Throughout the world, we are seeing a widespread and much-needed debate about the sort of oversight we need for our financial services. It is becoming clear that we are suffering the consequences of a toxic mix of poor business decisions, badly misaligned incentives and a failure of regulation. For some, though, the very principle of free, competitive markets is in the dock.
Yet analysis of this and previous crises shows that it would be wrong to see competition as part of the problem, and deeply harmful if restricting competition was part of any solution.
As Adam Smith acknowledged, while self-interested behaviour on the part of business and consumers often acts in the public good in the form of better and cheaper products, such behaviour is not always aligned with the public interest and for that reason there is a need for appropriate regulation.
The trick is in identifying correctly where regulation is needed and how it should be implemented. A competitive groceries market brings us a wide variety of keenly-priced products via our shops and supermarkets, yet this is necessarily underpinned by, for example, clear food safety and environmental health standards.
Likewise in the airline industry regulation is needed to ensure passenger safety (so aircraft do not fall out of the sky) as well as the stability of the wider market (because a crash affects the whole industry as scared passengers stop flying). But because airlines have increasingly been left free to compete on other grounds such as price and new routes, and new entrants have been allowed into the market, in the past 20 years there has been huge growth in choice and value but with no obvious dilution of safety standards.
As with these markets, so with financial services. Financial regulators have become ever more specialist, and their work will clearly need to be smarter and more incisive given the complexity they face. The G20 agreement and last month’s report by Lord Turner, the chairman of the Financial Services Authority, provide a roadmap for this. But the challenge for regulators and governments alike, as set out in the Office of Fair Trading’s Financial Services Strategy published today, will be to ensure that new forms of regulation do not inadvertently stifle competitive market dynamics.
In the short term, we may face some difficult decisions as the government manages its newly-acquired stakes in a number of banks. Longer term, however, ensuring a level playing field when moving these back to full private ownership presents a greater challenge. As the European Commission has said, public support must not give undue advantages to poorer-performing banks compared with those that are fundamentally sound and better performing.
But while one can count on existing competitors to cry foul to regulators in the event of an unfair market, we must not lose sight of the arguably more serious possibility of a two-tier system between the incumbents and potential new entrants. The latter will have the weakest voice in the policy debate in the coming months, yet inadvertently restricting their access would deliver only monopoly profit to the incumbents at customers’ expense.
This matters because new players in a market – wherever they are from – are far more likely to drive innovation and competition that delivers better value for consumers and the economy. The recent concentration of the banking sector and the resulting lessening of competition makes this all the more important.
History tells us that restricting competition can look attractive to policy-makers faced with distressed businesses in a recession. Yet the relaxation of competition rules in the US during the Great Depression and in Japan in the 1990s prolonged the recession in both countries by allowing monopolies and cartels to reduce output and raise prices, generating inefficiency. When the current recession is over, the UK will face even stronger competition from growing economies, and restrictions on competition now would represent a serious long-term drag on the economy.
Learning from history and the clear link between competition and productivity growth, we need to ensure that today’s solutions do not inadvertently become tomorrow’s problems. Airlines and other industries demonstrate the value of securing the right balance of effective regulation and strong competition. Failure to achieve this in the banking sector by overlooking the nature of market dynamics would lead to beleaguered consumers being the losers all over again.