Rolling the rock: The cycle of deregulation, crisis and regulation

Speaker: Charles Randell, Chair, Financial Conduct Authority
Location: AFME Annual Conference, London
Delivered on: 2 October 2018

Highlights:

• The cycle of deregulation, crisis and regulation is particularly damaging.
• The most important way to avoid a damaging cycle of deregulation, crisis and regulation is to keep an open mind about the shortcomings of our existing rules.
• We need to have the humility and the confidence to acknowledge that we do not always know best and that our past decisions have not always been optimal.
• We should try to ensure that the total programme of regulatory change is phased and coordinated in a proportionate way.
• The FCA does not see the UK’s withdrawal from the European Union as an opportunity to join a race to the bottom in regulatory standards – quite the contrary.

Note: this is the speech as drafted and may differ from the delivered version.

The Greeks know a thing or two about financial crises. So it’s fitting that Greek mythology gives us the story of Sisyphus, condemned to roll a huge boulder up a hill, only for it to roll down again before it reaches the top, repeating this action for all eternity. His sins, you may recall, were trickery and arrogance, two words which don’t – as far as I know – appear in the FCA Handbook. But perhaps they should: they are strong indicators of serious problems in a financial firm.

The myth of Sisyphus is a good metaphor for the cycle of financial deregulation, crisis and regulation that societies have gone through again and again. After each crisis, we bring in a weight of new regulation. We push it up the hill to implementation. And then we deregulate. And then a new crisis starts the process all over again.

Are we condemned to repeat this for eternity, or can we break the cycle? It’s the right time to ask this question, for two reasons.

First, the worst of the global financial crisis is now ten years behind us. I can remember what I was doing 10 years ago as if it were yesterday, in a team responding to the imminent collapse of numerous global banks. It’s not something I want to repeat, although I was one of the lucky ones.  For me, the crisis was a professional assignment, but for many people it brought personal tragedy: loss of their jobs or businesses, loss of their mental or physical health, and in some cases loss of their lives. Now some memories are beginning to fade, and there are voices calling for deregulation again.

And secondly, as the UK leaves the European Union, we may have some choices to make about exactly how to achieve the regulatory outcomes we need to continue to deliver.

Deregulation and crises

An IMF Working Paper earlier this year summarised some of the many episodes in financial history when deregulation, or liberalisation as it is sometimes called, led to a financial crisis.

The most obvious form of deregulation is when policymakers repeal existing rules. In the UK, we have seen this kind of cycle in the consumer credit world. The 1974 Consumer Credit Act – one of the most complicated pieces of legislation ever to enter the statute book - was on the one hand highly regulatory, imposing stringent new disclosure requirements, and on the other highly deregulatory, repealing the presumptive cap on interest rates. Then advertising and the internet fundamentally changed the way that some firms and consumers behaved. The rise of a group of payday lenders combining slick advertising with loose affordability criteria and excessive interest rates led to widespread consumer harm and the eventual re-imposition of a cap in 2015.

But another form of deregulation is when policymakers decide not to apply existing principles to some apparently new financial innovation because ‘this time is different’. This allows the industry to deregulate itself by diverting financial activities into new unregulated channels. As Reinhart and Rogoff show, this time isn’t different very often. The Great Recession which started in 2008 is only the most recent example of many. The political drive to make home ownership available to more Americans contributed to sub-prime lending flourishing without appropriate regulatory oversight. Loose regulation of derivatives and securitisation structures, hailed as a new way of ‘completing markets’, allowed massive amounts of leverage to enter the sub-prime market. Sub-prime lending contributed to a broader real estate bubble which inevitably burst.

The cycle of deregulation, crisis and regulation is particularly damaging not just because vulnerable people’s lives are hit much harder by financial crises than those of financial executives, politicians and regulators. Constant regulatory change can sap the confidence of the public and industry in the regulatory process. Constant regulatory change can also damage competition: the largest firms with the best lobbyists often seek to influence the process; and the bigger the firm, the bigger its economies of scale in absorbing lobbying and compliance costs. Constant regulatory change can also damage the quality and efficiency of regulation, because the changes are often patched on to the existing regulatory framework, which becomes more and more complex and less and less coherent.

Constant regulatory change can also damage the quality and efficiency of regulation, because the changes are often patched on to the existing regulatory framework, which becomes more and more complex and less and less coherent.

I would like to offer some thoughts about how we should approach our work in the future to limit, if not avoid, this damaging cycle. In doing so, I would commend (to those of you who have not already read it) the FCA Mission publication[1] of last year, in which the FCA under Andrew Bailey’s leadership set out our blueprint for approaching our tasks. It provides a logical and robust architecture which will endure after we have left the European Union.

Keeping an open mind

I would suggest that the most important way to avoid a damaging cycle of deregulation, crisis and regulation is to keep an open mind about the shortcomings of our existing rules. Not all deregulation is undesirable. Nothing is more damaging to the cause of regulators than defending poor regulations if it’s clear that they produce perverse consequences, impose excessive costs that consumers and businesses ultimately bear and prevent innovation from which consumers and businesses would benefit.

We undoubtedly have plenty to do to continuously improve our existing rules and the way we supervise, keeping pace with the opportunities that new technology and new insights offer us and with the way that the financial services industry itself is innovating and evolving.

But given the risk that our rulebook becomes a patchwork, we also need to stand back and take a fresh look from time to time to ensure its overall coherence and consistency. That’s why the FCA has committed to a review of its Handbook as part of the Mission and will take this forward when the time is right, once the post-Brexit landscape is clear and we and the firms we regulate have absorbed any changes resulting from leaving the EU.

As Chair of the FCA, I am struck by the fact that both consumer and industry representatives have many of the same complaints about regulation. For example, they have the same complaints about customer onboarding procedures, disclosures and paperwork requirements. At the same time, behavioural scientists have found that personalised, targeted explanations of key facts to consumers are far more effective at promoting their engagement with financial decisions than disclosing everything there is to know about them in a bewildering sheaf of paperwork.

So I can’t defend all our current requirements and I shouldn’t. As technology changes and as we learn more about shifts in consumer behaviour, we should keep an open mind about the best ways to achieve the outcomes we want. There’s a lot we can do to look at how our rules are working in practice and listen to those who bear the brunt of them – the users and providers of financial services.

So I can’t defend all our current requirements and I shouldn’t. As technology changes and as we learn more about shifts in consumer behaviour, we should keep an open mind about the best ways to achieve the outcomes we want.

As we go about this, we have a great asset: the insight that we get from our independent expert panels and the stakeholder feedback that we receive directly from consumers, businesses and industry professionals in Europe’s largest financial market. So in considering how to improve existing regulations, we need to continue to make full use of this asset, which is a huge comparative advantage of UK financial regulation.

We also need to have the humility and the confidence to acknowledge that we do not always know best and that our past decisions have not always been optimal. Last month the FCA published its first ex post evaluation of the impact of our interventions[2] in the guaranteed asset protection insurance market. We found that our interventions had had a positive overall impact, including significant savings to consumers, but they had less impact in some areas than expected. We can learn a lot from this type of exercise when designing future remedies; and it also makes clear that the best-intended regulation may not deliver all the promised benefits. Ex post evaluation papers will be an important, transparent part of our regulatory toolbox, giving us evidence of where we may need to change tack.

Less can be more

It isn’t possible to generalise about regulation and deregulation. In some areas – such as the area of disclosures and paperwork that I’ve mentioned – we may need different, smarter regulation that’s better at producing the outcomes we want; in other areas we may simply need to use different tools. In that sense, less can sometimes be more.

The FCA has committed in its Mission to choosing the right tools to deal with the harms it sees. Our policy tool – making new rules – is just one of the tools in our toolkit. Sometimes more supervision of compliance with existing rules, and crucially, focussing on outcomes and principles can be a better response; or using our competition or enforcement powers.

Just as governments can tend to prioritise legislation over delivery, regulators can tend to prioritise rulemaking. So we need to make sure that we don’t reach for the rulemaking tool when it isn’t the best response.

Timing and coordination

In a similar vein, there’s a good case for re-examining the way in which multiple and sometimes competing regulatory demands hit participants in the financial sector, often at the same time. Even where only one regulator is involved, there is the risk that the phasing and impact of separate regulatory initiatives won’t be coordinated.

We do not want regulatory changes to inadvertently heighten the risk of operational failures. Firms have finite resources to meet regulatory change demands as well as the need to adapt their businesses in a world of changing consumer expectations and business models. Smaller firms in particular have a more limited ability to respond to our consultations and policy changes, so we need to ensure that our communications and timetables take their needs into account.

That’s not to say that we should go soft on the industry. But we must be guided by the objectives and the principles of good regulation set out in our statute. So we should try to ensure that the total programme of regulatory change is phased and coordinated in a proportionate way.

Evidence based regulation

A strong safeguard against unjustified regulation (and deregulation) is to insist on the sound use of evidence to evaluate policy decisions.

This is an area which is developing fast.

The FCA has for some time been subject to various requirements to conduct cost-benefit analysis and it has very recently published an up to date statement on how it approaches such analysis[3]. However, it’s important to acknowledge that cost-benefit analysis alone can never fully answer questions about whether to regulate or deregulate.

It tends to be narrowly focused on the implementation of one discrete new policy; it may sometimes rest on assumptions which can be contested; and in particular there is always the risk that regulators underestimate the costs of regulation, which are often passed on to consumers. Furthermore, as John Cochrane has said:

‘The biggest costs are unseen: the businesses that didn’t get started, the people that didn’t get hired by those businesses, the innovative financial products that didn’t get innovated, the better lives their consumers would have lived, the improved savings and investment vehicles that would have cushioned risks and improved people’s lives in their old age, the economic growth that didn’t happen.’

These costs are inherently difficult to estimate.

Moreover, conduct regulation is often about quite specific distributional questions rather than overall macroeconomic impacts. One person’s benefit can be another’s cost. Is it better for 100 people to have more access to high cost credit, if 85 of them use it productively and repay, 15 of them suffer mental or physical health problems as a result, and 2 of those end up homeless? How can you possibly put a price on each of these consequences?

We also need to look at these questions through the lens of real world impacts on individual consumers rather than economic aggregates. So the FCA has been leading the way among financial regulators in extending its evidence base into the area of real world consumer behaviour[4]. As we move towards a world of ever bigger data and a greater capability to understand it, we may gain further insights.

And we need to be honest about the extent to which our regulation is based on judgments about social policy choices rather than quantitative evidence about cost and benefit.

Regulatory independence

Some of these social choices should be made by elected politicians, not unelected regulators. However, regulators have a critical role to play in giving independent advice on proposed policy changes and drawing attention to the inadequacies of existing policies.

So we need to continue to make sure that we maintain robust governance structures and diverse governing bodies, to secure our independence.

So we need to continue to make sure that we maintain robust governance structures and diverse governing bodies, to secure our independence.

But we must acknowledge that there are a number of problems in our society we can’t solve through FCA rules. There are pressing social issues such as the cost of housing, low financial resilience in general and unsustainable personal debt in particular, and inadequate saving for retirement and care in later life. Solving these issues extends well beyond financial regulation. We need to continue to speak up about the limits of what we can and should seek to achieve by ourselves.

And where new areas of financial activity emerge, we need to be able to draw attention to gaps in protection which may require lawmakers to act. That’s why the FCA has committed to publishing an annual statement[5] about so-called ‘perimeter issues’.

Competitiveness

It’s often been argued that regulators should have a competitiveness objective[6]. The FCA has an objective of promoting competition, but those who argue for a competitiveness objective want something a little different. They particularly want UK financial regulators to have a duty to ensure that the UK financial services industry can be internationally competitive.

This could imply that UK regulation would be set to a lesser extent than today by the public interest - the needs of UK consumers and businesses - and to a greater extent by the interests of the financial services industry or by decisions taken by policymakers in other jurisdictions. It could also imply some very difficult trade-offs with our other objectives: how much loss of competition should we tolerate to ensure that a sector is competitive? How much loss of consumer protection? How much loss of market integrity?

I believe that if we deliver our existing statutory objectives of making our markets work well, consumer protection, competition and market integrity, then there should be nothing to stop the firms we regulate from making money and growing in global markets. In fact, our standards of regulation should support the confidence that global clients and overseas regulators can have in the firms we authorise.

But that’s not to say that we ignore competitiveness. In fact, we already consider the recommendations we receive from the Government in their remit letter[7], which currently sets out the Government’s commitment to UK financial services being effectively regulated; securing the right balance between a financial sector that is globally competitive, works for consumers, and is secure over the long-term. We also consider the costs of our regulation through cost-benefit analysis, and ex post evaluation, and these costs should include the costs to the economy which would result from a less competitive industry.

We have shown how we can pursue our objectives in a way which also supports growth and competitiveness through Innovate and the Sandbox, and in the way we have approached the authorisation of new banks. We should continue to consider where we can bring similar approaches to bear in support of our objectives.

International engagement

Finally, the date for the United Kingdom to leave the European Union draws ever nearer. The agreement covering the UK’s withdrawal from the European Union and the framework for our future economic partnership will both have important implications for the way we approach our regulatory tasks in the future.

That’s why I believe that consumers and businesses across Europe will expect to have continued access to the best financial services that are available in their time zone, maximising their own welfare and the potential of their nations’ economies.

The FCA does not see the UK’s withdrawal from the European Union as an opportunity to join a race to the bottom in regulatory standards – quite the contrary. We will need to redouble our engagement with our policymaking and regulatory colleagues in Europe and across the world, to continue to influence global standards of financial regulation. As last week’s IRSG Report on Global Regulatory Coherence within Financial Services[8] rightly emphasises, strong global standards dampen the cycle of deregulation, crisis and regulation because they reduce the opportunity for individual jurisdictions to race to the bottom, and for firms to engage in regulatory arbitrage. Strong global standards also reinforce the competitiveness of the UK financial services sector.

This is most definitely not a zero sum game. Open and consistently regulated financial markets bring benefits to consumers and businesses in all jurisdictions. That’s why I believe that consumers and businesses across Europe will expect to have continued access to the best financial services that are available in their time zone, maximising their own welfare and the potential of their nations’ economies.

Conclusion

We remain committed to high standards of regulation in the UK and to contributing to high global standards. Consumers and businesses need high quality, stable and predictable regulation. The cycle of deregulation, crisis and regulation is damaging in so many ways.

But we must keep an open mind about our existing regulation and be ready to make it better where it is not producing the outcomes we need to produce. Confident enough to be open minded and transparent, listening to the unique resource that consumers, businesses and industry professionals in Europe’s largest financial market provide us with.

Above all, we must avoid that arrogance for which Sisyphus is condemned to roll the rock for all eternity.