This well-written and well-presented volume arises from a conference held in July 2000 at the law faculty in Cambridge on "The challenges facing financial regulation". Usually I do not bother to read such books because editors often feel obliged to include even the weaker papers, most presentations tend to age fast and, in the internet age, one has almost instantaneous access to conference contributions. But in this case the effort was worthwhile.
The contributions to this book have not aged, not only because in the field of regulation, issues evolve at the slower speed of politics (as opposed to business or science), but also because the contributors are influential experts on the issues and go deeply enough into them that their arguments remain topical. Moreover, the editors, Eilis Ferran, director of the Centre for Corporate and Commercial Law at Cambridge, and Charles A. E. Goodhart, director of the Financial Markets Group and professor of banking at the London School of Economics, have done a superb job, giving the book a clear structure in an efficient, almost surgically precise way. The fact that the contributors range from Sir Howard Davies, chairman of the Financial Services Authority, to Lord Eatwell, president of Queens' College, Cambridge, and Mary Schapiro, president of National Association of Securities Dealers Regulation, Inc. - all of them known for their intellectual and their academic credentials - must have made the job of editing easier and more fun than usual.
The book will be of interest to anyone active in financial services and in public policy, but it is essentially written by regulation insiders. No one argues the case against regulation. The debate is about how, by whom and with what objectives regulation should occur.
This is hardly unfarmed territory. Speaking of the Financial Stability Forum, established by the G7 countries in February 1999, Andrew Haldane comments: "A Martian landing on earth is asked: what do you find strangest about this planet earth? A shortage of fora for discussing international financial issues is unlikely to appear high on the list. There is already a plethora of international financial agencies and groupings, of various degrees of formality and with widely varying constituencies and objectives. Their titles alone are an alphabet soup - and are about as appetising." Davies himself informs us that "the FSA is the UK member of 130 international organisations or committees".
As a detached and critical observer, I must ask myself: why is it that such formidable brain power is applied to such a potentially boring matter as the curbing of financial abuse or the reduction and possible elimination of systemic risk? Where is there a similar powerful conference, a similar intellectually strong book on how to control petty crime, which is so much more relevant to the average man or woman in the street?
Davies admits: "The concerns of the regulated have been articulated more clearly and vociferously than the concerns of those in whose interest the system is designed." I assume he means that the latter group of people, that is the investors, do not seem to be particularly interested in the huge legislative effort made on their behalf. Dare I cynically suggest a blatant case of Aunt Agatha? Nephews and nieces are terribly worried about someone abusing Aunt Agatha's trust if she happens to be a wealthy woman, but much less so if she lives on the basic state pension. Aunt Agatha herself would probably best like to be left in peace, but to have quick and effective recourse to justice should she ever need it.
No matter what the common man or woman may think, those responsible for public policy in the developed world, such as the contributors to this book, believe that financial regulation is necessary to minimise systemic risk and to protect investors. Where differences between them arise is whether to aim directly at global supervision, and how best to align the regulatory framework along the lines of supposed domestic sovereignty. Furthermore, there are cultural differences between the continental European philosophy of regulation, based on ex ante capital hurdles, the UK rule-based conduct of business approach and the US ex post incentive-based approach (as discussed by Colin Mayer).
Only four countries in Europe, according to Amelia Fawcett, have a single regulator. The others prefer segmentation, which by definition leads to regulatory arbitrage. The problem with a single regulator is that, in the FSA chairman's words: "Running a single regulator is rather like having a skip in front of one's house in London. All the neighbours dump things in it before you get around to using it yourself."
Two major issues are peculiar to the Financial Services and Markets Act, which came into force in the United Kingdom on December 1 2001. These are: the approved persons regime, leading to the contemporary regulation of companies and individuals, well analysed by Colin Bamford and Sir Adam Ridley; and the, as yet untested, possible conflict between UK regulatory discipline and the European Convention on Human Rights, well covered by Daniel Waters and Martyn Hopper.
To my surprise, some of the contributors who preach controls do so under a strong emotional urge. Rahul Dhumale of the New York Federal Reserve Bank writes: "Systemic risk is to financial markets what dirty smoke is to the environment. In calculating the cost of production, the factory owner rarely accounts for the costs which the smoking chimney imposes on society... The result is pollution.... Consequently, similar to pollution, investors in free markets may participate in excessive risk-taking."
This is pure distilled emotion. Dirty smoke is a voluntary act. Where is it demonstrated that the trigger for unwanted systemic risk is a voluntary act? And that the trigger is necessarily excessive risk-taking by one or more investors or intermediaries? A few sporadic incidents do not make a proof. Dhumale is presumably well versed in mathematics, as a faculty member of the Judge Institute at Cambridge, but how can he judge whether investors are taking "excessive risk" with their money? Pushing the argument further, are people going to be prevented from engaging in dangerous sports or dangerous research just because they might endanger future cash flow for their dependents or the Inland Revenue?
Dhumale refers with some sympathy to the case for mandatory subordinated debt for banks. I have been for many years at the receiving end of investment bankers' sales pitches for subordinated debt. I find it ludicrous to assume that the pricing of such instruments may better reflect risk than the pricing of banks' equity.
In this regard, a statement by Davies caught me by surprise: "The view that the Bank of England may take on the appropriateness of lender of last resort support is not influenced by any responsibility for the continued supervision of the institution." I was under the clear impression that the concept of "lender of last resort" had been buried a long time ago under ten feet of solid earth and that the most we would see central bankers do would be to flood the market generally with liquidity, as happened in anticipation of Y2K. Is this a misapprehension on my part or revisionism by central bankers?
In the chapter about continental European regulation, one misses a clear warning about European central banks. Left without a proper daytime job and unwilling to contemplate unemployment or turning themselves into statistical bureaux, European central bankers may be tempted (some have already succumbed) to meddle with competition and promote national "champions", as in the bad old days of strong trade unionism.
As a former practitioner and a former part-time regulator during the much-maligned era of self-regulation, I enjoyed this book. But I am far from convinced that the current framework for worldwide regulation of the financial services industry is effective. Let me close by stating my chief reasons.
First, to quote from Mayer's contribution: "One study of the growth rates of industries in different countries reveals that information disclosure and protection of minorities increase growth and investment in some but not all industries. The main route through which financial systems influence activity in developed economies appears to be via research and development rather than fixed capital formation." I fear an unholy alliance between financial services operators and regulators in making the financial services industry seem more important than it really is.
Second, there is a fashion for translating every problem into a money issue. Thus anti-money laundering legislation will supposedly curb crime and terrorism. In my view, fighting crime and terrorism head on with adequate police and judicial systems is what is really needed. Hiding behind formal controls of sporadic effectiveness and the occasional confiscation of a small fraction of crime-related assets will delay the day of reckoning.
Third, the smart kids in investment banking just give up when the regulatory terrain is too hostile and move on to the next underregulated profit opportunity. These days they no longer bother with credit, market or operational risk.
Finally, speaking as an investor, I do not want to spend my time reading investor protection literature. If I had to start again as a 24-year-old in today's regulated financial services industry, no amount of greed would get me to risk reputation and freedom just because I may have forgotten one paragraph in the rule book - even with huge compliance departments to help me on my way. Even those who write the rules cannot know them all by heart; it is not humanly possible. I would rather go and build bridges or aircraft. By comparison with the laws of financial regulation, the laws of physics and engineering are few enough, internally and externally consistent and easier to remember.
Rudi Bogni is a former investment and private banker, currently a director and trustee of several companies and foundations and chairman of the international advisory board, Oxford Analytica.
Regulating Financial Services and Markets in the 21st Century
Editor - Eilís Ferran and Charles A. E. Goodhart
ISBN - 1 84113 9 9
Publisher - Hart
Price - £45.00
Pages - 345