13.2 Financial regulation in the uk

The assumption then is that self-regulation is almost certain to be lighter than

statutory regulation. There is a danger, however, that self-regulation may turn out to

be an awkward halfway house. It must be supported by some government regulation

at least to the extent that rms are legally required to join the industry regulatory

scheme. Otherwise, an incentive would be created for some rms to act as free riders,

hoping to benet from any increase in reputation of the industry resulting from the

behaviour of rms within the regulatory organisation without paying the costs of

membership.

More importantly, self-regulation creates less moral hazard than statutory regulation

only to the extent that it leaves an element of risk for both consumers and producers.

Once risk exists, the degree of risk has to be assessed to allow a judgement to be made

of the risk/return prole of an investment. This should cause no worries to profes-

sionals, but the general public faces two types of difculty. Firstly, it may be time-

consuming and costly to acquire the necessary knowledge to assess risk accurately.

Secondly, the ability of non-experts in a eld to assess risk is notoriously poor. There

is a strong tendency for people to respond to risk by adopting one or other extreme

position. They may, as responses to food scares show, eschew a product or activity

completely as soon as the existence of risk becomes apparent. Alternatively, they may,

as people’s behaviour as car drivers or smokers attests, believe that risk exists only

for other people. Thus, the possibility of consumers assessing risk at all accurately is

remote, especially in markets in which producers have both the incentive and the

capacity to mislead consumers.

Further, the existence of consumers who are, in the eld of nance, risk-takers or

who underestimate the true level of risk ensures that dubious rms continue to

survive despite the apparent reduction of moral hazard. On the other hand, those

who are risk-averters or who overestimate the true risk may be driven away from

products from which they might have beneted. Nor does self-regulation perform

particularly well in terms of the other complaints about regulation. By denition,

self-regulation places regulation in the hands of the producers. Indeed, it places it in

the hands of existing producers and provides an incentive for them to use regula-

tion to increase barriers to entry to the industry. Thus, it may lead to a lowering of

some kinds of compliance costs, but not necessarily all.

13.2Financial regulation in the uk

Financial regulation in the UK went through two major reorganisations in little over

a decade. The rst set of changes occurred in 1986 and 1987.

Among them we can distinguish three particular landmarks – the ‘Big Bang’ in

equities markets in 1986, with the associated changes in the organisation of the bond

market; the Financial Services Act of 1986; and the 1987 Banking Act, following

earlier changes in 1979 and 1984. This reorganisation of the practice of regulation

followed a series of developments in the nancial markets.

Perhaps the single most important of these was the rapid internationalisation of

the markets. This had several causes. Firstly, major nancial imbalances had developed

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Chapter 13 • The regulation of nancial markets

among countries. These arose initially with the oil price rises of 1973 and 1979 and

the consequent need to recycle the surplus funds of oil-producing countries. They

continued through the 1980s and into the 1990s with the huge current account

decit of the US and surpluses of West Germany and Japan, and with the growth of

the debt crisis of Latin American and other developing countries. Political crises in

developing countries led to large movements of ‘ight’ capital from those countries.

The huge growth in sovereign lending required a great increase in international

co-ordination among commercial banks, with many loans being syndicated by more

than 100 banks from many different countries.

Secondly, transnational corporations continued to grow in importance, contribut-

ing substantially to the movement of funds across borders. The sharp movements

in exchange rates, which have characterised the past thirty-ve years, increased

the need for these companies and others engaged in international trade to protect

themselves against foreign exchange risk. This, together with the greater availability

of funds and the increased international competition and greater freedom in the

movement of capital in much of the world, resulted in the continued expansion of

world capital markets such as the eurobond, eurocurrency and euronote markets and

the development of a range of highly sophisticated nancial products to meet the

changing needs of companies and governments. Perhaps the most striking change

has been the rapid growth of nancial derivatives markets, with a vast increase

in the number of types of contracts sold. These changes were facilitated by major

developments in computerisation and communication that led to twenty-four-hour

worldwide markets.

As well, the growth of nancial imbalances was associated with the almost con-

stant threat of instability and the fear of collapse of nancial institutions, which

(because of the huge increase in international interbank transactions) have at

times appeared to be a threat to the whole nancial system. This concern has caused

national monetary authorities to meet to attempt to agree upon rules relating to

institutions engaged in offshore nancial markets under the auspices of international

organisations such as the Bank for International Settlements.

Within the UK system, too, the changes were numerous. The renewed need for

the authorities to nance public sector decits in the 1990s following four years

of surpluses emphasised the importance of bond markets. For much of the 1980s

and 1990s equities markets ourished, fuelled by the privatisation of large public

corporations and by a great deal of takeover activity among companies. New markets

developed, for instance the unlisted securities market and the market for commercial

paper. Institutions, notably pension funds, grew rapidly. The government sought to

encourage small investors into markets and introduced changes such as those in

pension arrangements that led to the development of new nancial products. The

Single European Act 1986 and the steps taken to implement its terms in nancial

markets added yet another element to the changes occurring.

Among all of these and other changes, supervision of the activities of rms and the

operation of markets became, at the same time, increasingly important and increas-

ingly difcult. It is in this light that we need to consider the regulatory changes of

recent years.

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