The right way to regulate financial services

Robert Peston reports the Conservatives' new proposal for financial regulation. I'm not a fan of the title: "Proposal for sound banking" sounds like a "proposal for secure borders" or "proposal for safe streets after 11pm": the choice of language prejudices the solution.

But to be fair, every policy document has to be marketed to the voters. So I will try not to make assumptions about the content. Note that I haven't read the document, as it has not been published yet. But the Tories' embargoes are less strict than the government's [I still have an unpublished draft blog posting from two months ago based on Peston's accidental release, seven hours early, of the Treasury Select Committee's report on the banking sector], so he has been able to outline most of the key details of the document in advance of its release.

A simple summary:
  1. Macro-prudential regulation transferred from the FSA to the Bank of England, creating a new Financial Policy Committee
  2. The FSA's remaining consumer regulations supported by Thaler & Sunstein's proposal to electronically publish all details of credit card and other financial contracts
  3. Consider forced demergers of banks that are too large from a consumer point of view
  4. No Glass-Steagall-style separation of investment and regulated banks, but higher capital requirements on "risky" activities which should discourage excessive investment banking by deposit-insured retail banks.
Peston raises a few interesting questions about the medium-term future of the FSA and its staff, but I'm going to go in a different direction in this discussion. My concern is not the details of which of Lord Turner or Mervyn King can claim to be more powerful than the other; it's about the behaviour and incentives of participants in the financial markets.

The behaviour of bank employees is one thing; the behaviour of financial regulators is another; but both are a red herring. Banks and regulators make, on balance, only a marginal impact on market outcomes. Despite Brad DeLong's suggestion, banks are only slightly long on financial assets; the rest of the population have much more to worry about in the value of their savings assets than banks, and the rest of the population are also mostly the ones who borrow. The banking sector as a whole has a small net positive position on financial assets, while everyone else is divided into two groups, one with a huge ($50 trillion maybe) asset and one with a nearly equally vast liability.

(Incidentally, and again a propos of DeLong, this illuminates just why the financial bailout was politically irresistible: never mind the banks, it's 50% of the population whose assets were at stake. More to the point, it's about 75% of the likely voting population; and the loss aversion of savers is far stronger than that of taxpayers.)

The real point of financial regulation is to understand and influence the behaviour of the investors, depositors and borrowers who make up 99% of the population, not the bankers who make up 0.1% of it. How should we do that?

Thaler does have some valuable insights into this; and his proposal for transparency of consumer financial products is a good start. George Osborne has done well to pick this up. But it's only one of many possible directions.

A general theory of consumer finance behaviour is what the regulator really needs to understand and influence the sector appropriately. One simple example: to analyse the property market, add up the total relevant financial investments of all parties who are long on property, net off against those who are short, and compare it to the total market value of all real property assets. I suspect you'll find that - in 2006 at least - the net long position of financial investors in property exceeded the actual value of real estate against which the assets were secured.

On a smaller scale, examine the risk preferences of individual equity investors - for instance as proposed in this article - and compare to the actual potential financial returns of the equities they hold. If there's a discrepancy, that's the real explanation for financial risks and never mind trying to control the behaviour of the stockbrokers.

The Conservatives might have some valid ideas about the UK's regulatory triangle, but they aren't going to make any difference until the behaviour of consumers is incorporated. And regulating that is a much more subtle question. At least I hope it's subtle: anyone who wants to call out "debt is the problem" had better be willing to explain exactly what the right level of consumer debt is, relative to GDP, and justify their figure.

The electoral arithmetic must surely point the same way: how many voters in swing constituencies are going to choose the Conservatives because of their plans to transfer macro-prudential regulation from the FSA to a newly consituted committee within the Bank of England? If this is going to be a political issue, it's time to engage - intelligently - with the question of how we all lend and borrow economic resources from each other through the medium of finance. It's not an easy political fight to pick, but it's about the most important one there is.


Ollie said…
A general theory of consumer finance behaviour is what the regulator really needs to understand and influence the sector appropriately.

But surely the sector (read banks) have been shaping this model with cheap credit and therefore distorting the consumers (read voters) view of any of the markets for years.

No political party is willing to tell the consumers (voters) they can't afford there house\car\life style...

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