Post-Brexit, it might be expected that the UK has an opportunity to reduce the burden of regulation, in areas where European standards have been more restrictive than we might have decided to impose on our own. One place where commentators appear to have been particularly keen on deregulating is in the key export market for financial services. But people are correctly suspicious of financial deregulation, as it appears to have been the source of several disasters in the past. Why and how does deregulation go wrong, and is there any way of doing it correctly? Let's start by thinking about lettuces.
Different markets have different tastes. As we can see from the fact that British supermarkets have chosen to ration lettuces to three per customer after bad weather in Spain has left Europe in short supply (while supermarkets on the continent are full of produce at triple the normal price), there are some things which the British consumer just won't bear. Paying more for vegetables is one of them. Fees for cash machine withdrawals and in-credit bank accounts is another. And pension advice is a third.
The trouble is that 'maintaining standards' easily shades into 'maintaining incumbents'
Although these are three very different markets, they all got how they are in the same way – years of of jostling for market share in a highly competitive sector educated the consumer into taking certain things as normal. That lettuces would be provided below their cost, that overdrawn customers would subsidise everyone else's free bank accounts, and that long-term savings products would be sold mainly by people with a conflict of interest. Once these norms were established, they are very hard to shift. Although the salad shortage is likely to be temporary and minimally harmful, the two examples in financial services are quite significant distortions and both of them have proved highly resistant to any regulatory action to ameliorate them.
We're well used to price wars and fierce rivalries between supermarket chains in the UK, but the level of competition in financial services is determined more by government regulation.
The current account market is what it is today because the building society sector was deregulated, leaving the old clearing banks competing face to face for deposit business. The long term savings market is where it is because of the way in which the pensions industry was initially opened up to competition, with successive waves of restrictions on conflicts of interest only coming in response to successive waves of misselling scandals. Banks which tried to maintain transparent pricing, or savings companies which tried to provide unbiased advice rather than a hard sell, lost market share. Over time, consumers got used to the new norm. A sort of Gresham's Law operated, as 'bad practice drove out good'.
Similar stories can be told about episodes from the US mortgage boom and housing bubble, to the collapse of the Vancouver Stock Exchange [PDF]. Historically, nearly every financial market appears to have begun its life as a self-regulatory group, right back to the time when it was decided to require minimum standards of commercial behaviour in insurance broking to anyone who wished to drink at Lloyd's Coffee House. In a market where quality is difficult to determine and where product turnover is low, producers with high standards are very vulnerable to less scrupulous competitors who can promise what looks like a better deal up front, at the expense of the customer in the long term. That's what regulation is there to prevent, and it's the fundamental economic reason why financial firms have such a close friendly-enemies relation with their regulators. It's also the reason why, contrary to popular myth, the UK in the last ten years has been a proponent of tougher financial regulation in Europe, not looser.
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The trouble is that 'maintaining standards' easily shades into 'maintaining incumbents'. If regulations are costly to follow – which is always the case if they require documentation of processes – then they impose a de facto minimum scale on market participants, preventing entry. And not all falls in standards are undesirable – 'providing a worse service at a lower price', one of the workable Fintech models, can mean that an entrant is undoing the incumbents' use of 'bundled' services to extract rents. In UK financial services regulation, this problem is addressed by use of the 'sandbox' – a relatively rule-light, high-touch approach from the regulators to innovative fintech businesses, allowing them to develop business models at small scale, and with careful checks on what the true minimum standard really is and whether scaling up would undermine it.
This is potentially a model of careful, gradual deregulation which could be followed post Brexit, looking at rules one by one to see how and whether they might be changed to facilitate more competitive new markets. But it is unlikely to deliver the kind of Wild West, tax-haven outcome that people might have expected. Big financial industries have lots of regulations, not so much to protect the customers, but to protect the industry itself from its least scrupulous members.