Why financial regulation fails

The supposed prime objective of banking rules and regulation is to protect and reduce risk. As the credit crisis has clearly demonstrated regulation has failed to do so. Despite this the proposed solution is more regulation.

Rules and regulations are focused on mechanically risk weighting loans and allocating capital against that perception of risk in a prescribed formula that sounds complicated and is complicated. The capital charade and secrecy with government backing for large banks and almost all deposits means market scrutiny is all but removed from the banks. Detailed P&L and balance sheet data only goes to a few regulators opposed to the many that deposit, invest and research the banks thus limiting market review, risk assessment and analysis.

There is also a major skill set asymmetry with the many PhD brains of the banks easily able to outwit a few £60,000 a year PRA and BoE staff. Consequently the SIV CDO3, inverse IO and many other regulatory compliant but circumventing structures and strategies are created. The fixed formula driven official capital ratios all look to be unchanged at a level we are told is strong. The risk weighting of a loan to a business that is 1000% geared with no sales is the same as a loan to a 1% geared business that has a 50% operating margin from 50 year government contracts. The market would never be so simplistic and will always look forwards opposed to regulators that tend to look backwards. The market would allow much more leverage for genuinely low risk lenders and require much less for high risk lenders.

Today all banks essentially work to a very similar core capital ratio. The regulation based system allows banks to disclose as little as possible to as few as possible, complicating obscuring and circumventing. A market based system would encourage transparency, simplicity and full disclosure to as many as possible. Without regulation there would be little restriction on new banks being created and consequently there would be more specialists and more competition.

The abolition of regulation would make banks less risky. With banks that are too big to fail and deposit protection all banks can borrow cheaply regardless of the risks they take. Removing this will require banks who want cheap deposits to prove they are worthy of them. A market based pricing structure will be created with each bank having to fight for its funding. With very low real deposit returns the demand for disclosure, balance sheet transparency, simplicity and capital strength will be high. Where this is not the case real returns for depositors will be high.

With depositors now determining how much capital is required for any given deposit cost the subordinated debt now, now not ranking in line with the depositors will be priced based on the preference and equity capital structure. Today return on equity is maximised by reducing equity as much as the rules will allow with there being no correlation between capital strength and funding cost. In a market driven world the key funding cost will fall as equity increases. The correlation analysis below shows not only that pre-crisis capital and risk were inversely correlated, but also that risk and return were even more strongly inversely correlated. The strongest inverse correlation is, however, between Growth and Risk.

With rules based regulation that evolves slowly and usually only changes after a major problem banks can easily manipulate their balance sheets to comply with the letter if often not the spirit of the regulation. With the market/depositors setting a bank’s funding cost, the risk perception and analysis of anything new, complicated, or unclear should immediately impact the bank. Consequently the banks focus will shift to genuine economic profit based risk and reward analysis opposed to regulatory arbitrage.

Over time better banks will secure more funding at better terms rewarding appropriate risk assessment with those who operate inappropriately way failing. Evolution will be returned to the banking sector by the removal or regulation. Largely unregulated sectors such as retail have evolved rapidly providing customers with the Amazon service they desire replacing the Woolworths service they do not.

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Young Writer on Liberty Competition 2014

The Adam Smith Institute invites you to enter our annual student competition, Young Writer on Liberty. This year's theme is:

Three policy choices to make the UK a freer country

Each entrant must write three essays in the style of the ASI blog, each no longer than 400 words, and each explaining a different policy choice that could make the UK freer, richer and happier. No policy choice is out of the question—indeed counterintuitive policy choices may be particularly interesting if backed up by strong arguments.

The winner will receive £250 and have their three posts published on our blog. They will also get a box of liberty-themed books and the opportunity to do two weeks of work experience here at the ASI.

Twos runner-up will also have their posts published on the blog, as well as receiving a package full of interesting books.

Last year's winner was George Kirby, who argued that we should legalise markets in organs, that there should be greater roaming rights in the UK, like those enjoyed in some Nordic countries, and that the UK would benefit from US-style federalism.

Entrants must be 20 or under on the closing date, 21st March 2014. Please submit all entries to schools@adamsmith.org. Good luck, and I look forward to reading all of your pieces!

Comment: Minimum wage increase will hurt the poor

Commenting on the Chancellor's backing for an above-inflation rise in the National Minimum Wage, the Adam Smith Institute's Research Director Sam Bowman said:

"A minimum wage increase will hurt the poor, particularly young people and vulnerable groups like migrant workers. Most of the empirical economic evidence has found that increases in the minimum wage cause increases in unemployment. The evidence also suggests that minimum wage increases lead to slower job creation for low-skilled workers.

"Minimum wage work is usually a stepping-stone to something better where employees can acquire human capital. There is also evidence to suggest that minimum wages stop young workers from acquiring the skills that allow them to get better jobs in the long run, so today’s increase could have far-reaching harmful effects by keeping people in low-paid jobs.

"One way to actually help low-income workers would be to raise the income tax and National Insurance threshold to the current minimum wage level, which would give these workers a take-home pay equivalent to a minimum wage. That would require spending cuts or tax rises elsewhere, but it would be a responsible and effective way to improve the lot of the working poor that would carry none of the unemployment risks that this minimum wage increase does – in fact, it would create jobs.

"Increasing the minimum wage runs an indefensibly high risk of creating more unemployment and harming the people that supporters of the increase want to help. Even if the immediate impact is not large, this increase will lead to a long-run decline in job creation and standards for Britain's poorest workers. It will hurt the very people it is supposed to help."

For further comment please email media@adamsmith.org.

Introduce school vouchers and liberalise free school creation to improve UK education

As Britain faces dire PISA education rankings, the government should liberalise the free schools application process and give parents a voucher for a place in any approved school, state or private, says a new research report from the Adam Smith Institute and the Centre for Market Reform of Education. (School Vouchers for England: Harnessing choice and competition for greater quality and equality in education. Executive summary here.)

The move would abolish the restrictions that prevent poorer parents from accessing England’s best schools. Proximity-based admissions should be scrapped, being replaced by lotteries and subsidised transport in cases of oversubscribed schools.

At a time when many areas will face a 20% shortfall in places by 2015, urgent and cost-efficient action is required, the report says. Parents may be left without schools to choose from unless the government accelerates the development of new free schools.

The government therefore must simplify the school creation process, says the report, cutting through red tape and introducing a voucher system so that parents can signify where and how they require schools to be built.

Gabriel Heller Sahlgren, co-author of the report and Director of Research for the Centre for Market Reform of Education, said:

“Parents are currently restricted to choosing schools they can afford or the schools they can afford to buy a house near. Giving parents a voucher, redeemable to all state schools and participating private schools, would usher in a new era of social mobility and reverse the decline in the quality of English education.

“A voucher programme would expand the number of schools that parents could choose. Parents could choose participating private schools, which would be incentivised by the prospect of a more steady income. The resulting increased competition between schools to attract pupils would cause significant improvement in education.

“Good schools in sparsely populated areas would be incentivised to expand by receiving more pupils and money. Similarly, bad schools would be incentivised to improve by the threat of losing pupils, and therefore funding. A voucher programme would avoid the need to build more costly free schools, as well as the huge costs and regulations surrounding which have hampered the government’s education reforms."

Notes:

A copy of the paper is downloadable here: http://www.adamsmith.org/sites/default/files/research/files/Voucher%20paper%20web.pdf. An executive summary of the paper is downloadable here: http://cmre.org.uk/uploads/publications/Voucher%20exec%20summary.pdf.

Please contact Alexander Blackburn to arrange an interview with the paper’s authors by calling 020 7799 8903 or 07400 902 290, or emailing ablackburn@cmre.org.uk.

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