12.5Summary

The efciency of modern economies is greatly enhanced by a well-functioning

nancial system but failures in nancial markets and institutions can cause problems

for investors and employees as well as for the markets themselves. Problems arise

concerning the ability of rms and individuals to borrow, the extent of savings in

the economy, the occurrence of booms and crashes in markets, and the regular

occurrence of nancial scandals in both nancial markets and institutions and in

non-nancial markets.

One long-running debate has concerned the nancing of new and small rms.

Governments have, over the years, taken several initiatives to try to improve the

position, the most recent example of which has been the tax advantages given to

investors in venture capital trusts (VCTs). UK nancial institutions have also been

criticised for providing nance to overseas governments and rms at the expense

of domestic rms and for taking a short-term perspective in the treatment of rms.

Evidence relating to this last point is unclear but the issue remains important. A quite

different problem concerns the exclusion from nancial markets of poor households.

This nancial exclusion imposes considerable costs upon them and helps to preserve

inequalities in society. The government has become particularly interested in this

issue in recent years; much research has been done and attempts are being made to

improve the position.

There is a strong view that the level of saving in the economy is inadequate.

One government response has been to set conditions for a range of simple nancial

products known as stakeholder products although these do not as yet appear to be

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Further reading

having much success. The problem of a lack of saving has come to the fore particularly

in relation to the nancing of pensions. Problems have arisen with dened benet

pension schemes and many of these have now been withdrawn by rms. A different

long-term savings problem emerged in the early years of the decade concerning

endowment mortgages.

Another much debated issue has concerned the causes of nancial booms and

crashes. There has always been a difference of opinion over whether these are caused

by irrational behaviour or whether participants in nancial markets can always

be assumed to act rationally. We need also to consider whether nancial instability

is an inevitable part of the capital market system. That system also appears to pro-

duce regular examples of nancial scandals and fraud. Even fraud in non-nancial

companies has serious implications for the operation of nancial markets and

institutions.

Finally, there are serious implications of possible international nancial instability

perhaps associated with the free movement of capital and with the wide gap in wealth

and income between rich and poor countries.

Questions for discussion

1	What is meant by ‘short-termism’? List and discuss the arguments in support of theview that the UK nancial system has been ‘short termist’.

2	Why is it a potential problem if long-term savings are too low?
3	Consider the disadvantages in being nancially excluded. Are there any advantages?
4	Why are stakeholder nancial products so called?

5	Why were stakeholder products not much taken up during the rst year in which theywere offered?

6	Look up the events of the tulip boom and crash in the Netherlands in the late seven-teenth century. Is it possible to see these events as the outcome of rational behaviour?

7	What has happened since this text was written in the Enron and Parmalat cases?

8	The text mentions WorldCom as another major scandal. What was the basis of that fraud?

9	What is a ‘Tobin tax’? What prospect is there of its ever being implemented?

Further reading

Bank of England, ‘The Distribution of Assets, Income and Liabilities Across UK Households:

results from the 2005 NMG Research Survey’, Bank of England Quarterly Bulletin, Spring 2006,

www.bank of endland.co.uk

A Fazio, ‘Fact-nding with regard to the relationship between rms, nancial markets and the

protection of savings’, Economic Bulletin, 38, March 2004 (Rome: Banca d’Italia)

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Chapter 12 • Financial market failure and nancial crises

J A Frankel and K A Froot, ‘Chartists, fundamentalists and trading in the forex market’,

American Economic Review, May 1990, pp. 181–5.

HMSO, Report of the Committee to Review the Functioning of Financial Institutions (Wilson

Report), Cmnd. 7937 (London: HMSO, June 1980)

HM Treasury, Promoting Financial Inclusion(London: HM Treasury, December 2004)

HM Treasury, ‘Sandler Report’ (2002) at www.hm-treasury.gov.uk/documents/nancial_services/

savings/n_sav_sand.cfm

C P Kindleberger, Manias, Panics and Crashes. A History of Financial Crises(New York: John

Wiley and Sons, 3e, 1996)

Nottingham University, ‘Poor and ethnic minority areas bear the brunt of bank branch closures’,

Nottingham University press release PA31/06, 23 February 2006 http://www.nottingham.ac.uk/

public-affairs/press-releases/

M Sullivan, Understanding Pensions(London: Routledge, 2004)

J Tobin, ‘Money and Finance in the macroeconomic process’, Journal of Money, Credit and

Banking, 14(2), May 1982, 171–204

http://www.pensionprotectionfund.org.uk/www.ceedweb.org

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CHAPTER13

The regulation of nancial markets

Objectives

What you will learn in this chapter:

lGeneral reasons for and against regulation

lSpecic reasons for the regulation of the nancial services industry

lArguments for and against self-regulation of nancial markets

l	The major changes that have occurred in the regulation of nancial markets inthe UK in the 1980s and 1990s

l	Details of the principal British Acts of Parliament governing the banking and nancial services sectors

l	Details of the regulation of banking and nancial services across the European Union

l	The nature of the problems caused by the globalisation of the nancial sectorand by the developments in derivatives markets

l	Details of the international attempts to deal with regulatory problems

The nancial services industry has always been politically sensitive and, conse-

quently, heavily regulated. Such regulation has many aspects. It may be concerned

with the degree of competition in a market, the protection of consumers of nan-

cial services, the encouragement of small investors, the capital adequacy of nancial

institutions, the ability of small rms to obtain venture capital, or the preservation

of the reputation of the market and the practitioners in it. As well as theoretical

arguments for and against regulation in general, there are practical explanations of

the regulation of specic segments of the nancial sector.

The banking industry, for instance, relies on public condence. The fractional reserve

banking system (see Chapter 3) vastly increases the potential protability of banks

but also leaves them at risk from the loss of public condence, which may cause a

run on their deposits. The risk of collapse is made greater by the contrast between

the liquid nature of bank liabilities (deposits) and the illiquid nature of their assets

(loans). There are three principal areas of concern in relation to bank collapse.

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Chapter 13 • The regulation of nancial markets

Contagion:The collapse of one nancial institution leading to bad debts and/or a loss

of condence in other nancial institutions, possibly causing their collapse – a particular

problem for banks.

The rst is the prospect of contagion. This, in turn, might have serious conse-

quences for the real economy. Contagion might arise to the extent that a failure of

one bank causes a loss of condence in banking in general. Another possible source

of contagion is the very high level of interbank dealings in modern banking – the

collapse of one bank creates bad debts for other banks.

The second concern is with consumer protection. The efciency of a modern eco-

nomy is greatly enhanced by the development of the nancial system and thus it is

desirable that as many people as possible participate in that system. It follows that

collapse of nancial institutions within a sophisticated nancial system is bound to

affect large numbers of people, small savers as well as large. Further, many people who

take part in nancial transactions have little knowledge of either the products or

the processes of the nancial system. In addition, prices in nancial markets depend

heavily on expectations and can move very sharply as a result of market optimism

or pessimism. Large prots (and losses) can be made with great rapidity. It is hardly

surprising, then, that greed, chicanery and gullibility are present to a greater extent in

nancial markets than in many others. Consumer protection becomes a particularly

sensitive issue when small savers are threatened with the loss of their life savings. The

safest response for politicians is to attempt to regulate the market in the hope of pre-

venting such situations from occurring and/or to provide insurance where they do arise.

Box 13.1 considers two contrasting British cases of consumer loss in nancial markets.

Box 13.1

Attitudes towards losers in nancial markets

Lloyd’s of London names

Lloyd’s of London is an insurance market organised into 400 syndicates supplying

a range of insurance services. Syndicates are backed by ‘names’ who guarantee to

meet any syndicate losses from their personal wealth on a basis of unlimited liability.

In protable years, ‘names’ do not have to provide funds and thus earn a rate of return

on money that can also be invested elsewhere. However, in the late 1980s and early

1990s, several syndicates experienced years of large losses and ‘names’ backing these

syndicates were called upon to pay large sums. It was claimed that some losses were

the result of manipulation by professionals in the market and the market felt obliged to

provide some compensation to losers in order to try to salvage its reputation. Many court

actions were undertaken by ‘names’. Nonetheless, there was little public sympathy for

‘names’. It was widely believed that they were happy to accept the high returns without

being prepared fully to accept the accompanying risk.

UK private pensions

In the late 1980s, new legislation opened up the possibility of people taking out private

pension plans. Large insurance companies saw this as a major new market and set

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about persuading large numbers of people to switch from their existing pension schemes

operated by their employers to private pension plans or to take out personal pensions

rather than joining employers’ schemes. Between April 1988 and June 1994, many

people were misled by insurance companies into believing they would be better off with

a personal pension plan when the reverse was the case. When this became clear, there

was widespread public and political anger. The industry regulators imposed nes on

the companies involved and required that compensation be paid. However, the form of

compensation was not agreed until some years after the problem become known. The

mis-selling review was not completed until early 2003. Compensation offered by the

insurance companies was over £11.5bn and nes of more than £10m were levied on

the companies. The administration costs of the review were £2bn.

Losers and the search for remedy

We have seen in the personal pensions case and shall see again with regard to split

investment trusts in Box 13.2 that there is sometimes a case for losers in nancial

markets to be rescued. On other occasions, as with bank deposit insurance, losers are,

up to set limits, insured against loss. In the personal pension example, industry regulators

sought recompense for the wronged parties. Mostly, however, losers must seek legal

remedy, as with the Lloyd’s names above and the Mirror Group pensioners considered

in Box 13.3 (later). We mentioned another interesting legal case in Box 10.6, with the

ratepayers of Hammersmith and Fulham being rescued by the courts from the folly of

their council ofcials. Other cases abound. All of these cases raise, in different ways, the

question of the extent to which people should be held responsible for their actions in

complex nancial markets.

Box 13.2Consumer protection – split capital investment trusts

Split capital investment trusts are investment trusts – companies listed on the London

stock exchange that raise funds to invest in other companies. Investors benet from both

dividend income and capital growth. Split capital trusts typically have two types of share-

holders with different investment needs – those interested principally in income who collect

dividends and expect their capital returned at the end of the trust’s life, and those inter-

ested in growth who opt for zero dividend preference shares (zeros), receiving in return

for forgoing dividends a share in all the capital growth of the fund at the end of its life.

In the late 1990s, when share prices were booming, split capital trusts were heavily

marketed and extravagant promises were made. High annual rates of return were mentioned

and the trusts were said to be ‘low risk’. Shares in the trusts were bought, in particular,

by parents saving for school fees and pensioners wanting income or lump sums.

However, when share prices began to fall sharply in 2000, many trusts did not have

enough cash to pay the scale of dividend they had promised. Some trusts borrowed

heavily to buy more shares (they became heavily geared) and also invested in each other

(crossholdings). One trust lost over 68 per cent of its value in one year. By October 2002,

eight split capital trusts had called in the receivers and up to 40 of the 120 trusts were

thought to be in serious trouble. Perhaps 50,000 people have lost money in the trusts,

some losing heavily. There were stories of pensioners losing their homes.

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Initially it was thought that losers had little chance of compensation. The invest-

ment industry sought to blame the buyers of zeros. Further, since investment trusts are

technically companies rather than regulated funds, the Financial Services Authority (FSA)

claimed no responsibility for them and the Financial Ombudsman Service (see Box 13.4)

can deal with them only on a voluntary basis.

However, in February 2003, the House of Commons Treasury Select Committee issued

a report on the trusts, which accused one of the biggest rms in the sector, Aberdeen

Asset Management, of recklessly misleading promotion. More generally, it suggested

widespread conicts of interest and collusive behaviour in the sector, possibly amounting

to corruption. This considerably increased the prospects of investors suing companies

for mis-selling. The Treasury Committee chair called for compensation, with extra cash

where collusion or corruption could be shown. Following an investigation into the selling of

splits, the FSA proposed to the rms involved that they take part in collective settlement

negotiations leading, where appropriate, to rms compensating investors and taking dis-

ciplinary action against staff. This led to the establishment of Fund Distribution Limited

(FDL) to administer the payment of compensation to aggrieved investors. FDL made an

initial offer of 40 pence for every pound lost, in return for which investors were required

to give up the chance of securing potentially higher payouts through the courts or by use

of the ombudsman service. The closing date for acceptance of the offer was 15 May

2006. In early June 2006, FDL announced that 96 per cent of the 25,000 eligible investors

had accepted the offer and that a second payment would probably bring the total com-

pensation to around 50 pence in the pound.

The split capital investment trusts affair illustrates several points:

l

The notion of moral hazard – the existence of a powerful regulator and an ombudsman leads small investors to feel their investments are secure. They do not, as a result, always read the small print attached to nancial products, even though it could be argued that the high rates of return offered should have alerted investors to the degree of risk they faced.

l

The difculty in determining the extent of consumer responsibility for their loss. Was this really a case of mis-selling, with innocent consumers being misled by dissembling or dishonest professionals? Or were consumers led into the investment partly by greed – the promised high rates of return causing them to act in a foolish way? This raises the question of how much consumer protection should be provided.

l	The damage to the industry caused by cases such as these – the Association of Investment Trust Companies felt the need to set up a hardship fund to help out, seek- ing contributions from fund managers who wanted to restore the battered reputation of the investment trust sector.

The third concern with banks is that their liabilities form the means of payment.

Thus, bank regulation aims to guarantee the integrity of the transactions medium

and to prevent the process of nancial intermediation from failing.

The special features that explain the high level of regulation of the insurance

market include the very long term of some contracts, the size of many of the risks

being insured relative to policyholders’ incomes, and the lack of transparency of

many of the products. Until quite recently, in other nancial markets – for equities,

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