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Andrew Milligan, Standard Life Investments

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Comment: Trains, planes and financial regulation

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Andrew Milligan, head of global strategy at Standard Life Investments, argues that it will take time before the effectiveness – or otherwise – of the UK’s proposed new structure financial for financial regulation becomes clear.

Anyone who flies into Edinburgh airport sees one of the great sights of Victorian engineering: the Forth Rail Bridge. This magnificent structure, built to withstand all that nature could throw at it, has an interesting history. Only a few years before, public attention had been caught by a great disaster, the collapse of the Tay Rail Bridge, with substantial loss of life. Engineers learn from such shocks and re-design.
 
Just as in engineering, lessons are learned from financial disasters. Out of adversity comes a response. Back in 1992, sterling was ignominiously forced out of the European Union’s Exchange Rate Mechanism. Within a few weeks, the UK Treasury had announced key changes to monetary policy and inflation targeting, which in 1997 led to the creation of the Bank of England’s Monetary Policy Committee. The UK formally adopted a low inflation target and an independent central bank to achieve it.
 
The recent Mansion House speech by the Chancellor of the Exchequer falls into that category. The death of the Tripartite Arrangement was formally announced – everyone was dressed in black for the occasion! That arrangement, co-ordinating the Treasury, the Bank of England and the Financial Services Authority, clearly did not work effectively at various times in the great financial crisis of 2007-09. A new bridge has to be built, in effect spanning the City of London and the City of Westminster.
 
Alongside the Monetary Policy Committee will stand a Financial Policy Committee, a new subsidiary of the Bank of England. The Bank adds to its list of objectives but has also been given extra tools. As well as using interest rates and quantitative easing to target inflation, it will use ‘macro-prudential regulations’ to control the financial system more generally.
 
Such jargon hides an important fact; going forwards, the Bank could implement lending restrictions, for example in the mortgage market, to dampen down over exuberant borrowing. Rather than standing back and expecting markets always to be efficient, we should see the Bank of England periodically step in to direct parts of financial services.
 
The foundations of the new bridge have been announced but the precise shape of the structure is still to be seen – indeed the FSA will remain in some form until 2012 before it is split between a consumer protection agency and a prudential regulator. The announced commission on reform of the banking sector, examining whether to break up some of the large banks, will not report for a year.
 
The implications for financial markets could be considerable. There will be a risk premium associated with financial sector assets for some time to come. The future profitability of the stock market could be affected; after all global financial companies make up about one fifth of UK stock market profits.
 
The UK’s regulatory changes have to be considered alongside some important and very detailed international measures (Solvency 2 for insurance companies and Basle 3 for banks) that could lead to further changes in the global regulatory environment. The Forth Rail Bridge has stood the test of time. We will have to await the next major downturn in the UK economy – whenever that occurs – to see whether the new enhanced Bank of England edifice is similarly successful.

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