The Foundations and Future of Financial Regulation

Governance for Responsibility

Mads Andenas, Iris H-Y Chiu

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135043360
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

Financial regulation has entered into a new era, as many foundational economic theories and policies supporting the existing infrastructure have been and are being questioned following the financial crisis. Goodhart et al's seminal monograph "Financial Regulation: Why, How and Where Now?" (Routledge: 1998) took stock of the extent of financial innovation and the maturity of the financial services industry at that time, and mapped out a new regulatory roadmap. This book offers a timely exploration of the "Why, How and Where Now" of financial regulation in the aftermath of the crisis in order to map out the future trajectory of financial regulation in an age where financial stability is being emphasised as a key regulatory objective.

The book is split into four sections: the objectives and regulatory landscape of financial regulation; the regulatory regime for investor protection; the regulatory regime for financial institutional safety and soundness; and macro-prudential regulation. The discussion ranges from theoretical and policy perspectives to comprehensive and critical consideration of financial regulation in the specifics. The focus of the book is on the substantive regulation of the UK and the EU, as critical examination is made of the unravelling and the future of financial regulation with comparative insights offered where relevant especially from the US. Running throughout the book is consideration of the relationship between financial regulation, financial stability and the responsibility of various actors in governance.

This book offers an important contribution to continuing reflections on the role of financial regulation, market discipline and corporate responsibility in the financial sector, and upon the roles of regulatory authorities, markets and firms in ensuring the financial health and security of all in the future.

Part 1

The objectives and governance landscape of financial regulation

1 Introduction

The world of finance has undergone an upheaval since 2008–9 with the onset of the global financial crisis that has largely afflicted the major Western economies. These economies have developed structures of financial supervision and implemented leading standards in financial regulation. Much has been written about the diagnosis of the crisis¹ and the book will not belabour this issue. Taking stock of the post-crisis reforms so far, this book critically analyses the aspects of postcrisis financial regulation that relate to the resurgence in the importance of financial stability. The resurgence in the importance of financial stability has led to an extension of the regulatory net over many hitherto unregulated areas in finance, reforms in micro-prudential and macro-prudential regulation and increasing levels of consumer protection. The surge in regulatory control over finance also allows us to question whether the fundamental premises of financial regulation are changing, to what extent financial regulation may be transformed and whether such transformative effects, if any, will endure.

The global financial crisis, often described as the worst episode since the Great Depression of the 1930s,² has potentially brought about a Kuhnian³ paradigm shift in financial regulation. Although financial regulation serves a number of different objectives,⁴ the general character of financial regulation leading up to the global financial crisis was primarily facilitative of market-based governance.⁵ The crisis has deeply questioned the market’s ability to address severe externalities,⁶ as state bailouts have become the norm for failed banks. The authors observe that a concern for financial stability has come to dominate post-crisis financial regulation rhetoric. We will examine to what extent the concept of governing for financial stability will change, ideologically and fundamentally, the character of financial regulation.⁷

As the financial market is transactional in nature, the market itself has often been regarded as the first port of call for solving problems generated in the market.⁸ Against the backdrop of neo-liberalism and deregulation that supports financialisation,⁹ economic rationale for regulation have become the dominant justifications for regulation. Hence, the role of regulation in financial markets is framed in the economic language of ‘market failure’, such as in cases of regulation to overcome information asymmetry in securities and investment markets and the ‘agency’ problem between investment intermediaries and clients.¹⁰ The role of financial regulation is also to provide ‘public goods’ such as systemic stability, which underpins micro-prudential regulation and deposit guarantee schemes.¹¹ Such a role may suggest that the regulatory stance adopted for the purposes of maintaining financial stability is more protective or paternalistic in nature. However, regulation purposed towards maintaining financial stability is also couched in the language of economic rationale, ‘public goods’ being defined as goods that are collectively enjoyed by society,¹² but the provision of which is often subject to a collective action problem, and so the state is ultimately looked to in order to supply it.¹³ Regulatory interventions based on economic rationale tend towards being proportionate and favouring efficient solutions that the market can generate. The point of financial regulation is not to assume responsibility for or adversely affect the core intermediation and resource allocation functions of the financial sector.

Hence, the authors are of the view that financial regulation has been intensely pragmatic and is used mainly to resolve market failures generated by the financial services industry. In the UK, the overall framework of regulation up to the 1980s, providing for basic public goods such as enforcement against fraudulent sales of securities and collective investment products¹⁴ and deposit guarantee protection (which may be seen as a facilitative type of legislative instrument to encourage bank deposits), came into being without being too intrusive for the industry. A regulatory system for authorising and supervising all banking institutions was only established in the Banking Act 1987,¹⁵ and the conduct of the investment and securities industry was largely self-regulatory, with industry self-regulatory organisations providing rulebooks and discipline to members under a general umbrella of accountability to the Securities and Investments Board.¹⁶ Developing more general oversight and regulatory frameworks for the financial sector is a recent phenomenon. The major driving forces behind such developments are the functional approach to financial regulation culminating in the creation of the Financial Services Authority (FSA) after the election of the Labour government in 1997 and the increasing legal integration in financial services law in the European Union as a means of market integration under the Financial Services Action Plan (FSAP) of 1999.¹⁷

One of the major regulatory reforms led by the Labour government after its successful election in 1997 was to introduce a consolidated and unified structure in financial regulation and supervision in the form of the FSA. The FSA had multiple objectives in its financial regulation remit,¹⁸ and positioned itself as appropriately structured to deal with the increasing consolidation of financial services firms into global financial supermarkets,¹⁹ offering banking, investment and even insurance services across group operations. Efficacy of oversight and economies of scale were strong supporting arguments for the establishment of the FSA,²⁰ although the industry was wary of the growth in both substantive regulation and supervisory oversight that could ensue. Hence, the FSA undertook a risk-based approach to regulation,²¹ which emphasised the proportionality of regulatory interventions and cost-effectiveness in the deployment of regulatory resources. The risk-based approach to regulation since developed into a rather light-handed approach to enforcement,²² which was ultimately criticised as contributing to the global financial crisis of 2008–9.

The major push towards exponential growth in substantive financial services regulation has also come from the EU, which sees the legal integration movement as supporting market integration. Legal integration is driven by the FSAP 1999 and the fast-tracked legislative process recommended in the Lamfalussy Report 2001 at the EU level.²³ Substantive laws in product regulation, such as securities²⁴ and collective investment products,²⁵ have undergone harmonisation. As for financial firms, regulatory harmonisation has taken place in prudential and consolidated supervision in the banking sector, the prudential,²⁶ conduct of business and home country control principles in the investment firm sector,²⁷ rules dealing with settlement, collateral and clearing,²⁸ consumer-facing rules in distance marketing of financial services,²⁹ and rules dealing with the supervision and enforcement of market abuse³⁰ and financial crime.³¹ Pre-crisis, it may be argued that financial regulation was already developing towards ex ante safety and protection objectives in view of financialisation across the EU. However, it may also be argued that the main incentives for legal integration have been the probusiness need for legal certainty and legal integration has been rapid thanks to industry support.³²

The global financial crisis has brought about an opportunity to critically reexamine the character of financial regulation.³³ The Turner Review is of the view that

the crisis … raises important questions about the intellectual assumptions on which previous regulatory approaches have largely been built. At the core of these assumptions has been the theory of efficient and rational markets … these assumptions [are] now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities.³⁴

The tendency of financial regulation to support market-based governance is now deeply questioned as the crisis is regarded as a failure in market-based governance. There is now emphasis on the reassertion of public regulatory power in governing finance³⁵ to provide the ‘public good’³⁶ of financial stability. Kaul and others³⁷ opine that modern public goods such as financial stability arise from the complexities and interconnections caused by liberalisation and the expansion of private transactional freedoms. Hence, financial stability is a ‘framework’-type public good that is enjoyed by all in order to further private aspirations and utility. De la Torre and Ize³⁸ also argue that the crisis contains lessons that underline the importance of the role of regulation as the financial system could suffer from collective failures of cognition that undermine welfare for the system. However, what does the ‘public good’ of financial stability mean? We suggest that there are two possible interpretations. First, the ‘public good’ of financial stability refers to the economic concept of ‘public goods’ underpinning regulatory matters such as micro-prudential regulation, and the policy emphasis on the ‘public good’ of ‘financial stability’ therefore refers to the impetus on policymakers’ part to supply such public good that has been under-supplied in the pre-crisis years. Second, the ‘public good’ of financial stability may actually mean something different from the economic understanding of ‘public goods’ and refers more closely to the importing of sociopolitical dimensions in construing the needs of financial stability from citizens’ point of view. In which case, the term ‘public good’ would have been used loosely in policy rhetoric but it imports of a change in perspective as to what financial stability means and how such perspective should shape financial regulation.

Beck³⁹ argues that global financial risks inevitably present ‘risk conflicts’ when the private sector engages in risky activities that put increasing numbers at risk of harm. Economists might call these externalities, although the risks may never materialise. Beck calls this ‘organised irresponsibility’, a shifting of risk through deliberate and rational organisation in private spheres. One of the consequences of ‘organised irresponsibility’ is the rise of Beck’s ‘cosmopolitan moment’, where the collective consciousness of society rises up to challenge the situation of ‘irresponsibility’ and frames the discourse not in economic, rational and efficiency terms, but in terms of justice and rights.

In the sphere of post-crisis financial regulation, we are witnessing ‘cosmopolitan moments’ in a number of Occupy movements around the world, in New York, London and Hong Kong. Although these have been forcibly put down after protracted legal proceedings in various places, such as London and Hong Kong, Occupy movements express the view that the social dimension of financial regulation has not gone far enough. It is this social dimension that may shape a new and emerging understanding of ‘public interest’ in regulating finance.

Post-crisis, policymakers have introduced legal reforms that address the immediate problems of the crisis, reasserting regulatory power to provide the public good of financial stability that has been under-supplied pre-crisis. Such legal reforms are underpinned by the meaning of public goods in the economic sense, as mentioned above. We also discern a number of legal reforms that are purposed to deal with more general and prospective issues in regulating finance, such as ‘...

Table of contents

• Cover Page
• Half Title Page
• Series Page
• Title Page
• Copyright Page
• Contents
• Acknowledgements
• Table of cases
• Table of legislation
• Part 1 The objectives and governance landscape of financial regulation
• Part 2 Investor protection in financial regulation
• Part 3 Regulating financial firms
• Part 4 Macro-prudential supervision
• Bibliography
• Index