Labour declared economic growth its primary aim in the run up to the election and reiterated that goal in its first Budget. But the OBR’s forecasts for growth over the next couple of years are historically low. David Murphy argues that it’s time for the Government to revisit the overly restrictive financial regulation put in place after the 2008 financial crisis, as a way of unlocking future growth.
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Growth is a big issue currently. “Unlocking long term growth” appears on the first page of Labour’s first budget statement. The current OBR forecast is for the UK to grow 1.1 per cent this year and 2 per cent in 2025. These are historically low rates. If they are not significantly surpassed, it is hard to see how the government can pay for its plans without more tax rises. But, in order to grow, the economy requires access to funding. That largely comes from the financial system. So why hasn’t the financial system’s efficiency come under more scrutiny?
Has financial regulation produced a system which indeed supports growth and serves the needs of business and citizens? This is a fundamentally political question, not a technocratic one.
The legacy of 2008
Part of the answer is the global financial crisis of 2008. This was enormously damaging. After it, politicians rightly demanded action to build a stronger regulatory framework for the future financial sector, which would “support sustainable global growth and serve the needs of business and citizens”.
A tsunami of financial regulation followed this. These rules dramatically increased bank capital levels and transformed the financial system. Politicians largely let regulators do this work unchecked. But has it produced a system which indeed supports growth and serves the needs of business and citizens? This is a fundamentally political question, not a technocratic one. And it is one that politicians should not avoid asking if they really want to help the economy to grow. In order to examine it, we need first to ask what financial regulators have been told to do.
The first issue here is that this is a “safety at any price” mandate.
Regulators’ mandates
For the Prudential Regulatory Authority or “PRA” – the prudential regulator of all large UK banks and insurance companies, as well as much else – the primary objective is to promote the safety and soundness of PRA-authorised firms (with an objective specific to insurance firms for the protection of policyholders).
The first issue here is that this is a “safety at any price” mandate. It could be fulfilled by ensuring that regulatory burdens are so high that regulated firms seldom fail – a situation Jonathan Hill, in the context of EU financial regulation, evocatively described as the stability of the graveyard. Similarly, making it difficult for life insurers to invest in infrastructure projects, even though their investment needs often match the long-term profile of these projects, is preferred under this mandate, because it makes insurers a little bit safer.
It is also clear that the mandate’s focus is not on the UK financial system, but on the PRA-regulated parts of it. Based on this, there is no issue if credit provision from non-banks grows at the expense of bank lending, even if it is more expensive and probably less focused on the long term health of the borrower, as long as that growth does not pose a risk to PRA-regulated firms or financial stability. It is good too, from the perspective of the PRA’s mandate, that banks no longer play a central role in intermediating many capital markets, because that makes them more robust. Never mind that their replacements – principal trading firms and hedge funds – are more fragile and likely less willing and able to support markets in stress.
There is a huge distance between revoking independence and asking whether the current mandate best serves the needs of business and citizens.
Revising the mandate
It is unreasonable to complain that the PRA is doing what it has been told to do – make regulated firms safe. But it is also legitimate for politicians to ask if that is the principal thing that they want them to do.
There have been various changes to regulators’ mandates since 2008. In 2014, with the creation of the PRA, a secondary objective to facilitate effective competition was introduced, and in 2023 the need to consider the international competitiveness of the UK economy was added too. But these secondary objectives are just that – secondary. Keeping PRA-regulated firms safe is primary. As Andrew Bailey put it, “secondary objectives are only considered subject to achieving the primary objectives”.
Removing the operational independence of the Bank of England would be enormously destabilising and would likely cause a spike in the government’s borrowing costs. To state the obvious, that would be counterproductive. But there is a huge distance between revoking independence and asking whether the current mandate best serves the needs of business and citizens. Suppose the PRA’s primary mandate was recast to focus on ensuring that the UK financial system provides key economic functions efficiently and robustly in all conditions. This would balance financial stability and efficiency: a failing firm cannot provide economic functions robustly, but a stable one does not necessarily serve the economy’s needs. Such a mandate might better reflect the role regulators should play than the current safety first approach.
The Treasure Select Committee has a relatively small staff and an enormous mandate. There is a case for establishing an Office for Regulatory Performance to provide a source of impartial, specialist advice.
Resources to support accountability
Modern financial regulation is really complex. Currently, for instance, international bank capital rules fill an 1,845 page document and there are many more rules in addition to these.
Why did Credit Suisse fail, even though it had much larger amounts of capital and liquidity than these international standards required? Would following the rules for winding up large banks in the case of Credit Suisse, really “have triggered an international financial crisis”, as Swiss Finance minister Karin Keller-Sutter claimed at the time? Why do we have these rules and ring-fencing in the UK, even though they both do broadly the same job? These are reasonable questions.
How can politicians get answers to questions like these without asking the rule writers, who are obviously invested in defending their own standards? This is not to suggest that there is any tendency towards dishonesty on the part of regulators: just that accountability arrangements are buttressed by independent, expert advice.
Currently, obtaining this kind of counsel is difficult. There are vastly more staff specialising in financial regulation in the PRA than in HM Treasury. The Treasury Select Committee has a relatively small staff and an enormous mandate. There is a case for establishing an Office for Regulatory Performance to provide a source of impartial, specialist advice.
Asking questions, assessing answers
Regulators should have a mandate which reflects the mission that politicians want them to undertake. This means delivering an efficient, robust financial system which supports growth. And accountability mechanisms are needed which give politicians access to the right resources to hold regulators to account for their performance against their mandate. It is time for policy makers to ask if the current arrangements really do deliver these key requirements.
All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.
Image credit: mkos83 Shutterstock
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