The Contradiction at the Heart of the Financial Services Authority (FSA)

Imagine you are the parent of a young child. Because you are a little cruel, you decided to name your child ‘the financial sector’ (or TFS for short). TFS goes to a nursery, which has been somewhat strangely named the Financial Services Authority (FSA) nursery. Arriving at the nursery to pick up TFS, you discover that the staff who you had entrusted with keeping little TFS safe were doing no such thing.

Understandably angry, you approach the head of the FSA nursery, one Lord Turner, and demand to know what the staff think they are doing. ‘TFS is perfectly capable of looking after himself’ he replies. Now you are really mad. ‘So if TFS is able to look after himself, what on earth am I paying you for?’

Unfortunately, the previous paragraphs pretty much sum up the FSA approach to regulation pre 2008. In 2009 the FSA published the Turner review, in which Lord Turner outlined the philosophy behind the FSA’s regulatory stance (pre 2008):

1.       ‘Markets are in general self correcting, with market discipline a more effective tool than regulation or supervisory oversight through which to ensure that firms’ strategies are sound and risks contained.

2.       The primary responsibility for managing risks lies with the senior management and boards of the individual firms, who are better placed to assess business model risk than bank regulators, and who can be relied on to make appropriate decisions about the balance between risk and return, provided appropriate systems, procedures and skilled people are in place.

3.       Customer protection is best ensured not by product regulation or direct intervention in markets, but by ensuring that wholesale markets are as unfettered and transparent as possible, and that the way in which firms conduct business (e.g. the definition and execution of sales processes) is appropriate.’ [1]

This philosophy, in a nutshell, is the belief that markets are efficient. In some markets this may be a reasonable assumption to make. However, financial markets are fundamentally different from most markets. They are primarily involved in the collection of information, specifically assessing the risk and return of various projects. The important point is that if this information is imperfect, the resultant outcome may not be (pareto) efficient, unlike in competitive markets with perfect information.

Yet, despite the well known differences between financial markets and textbook models, the FSA had faith in the markets, the incentives, and the ability of the key players to manage their own risk. But this creates a contradiction. How can the organisation placed in charge of regulation believe that regulation is not required? Did they not understand their own jobs?

The problem was a failure to grasp the interconnectedness of financial markets. As Stiglitz puts it; ‘managing ones own risk, from the perspective of maximising the value of the enterprise, is what financial institutions are supposed to do. If that were all there were to the matter, there would be no need for regulation’.

However, that is not all there is to the matter. Regulations are required for several reasons, including  investor protection, competition and ensuring continued access to credit. However, for our purposes, the most important reason for regulation is the potential for large, negative externalities. An externality occurs when two agents engage in a transaction that has an (unrequested) effect on a third party which is not fully transmitted through the price system. Due to the interconnectedness of the financial system a bank going bankrupt could create systemic effects (a  negative externality), not just on the financial sector, but on the on the economy as a whole. Bank managers cannot calculate these social costs, nor do they have any incentive to.

Even in a financial system without ‘too big to fail’ banks, where banks can perfectly judge their own risk, bankruptcies, bail outs and the associated negative externalities can still occur. This is because banks can, and do, engage in correlated behaviours – whilst an individual bank may not be systemically important, a group of such unimportant banks, unintentionally acting in unison, may have systemically important behaviour.

For example, a bank may use a computer system which determines when to buy and sell a stock. If all the banks are using a similar system, and the computers tell them all to sell at the same time, the price of the stock would drop like a stone. Thus correlated behaviours can produce instability, and the interdependence of financial institutions can lead to a ‘cascade’ of bankruptcies. Unfortunately the FSA’s belief in efficient markets lead to ‘a focus on the supervision of individual institutions rather than on the whole system’ [1].

However, the FSA’s legal framework also directly undermined their purpose. The Financial Services and Markets Act 2000 (FSMA) [2] include within it ‘principles of good regulation’, which guides regulators as to what regulations should take account of. Principle number four states:

4.       ‘Innovation: The desirability of facilitating innovation in connection with regulated activities. Involves allowing scope for different means of compliance so as not to unduly restrict market participants from launching new financial products and services.’ [2]

Did the FSA not understand the nature of the innovation which was occurring in the Financial Sector? Much of it was directed at circumventing regulations/accounting standards, exploiting borrowers, or avoiding taxes [1]. A direct example of such an innovation would be collateralised debt obligations. The Link explains how this financial innovation manged to turn sub-prime lending into triple-A rated assets. Even in the cases where these innovations did create some small benefits, the increase in instability and the obscuring of risk should have seen the FSA put a stop to it.

The problems with the FSMA’s ‘principles of good regulation’ do not stop there. Principle number six states that any regulation must take account of:

6.       ‘International character: The international character of financial services and markets and the desirability of maintaining the competitive position of the UK. We take into account the international aspects of much financial business and the competitive position of the UK.’ [2]

It is not hard to see how the desire to keep the financial sector internationally competitive could lead to banks becoming ‘too big to fail’. After all, in order to be competitive internationally a bank would need a solid base from which to build on i.e. a large domestic market share.

Whilst I have been highly critical of the FSA approach to regulation, as we have seen the FSA’s mandate was unclear – it was asked to regulate yet keep banks profitable and competitive. It was also not alone in its mistakes – many other regulators made similar errors. What is more it has now acknowledged many of its own failings. However this does not excuse its philosophy, which was a contradiction of its role – we do after all have regulations for a reason. Furthermore, in an uncertain world the emphasis should have always been on safety first, especially in a sector which is so essential to the rest of the economy.

A full reserve system would solve many of the problems outlined above. Full reserve banking would decrease the likelihood of an asset price bubble (and therefore a financial crisis), as private banks would no longer have control of money creation. A full reserve system is also inherently safer than the current system, as risky assets cannot be paired with risk free deposits – thus bailouts become unnecessary. In this scenario regulation becomes less critical, as the rules of the game have been set up correctly – making the system inherently safer.

References

[1] The Turner Review, A regulatory response to the global banking crisis, March 2009, FSA.

[2] The Financial Services and Markets Act 2000

[3] Interpreting the cause of the great recession in 2008. Joseph Stiglitz. Lecture to BIS conference, Basel, June 2009