Financial regulators and the free market

Adam Smith’s great insight was that in a commercial transaction both parties benefit. Before his time, it was generally believed that in an exchange of goods, one party usually gained what the other lost. The mistake was to misunderstand value: it is different to different people. A seller places greater value in the money than the product he sells for it, and the buyer places a greater value on the product than its cost, otherwise the deal would not happen.

Lovers of regulation do not seem to understand Adam Smith’s perception of enlightened self-interest. They believe unprincipled capitalists steal the widow’s mite. The prevalence of regulation, particularly in Europe, where everything must be regulated, is in this sense a complete denial of all economic progress since the days of mercantilism.

Regulation often defeats its objectives, a point which was made clear to me many years ago. I met the managing director of a spread-betting business at the time when there was a debate about whether or not spread-betting should be regulated as an investment activity. He welcomed regulation, because it would give his business added credibility, despite by definition being gambling. He was right: that is why everyone in the financial services business dealing with the public wants regulation. It enhances their credibility.

Unregulated, a business’s reputation is its most valuable asset. A regulated business does not have the same problem, so long as it obeys the regulations. Regulations replace the overriding need for a business to protect its reputation, and it is no longer solely concerned for its customers: the rule book has precedence. And the more regulation replaces reputation, the less important customers become. Nowhere is this more obvious than in financial services.

Back in the Eighties when single capacity was scrapped in London, and securities businesses were allowed to act as both brokers and market-makers, the conflict of interest was meant to be resolved by the interposition of a Chinese wall. We hardly ever hear the term nowadays, but this sham separation of broking from market-making demotes customers’ interests. Predictably, they have become cannon-fodder for the trading book, where the real profitability lies. And then there is the egregious example of MF Global, which it appears, has been permitted by the regulator to gamble and lose its customers segregated money.

The regulators assume the public are innocents in need of protection. They have set themselves up to be gamed by all manner of businesses intent on using and adapting the rules for their own benefits at the expense of their customers. These businesses lobby to change the rules over time to their own advantage and hide behind regulatory respectability, as clients of both MF Global and Bernie Madoff have found to their cost.

Where is the protection? Adam Smith must be turning in his grave.

This article was previously published at

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2 replies on “Financial regulators and the free market”
  1. says: Paul Danon

    Another bad thing was Mr Darling bailing out Northern Rock. Had it been allowed to collapse, people would have re-examined their banking-arrangements. This bad situation was compounded by bailouts for Lloyds and RBOS. Bad bankers continue in post.

  2. says: The Big Fish

    Great article! And so true unfortunately. Politicians driven bank bashing and erroneous understanding on the role of banking in general and the role in the financial crisis of 2008 has created a blind anger toward the City and the financial sector which is concealing one of the worst attacks to freedom similar to that of a communist/fascist regime.
    Reputation still is a strong incentive in the City, but as you well say, the real meaning of reputation is getting diluted and confused with “being compliant with regulation” (e.g. directors of a firm want to comply with the regulation because of fear of a reputational risk which they associate with a sanction from the FSA).
    More alarming though are the specific issues of the “more intrusive supervision” and the “credible deterrence” philosophy being implemented by the UK FSA but also elsewhere. This terrible attack on the freedom of enterprise is a direct consequence of the idea of “public interest” and protection of consumers which is based on the regulators misconception that (as you mentioned) “the public are innocents in need of protection”
    The FSA is stepping up this intrusion in private enterprises. For example (and this is just one among so many!), with the recent ban on marketing of Trade Life Policy Investments. Surely those are risky products, but as long as they are properly explained to clients, they can do whatever they want with their money, even flushing it down the toilet if they want.

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