Legislator Beliefs

Over the years, there has been a fair share of market failures illustrating that financial markets regulation is critical for protecting consumers. But can we trust that financial regulation reduces the systemic risks in the financial system? How do we know that regulatory frameworks are based on a solid foundation and not a just knee-jerk reaction on previous crises?

Beliefs

Pension funds, which act as stewards for their members, face similar challenges as regulators. The scale is smaller, but the principles are the same. A cornerstone for good pension fund governance, is that trustees formulate their investment beliefs and publish them. Implemented in the right way, investment beliefs helps trustees prioritise and provide useful direction for the internal, and external, investment teams that are investing members’ money.

Some of the investment beliefs are well proven so it is fair to say that the jury has reached a verdict. For other beliefs the jury is still out. Some beliefs are more of a belief than others, and for those the jury has not yet been assembled. The strength with this approach is that when new information becomes available, the current beliefs can be contested and adjusted if necessary. It is an adaptive learning approach.

Legislator Beliefs

Recently, I listened to a speech by Nausicaa Delfas, the Chief Executive of the Pensions Regulator in the UK. She talked about the importance of driving consolidation among pension funds. She also mentioned that transparency would result in that those schemes who do not deliver value for money would wind up since the informed buyers (employers) would move to the best schemes. It was refreshing to hear an outspoken regulator. Her words triggered my mind which wandered off. What are the beliefs through which legislators see the world?

What if legislators had to write down their beliefs and publish it on their website? This would provide transparency and allow academics to closely investigate which of the beliefs have a solid foundation and which are just perhaps, talk.

In jurisdictions with multiple legislators, it would be particularly helpful if the beliefs were formulated and published. In the UK, there are two overlapping regulators; the Pensions Regulator who answer to the Department for Work and Pensions and the Financial Conduct Authority who answer to HM Treasury. If both these legislators would state their respective beliefs, it would be easier for their corresponding regulators to work out the details. In addition, explicit beliefs would help the industry to better grasp the intent and think in a more innovative way.

What are the legislator beliefs?

Let’s start from the other end and try to identify what the UK’s legislator beliefs might be. Many beliefs can be traced back to Thatcher’s Financial Services Act of 1986 with deep roots in neo-classical economic theory. That said, globally there are some financial regulators that have taken a step beyond neo-classical theory and consider the financial markets as complex systems that cannot be controlled.

Implicit Belief:?? ? Economies of Scale

Most regulators have a strong belief in economies of scale, that larger organisations are able to deliver better outcomes than smaller organisations. There are clearly economies of scale when managing complicated processes, which are largely predictable, such as record keeping. For investments decisions, which is about understanding complex systems, there seems to be dis-economies of scale when investment organisations grow too big.

The stated ambition by the pensions regulator in the UK, is to consolidate to a handful of Master Trusts servicing the DC market. But this does not necessarily guarantee that members will get better financial outcomes. In addition, given high entry barriers, it may lead to an oligopolistic market.

Implicit Belief:?? ? Markets are efficient

There appears to be a strong belief that consumers and employers are rational agents that optimise their utility function. Although in practice, this does not seem to be the case for a combination of financial services and humans. The argument in defence for this belief is that the lack of information hinder consumer and employers from making rational choices. Don’t get me wrong, transparency is critical, but I don’t expect that it will change human behaviour. Most decisions makers are ‘satisficers’ and not ‘optimizers’ especially when it comes to making decisions based on partial information.

Implicit Belief:?? ? Markets can be controlled

Another belief is that markets can be controlled. That models are good predictors of market dynamics and therefore can be used as a foundation for both regulation and supervision. It was clear from the global financial crisis in 2008 that the risk models were not even able to remotely predict the observed market dynamics. If markets could be controlled, it would make perfect sense to push for a regulatory regime based on centralisation and control, such as central clearing of derivatives.

But if markets cannot be controlled, then decentralisation and redundancy is a more robust foundation for a regulatory framework. It is a bit ironic that classic capitalism was based on decentralisation and redundancy, while state socialism was based on centralisation and control.

The Power of Transparency

In my opinion, transparency is the best disinfectant for financial markets. Shining the light of transparency into the darkest corners of the market will help reduce the worst practices. But the need for transparency applies to all involved in the financial sector, including the legislator. If I was prime minister for a day, I would issue a decree that all government departments must write down their legislation beliefs in an accessible document and publish it on their website.

This would be a very cost effective way of increasing transparency, since the beliefs could be tested and data could be collected to either support or contradict the different beliefs. When contradicted, beliefs should be updated. This would be a proactive way to protect consumers since it fosters an evidence based legislation that can evolve as we learn more. This is nothing new, Keynes highlighted this many years ago. When asked why he changed his mind so often, he candidly replied “When the facts change, I change my mind. What do you do?”

The list of legislator beliefs could be made longer and so, if you have any suggestions or ideas, please share them in the comments below.