the law (Howard, 2014). The underlying idea is that regulation should not be overly detailed, which arguably comes in as a result of pressure from special interest lobbies. For example, instead of using detailed rules governing nursing homes, a broad principle can be used to provide “homelike environment” and to respect the dignity and privacy of the residents (The Economist, 2014a). While this argument is valid for the regulation governing nursing homes, it is unlikely to work with bankers who are very skilful at avoiding the tightest of regulatory rules.

Moran (1986) argues that the immediate origins of regulatory change in financial markets lie in the structural transformation of markets that occurred in recent decades. He identifies four kinds of structural change that have led to the evolution of financial regulation: (i) an extraordinary rate of growth in the volume of business conducted in financial markets; (ii) a sharp increase in the fierceness of competition; (iii) frenetic bursts of innovation; and (iv) the use of satellite and computer technologies to organise markets on a global scale. Moran seems to overlook one important factor, which is growing corruption in the financial sector.

1.2 Forms of Regulation

Regulation may take several forms. It may take the form of legal restrictions imposed by the government. It may also take the form of public standards or statements of expectations issued by regulators. In many cases, regulation requires registration or licensing, whereby the regulator approves and permits (or otherwise) some economic activity. The regulator may conduct periodic inspections to ensure compliance with prescribed standards, including the reporting and management of non-compliance. Licensing implies the possibility of de-licensing, whereby a firm that is deemed to be operating unsafely is ordered to stop operating or suffer a penalty for acting unlawfully, improperly or recklessly. In extreme cases, regulation takes the form of prohibition of an entire activity such as insider trading, money laundering and short selling. Distinction may be made between private (or self-) regulation and public (government) regulation. However, Moran (1986) suggests that this distinction is “difficult to maintain” since self-regulation is effective only because it is underwritten by state power. He points out that “unusual hybrids of public and private regulation are constantly developing”. However, experience shows that “selfie”, which is what bankers like and advocate, is tantamount to allowing the inmates to run the asylum.

Viscusi et al. (2005) distinguish between economic and social regulation. Two types of economic regulation can be identified: structural regulation and conduct regulation (Kay and Vickers, 1990). Structural regulation pertains to market structure, including issues such as restrictions on entry and exit, and rules mandating firms not to supply professional services in the absence of a recognised qualification (for example, financial planning). Conduct regulation, on the other hand, pertains to the behaviour of producers and consumers—examples are price controls, the labelling of products, advertising rules and minimum quality standards. Economic regulation is exercised primarily on natural monopolies and market structures with imperfect or excessive competition. The objective in this case is to offset the negative welfare effects of the behaviour of a dominant firm and to stabilise market processes. Social regulation pertains to the environment, occupational health and safety, consumer protection and labour. Examples of social regulation are measures taken against the discharge of environmentally harmful substances, safety rules in factories, the obligation to include information on the packaging of goods, and the prohibition of the supply of certain goods and services without a permit.

Machan (1988) distinguishes among regulation, management and prohibition. This distinction seems to be rather superficial, as both management and prohibition are forms (extreme forms) of regulation. A government may choose to nationalise an enterprise and manage it to circumvent the problems associated with monopoly power, which falls under the regulation of monopolies. Prohibition is an extreme measure of regulation that may be taken when necessary. For example, the regulation of short selling may take the form of a total ban (prohibition) or allowing the practice with restrictive conditions (for example, by restricting the list of shortable stocks or by allowing covered short selling only). Alternatively the regulation of money laundering takes one form only, prohibition, because it is (or should be considered) a criminal activity.

In this book, we are mainly concerned with financial regulation, which may be classified into two forms: safety-and-soundness (or solvency) regulation and compliance regulation. The basic objective of safety-and-soundness regulation is to protect fixed-amount creditors from the losses arising from the insolvency of financial institutions owing those amounts, while ensuring financial stability. Examples of fixed-amount creditors are bank depositors and claimants of insurance companies. This kind of regulation does not cover those holding stock portfolios with fund managers (and similar arrangements) because the next step would be to protect gamblers and compensate them for the losses they incur at the Blackjack and roulette tables in casinos. However, regulation aimed at financial stability should reduce the amplitude of boom and bust cycles in financial markets, thus reducing the incidence of big losses on securities portfolios. Likewise, anti-corruption regulation should help investors in hedge funds avoid the fate of those who invested with Bernie Madoff.

For more than three centuries that banks and insurance companies have been chartered by governments, regulatory measures have been imposed to ensure that these institutions remain both solvent (assets exceed liabilities) and liquid (they can meet payment requests, such as cheques and insurance claims, when presented). The predominant form of solvency regulation is capital regulation, whereby financial institutions must maintain a positive capital position (assets exceed liabilities). For example, the Solvency II Directive (put through in 2012) is used to codify and harmonise EU insurance regulation, which is concerned mainly with the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. Other solvency regulations are designed to achieve asset diversity, by limiting loan and investment concentrations among various classes of borrowers, and the amount of credit extended to any one borrower. In general, safety-and-soundness regulation is intended to curb the tendency of banks to gamble with depositors’ savings, which is reinforced by the absence of separation between commercial and investment banking.

Solvency regulation is enforced by inspectors who assess the value of an institution’s assets and liabilities. A financial institution can become insolvent (the value of liabilities exceeds the value of assets) if it endures a large sudden loss or a sustained period of smaller losses. Likewise, a seemingly solvent institution may turn out to be insolvent if inspectors find hidden losses—overvalued assets or liabilities that have not been recognised. For a long time before its eventual collapse, Enron (through fraudulent accounting) appeared to be solvent when it was not. While fraud is quite often the underlying cause of those losses, a firm with honest management may also experience sudden losses—for example, a natural disaster is likely to cause a spike in insurance claims, resulting in operational losses caused by an external factor (the natural disaster).

Often, an insolvent bank is illiquid—that is, the bank does not have adequate cash on hand to meet withdrawals, which is certainly true when there is a run on the bank. This, however, does not mean that illiquidity cannot strike a solvent bank, although that is relatively rare. To prevent banking panics in the event that banks cannot accommodate withdrawals, central banks are typically authorised to act as lenders of last resort by standing ready to lend to illiquid banks when no one else will, provided that those banks can fully collateralise their loan with high-quality assets. The basic difference between solvency and liquidity is that solvency pertains to the ability to meet long-term financial commitments whereas liquidity refers to the ability to cover short-term obligations and to sell assets and raise cash quickly. In Chapter 5, we will come back to this issue and discuss it in relation to Northern Rock (a British bank that experienced a run in 2007).

Compliance regulation is intended to protect individuals from “unfair” dealing by financial institutions, to impede illegal activity (such as money laundering and insider trading), and to ensure “fair” and non-discriminatory treatment of the customers of financial institutions. Compliance regulation is a firm’s adherence to laws, regulations, guidelines and specifications relevant to its business. Violations of regulatory compliance often result in legal punishment, including fines. Examples of regulatory compliance laws and regulations include the Dodd–Frank Act and the Sarbanes–Oxley Act. Compliance regulation has become a major responsibility for the regulators and a major cost burden for financial institutions. For example, the Credit Suisse Group (2001) estimated the Basel 2 compliance costs to average $15 million for about 30,000 banks worldwide. Even worse, compliance is sometimes required for the sake of compliance, as in the case of the Basel accords. Moosa (2012a) argues that Basel 2.5 (the transitory accord between Basel 2 and Basel 3) is not a risk management exercise but rather a pure compliance exercise—effectively compliance with the requirement of “buying insurance against possible losses”. He further argues that while compliance with effective regulation is good to strive for, the Basel accords are neither simple nor effective. If compliance is required for the sake of compliance, the underlying regulation must be bad—this is one reason why the Basel accords represent bad regulation. We will elaborate on this issue in Chapters 6 and 7.

1.3 The Public Interest Theory of Regulation

The public interest theory was developed initially by Pigou (1932). The underlying proposition is that the supply of regulation comes in response to the demand of the public for the correction of inefficient or inequitable market practices. The basic assumption is that regulation benefits society as a whole rather than a particular vested interest. Other assumptions are that markets may operate inefficiently or inequitably and that regulatory bodies represent the interest of society. Criticism directed at the public interest theory is based mostly on scepticism about the validity of these assumptions.

In the public interest theory, the government steps in to regulate markets when they are unable to regulate themselves (which the proponents of regulation believe to be the rule rather than the exception). In other words regulation is government intervention triggered by market failure, a situation where the price mechanism breaks down and the allocation of resources is sub-optimal. Public interest can be described as the best possible allocation of the scarce resources available for a particular economy. In theory, it can be demonstrated that, under certain conditions, the allocation of resources as dictated by market mechanism is optimal (Arrow, 1985). Because these conditions are not satisfied in practice, the allocation of resources is not optimal, which brings about the need for improvement. One of the means for achieving allocative efficiency is regulation, whereby resource allocation can be improved by facilitating, maintaining or imitating market operations. For regulation to be effective, regulators must have sufficient information and enforcement power to promote public interest. Furthermore, regulators must be benevolent and aim to pursue public interest. Opponents of regulation question the validity and soundness of the proposition that regulators have sufficient information and that they are motivated by (and only by) public interest.

The public interest theory explains regulation in terms of imperfect competition, unbalanced market operations and missing markets, as well as the need to prevent or correct undesirable market outcomes. The correction of undesirable outcomes can be desirable for other than economic reasons, such as considerations of justice, paternalistic motives and ethical principles. Posner (1974) interprets the public interest theory more broadly to imply that regulation is intended to correct inefficient or inequitable market practices. Examples of the laws and rules aimed at preventing or ameliorating undesirable market outcomes are legal minimum wages, maximum rents, rules enhancing accessibility to health care, and rules guaranteeing income in the event of sickness, unemployment, disablement, old-age and so on. In all of these cases, trade-offs may arise between economic efficiency and equity. Free marketeers, however, are concerned with efficiency and nothing but efficiency, which means that trade-offs do not count and that regulation that reduces efficiency to achieve a non-efficiency objective should be abandoned or not implemented in the first place.

The public interest theory has been criticised on the following grounds. First, criticism is directed at the notion of market failure because the market mechanism itself is often able to compensate for any inefficiency. For example, the problem of adverse selection resulting from inadequate information can be solved by c...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Preface and Acknowledgements
• List of Abbreviations
• 1 Definition and Theories of Regulation
• 2 Arguments for and against Regulation
• 3 Regulation, Deregulation and Financial Crises
• 4 Good Regulation: Payday Loans, Securitisation and Insider Trading
• 5 Good Regulation: Leverage and Liquidity
• 6 Bad Regulation: Basel 1 and Basel 2
• 7 Bad Regulation: Basel 2.5 and Basel 3
• 8 Bad Regulation: Short Selling
• 9 Bad Regulation: High-Frequency Trading
• 10 Bad Regulation: Too Big to Fail, Bail-Out and Bail-In
• 11 Concluding Remarks
• References
• Index