Why regulate securities?


In this talk, John describes some of the differences between an economic approach to regulation – concerned with indentifying market failures – and how markets mechanisms can be best adapted to deal with them. He contrasts this with the legal style of regulation which has been the historic basis of monitoring financial services. The conclusion is that we might manage our financial services better if, in inventing the regulation, the role of economists were greater.

My topic is ‘why regulate securities’? As I look at the audience I see six people from the Financial Services Authority, and almost as many from the Takeover Panel. I can sense that there is already some nervousness about what I might conclude. Let me therefore begin by offering some relief. I have no doubt that there are good reasons for regulating the securities industry. However, I think we will do the job of regulation better if we focus attention rather precisely on what these reasons are.

Geoffrey began by referring to what I said on this subject ten years ago. I don’t always continue to think what I did ten years ago. But I was rather pleased that the quotation Geoffrey made was one to which I still subscribe. What I have to say today will be an elaboration of that.

My professional and academic interest in regulation has been as an economist, and has extended over the last fifteen years. My principal interest during that period has been in the regulation of utilities, my interest in the financial services industry and its regulation has been secondary. But we should begin by noting that these are the two largest groups of regulated industries in the United Kingdom and, indeed, in most other countries.

For an economist there is one key difference between financial services regulation and utility regulation. It is that utility regulation was to a very large degree invented and is today run by economists, while financial services regulation was invented by, and is still very largely run by, lawyers. I think a key question to examine is whether this follows from differences in the nature and objectives of regulation in the two industries. Or whether this difference – which pervades style and structure – is simply an historic accident.

The difference goes back to the beginning of modern regulation of these industries. The present structure of regulation in the UK was largely set by two reports which the government commissioned in the early 1980s. The report that was relevant to financial services was written by Jim Gower who was a Professor of Law. The report that was germane to the regulation of utilities was written by Steven Littlechild, a Professor of Applied Economics. And fundamental differences between legal and economic approaches to regulation emerge immediately from a study of these reports. It was axiomatic for Gower that financial services regulation was required and the issues were simply those of the most appropriate form. For Littlechild, however, the objective was to establish a regulatory regime that would be self-destructive – the purpose of regulation was to create a market structure in which regulation was no longer necessary. And although the telecommunications industry with which Littlechild was concerned has required more regulation, and longer regulation, than he envisaged, it is nevertheless true that one can see a day ahead at which much less regulation of telecommunications will be needed.

So a primary objective of utility regulation, not just in telecommunications but in other industries, has been to alter market structures. This has been to increase competition, to allow the access of new entrants, and to secure reductions in the market share of established incumbents. Utility regulation is deeply concerned with its effect on market structure. This is very different from the way in which financial services regulation operates. Indeed for a financial services regulator it is almost considered improper to ask the question ‘will this rule advantage some firms relative to others?’ That is true although practically every regulation will operate to benefit some firms in the industry relative to others. The lawyer starts with rules and the consequences for market structure fall as they will. The economist is concerned and largely guided in determining his rules by what these consequences for market structure will be.

It is almost axiomatic for those engaged in financial services regulation that its objective is to ensure high standards of behaviour and/or appropriate productions for the customers of financial services. Let us suppose, for the moment, that our question today was not ‘why regulate financial services?’ by ‘why regulate hamburgers’?

Now we don’t regulate the sale of hamburgers very much. The main purpose of our regulation is to ensure that poisonous hamburgers are not put on the market. The regulations which we impose are almost entirely confined to that. There is no suggestion that regulation should ensure that the hamburgers we eat are nice. We don’t seek to impose regulation to ensure that people buy only hamburgers that are appropriate to their tastes and their state of hunger. We do not in any way regulate the price that people pay for their hamburgers. We would not dream of asking the question whether obtained best, or even good or any advice when they make their decision to purchase a hamburger.

The fact that people find this question amusing shows how big a difference there is between financial services regulation and hamburger regulation. Take another product. How do we regulate carpets? Not at all is the basic answer. We are satisfied with the general rather modest regulation of trading standards, which is designed to prevent misdescription. There is no specific carpet regulation. There is no Office of Carpet Supply, whose purpose is to maintain high standards of behaviour in that trade.

Why the difference? Is it that financial services are more important, even more dangerous, that hamburgers or carpets? I am not so sure. More people died last year from tripping on badly laid carpets than as a result of pensions misselling.

Of course, we can these analogies only so far. But we do actually have to ask the question “why regulate financial services?” Why is it that in this industry we have special rules, special agencies and special legislation. There are a few others, such as utilities, in which we have rather focused and targeted regulation. But the majority of industries have no provisions other than the general ones of commercial law and competition policy. Let me try and answer the question “what is special about financial services?”

The first thing that makes financial services different is that the financial services industry is one which is particularly attractive to crooks, because money is the product which is being sold as well as the medium in which it is being bought. Of course, we do have general legislation against thieves. In addition to general rules against theft, we also perceive a need for preventive activity. We are not content with having a rule and a law which says I am not allowed to burgle your house. We employ police to patrol the streets, and one of the objectives of their patrolling is that if I walk along the street in a stripey jersey carrying a bag labelled swag and waving a jemmy in my hand, it is possible to act to prevent the crime before it is actually committed. So preventive activity of this kind is a central objective of financial services regulation. It is not that there is anything unique about financial services, simply that financial services are particularly attractive to people of a criminal disposition and the kind of crimes which are involved are of an unusually sophisticated nature.

However this prevention of criminality is a small part of the totality of financial services regulation, also a relatively uncontroversial one.

The second special feature of financial services is that financial service industries are subject to systemic risk. There is something here which really fundamentally differentiates financial services from curtains, carpets and hamburgers. It is the possibility of contagion across different financial services firms and different financial services institutions. A badly run bank fails and this affects not only the badly run bank but all other banks. This means that the financial services industry has potential macroeconomic consequences as a result of its behaviour in a manner that is not true of the other industries I have been describing.

A third, and central reason for regulating financial services is that financial services activities are particularly prone to issues of asymmetric information. I can best explain this piece of economist’s jargon by giving an example. How much would you be willing to pay me for the money which is in my wallet? You might start by asking how much someone coming in to the City on a day like this is likely to have in his wallet? May I invite offers on that basis? Anyone bid £30? £40? £60. Geoffrey Turner, chairman of the meeting, offered £60. Anyone willing to bid more?

I am not going to accept Geoffrey’s offer. Think for the moment about the implications of that. The reasons why I won’t accept Geoffrey’s offer are simple. I know how much money I do have in my wallet and it is slightly more than £60. I went to the bank yesterday, and as a result I have £90 in my wallet. Had I been offered £100, of course, I would have accepted. The force of the example is that the only circumstances in which you will get my wallet are those in which you are offered more than the amount of money which is actually in it. In other words, having your offer accepted reveals that you are making a mistake. No-one ought to bid in an auction of this kind, because the only basis for trade is your misinformation.

You may think this is a very artificial example, and in a sense you are right. But actually, there are elements of the issue I have described in almost every financial services transaction. One side is better informed about the value of assets or securities than another, and trade mostly takes place because of differences and expectations about what the true value of the underlying asset or security is.

This kind of thinking in economics has developed a good deal in the last twenty years. Another illustration of the wallet problem is the one known as the market for lemons. What is meant by a lemon here is not the yellow things you squeeze into your gin and tonics. These were the days before the Japanese had taken over the car industry and a lemon was the type of car which was made after the workers had spent Friday lunchtime in the pub; one which kept having minor faults throughout its life.

The point about the market for lemons was the following. The price of secondhand cars will clearly reflect the knowledge the some cars which will be on sale are lemons. The person who is selling the car knows whether the car is or is not a lemon; the buyer does not. If the price reflects the average probability of lemons in the population, it is a price at which it is rather attractive for people whose cars are lemons to sell, one which is correspondingly unattractive are for those who know that their cars have no comparable problems. The result, of course, is that the proportion of lemons in the cars which appear in the secondhand car dealers will be higher than the proportion of lemons among the cars on the road.

The result of that would be that the price of secondhand cars would fall, and the proportion of lemons among those that are on the market would increase. What we would expect to see is a rather imperfect market in which prices are rather low and many of the cars in that market are defective. What we should recognise is that this is a widespread experience which people have of dealing in secondhand cars.

That gives us three groups of reasons for regulating financial services. None of them are completely unique to financial services, but all of them are found in that industry in relatively extreme form. They provide a basis for my economic approach to regulation. That is to say that the purpose of regulation is not to promote high standards of conduct and excellent customer service. It is to remedy the specific ways in which the market fails – in contrast to most industries – to deliver the goods and services which people would like. So let me turn to what is involved in regulation to deal with each of these issues.

I need say little more about preventive activity in deterrence of criminality. The regulation which is required here for the bulk of financial services activities is pretty limited. It is limited because most of these activities are conducted by large firms which have the same internal incentives to prevent this kind of activity as does the regulatory system as a whole. Indeed, if there is a problem it is the same problem for the firm as for the regulator – the incentive rests with the firm rather than the firm to act here as individual manager. Cases of successful fraud evolved from inadequate vigilance by surrounding managers.

There is an important implication of this. Generally, competition and overlapping jurisdictions among regulators is seen as undesirable. But the truth is that in relation to the detection of impropriety, competition is important, and rather effective. The fear of external intervention and external consequences gives firms strong incentives to ensure that their own internal standards of probity are high.

Let me turn again then to systemic risk. There is indeed a problem here. But the number of financial services business whose failure would raise major issues for the financial system as a whole is actually a rather small number of firms in rather limited areas of the business. We might take as example what is perceived as the largest regulatory failure in this area, which is the collapse of Barings. The question which is most often asked is what can be done to prevent another failure like this. We might better ask the question: why was it necessary or desirable to regulate Barings at all? Because in the Barings case the feared systemic risk did not in fact arise. Even if the deposit taking activities of Barings had failed – which in the end they did not – this would not have provoked, and the possibility that these activities might have failed did not provoke, substantial problems for other institutions. I believe that the number of institutions which pose real issues of systemic risk for the British financial system is actually relatively small, probably less than 10; almost certainly all of these are in that group because they have large retail deposit taking businesses. Another, and perhaps more appropriate, way of dealing with this would be to require such institutions to have fire walls between a retail deposit taking activities and their other businesses.

I have emphasised that information asymmetry is a feature of financial services. Of course, in a complex modern world there is information asymmetry in relation to almost all the transactions we engaged in. I talked earlier about carpets and hamburgers and just as it is true in financial services that people who sell them know more than the people to whom they are selling, that is equally true of these industries. Buy carpets and hamburgers from manufacturers and even sales people who know more about what they are doing that we do.

So what gives you protection in carpets and hamburgers? The answer is that reputation and branding are the normal mechanisms by which the market deals with problems of asymmetric information. This is important. I deal with information asymmetry in these industries not by obtaining very large amounts of information about the technical characteristics of the carpets or the hamburgers that I buy but by focusing on more limited aspects of information – the characteristics of people and institutions which are selling them. Information asymmetry, in short, is typically dealt with by branding and reputation rather than by bombarding customers with information.

There is a difference between this solution and what has recently been the normal regulatory response to recognise issues of information asymmetry. I deplore the fact that consumers are badly educated about personal financial services and assume that what we need to do is to make providers explain the products fully to them.

You all know what that means. The IFA arrives and says that he is obliged to hand over a sheet of paper, which consists of a lengthy description of different types of financial intermediary, then says I have to go through all this. When the product has been sold the bottom half of the sheet of paper which describes it contains a good deal of incomprehensible information in very small print.

Of course the reason people buy intermediary services in the first place is that they have neither the time nor the inclination nor possibly the ability to assimilate information of this kind. The way in which we regulate doctors for example is not of this kind. We do not wish to be lectured about the doctor’s status and qualifications at the beginning of the consultation, nor do we wish at the end of it to have the possible diagnosis and the risks and probabilities associated with each. What we want from a doctor is advice from somebody we can trust. What we want from a financial intermediary is the same thing.

The problem which we all recognise is that of course in many instances consumers did not get it. Not just from the kind of dodgy dealers we see in the used car business but also from established firms which had reputations that had not been earned or deserved either by the quality of the product or the quality of advice which customers were receiving. A great achievement of regulation in this period has been to make it very much harder for firms to have unearned reputations.

I applaud this kind of regulation which goes with the grain of the market. It is not trying to second guess the market but trying to make sure that market mechanisms, which in this area depend on brands and reputation, actually work better.

The effect of this kind of thinking is largely to internalise the detail of regulation. To rely rather more on the reputation of firms, and rather less on detailed rules prescribed across the board for all firms. To pursue a framework which is less detailed and less bureaucratic. Most of us would, I believe, favour that, although we need to understand that there is a central conflict between people’s expectations of clarity and certainty in regulation and their desire not to be burdened with a great deal of detail.

But these issues of style of regulation are bigger than I have time to deal with this afternoon. What I have sought to do is to describe some of the differences between an economic approach to regulation – concerned with identifying market failures – and looking at how market mechanisms can best be adapted to deal with them more effectively and contrasted it with the legal style of regulation which has been the historic basis of monitoring our financial services. You will not be surprised if I conclude that we might manage our financial services better if the role of economists in inventing a regulatory framework for them were rather greater.

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