Good Regulation, Bad Regulation

Before discussing the pros and cons of regulation in general and financial regulation in particular, we have to understand what regulation is all about and what forms it takes. Although there are arguments for and against regulation in general (hence against and for deregulation), some arguments are type-specific. For example, environmental regulation is motivated by the desire to protect human health from the effect of pollution (which provides an argument for regulation) whereas a primary argument for financial regulation is corruption in the financial sector. Regulation in general is a form of government intervention in economic activity and interference with the working of the free-market system. According to some views, regulation is “synonymous with government intervention in social and economic life” (Moran, 1986). Free marketeers dislike regulation because they do not like any form of government intervention and prefer to feel the full power of the market. However, those who believe that government intervention may be necessary (even a necessary evil), and that people should not be exposed to the full tyranny of the market, find regulation to be tolerable, even desirable.

In this chapter we present arguments for and against regulation in general and financial regulation in particular. Arguments for regulation may come in response to arguments against deregulation, and vice versa. This is why arguments for and against regulation are lumped together rather than separated, and this is why there may be some overlapping in the arguments. We reach the conclusion that corruption is (or should be) the main justification for financial regulation and that it is related to other justifications for regulation. For example, it is argued that corruption and greed can cause financial instability, which is typically considered to be the main objective of financial regulation.

The tendency to deregulate financial markets and institutions is driven by strong belief in laissez-faire, the free-market doctrine. In general, this doctrine implies a structure whereby the production, distribution and pricing of goods and services are coordinated by the market forces of supply and demand, unhindered by regulation and government intervention. An economy that is composed entirely of free markets is referred to as a free-market economy. The origin of the concept of a free market is traced by Gray (2009) to mid-nineteenth century England.

For free marketeers, no regulation is good regulation and any regulation is bad regulation. But for those who believe that regulation can be good, it is not easy to characterise good regulation. Thomadakis (2007) argues that “good regulation must start with a clear understanding of the objective – and this necessitates a trilateral dialogue between regulators, the regulated community, and the beneficiaries of regulation”. He wonders what makes good regulation and responds with a very simple answer: “good regulation serves the public interest through supporting ongoing confidence in processes, such as the market process, in which the public participates and in activities, such as auditing, on which the public relies”. He then explains why regulation is necessary to support confidence in markets. Thomadakis suggests some criteria for good regulation: necessity, transparency, proportionality, effectiveness and flexibility. D’Arcy (2004) suggests another list of criteria for good regulation: fair (applied equally), simple, inexpensive, enforceable, targeted and proportional.

The level of debt held by a firm is measured by the leverage ratio, which is calculated in various ways, such as the debt ratio and the debt-to-equity ratio. With respect to a firm’s capital structure, the debt ratio (D/A) is simply total debt (D) divided by total assets (A), where assets are financed by equity and debt (A=E+D). The inverse of the debt ratio as defined here (A/D) may be called the asset multiple (with respect to debt). For example, if a firm has $10 million in debt and $40 million in assets, the debt ratio is 0.25 or 25 per cent. In an inverse form the ratio is 4:1. The corresponding capital ratio (E/A), where capital is taken to be equity, is 0.75 or 75 per cent. In an inverse form, the ratio is 4:3—that is, for each dollar of equity the firm has 1.3 dollars in assets. The debt ratio and capital ratio are related, in the sense that when one is fixed the other is determined automatically.

In 1988, the Basel Committee on Banking Supervision (BCBS or the Committee) established an international standard for measuring capital adequacy for banks, which came to be known as the Basel 1 Accord (also known as the 1988 Accord). One motive for establishing this framework, which is described in detail in BCBS (1988), was to bring consistency to the way banks were regulated in different countries. According to the BCBS, Basel 1 had two basic objectives: (i) to establish a more level playing field for international competition among banks; and (ii) to reduce the probability that such competition would lead to the bidding down of capital ratios to extremely low levels. We will find out that the establishment of an international level playing field is not a good idea and that the very international characteristic of the accord makes objective (ii) unachievable.

On 1 January 2012, a “milestone” of international financial regulation was passed when a precursor to Basel 3, Basel 2.5, presumably came into force. While the development of Basel 2.5 (and Basel 3) is the product of the realisation that Basel 2 could not have dealt adequately with the global financial crisis, nothing much has changed in the sense that most of the criticism of Basel 2 can be directed at Basel 2.5. It is a complex and tedious set of capital-based regulations that overlook critical issues such as leverage, liquidity, the separation of investment and commercial banking, and the problem of TBTF. The treatment of leverage and liquidity was left for Basel 3, which is scheduled to be implemented in 2019, as if these were trivial matters that can wait. Worst of all is that Basel 2.5 maintains the procedure whereby regulatory capital is calculated on the basis of risk-weighted assets, where weights are determined primarily by the credit rating agencies.

Short selling involves the selling of a stock (or any other financial asset) that has been borrowed from a third party with the intention of buying it back at a later date to return to that third party. While the object of short selling may be any asset (including currencies and derivatives), the regulation of short selling is mainly directed at the short selling of stocks. For some reason, it has been the case that it is fine to sell short a currency or a crude oil futures contract but if you short sell a stock, you inflict damage on the underlying company, the whole market and the economy at large. For the purpose of this chapter, “short selling” is the short selling of stocks, since there seems to be no controversy about the short selling of anything except stocks.

As we saw in Chapter 8, the global financial crisis ignited interest in the regulation of short selling on the grounds that it led, among other things, to market collapse and the bankruptcy of some companies. Since 2010, however, interest has shifted to high-frequency trading (HFT), with calls mounting to regulate this style of trading on several grounds, including some (such as the effect on volatility and liquidity) which are similar to those used to justify the regulation of short selling. The only difference (which is a fundamental difference) is that while we know exactly what short selling is, no one seems to know what HFT encompasses. A necessary condition for successful regulation is that regulators identify the target of regulation. It is claimed that some activities that are classified under HFT involve malpractices, some of which are dubious and others possibly illegal. It may be useful to state my position at the outset: if abusive and illegal practices are involved, these practices must be banned, but it makes no sense to condemn and punish traders who buy and sell more frequently than others, which is what HFT should be about.

As we saw in Chapter 2, a (flawed) argument for regulation is that the government should intervene to prevent “important” enterprises from failure—this is the TBTF argument. In this chapter we address the actions taken by regulators to save failing financial institutions that have the TBTF status by bailing them out (using taxpayers’ money) or bailing them in (using depositors’ money). This is what is meant by “bad regulation” in the heading of this chapter. However, regulation aimed at mitigating the TBTF problem by preventing the occurrence of a TBTF situation is good regulation. In fact, it will be argued that good regulation is required to deal with the TBTF problem.

The debate on regulation in general and financial regulation in particular typically takes the form of a confrontation between free marketeers, who want to see no regulation whatsoever, and those who favour regulation. In this debate, regulation is either all good or all bad. In this book, a different perspective is presented: regulation is not all good and not all bad—rather, some regulation is good and some is bad. In this sense, regulation refers to either the regulation of a certain activity, such as short selling, or a certain set of regulatory rules, such as the Basel accords.