Free trade should empower consumers – not the lawyers who write trade agreements
The extent to which we have become regulatory junkies in this country is alarming. Indeed, one reason why I voted Remain is that I have perceived this trend in the UK for some time. I have always believed that the idea that leaving the EU would lead to less regulation in Britain was a fiction. I believed that partly because of the way in which the UK pushed through the EU huge extensions of costly regulation and pushed through the harmonisation of regulation in many areas. And then when we implement such regulation, we gold-plate it. So, for example, MiFID II (Markets in Financial Instruments Directive) involves 1.7 million paragraphs of regulation. 1.7 million paragraphs, all designed to promote transparency!
This is all a far cry from when the single market developed. If one reads contemporary accounts from professionals involved in financial markets in the late 1980s and early 1990s, three things immediately jump out. The first is that the UK had liberally regulated markets and regulation was mainly by non-state institutions such as exchanges and professions. The second is that, insofar as the European Commission did act to unify approaches to regulation, it was by prohibiting certain forms of regulation, normally in continental Europe, when they inhibited trade. Thirdly, the principle of mutual recognition prevailed. Subject to some very minimal harmonised standards, different countries had different regulation.
Not only has the UK promoted harmonisation in recent years, it has promoted a huge expansion of regulation too. I have mentioned MiFID already. To take another example, the implementation of the EU Solvency II regime for regulating insurers is estimated by the UK Treasury to have cost £2.6bn with an ongoing direct cost of £196m a year. The total length of the Solvency II directive and related instruments is 3,200 pages and the UK regulator will impose further costly requirements on top.
It is against this background that any relaxation of regulation is described in pejorative terms as moving towards a “Mad Max Economy”. Perhaps David Davis, who made this point, should reflect on the fact that the 1870 Insurance Companies Act, which successfully governed a very stable life insurance market in the UK for over a century, was about nine pages long with about nine pages of associated financial returns that had to be made by insurance companies.
In contrast to that, Solvency II develops complex models, not even understandable to most actuaries that set capital requirements so that insurance companies have a 1 in 200 chance of failure over one year. This takes us way beyond any reasonable job we can expect regulation to do – hence its complexity. Not only that, it would seem unnecessary. Insurers do not generally want to go bust – it is not good for business. That is why, in practice, insurance companies normally hold sufficient capital so that the risk of ruin is far lower than 1 in 200: 1 in 5,000 would be more typical.
So, I don’t see much hope of the UK government doing anything to relieve the financial services industry of this huge regulatory burden, a burden that does so much to promote opacity in the sector.
Where should we go specifically when it comes to regulation? As it happens, the EU is not the only international regulatory game in town. Almost any random collection of letters creates the acronym of an international regulatory body. Regulation is increasingly being harmonised on an international level which transcends the EU and this tends to create the framework for governing trade in services.
International standardisation of regulation (including at the EU level) creates many problems. International regulators may believe that they can choose the “right” form of regulation and impose it on all co-operating companies. But we don’t know the “right” form of regulation in advance. Differences between regulatory systems allow alternative approaches to be tried. Harmonisation means that, if we get things wrong, regulation goes wrong everywhere in the same way at the same time. Harmonisation creates new forms of systemic risk.
As Yale law academic and NBER scholar Roberta Romano put it: “Recent experience suggests that regulatory harmonization can increase, rather than decrease, systemic risk. By incentivizing financial institutions worldwide to follow broadly similar business strategies, regulatory error contributed to a global financial crisis […] there are bound to be regulatory mistakes, both large and small. Moreover, an internationally-harmonized regime impedes the acquisition of information concerning the comparative effectiveness of differing regulatory arrangements, lowering the quality of decision making, as nations are discouraged from experimenting with alternative regulatory arrangements.”
So, what do we do? We should try a three-pronged approach. Firstly, we should return to the principle of subsidiarity and the approach of mutual recognition. Consumers should be able to know by which regulatory regime products and services are regulated, but there should be the minimum of harmonisation across national boundaries.
Where for some reason mutual recognition could not work, we should accept that separately regulated subsidiaries may have to be established in different countries. The focus in trade negotiations should be on ensuring that different regulations adopted in different countries do not distort trade. It is still possible to freely trade services with different legal personalities being adopted by businesses in different countries. This is how most insurers operate. The non-life insurance industry is extremely international, yet nearly all cross-border trades takes place through separate subsidiaries. HSBC operates its international business entirely through separate subsidiaries.
The only case for international regulation is that it reduces costs of compliance for big companies operating internationally allowing them to operate their whole international business according to one set of regulatory rules.
There is a simple solution to this. International bodies, including the EU, can develop regulatory frameworks which large, transnational companies can opt into. This will promote the advantages of international regulation (if they exist) without the disadvantages.
The focus in trade negotiations should be on ensuring that countries (the UK, the rest of the current EU and other countries with which we have trade agreements) do not distort trade. We should not seek regulatory uniformity. Indeed, we should welcome regulatory diversity. International frameworks of regulation should be there as an option for those companies that wish to take advantage of them. Those companies that do not adopt the international regulatory regime may have to accept that they can only operate in other countries by establishing separate subsidiaries.
Trade agreements are thousands of pages long because we are trying to shape internationally harmonised regulations to fit a whole range of services industries. That is not what free trade is all about. Free trade should give power to the consumers not to the lawyers who write trade agreements.
The UK government needs to take more risks with under-regulation in the post Brexit era. Ever since 1980, we have been trying to control financial institutions with ever more regulation. It has not been a success. Rejecting 1.7 million paragraphs of rules designed to implement MiFID II is not to embrace a Mad Max economy: it is to turn our back on regulatory madness.