Thursday, January 8, 2009

(No.7) A vital sound: swishing of the regulatory stick

Strong, comprehensive and vigorous prudential regulation by government of financial services including insurance is necessary to protect the consumer and preserve the integrity and soundness of the financial system. But certainly not the American variety of financial regulation and deregulation which facilitated the sub-prime mortgage debacle and its contributing role in the current meltdown in the US financial system.

Nor do we need the sort of US regulation under which, as we now see, the outcome of the rule in the financial business becomes -- heads you win, tails the taxpayers lose. Nor is there any attraction except to simple-minded adherents of 'market place freedom' of the actual 'unregulation' of aspects of that financial system ( like credit default swaps, so-called to avoid the use of a more accurate word -- insurance -- which would have attracted regulation). The self-serving and the ideologically deluded for too long loudly declared their belief that markets are self-regulating. Obviously they are not. As the chair of the US Securities and Exchange Commission has now admitted: voluntary regulation doesn't work.

In the run-up to the current financial mess in the US, it has been accurately observed (in the New York Times among other places) that financial regulation did not reduce risk it allowed it to be hidden; investors (including supposedly highly sophisticated ones) had no real idea of how exposed they were to unacceptable risk.

Is it not fair to question the value of a financial regulatory system that did little or nothing to prevent or even impede the development of a huge sub-prime mortgage industry in the US based on the promiscuous and sometimes illegal promotion of millions of residential mortgages to house buyers whose credit worthiness went unchecked, whose income levels were ignored and whose financial ignorance and gullibility was the basis of their signing of mortgage documents?

What we have seen since the onset of massive US government bailout activity is an unappetizing lining up of various financial services companies, auto makers et al (even the porn industry is asking for $5 billion) to receive taxpayer funds. So far requests, too often, seem to be greeted with what seem like minimal or non-existent government controls, insufficient accountability, minimal compliance requirements but not by even elementary tracking of the actual use of the billions of dollars being handed out.

I suppose it can be argued that such a pattern merely corresponds to the corporate incompetence and misconduct that was central to the mess that we as well as the Americans are in. After all how much more ridiculous can it be that, for example, during pre-meltdown activity in the market, financial companies could shop for a favourable rating among rating agencies -- as Lehmann Bros. did and received a AAA rating 4 days before it failed.

But financial regulation needs to be both informed and effective and therein lies one of the challenges to insurance regulation in Canada. Some Canadian insurance regulators have (as one senior and experienced insurance regulator said to me privately) no real understanding of the business they are regulating. There are many stumbles along the road to effective regulation and I have long resisted the common call within the business to reduce financial regulation, as if its reduction constituted some sort of ideologically-driven vehicle to carry business to the promised land of market place capitalism.

But when it comes to selling insurance, and the division between provincial and federal regulators and between prudential and market conduct regulation, we must aim for an appropriate balance at the provincial/market conduct level between regulation and handicap, as well as distinguishing usefully between the vital prudential or solvency regulation of insurance companies on the one hand and appropriate levels of market conduct regulation of agents which -- if not properly understood, set and directed -- can unnecessarily reduce both service to the public and their opportunities to buy a client-resistant core product, i.e., life insurance.

Having sat for many years on the companies' side of the table dealing with regulatory issues I know that carrots to encourage voluntary behaviour by business are all very well but they need to be backed up generally by some sort of regulatory stick, explicit or implied. Why? Because some life companies will bend over backwards to do what most of us would regard as the 'right thing' but there are others which will do far less on their own or in some cases nothing at all unless there is a regulatory stick swishing about somewhere behind them.