Impact-driven or crisis-creating: what is the future of financial regulation post-Brexit?

Lab CEO Jesse Griffiths and Researcher Robin Watts set out the potential and the pitfalls of the government’s push to redefine how the financial sector is regulated.

For UK finance, Brexit is a major shakeup, with the centre of regulatory power moving from Brussels to London. The government has launched a consultation on how finance should be regulated in the UK post-Brexit, posing two of the most important questions when it comes to creating a financial system that works for people and planet. First, given that the financial sector is – and must be – structured by strong regulation, what objectives should guide this regulation?  And second, how should regulators be held accountable to make sure they serve the public interest rather than becoming ‘captured’ by the industries they regulate? Here are three ways the government can show real global leadership on this critical agenda, taken from the Lab’s detailed submission to the consultation.

1.   Make social and environmental impact the real compass for regulation

As our major 2018 report The Regulatory Compass found, the current system focuses on minimising the risk of bad individual outcomes, such as damage to consumers or the risks of banks failing, rather than on good system-wide outcomes, such as adequate pension provision, financing to meet climate goals, or ensuring everyone is able to access essential financial services. Regulation can, as a result, ignore many of the most important outcomes that the financial system should be geared towards.  

The global financial crisis of 2007-8 caused one welcome shift, when overall financial stability became a key objective for regulation. Now is the time for the government to take the next step and incorporate social and environmental purpose into the mandate of regulators to ensure they are guided by the outcomes we need the system to produce. Such a mandate would force them to ask the tough but vital questions such as, how do we align regulation with the goals of the Paris Climate Agreement or the Sustainable Development Goals? How do we make sure the system provides fair, affordable services to everyone without exclusion or discrimination?

This shift would actually be in line with existing trends and best practices. A recent study of the mandates of 135 central banks found that 12% already have explicit sustainability mandates, and an additional 40% have a mandate to support government policy priorities, including sustainability goals.

2.   Resist a crisis-creating alternative: the ‘competitiveness’ agenda

There is a dangerous counter-proposal with powerful backers: that regulators should be given the objective of promoting the global ‘competitiveness’ of the UK finance industry. The idea that the growth of the financial sector should be pursued as an end in itself would inevitably undermine the role it needs to play in supporting the real economy – the economy excluding the financial sector – and social and environmental outcomes. In fact, competitiveness was actually removed as a regulatory objective in 2012 – because this focus pushed regulators to ignore systemic risks – and thus contributed to the global financial crisis.

This is particularly important given the evidence that too much growth of the financial sector is bad for the rest of the economy. IMF researchers estimate that the financial sector reaches its optimal size when credit to the private sector is around 90-100% of GDP, much lower than the UK average. This helps explain why the UK financial sector is so bad at directing finance to where it is needed – one estimate is that as little as 12% of UK finance goes to the real economy, the rest goes to real estate and the financial sector itself. Imagine being a regulator trying to make the system climate-friendly but under pressure from powerful industry lobbyists who argue that everything you propose would damage the ‘competitiveness’ of the firms they represent. It would be a catastrophic mistake for the government to put regulators in that position.

3.   Strengthen accountability by making sure the public interest comes first

Regulators are tasked with acting in the public interest, and their ability to stand up to powerful finance interests should be bolstered by strong systems of accountability and transparency. Our submission suggests six ways the government could strengthen these:

  • A presumption of transparency: The main transparency principle – which is the rationale for UK freedom of information legislation – is that people have a right to know about the activities of public authorities, unless there is a good reason for them not to. Shifting to a presumption of disclosure, adopted as best practice by organisations including the World Bank, would not mean that all information should be publicly available – regulators have a duty to prevent disruption to financial markets for example – but rather that there should be no assumption that it should be kept secret.
  • True participation and public engagement: Effective accountability depends on stakeholder participation and public engagement. One study of several thousand EU agency consultations found that in 85% of cases non-business interests represent less than 10% of submissions. Providing resources for civil society groups representing citizens and social and environmental concerns to engage would help rebalance the system. Stakeholder groups could be made a maximum of 50% industry representatives. A Supervisory Board consisting of stakeholders with no direct links to the regulators themselves or the firms they regulate could help regulators to face greater independent external scrutiny.
  • Strengthened integrity standards: Preventing fraud, corruption and malpractice, and enhancing the integrity of the financial industry should obviously also be a priority given the slew of scandals in recent years.
  • Protecting whistleblowers: A recent report found that 70% of whistleblowers were victimised or dismissed, and 33% of concerns were ignored. This illustrates how much work has to be done. Evidence suggests that the current system actually puts whistleblowers at risk, and the regulators play a role in that. The establishment of a whistleblowing organisation independent of the regulators would help to prevent any conflicts of interest and signal the importance given to supporting whistleblowers.
  • Reducing the influence of the industry: The UK’s lobbying register needs to be made complete – it currently only includes consultant lobbyists, not in-house lobbyists, meaning that a mere fraction of the lobbying that takes place is captured. Tackling the ‘revolving door’ – when regulatory officials leave their posts and are swiftly employed in the industries they regulate – should be another priority.
  • Parliamentary scrutiny: The strengthening of parliamentary scrutiny over both the regulators and future changes in regulation will be important for the system to work effectively.

The Lab just submitted our detailed evidence to the government’s consultation, and also to the Treasury Select Committee’s inquiry into the same topic. The rewriting of financial sector regulation triggered by Brexit is an opportunity to focus effective regulation that promotes social and environmental ends, keeps the system stable and prevents malpractice. It is time for the UK to show real leadership on this crucial agenda.

See more work and thinking from the Lab and the Lab community about the future of the financial system post-Brexit and post-COVID-19 here.