As the country awaits its new prime minister, one central question of policy for the candidates and country will be how to boost the rate of economic growth and unleash the talents and entrepreneurship in Britain’s businesses.
If we are to excel economically, painstaking work is now necessary to reform our legal and regulatory arrangements.
Take financial services as an example – one of the foremost UK sectors, where the City is a global leader. Success needs free, competitive and well-regulated financial markets that allow for the most efficient allocation of capital and power in our economy.
The markets need rules. It is for the regulators to ensure that market participants have the information they need, that bad actors do not disrupt market pricing, and that buyers with long term contracts can be assured that sellers will generally be around to deliver on their obligations.
The UK’s business-friendly regulatory regime has safely managed the financial markets for generations. We managed to avoid the worst effects of the Wall Street Crash of 1929. We were, however, let down by the European Union’s regulatory system, with all its flaws, in the financial crisis of 2007-8, which taught the EU, and reminded us, that systemic risk – i.e., risk arising from the system itself – is another factor to be managed by the regulators.
Now that we are out of the EU, we can reclaim our safe yet permissive methods. For that, we must shake off the EU’s controlling approach, and purportedly exhaustive statutory regulations.
As matters stand, the UK Government proposes to move inherited EU regulations from our statute book to the rulebooks of our regulators, allowing them to reformulate those rules using their own, statutory powers – a decision announced in Parliament in May and now contained in the new Financial Services and Markets Bill.
Proposals to reform the main EU-inherited insurance regulation, Solvency II, are still being debated.
But more needs to be done if we are to avoid being ground down on individual issues through a slow, piecemeal process, by rapidly moving to the safe arrangements under which the UK market has functioned efficiently.
Only then will market participants be able to reap in full the benefits they contract for. The future must allow the market to reward success, participants to bear the risk of their own failure, and regulators to protect the system and consumers from risk.
To strengthen our own market-based approach, two separate but related problems must be addressed – those of the homegrown UK regulation and inherited EU rulebooks.
To address both issues, a clear direction and strength of purpose will be needed, to navigate the inevitable reluctance of our system to fetter the regulators, or indeed of some financial firms who are concerned at the potential wastage of expenditure on compliance.
First, constraints are needed for how our regulators use their increased post-Brexit powers to make their rules, and how they then supervise and enforce those rules. There is no formal system of governance laid down for regulators to follow for their new, post-Brexit role.
Instead, the UK regulators are supposed to control their numerous staff as they will. In principle it is for Parliament, through its Treasury Select Committee, to oversee the regulators in their use of the powers it has given.
However, though this can operate at a high level, it leaves the routine imposition of the regulatory system unchecked.
The UK regulators should now be required by statute to supervise and enforce predictably in accordance with their own published rules, ensuring that their decisions are consistent between firms which operate businesses of a similar size and scope.
There should also be an independent check, by allowing firms to appeal to the courts, during a short (defined) time period after the regulators have made significant supervisory or enforcement decisions under their rules, for the courts to determine whether the statutory disciplines have been observed.
This process would force the regulators to provide sufficient explanation in their decisions to withstand scrutiny, and to serve as precedents for the future application of their rules. It would also restrict the regulators from using inappropriate and vague rules for the purposes of enforcement, and restrain them in the exercise of retrospective judgment.
There is an additional problem in that senior managers must also contend with a parallel UK regulatory regime that contains uncertainties equivalent to those which arise for the firms themselves.
Here, it should be a priority to resolve how these executives are to be held directly accountable for their actions and those of others, and on what grounds.
To bring the UK and financial sector more into line with the legal approach used elsewhere, including the US, senior managers should be held to a precise standard.
They should be expected to act with a reasonable and good faith assessment of the rules applicable to their firm as a matter of law and at a level of appropriate diligence, in the areas for which they are responsible – but no more.
Secondly, we have inherited vast swathes of overly controlling EU regulation, which is often poorly drafted.
This forest of restrictions removes much of the ability for the market to be entrepreneurial. One EU regulation alone, MiFID2, contains an extraordinary 1.7 million provisions.
This regime actually introduces systemic risk, as shown by the EU’s dangerous regulatory arrangements for the eurozone.
The regulators are then pulled in on the act and use their interpretative discretion to buttress the ever-changing political purposes of the code-makers.
Ask a continental regulatory lawyer for advice when the law is uncertain, and their first question is typically: “When can I go and ask the regulator?”
But the markets run scared of unnecessary restrictions and uncertainties, as was evident with capital flight away from the former Communist bloc. Global banks are now discovering how they cannot be as free, creative or profitable under the continental system.
The hard work of reformulating EU-inherited financial regulation must therefore be a major priority. Our regulators will need to remove unnecessary red tape and rewrite those rules which remain, to make them clear. A Parliamentary committee should oversee the process, setting deadlines which force the pace. We have the expertise, collectively, to pull this off quickly.
Emerging markets around the world want to use the UK’s traditional system to keep their markets secure and transparent. They seek the advice of our own legal profession to create new systems and help the regulators draft their rules. They know this is the surest way to attract financial business and increase their rate of growth.
The UK must now take pride in its own system, one proven over centuries. It should have the faith that its own system is second to none. The message for our new Prime Minister and government is to restore clear and accountable arrangements so that UK businesses can seize the opportunities of Brexit to grow.
Barnabas Reynolds is a partner at Shearman & Sterling LLP and the author of Rules for the Regulators: Regulating Financial Services Post Brexit, just published with Politeia