On the "value" of regulation

Considering he is a Vulcan and works for Call Me Dave, John Redwood makes a lot of sense sometimes:

236 people were employed in the USA to regulate Fannie Mae and Freddie Mac. Were their jobs really necessary? They were slow to realise the seriousness of the predicament these two large companies got into, and were unable to do anything against the lobbying power of the mortgage companies when they did think there was room for improvement. Despite the Regulators the companies got into financial trouble which required a huge Federal bail out.

He then goes on to say:

Northern Rock was a heavily regulated business in the UK. Its business plan and accounts were permitted by the FSA. It took its regulatory duties very seriously. No-one suggests it bent the rules or tried to misinform the Regulator. Indeed, in the last Accounts before the crash the Directors were busily planning how to reduce the amount of capital they held for a given level of business in response to the relaxation of capital standards being pushed through by the world Regulators in Basel II! I was told by the Chancellor I was wrong to propose getting rid of the mortgage regulations the present UK government brought in, as that would be dangerous! In all the years when we did not have such specific mortgage regulation we had no run on a mortgage bank. Its enactment and enforcement did not save Northern, or prevent Northern and others lending money to people against high house prices on high multiples of earnings. So what was it for?

So, Northern Wreck was playing with an absolutely straight bat, as far as we can tell. This is the crucial bit:

The Northern Rock saga should remind us that sometimes regulations preversely make things worse rather than better. If there had been no capital adequacy requirements laid down, Northern’s Directors may have been more cautious. Because standards are laid down, Directors are tempted to say “Let’s deliver the required standard” assuming that will be prudent.

And therein, as the Bard said, lies the rub: by deferring your own judgment to the government's regulation, you are assuming that the government has got good judgment.

It's important to note that the directors could have played even faster and looser with their capital adequacy, I'm not denying that! But they played things according to government rules and we then discovered that the government rules were completely inadequate. How can we blame NR for getting it wrong, when they did exactly what the government told them to do?

And more worryingly, if they completely screwed the pooch for NR, how safe is any other bank?

John Kay gave us a more modest list of things regulators could do. They could concentrate on policing activities to try to prevent or intercept criminal activity within financial businesses - attempts to steal client money in one way or another. They could ensure a comprehensive deposit protection scheme. The Central Bank should concentrate on providing cash to the system - where it has a monopoly - against reasonable security from the banks. The rest should be left to the market.

And I think there's a lot to commend in that kind of thinking: don't focus on the minutiae of regulation, because a) you will inevitably get it wrong and b) it creates a barrier to entry, which benefits only incumbent businesses. Our regulatory watchdogs have shown themselves time and time again to be utterly toothless when it comes to prosecuting fraudsters and we don't have an adequate deposit protection scheme.

So: focus on what you want to achieve and do the minimum to ensure that; don't try to get too clever on the details; make sure that what you actually choose to do is properly policed; and for the rest: get out of the way.