Why do regulators of financial institutions issue regulations?  

 

During my career, the volume and complexity of regulation of financial institutions has increased significantly. Executives and staff of banks, superannuation funds, insurers, credit societies and so on have laboured under an increasingly suffocating mass of obsfucatory laws, regulations, practice standards, guidelines to interpret practice standards, class orders, announcements and frequently asked questions. Why is it so? What problems have been fixed by any of these new regulations? Why should a regulator decide how insurers must determine a capital adequacy reserve? Why should a regulator determine what is an appropriate solvency margin for a superannuation fund? 

 

Most, if not all, executives and staff of prudential regulators are well-intentioned. In my experience, they believe that regulation is necessary to guard against certain types of unsociable, unethical or simple incompetent behaviour by market participants to guard against losses adversely affecting the financial assets of consumers. The regulators believe that they can, to large extent, regulate away problems.

In the real world, problems cannot be regulated away. Laws against insider trading do not stop insider trades. Laws mandating certain solvency margins do not stop all insolvencies. Laws specifying in gory detail what numbers must appear on a periodic statement to a depositor do not make depositors any better informed.

 

Regulation is judgement. Why does a Government bureaucracy think it has better judgement about running an insurance company than the insurance company’s board of directors? When Governments regulate, they replace private commercial judgement with bureaucratic judgement. I have never met a regulator who knows the operations of a financial institution better than the executives of that institution. The fatal conceit of the regulator is to believe that they know best and that regulation is the key to financial stability and prudence.

 

Regulation promotes complexity and expense. Consumers pay for this.

 

The best form of regulation is that applied by institutions themselves, provided that there is no explicit or implicit publicly funded bail out mechanism should that institution get into trouble. Bail-outs change institutional behaviour.