As calls for deregulation in financial services grow louder, financial advisers must navigate a shifting regulatory landscape. In this analysis, Gavin Sharpe, associate director at RSM UK, explores the delicate balance between fostering innovation and ensuring financial stability—reminding us that the lessons of past crises must not be forgotten.
It’s well over a decade since Andrew Bailey laid out the foundations for a new age of prudential regulation post-financial crisis at the Chartered Banker Dinner in Edinburgh. In that speech, the then Chief Executive of the newly formed PRA outlined his case for a ‘counter cyclical’ approach to regulation – restraining firms in the good times and supporting the system in the bad times.
Twelve years on, and the financial services sector is predictably facing a wave of calls for deregulation from across industry and the government under a widely held view that regulation is a barrier to growth. The apparent resilience of the banking sector in response to a wave of economic shocks since 2008 has led many to question the cumulative weight of regulation introduced since the crisis.
It was therefore timely when Andrew Bailey spoke again on the matter in February. While his speech to the University of Chicago Booth School of Business acknowledged the need for a debate about regulation, his defence of its importance was robust, stating ‘there is not a fundamental trade-off between growth and financial stability’. The FCA also seems to be leaning towards easing regulation, with its recently published strategy highlighting rebalancing risk as a core focus and stating: “regulation should be about enabling informed risk to be taken, not eliminating it completely.” The UK government’s financial services minister, Emma Reynolds, has emphasised the need to remove regulation which hinders growth, though she declined to specify acceptable levels of consumer risk associated with such deregulation.
Looking back over the last 50 years though, it’s clear that financial services regulation is essential for maintaining stability and integrity in the financial system. The 2008 global financial crisis underscored the devastating consequences of inadequate regulation, leading to widespread economic turmoil and necessitating significant reforms.
Throughout history, significant legislative changes have shaped the financial landscape, with periods of deregulation often preceding financial instability.
The historic cycle of deregulation and regulation has had significant economic impacts. Deregulation fostered increased risk-taking in the financial sector, which can sometimes lead to economic instability and job losses, thereby raising the unemployment rate. However, the tightening of regulations can reduce the likelihood of risky financial practices, contributing to economic stability and, over time, potentially lowering unemployment rates by encouraging more sustainable growth and job creation.
Research by Korinek and Kreamer in 2014 highlighted the redistributive effects of financial deregulation, emphasising the trade-off between efficiency in the financial sector and stability in the real economy. They argue that deregulation often benefits Wall Street at the expense of Main Street, creating a cyclical pattern of risk-taking, crises, and subsequent re-regulation.
This cycle is further supported by a study from Deng, Casu, and Ferrari, which emphasised the dual nature of post-crisis reforms in Asia, characterised by both increased prudential regulation and financial liberalisation. This pattern reflects the global trend of alternating between deregulation and re-regulation in response to economic conditions.
Meanwhile, research on bank efficiency following deregulation shows mixed results. While some studies have found negative impacts on the efficiency of a banks’ deployment of financial resources, and therefore profitability in the short term, others found long-term benefits from increased competition and innovation. However, these efficiency gains came at the cost of increased systemic risk.
Financial innovation, often facilitated by deregulation, played a crucial role in the 2008 crisis. Complex financial instruments like credit default swaps (CDS) increased interconnectedness in the financial system, amplifying the impact of the subprime mortgage crisis.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 represented a significant re-regulation effort in response to the 2008 crisis. Similarly, the introduction of Basel III regulations in Europe aimed to increase capital ratios and limit leverage in the banking sector.
The push for deregulation: underlying factors
Several factors are contributing to the current conversation around deregulation. One key aspect is the shift in financial activity away from traditional banks and towards non-bank financial institutions (NBFIs). According to Andrew Bailey, Governor of the Bank of England, “What also came out of the GFC and post-GFC policies was a further shift in the balance of financial intermediation from the banking to the non-banking system, with the non-bank sector now making up nearly 50% of global financial assets compared to 40% for the banking sector.”
Bailey highlights that the changing market structure involves “large shifts in leverage, pricing power, speed of trading and liquidity provision.” This evolving landscape necessitates a re-evaluation of regulatory tools and approaches.
A necessary safeguard against crisis
Caution is essential when considering deregulation. The 2008 crisis demonstrated that insufficient regulation may lead to systemic failures with far-reaching economic consequences. Prudential regulation is intended to ensure financial institutions maintain adequate capital buffers, manage risks effectively and operate transparently, thereby safeguarding the financial system and protecting consumers.
Prudential regulation also underpins several crucial objectives which enhance financial stability. It protects consumers, reduces systemic risks and enhances trust in the financial system, improving market confidence.
Prudential regulation obliges financial institutions to maintain a minimum level of capital. This acts as a buffer against potential losses, ensuring banks can absorb shocks without collapsing. Regulations also require the same banks to hold sufficient liquid assets to meet short-term obligations, helping prevent liquidity crises, which develop rapidly where there is a perception banks might be unable to meet withdrawal demands. Regular stress tests are conducted to evaluate how banks would perform under adverse economic conditions, identifying vulnerabilities, and ensuring that banks are prepared for potential downturns.
Good regulation fosters trust among investors and consumers. This is crucial for the smooth functioning of financial markets and encourages investment and economic activity. By mitigating the risk of financial crises, prudential regulation helps maintain confidence in the financial system. The 2008 financial crisis highlights the importance of effective regulation in preventing widespread panic and loss of confidence.
Challenges of regulation
However, prudential regulation is not without its challenges and potential drawbacks. These include increased costs, excessive administrative burdens, stifled innovation, systems challenges and unintended consequences. Differences in regulatory standards across jurisdictions can sometimes push financial institutions to pivot towards countries with more flexible regulations. Regulation can also lead to procyclicality, since some rule-based regulations tend to be backward looking and can therefore exacerbate economic cycles.
Smaller banks and financial institutions may find it particularly challenging to bear regulatory costs, potentially leading to consolidation in the industry, as smaller players are unable to compete. The introduction of the Small Domestic Deposit Taker (‘SDDT’) regime in the UK goes some way to reducing compliance costs, albeit there has been mixed feedback on the extent of simplification.
Regulated financial institutions may face competitive disadvantages compared to unregulated or less-regulated entities, such as fintech companies. These entities can operate with lower costs and greater flexibility, potentially attracting more customers.
The challenge for regulators is to strike a balance between ensuring financial stability and allowing for innovation and growth in the financial sector. As Andrew Bailey, Governor of the Bank of England, notes, “The answer is not to seek to stand in the way of change.” Instead, the focus should be on understanding new risks and vulnerabilities and adapting regulatory tools accordingly.
The risk of repeating history
The pattern of deregulation leading to crisis and subsequent regulatory tightening suggests a cyclical nature in financial oversight. As Bailey notes, attitudes toward regulation are not static: “Hyman Minsky wisely pointed out that as memories of crises past recede, so attitudes towards regulation change.” This highlights the importance of not forgetting the lessons of past crises.
Bailey emphasises that the answer is “not to seek to stand in the way of change.” But to understand the new risks and vulnerabilities and adapt regulatory tools accordingly. He stresses the importance of surveillance, and the ability to act on identified risks, ensuring the necessary tools are in place to address potential problems.
While the desire to promote economic growth through deregulation is understandable, prudential regulation remains vital in preventing financial crises. The lessons learned from the 2008 crisis underscore the necessity of robust oversight to protect the financial system and the broader economy. Therefore, any move toward deregulation should be approached with caution, ensuring that the safeguards established post-2008 are not compromised.
The ongoing cycle of deregulation and crisis underscores the need for vigilant and adaptive regulatory approaches. As financial markets continue to evolve, particularly with the growth of the non-banking sector, regulators must remain proactive in identifying and addressing new risks, while balancing the need for innovation and economic growth.
