Terry Arthur: Does Britain need a financial regulator?

Terry Arthur is a Fellow of the Institute of Economic Affairs and co-author, with Philip Booth, of Does Britain need a Financial Regulator? which is published today by the IEA.

In 1997 Gordon Brown removed the so-called “self-regulatory” system for financial services under the Securities and Investment Board and created the Financial Services Authority (FSA). The name is all; in fact the “self-regulatory” system consisted of regulatory monopolies ultimately responsible to the Treasury which were a million miles away from market-based regulation which springs up whenever there is a need for it. We forget that before the creation of the “self-regulatory” system in 1986, regulation of investment markets was undertaken by private bodies – and that they were very successful.

Predictably, the FSA has grown into a monstrous gung-ho state monopoly. It has powers to bankrupt and destroy individuals and financial firms in ways that are arguably outside the rule of law. Whilst the Stock Exchange’s motto was “My word is my bond”, the FSA’s appears to be “The more the better” as it hails chalking up “successes” or “results” and writes rule-book after rule-book with no economic rationale for its bureaucratic approach.

To achieve this, the FSA needs staff and funds; the former numbers over 3,000 (50 per cent up since inception) and the latter has more than doubled in the last six years. Is it any wonder that you can borrow with no fuss and bother, but in order to invest you face a mountain of form-filling, as does your appointed fund manager under the “know your client” rules? (If retailers such as shoe shops had to operate under the same strictures they would be heavily fined for selling carpet slippers to somebody who doesn’t have a carpet.)

Our monograph concentrates largely on investment services and particularly on stock exchanges. The picture is the same all over the world. Until about 100 years ago, stock exchanges were a clear symbol of freedom, with sophisticated rules which benefited both users and proprietors alike, the essential point being that companies who wanted a listing on a stock exchange had to accept that an exchange needs investors who are happy to use it! Companies want to list where the cost of capital is lowest and the cost of capital will be lowest – all other things being equal – on the exchange which has the best set of rules. This simple fact appears not to be acknowledged by the FSA.

In the United States a book has just been published with the title “The case for legalizing capitalism”, demonstrating that the US can no longer be associated with capitalism. The FSA’s equivalent, the SEC (Securities and Exchange Commission), came about after a false attribution of the causes of the Great Depression (plus ca change) and if anything is more fearsome than the FSA. Trading and investing in shares in the US – a key characteristic of capitalism – is heavily controlled by the state. The UK is not far behind.

A growing area of investment regulation comes from the European Union, whose tentacles cover both information provision and market conduct. In most cases the Directives to date shun the potential for competition between stock exchanges in favour of uniformity and compulsion – sad but hardly surprising.

Thus a Market Abuse Directive was implemented in 2005, covering (as per the UK) insider dealing and market manipulation. Yet, as our monograph shows, state regulation of these areas is not necessary. As is pointed out in another IEA paper on “Regulation without the State” (Readings 52) by leading US law academic Richard Epstein, “for a company to legitimize insider trading all it needs is a provision in its charter saying ‘if you want to deal in the shares of its company, please understand that every employee and every director is entitled to trade on inside information to their heart’s content. If you do not want to trade with us you are free to buy shares in our competitor which doesn’t allow that option’”. Precisely. Exchanges and companies’ own articles can deal with these problems. Exchanges want companies to list and investors to trade. They have every incentive to develop appropriate regulations – and history shows that they will do so.

We hope that readers will agree that our monograph has shown conclusively that markets trump the State even in regulation-making. Statutory authorities (ultimately accountable to politicians) have no incentives to strike balances, let alone discover them.

We argue that the simplest solution for the government would be to abolish the FSA altogether. Our proposals with regard to investment markets would remove the heart of the FSA, which can then be disbanded. The Bank of England could regulate those banks linked to the payment system – other regulatory functions are unnecessary.

Whilst in principle we would promote the return of regional stock exchanges as suggested recently by Vince Cable, this should only be a very first step and they should be entirely free of statutory financial regulation – a position that was hinted at in the Lib Dem manifesto. However, the government should not stop here – this liberty should then be extended to the rest of the investment market.