The rise and fall of light touch regulation

Light touch regulation is dead. It was a bad idea from the start and deserves to be buried. We would all be so much happier if only regulators had done their job. That appears to be the unanimous verdict on the world of global finance. What is less clear is whether a heavy-handed approach would have done any better, or what other policies could have been adopted to keep financial innovation under control. To find enlightenment, financial policymakers could do worse than take a peek at the telecoms industry. When it comes to regulation, light touch or otherwise, it is just possible that the telecoms sector could teach finance a thing or two.

For a start, anyone in telecoms can tell you that light touch in the sense of 'no touch at all' doesn't work. It was tried in New Zealand and written off as a failure years before the credit crunch entered our vocabulary. Then there is the awkward problem of 'regulatory capture', a nice term economists use to describe institutional corruption. This isn't new either. It was recognised well over a hundred years ago, but is mostly associated with the Chicago School and George Stigler, who wrote in 1971 that "...as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefits." The large box of tricks deployed by firms to extract private benefits includes lobbying, foot-dragging, court action against the regulator and even full-blown bribery, though such blatant tactics are rare. In the case of the UK finance sector, a hands-off approach in the City translated into full coffers in the Treasury, which amounts to much the same result if not quite the same means. But even where regulation is introduced with the best of intentions, it can all too easily distort market forces in favour of the incumbent. With hindsight, there is little doubt that the main beneficiary of the 1980s' duopoly in the UK was not Mercury, the struggling new entrant, but British Telecom, which was protected from all further competition for another 7 years.

Economists like to divide the liberalisation of network industries such as telecommunications into three distinct phases: 1) Monopoly; 2) Monopoly & Competition; and 3) Competition. Each phase, they argue, is associated with different levels of regulatory intensity, forming a curve shaped like a camel's back. The first phase requires a certain amount of regulation to protect consumers against abuses of monopoly power. The second phase needs the highest level of regulatory effort as competition is introduced, to address pricing and interconnection, competition issues and universal service obligations. In the third, fully competitive phase, only light touch regulation is needed to ensure fair competition.

This model underpins the European telecoms regulatory framework and reflects the philosophy of UK regulator Ofcom among others. It is based on the belief that sector regulation should be applied as an intermediate step only until general competition policy can take over. In the case of retail markets, the approach has worked well. But when it comes to bottleneck facilities, there seems to be increasing doubt that we will ever get off the camel's hump. We may, in fact, be sitting not on a dromedary but a two-humped beast.

Take the introduction of LLU, for instance. Nothing happened for years until European regulators started to get heavy with incumbent operators. In the UK, Regulation Lite produced 25,000 unbundled lines in four years. When Ofcom finally took off the gloves, the number shot up to 5 million. And the UK is not the only country to have introduced some measure of re-regulation. Sweden has tightened up its regulatory stance in recent years after a spell of laissez-faire in the 1990s. In Germany, a proposed 'regulatory holiday' for Deutsche Telekom was rejected despite intensive pressure from the federal government. The old light touch is starting to leave some bruises.

The debate is now focused on next generation technologies and access. Should operators be given free rein while they roll out fibre networks that will benefit society and enhance their country's competitiveness in the global economy? Or will this lead to a re-emergence of the old network monopolies we have been trying to get rid of for the last 30 years? One of the more far-sighted solutions that have been advanced suggests regulating next generation access in a way that mimics competition as far as possible without, however, standing aside and leaving the thing up to market forces. It acknowledges that in order to encourage investment, higher risk must equate to higher reward since the downside could be nasty -for the investor, that is, not the taxpayer.

And here is yet another history lesson for the finance industry. The experiment of decoupling returns from risk has been largely abandoned despite its many disciples when it was first introduced. Rate-of-return regulation, which guaranteed operators a fixed margin on whatever costs they managed to accumulate, had two noticeable and not wholly surprising side-effects: It induced managers to award themselves excessive pay rises and perks, as a higher overall cost base meant higher absolute profits. And it encouraged indiscriminate investment with little regard to efficiency or risk. This 'gold-plating' effect was recognised in the early 1960s. Financial regulators take note.

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