In the previous article authors emphasized that “governments are convinced that there is a need minimize the gap between regulated and uregulated financial activities because resulting regulatory arbitrage leads to outcomes that are negative for society’s wellbeing”. At the begining of this article authors are referring to this thought.
Dr Norman Bailey, Dr Alexander Mirtchev
To reach that judgment, economic theory asks the question: Would unfettered markets maximize social wellbeing? This is where the weakness of the arguments for tighter financial market regulation lies. It is not in the thesis or the framing of the question, but rather in the conclusion that is reached. To a large extent, the argument for ever-increasing regulation is like the argument that in order to minimize the risk of being run over by a car, one should walk as little as possible, or, alternatively, that in order not to catch the flu, one should stay indoors. This argument is embodied in the EU’s so-called ‘precautionary principle’ which essentially means that, if some activity is suspected of being harmful to society, it should be regulated in advance to prevent any suspected harm from occurring.
To maximize societal wellbeing, it may be worthwhile to return to the ‘primum non nocere’ principle, ascribed (rightly or wrongly) to the Hippocratic Oath of Ancient Greece. Its second line, after the (predictable) first one about respecting one’s teachers, ends with the phrase ‘abstain from whatever is deleterious and mischievous’. Perhaps this should be the guiding principle for the financial markets, too.
However, governments and international supervisory bodies have applied a different approach to financial markets. Instead, they have chosen the path of more and more regulation. For example, the new rules introducing tighter capital and liquidity requirements proposed by the Basel Committee on Banking Supervision are the result of sometimes desperate efforts by states to impose some form of control over the financial sector that could prevent future financial crises. This desire for more control led to the so-called Basel III framework which endeavors to tighten the rules on the ratio of bank deposits to lending. The assumed (and difficult to predict) impact on banks themselves is supposed to be to tighten profits (in other words, for banks to pass the cost onto the consumer via an increase in the spread between interest they pay on deposits and the interest they charge on loans). However, the overall economic effect is even more elusive to forecast, and to all intents and purposes could swing between a range of extremes that impact growth as much as volatility. Assuming successful reduction of volatility due to Basel III, the trade-off would have to be increased financing costs and lower investment, as higher capital and liquidity requirements raise the cost of external finance and reduce the loans-to-output ratio.
The stated goal of this and other regulatory changes is to protect investors, maintain orderly markets and promote financial stability; in sum, to improve the welfare of society. This goal assumes that the regulatory actions of a public authority (government agency or organization) are dictated by the public interest. However, this assumption does not reflect the reality of competing self-interests and group relationships that influence decision-making on the regulatory level. In reality, this means that the creation of regulations incorporates bias in favor of particular interests or groups, also known as ‘regulatory capture.’ A result of regulatory capture is that the societal welfare outcomes of regulation can never be optimal, as they are the product of ‘inefficient bargaining between interest groups over potential utility rents.’
Another form of influence on regulation is ‘political capture,’ where regulations are imposed to pursue specific political ends or in response to particular political considerations. Politically-influenced regulation, be it a tool of the government bureaucracy or of the ruling elites, does not have economic efficiency as its goal, which again results in sub-optimal outcomes. As regulation sets the ‘rules of the game’ for a given economy or industry, changing those rules to suit a specific group within society becomes at best a zero-sum game, and is more often than not a source of negative outcomes for all the parties involved.