Has the spirit of light-touch regulation ended with the UK regulator that embodied it?

The Guardian's Jill Treanor wrote an interesting column in which she talks about how it was not just the light-touch regulation practiced by the UK's Financial Services Authority, but also the interventionist policies practices by other western financial regulators that failed in the run-up to the financial crisis.

It is a very important point that regulatory oversight failed across the entire spectrum from light-touch to active interventionist.

The question is why?  Why did the combination of complex rules and regulatory oversight not prevent a financial crisis?

Regular readers know the answer is the combination of complex rules and regulatory oversight was used as a substitute for the combination of transparency and market discipline.  Not only was it used as a substitute, but the combination of complex rules and regulatory oversight created additional opacity in the financial system.  Opacity that eventually undermined financial stability.

Western financial systems are based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This combination produces financial stability because it puts on each market participant the responsibility for losses on their investment exposures.  This responsibility creates stability because each market participant has an incentive to limit their exposure to what they can afford to lose.

Opacity interferes with the mechanism that makes the financial system stable.  It makes it impossible for investors to assess the risk of their exposures and therefore limit them to what they can afford to lose.

This is particularly true when it comes to the banking system and the role of the financial regulators.  As the BoE's Andrew Haldane says, banks are 'black boxes'.  They do not disclose the information needed by investors to assess their risk.

This lack of transparency is made even worse by the action of regulators.  Regulators who engage in activities like stress tests and proclaim the banks to be solvent.

How exactly is an investor suppose to determine the true risk of the banks and properly limit their exposures when the regulators are saying that insolvent institutions are solvent?

Which brings us back to light-touch regulation.  Whether it is light-touch or activist interventionist regulation, it is the focus on "regulation" that distracts from the primary responsibility of the regulators under the FDR Framework:  ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed investment decision.

It was the watchdog that didn't bark. When the Financial Services Authority (FSA) was created in its current form by Gordon Brown, it was modelled on the all-powerful US regulators, but it is likely that it will be remembered for only thing: presiding over the near-meltdown of the UK's banking system. 

In its short life, the FSA failed to rein in the banks, and even encouraged the City to explode in the mid-2000s with a "light touch" approach to regulation. 

It did not notice that Northern Rock was built on such shaky foundations that it could easily run out of money, and failed to prevent the takeover of ABN Amro by RBS just as the credit crunch was biting in late 2007....

Please note that it is not the responsibility of the regulators to be the watchdog.  It is the responsibility of all the market participants to continue to monitor their investment exposures and make sure that their exposures do not exceed their ability to absorb losses.

Tearing up the FSA – which united the nine regulators that had existed before Labour was swept to power in 1997 – was one of the first key policy announcements by Osborne after the May 2010 election. 

But it has taken almost three years – much longer than expected – after he first pledged to disband Brown's regulator to fulfil the vision to create two new ones – the PRA (a subsidiary of the Bank of England to ensure banks have enough capital and liquidity) and the FCA (essentially charged with putting consumers at the heart of the matter when dealing with financial regulation)....

Do you notice how there isn't a regulator focusing on making sure that the banks provide transparency so that market participants can independently assess their risks?

Our current financial crisis showed that capital standards in the absence of transparency is hazardous for financial stability.  The reason it is hazardous is that risk is the important issue.  Without transparency, there is no way to measure risk.

While the FSA's legacy seems likely to be the banking crash, Kevin Burrowes, UK head of financial services at PricewaterhouseCoopers, acknowledges that the watchdog was not alone in missing the warning signs. "It's not apparent that any regulator from around the world can stand up and say they did a great job over this period," he says....

In the fallout from the crisis, they set about changing what Sants's predecessor, John Tiner, had described as principles-based approach to regulation. In 2006, reflecting the mood of the time, Tiner said: "Firms' managements – not their regulators – are responsible for identifying and controlling risks. A more principles-based approach allows them increased scope to choose how they go about this. In short, the use of principles is a more grown-up approach to regulation than one that relies on rules." 

But by 2009, Sants was saying, damningly: "A principles-based approach does not work with individuals who have no principles." 

Meanwhile, Turner was outlining to MPs what he saw as a major problem, telling the Treasury select committee: "It was not the function of the regulator to cast questions over overall business strategy of the institutions … You may find that surprising."

Thankfully, the new regulators are now being encouraged to be more curious and ask more questions....