Andrew Lilico and Helen Thomas

Rules versus discretion

Rules versus discretion
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Today's White Paper on financial regulation avoids introducing some unnecessary regulatory changes at the expense of failing to introduce some necessary ones.  In particular, it fails to recognise the abject failure of Gordon Brown's "tripartite" framework, in which prudential supervision of the banks was taken from the Bank of England and given to the FSA.

Prudential supervision is the proper task of the central bank, for only if it has oversight of banks can the central bank decide whether they should receive last resort lending when they need it.  Without prudential oversight, the Northern Rock debacle is the likely result, and the fact that we are still debating this the best part of two years into the credit crunch is a sorry indictment of UK policymaking in this period.  Also, if the central bank does not have prudential oversight of the banks, but is expected to maintain financial stability, it is necessary to enter into all kinds of strange contortions about "macroprudential tools" and "counter-cyclical capital controls".  These debates chase a problem that need not be: if the Bank of England had prudential oversight, it would automatically have all the tools necessary.

Mercifully, the White Paper attributes the crisis mainly to errors in the assessment of risk, rather than any nonsense about rejecting the entire structure of modern finance theory.  (The contrast here with Turner is stark). Yet it does not reflect upon the extent to which regulation might have actually added to risk assessment errors. Regulatory badging, the use of credit ratings agencies, bail-outs in past crises, excessively low interest rates, and the flawed Basel II capital requirements all skewed and at the same time coordinated the risk calculation. These and other regulatory interventions encouraged excessive leverage, inefficient innovation, and overly high risk-taking.  The White Paper neither accepts that regulation added to risk assessment errors nor attempts to refute this claim.

It sensibly opposes forbidding joint retail and investment banks - neither useful nor, probably, feasible - and equally sensibly opposes arbitrary size limits for financial firms.  But these rejections miss a key question: even if universal banks and large banks might have their place, do we want to break up the specific nationalised banks that we now hold when, eventually, we privatize them?  The White Paper gives us neither answer nor insight.

George Osborne, responding in the Commons, said that the Conservative Party would give prudential oversight of banks, building societies, and other significant financial institutions to the Bank of England.  This is good, but it raises a question: if prudential oversight is best done through the discretion of a central bank, rather than through a rule that any institution (e.g. the FSA) might enforce, where does that leave the Basel Accords?  Might the whole concept of devising rules that apply to all countries at all times be a mistake?  We shall have to wait for the Conservative Party White Paper - promised for later this month - to find out...

Andrew Lilico is Chief Economist, and Helen Thomas is a research fellow, at Policy Exchange.