Regulate but don't suffocate

Some time ago I was sitting in a meeting in which the discussion turned to administrative and procedural matters, none of which affected me. I realised that if I left the room I would not be missed and I could use the time to do something more productive. This is, of course, an experience familiar to many millions of people. Once we add up the amount of person hours wasted in processing apparently trifling administrative matters, we begin to understand the magnitude of the economic costs imposed by red tape.

Like many people, I tend to think of this problem as one which others should deal with. After all, I am not paid to be a bureaucrat – surely there must be someone else to take care of this. But so long as we are operating on the company's time, our employer has a right to ask us to deal with processes which make the company's life easier. In any case a lot of regulation is necessary. We cannot hope to operate in a complex economic system without a set of detailed rules governing the underlying processes. Indeed, without a lot of these rules, we would experience market failures far more frequently than we do. But that does not mean we should accept all regulation as good, or even necessary.

An example of "good" legislation is that designed to tackle the problem of environmental damage. It has a transparent aim of reducing the wider social costs associated with pollution, which yields obvious benefits to society. Of course producers have to adapt their production methods which can act as a spur to innovation but it also raises costs which are ultimately passed on to the consumer. Society thus has to carefully weigh the costs and benefits of regulation. One of the problems we are now beginning to understand is that as circumstances change, much of the regulation that sits on the statute book becomes outdated.

To this end, President Obama signed executive orders requiring federal agencies to review existing legislation to “determine whether any such regulations should be modified, streamlined, expanded, or repealed” with the purpose of making the “regulatory program more effective or less burdensome in achieving the regulatory objectives.” Consider the situation we are in today in which governments are increasingly concerned about the nitrous oxide emissions caused by diesel engines – the very same technology which was once seen as the solution to the problem of CO₂ emissions. That solution is increasingly being seen as a problem and regulation is being amended accordingly, with the likes of the UK and France planning to ban the sale of new cars powered by the internal combustion engine within the next 25 years.

Financial regulation is another case in point. Much of the legislation implemented in the past decade is designed to reduce the risks to society from the socialisation of a private sector problem (i.e. governments do not have to bail out banks) by preventing the emergence of banks which are too big to fail. Globally, banks now have to hold bigger capital buffers and are subject to much greater regulatory oversight. We will only see how effective the legislation has been over the longer term if it reduces the frequency of banking crises. What we do know is that the short-term adjustment costs are high, as banks increase the size of their compliance budget whilst getting out of, or being forced to turn down, business which was once extremely lucrative. In effect, a tax is being imposed on banking activity whose incidence falls mainly on the banks themselves: The wider social costs of this legislation are minimal and it satisfies society's demand for justice in the wake of the crash of 2008 by clamping down on banks’ activity.

But is it all good or necessary? The US Dodd-Frank Act, for example, comprises almost 14,000 pages and 15 million words. Nobody can possibly know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically the US Constitution, upon which a nation was built, contains just 4,543 words. Consider also the EU’s MiFID II legislation due to come into effect next year which is designed to offer greater protection for investors and inject more transparency across the financial services industry. EU financial instruments which fall within its scope will have to comply with the new regulations, irrespective of where they are traded. One of the other aspects of the regulation is that it forces sell-side institutions to charge money managers for their research, rather than bundling it in with transaction fees, in order that money managers’ clients have greater transparency over the fees they are charged (a topic I will deal with another time).

Suffice to say this is a big deal for the European financial services industry and has cost a lot of time and effort as banks and asset managers gear up for it. But according to a recent Bloomberg report (here), a lot of countries are struggling to be ready to implement the law in January. It will potentially change the nature of the industry – never mind Brexit – and before anyone suggests that the UK will benefit by leaving the EU, may I remind you that the UK was instrumental in driving through large parts of the MiFID II legislation.

I confess that I have a vested interest in this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry anyway, it reinforces my view that large elements of the non-EU financial services industry may simply expand their businesses in less heavily regulated areas. Frankfurt may grab a piece of the London pie but in the longer term it may well turn out only to be crumbs compared with what eventually relocates to Singapore and Shanghai