UK's financial sector

UK has long prided itself on its competitive financial sector and its comparative advantage in that sector. How did this advantage come about? Because of light regulation. In other words, the UK benefited from regulatory arbitrage. To put it more accurately in light of the ongoing crisis, UK bankers benefited from such arbitrage. So, what's to be done about it?

Martin Wolf reviews an astonishing report prepared by a committee that included UK's chancellor of the exchequer, Alistair Darling. The report recommends “ the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market”. They must be nuts to recommend this after seeing how the market has worked.

Wolf makes a set of eminently sensible suggestions:

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

Since "reforms" are the flavour of the day in India today, let me add that some of the above principles should guide banking sector policy in India as well.