The new UK Labour government has won fans in the City of London by announcing, after only a few weeks in office, a wholesale reform of financial regulation.
In general, we support the move to split regulation off from the Bank of England (and to make the central bank independent). But the role of the new regulatory body needs to be carefully thought out. There are some traps it could easily fall into.
The Bank of England has behind it the weight of 300 years of history and all the accumulated prestige that entails. Despite one or two much-publicized failures (notably BCCI and Barings), the quality of its regulation was generally well regarded.
The new authority will take over the mantle of the Securities and Investments Board, with the additional role of supervising commercial banks. The SIB has a perfectly decent reputation in the City, but it is less well-known abroad. It also started life as a self-regulatory body; most of its staff are former practitioners. That will give it less clout than the Bank.
The Bank of England will find losing bank supervision something of a relief. Every time one of its reporting institutions hit problems, this damaged the Bank's credibility in the area of monetary policy too. The danger for the SIB is that it would potentially be more damaged by a banking failure. It has no other aspects to its operations through which to rebuild prestige.
There are risks for the City too. The great strength of the British regulatory system, in our view, has been its flexibility and adaptability. Banks were judged more by the regulators' view of their management expertise and credibility than on dry solvency ratios. This contrasts with the US where the Federal Reserve and (especially) the Securities and Exchange Commission are much more legalistic. They insist on their charges sticking to the letter of the law, rather than obeying its spirit. That encourages banks to search for loopholes, rather than co-operating positively with their supervisers.
A touchstone will be what happens to the City Takeover Panel, which regulates merger and acquisition activity in the UK. It operates under a voluntary code, and is run by practitioners (on leave of absence from their banks). In the view of most, this works well. The takeover code can be applied flexibly when unprecedented questions arise. A regulatory system based on a more statutory approach would not allow this.
The SIB will also face a more human problem - staff. The Bank of England found it impossible to hire enough high-quality bank examiners on its low public-sector salaries. It had to resort to using officers on secondment from British banks. This caused resentment among the banks they regulated, which balked at the idea of their inner workings being examined by former (and future) competitors. The Bank of England could get away with this practice because of its long-standing reputation and perceived neutrality. The SIB, which will face the same staffing conundrum, might not.