Financial regulation: Britain the perennial outlier?
by Philip Whyte
Back in 2007, when the Labour government had abolished the business cycle and the City of London was booming, British policy-makers liked to vaunt the merits of ‘light touch’ regulation. Given the scale of British hubris in the run-up to the worst financial crisis since the Great Depression, the country’s EU partners can be forgiven for feeling a certain amount of Schadenfreude. Less justifiable, however, is the sense of vindication that has often accompanied it. Many European politicians have liked to give the impression that the financial crisis would not have happened if ‘Anglo-Saxons’ had regulated and supervised financial markets as strictly as Europeans; and that the task following the crisis is for Europeans to make sure that recalcitrant Anglo-Saxons are finally made to do so.
There are at least two reasons why this narrative is misplaced. The first is that Europe was not an innocent spectator in the run-up to the financial crisis, but an active participant in its genesis. Many European banks were as highly leveraged as Anglo-American ones (and vastly more so than hedge funds). Their lending standards deteriorated every bit as dramatically. And many enthusiastically underwrote or invested in exotic asset-backed securities like collateralised debt obligations (CDOs). (European banks’ voracious appetite for high-yielding securities with AAA-ratings was one factor that drove the growth in the market for CDOs). It does not necessarily follow, then, that the crisis would have been averted if regulatory and supervisory regimes in the Anglo-American world had been ‘more European’.
The second reason is that it ignores just how far the climate in Britain has changed since the crisis. Britain has not had to be bullied into abandoning its ‘light touch’ regime; it has done so of its own will. Changes to its regulatory and supervisory regime have been so wide-ranging that the UK is now at the strict end of the EU spectrum. For example, senior policy-makers, from the governor of the Bank of England to the chairman of the Financial Services Authority, have argued that EU rules on bank capital should be stronger, not weaker, than the Basel III accords. And the government has recently said that it will follow the recommendations of the Vickers Commission and ring-fence retail banking operations from investment banking ones – a move no other EU country is contemplating.
What does it matter if European politicians believe that the post-crisis task is to whip Anglo-Saxons into shape? Isn’t the belief harmless? Indeed, if it helps to rectify the problems that the crisis exposed, doesn’t it do more good than harm? Not necessarily. To start with, it risks creating needless friction between Britain and its EU partners. As host to Europe’s largest financial centre, the UK is disproportionately affected by some of the measures that the EU adopts – the recent Alternative Investment Fund Managers (AIFM) directive being a case in point. As other measures wind their way through the EU’s legislative pipeline and the recently-established European Supervisory Authorities bed down, it is in no one’s interest for EU initiatives to be seen in Britain as gratuitous attacks on the City of London.
Just as seriously, the popular European pass-time of bashing Anglo-Saxons diverts attention away from problems elsewhere in the EU. Consider Germany. In 2009, the country’s chancellor, Angela Merkel, told members of her party that they would no longer be dictated to by the City of London. Since then, her government has shown a striking reluctance to come clean about the weakened state of Germany’s own banks. This is why Germany played an active part in watering down stress tests for EU banks in 2010, and why it fought a rear-guard action to try and dilute the new Basel accords on capital adequacy. Seen from outside, Germany has appeared strangely reluctant to accept one of the central lessons of the financial crisis: that banks should hold more and better quality capital.
However absurd British paeans to light touch regulation seem now, there was more in common between Britain and the rest of Europe in the run-up to the financial crisis than is often recognised. Politicians, however, rarely find it easy to own up to failings at home. There was a brief moment in 2008 when the British government tried to pin all the blame for the financial crisis on events in the US – a claim that was hard to sustain given the carbon-copy, debt-fuelled boom that the UK went through. Unlike Britain, Germany never experienced a domestic credit-fuelled boom. This may explain why German politicians have found it easier to claim (and perhaps even believe) that they were the victims of shortcomings abroad, and why they have been slow to confront the problems at German banks.
Europe’s landscape, in short, has changed since the financial crisis. Britain is increasingly nervous about the huge contingent liabilities to which the country’s large financial sector exposes domestic taxpayers. It does not want to become Reykjavik-on-Thames. It is calling for tougher rules than even longstanding critics of light touch regulation are prepared to contemplate. The future of the City of London, it follows, will be influenced as much by the new climate in London as by the old one in Brussels (more hedge funds have left London in response to changes in the British tax system than because of the adoption of the EU’s AIFM directive). Critics will argue that Britain is as unilateralist as ever – and hence remains a European outlier. But if it is, it is in a very different sense from in 2007.
Philip Whyte is a senior research fellow at the Centre for European Reform.