Trust has lost all of its value in our state-regulated financial markets

Philip Booth
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THE spotlight in the Libor rate-fixing scandal has moved. Questions are being asked about the culpability of the FSA, which may well have ignored repeated warnings about Libor calculations from market participants. The role of the Bank of England and the Treasury is also being questioned.

Of course, regulators are not to blame for the actions of those at Barclays and elsewhere. However, we need to question the narrative that this problem all began with “deregulation” and then the development of “light-touch regulation” under Gordon Brown.

Given the millions of paragraphs of financial regulation and the existence of more than 3,000 compliance officers at large banks such as HSBC, we can dismiss the idea that we have light-touch regulation. But, those who suggest that there has been deregulation are not wholly wrong. More things are permitted these days – but those things that are permitted are more highly regulated.

The key question though is not how much regulation there is, but “who regulates?” Perhaps the most important change in the 1980s was not deregulation, but a move from regulatory institutions that emerged within the marketplace to statutory regulation.

When Elinor Ostrom, the late Nobel Laureate, visited the Institute of Economic Affairs last March, she was interested in the analogy between financial regulation emerging in the market and community management of environmental resources. She was fascinated by the fact that, when the stock exchange first started in a coffee shop, those who did not settle their accounts were put on a board under the heading “lame duck”; the exchange expelled people for bad behaviour; and it made the rules for companies that wanted a listing and for individuals and companies involved in trading. In order to prevent conflicts of interest, on the London exchange, companies could not trade on their own book and also give advice to clients. The motto became “my word is my bond” and the untrustworthy would not get business. This all ended with a transfer of regulatory authority to the state.

Other such mechanisms developed in banking. Mutual societies, trustee savings banks (TSB) and unlimited liability partnerships all developed to promote trust in an era where there was often no regulation and no protection. Trust and reputation were very important when promoting a brand. Governance mechanisms that led firms to be technically inefficient were often valued because they promoted trust.

There is evidence that the development of deposit insurance and the greater government oversight of the activities of financial institutions undermined the attractiveness of these institutions so that, when they were free to turn into proprietary banks, they did so. Some of these institutions were literally destroyed by government. The TSB had no defined ownership, so had to be nationalised in order to be privatised.

A reputation for prudence came to have no market value and, naturally, most institutions became big, remote, shareholder-owned institutions operating at the level of maximum technical efficiency – nothing else mattered. Of course, any institution that is “too big to fail”, and which is therefore able to take one-way bets with other people’s money, also attracts exactly the wrong sort of people into the industry.

We must reverse the trend. We should abolish deposit insurance and ensure that the providers of capital suffer the losses when banks fail. Prudence must matter when we decide to whom we give our money. Financial regulation must again be allowed to evolve within the market. A start could be made if politicians resisted regulation of new sectors such as peer-to-peer lending. Economist Tim Congdon has also suggested that the Bank of England could be the regulator of the banking system on a contractual basis in return for lender of last resort facilities: those not wishing to avail themselves of that facility could be unregulated. This may help too.

The polycentric institutions of governance that grew up in financial markets have been destroyed. Starting again will be difficult, but the alternative of statutory regulation is not working.

Professor Philip Booth is editorial and programme director at the Institute of Economic Affairs and professor of insurance and risk management at Cass Business School.