Case against introducing the Twin Peaks Regulatory System Robert W Vivian Professor of Finance & insurance
School of Economics & Business Sciences
University of the Witwatersrand
04 June 2016
It is the intention, motivated by National Treasury and the FSB the current regulator, to introduce a new regulatory system, the so-called Twin Peaks Regulatory System. This comment that the entire exercise will be a very expensive waste of time and money. This can demonstrated using the cost to benefit framework. However, from the outset an important distinction needs to be made between Twin Peak regulation itself and the Twin Peak Regulatory System. The System will be the expensive bureaucratic system which the Twin Peaks legislation is to create. These two are now examined.
Twin peak regulation
Twin peaks regulation has evolved spontaneously over a period of time and is a recognisable feature in most parts of the world. In this sense the two peaks refer to the two foci of regulation. The first focus is on prudential regulation – the financial sustainability of financial institutions. This is by far the oldest regulatory concern. The second, the more recent started emerging in the mid-1980s which is market conduct regulatory. Exactly what market conduct is and is supposed to achieve, how it will achieve what it is supposed to achieve is far from clear. Market conduct is characterised by catch phrases such as Treating Customers Fairly (TCF). So, from this, market conduct has something to do with the relationship between financial institutions and the customers. But since the beginning of time the relationship between institution and customer has been regulated by contract and the law of contract. Accordingly it is not clear how market conduct can operate side by side with the law of contract. One almost certainly will destroy the other. Almost certainly Gresham’s Law will apply – the bad will drive out, or destroy the good. For good or bad these two foci exist.
Twin Peaks Regulatory System
The objection is not against twin peak regulation, which exist, but against the proposed Twin Peaks Regulatory System. It is against the creation of two massive expensive bureaucracies (quangos).
Cost of the regulatory system
The current “regulator” is the Financial Services Board (FSB) acting in consort with National Treasury. Outside of the banking industry the FSB is currently responsible for regulation both peaks. The banking regulator is the Registrar of Banks, within South African Reserve Bank, and to the extent that two peaks can be said to exist in the banking industry these are regulated by the same regulator. So the single unitary regulator currently is the FSB. Its annual income is R634 m/pa. The regulatory system however also imposes costs on the private sector, in addition to funding the FSB. Surveys indicate, for example, that insurers consistently over a number of years, worldwide regard the greatest risk facing the industry is the burden of regulation. Each financial institution nowadays have created structures to ensure compliance including employing a staff such as compliance officers. Institutions have to submit detailed reports which are expensive to compile and audit and so on. A conservative estimate would be that the cost to the industry is at least twice the cost of the FSB’s costs or R1.3 bn/a. The estimated cost of a single regulator is thus R1.9 bn/a. In the proposed new twin peaks dispensation the FSB morphs into the market conduct regulator and a new regulator will be created for prudential regulation. It can be accepted the cost of the second peak will equal the existing cost, ie a further R1.9 bn/a giving a total annual cost of R3.8 bn/a. This is up from zero not so long ago.
These estimates are likely to be under-estimates. In every instance when attempts have been made afterwards to arrive at the actual costs, the original estimates turn out to be underestimates.
The regulatory institutions generally are quangos. Worldwide the number of quangos has increased and as it turns out these are difficult to finance and hence to become sustainable. These Twin Peaks regulatory quangos have solved this problem by allowing the quangos to impose their own levies directly on private sector institutions. These levies are outside of the control of parliament or any other authority. These quangos have managed to do what the Magna Carta prohibited 800 years ago – taxation without consent. Usually in the private sector costs are contained through the price system and competition. In the case of public sector parliament controls taxes. With these regulatory quangos these constraints do not exist since they can arbitrarily impose levies. On can thus simply expect the estimated costs to escalate out of control. In my opinion, in any event, the direct levy is contrary to fundamental constitutional principles established 800 years ago. The use of direct levies are now a regular feature across a wide range of recent institutions. It can be expected this will become the order of day.
No identifiable or perceived benefits
There are no identifiable or identified financial benefits from the twin peaks regulatory system. In South Africa it is not a solution to an indemnified problem. No attempt has been made to justify the system through the identification of the problems the system is supposed to solve or the benefits it is supposed to provide. Accordingly no cost to benefit analysis has been or can be carried out. No attempt has been made to identify and list the defects in the current system which the twin peaks is supposed to remedy. No attempt has been made to show how these, or indeed any, defects will be remedied by the twin peaks regulatory system. It is merely the creation of a regulatory bureaucracy.
In South Africa it is not surprising no beneficial analysis has been carried out. The last piece of legislation in the finance area where this was done, was with the promulgation of Financial Advisory and Intermediary Services Act 32 of 2002 (FAIS). The central justification for FAIS was what at the time was touted as the high lapse rate of life policies. The argument was that a better trained sales force would reduce the lapse rate producing the financial benefits of introducing FAIS. Very quickly after the introduction of FAIS the regulators ignored the lapse rate. This is not surprising since the lapse rate continued to rise, despite FAIS. On the basis of the reason for the introduction of FAIS it is a failure and should have been repealed. It has not been repealed. FAIS merely acquired a life of its own.
The Twin Peaks Regulatory System cannot be justified on a cost to benefit basis.
Justification given for introducing the Twin Peaks Regulatory system
In the absence of any identified problems or solutions or benefits or cost-to benefit analysis for the legislation on what grounds is the Twin Peaks Regulatory System being justified? It is usually justified with reference to the 2008 world banking crisis. The argument is that more “draconian and intrusive regulation” is called for to prevent a repeat of the crisis. The 2008 banking crisis as a justification is ill founded for a number of reasons.
It must be remembered that the 2008 financial crisis was a banking crisis. Remedies should be directed at banking not the entire financial market which is what the Twin Peaks Regulatory System does. The crisis started in the US and through contagion spread to other parts of the world. The contagion was twofold, across countries and then within countries. These two contagion mechanisms are different. The 2008 banking crisis was in any event a failure by regulators of note. It was not a private sector failure. To justify the Twin Peaks regulatory system National Treasury and the FSB argue the financial crisis was brought about by the absence of regulation, as they put it, ‘the [regulatory] light touch’ which prevailed at the time. So this ‘light touch’ will be replaced by ‘intrusive and draconian’ regulation. The problem with that argument is banks were and have always been heavily regulated. As Daniel Hannan put it the banking industry was the most regulated industry in the world save possibly the nuclear industry. Bank failure cannot be ascribed to lack of regulation. Prof Naill Ferguson, probably the world’s leading economic historian, in his Great Degeneration makes this point several times. “I do not believe this [lack of regulation] can be seen as the primary cause of the [financial crisis]. Banks were the key to the crisis, and banks were regulated” (page 57). He goes on to blame regulation for the crisis, holding it is the complexity of regulations which is to blame and all that has happened thereafter was the introduction of even more complex, which he holds will lead to the next crisis, “I believe excessively complex regulation is the disease of which it pretends to be the cure” (page 59). The ‘intrusive and draconian’ regulation has increased hand of fist in volume and complexity since 2008. Leading South African lawyers note the legislation is largely incomprehensible.
The cornerstone of European banking regulation is the Basel system implemented by the banks at the cost of billions of rands. It failed miserably. The Northern Rock was the first English bank to experience a run in nearly one and half centuries, yet weeks before its near collapse it proudly announced it was Basel II compliant. As indicated no attempt has been made to identify the defects in the system and to remedy these. The defects in the Basel system has not been identified, Basel had left to its own devices to bring out an even more complex Basel III which governments in Europe have uncritically accepted and now implement. It is nonsense to talk about the absence of regulation being the cause of the crisis. The implementation of a failed regulatory system is at the heart of the failure.
Origins of the Twin Peak Regulatory System
The Twin Peaks Regulatory System is the product of historical evolution. SA’s National Treasury is fond of saying by introducing the Twin Peaks regulatory system, South Africa is following best international practice. National Treasury is strong on statements but weak on analysis and fact. National Treasury is also fond of confusing matters, in this case confusing the twin peaks regulation and the twin peak regulatory system. The so-called two peaks regulation is well known, internationally, that is not the issue. It is the expensive regulatory system which is being introduced which is of concern. These two are different thing. The Twin Peaks regulatory system is a continuation of recent failed regulatory systems.
Failed UK Financial Services Act 1986
In the UK until 1986 the UK financial system was largely self-regulated. The London Stock Exchange for example was regulated by a committee of the exchange in terms of a 500 page rule book. Lloyd’s was regulated by a committee and so on. So until 1986 it would be incorrect to refer to the UK financial market as a regulated market which was de-regulated in 1986. The UK market was often contrasted with the high regulated German market.
In the early 1980s a one man Gower Committee was appointed to examine the regulation of the UK financial market. This was not prompted by a disastrous event in the financial market. The intention was to create a UK regulator. In other words this is the first time legislation was passed to create a purposeless bureaucracy and worse until this time each industry was regulated uniquely. The purposeless bureaucracy would straddle a number of industries. As a result of the Gower Committee the first attempt to introduce a centralised regulatory system was undertaken in terms of the mammoth UK Financial Services Act of 1986. Prof Gower wanted to emulate the US’s Securities and Exchange Commission (SEC) introduced in the 1930s, except in the UK it attempted to cover virtually all financial services excluding banks. As now in the case of the proposed Twin Peaks regulatory system, it was not aimed as any specific problem. Its function was merely to create a massive regulatory system. The idea presumably was if the bureaucracy is created the bureaucracy will work out what to do. It was not regulation by the rule of law but regulation by regulator.
Failed Financial Services Authority (FSA) Financial Services and Markets Act (2000)
Within a few years, it became clear it the Financial Services Act was a failure. With the collapse of Baring Bank, another banking failure, it was decided to repeal the Financial Services Act of 1986 and create a greater monolith regulator. The failure of the 1986 system, it was argued was the omission of including banking in the regulatory system. It was argued the host of regulators which has sprung up was the problem. Too many overlapping regulators. So the theory was combine all of these into one, the Financial Services Authority. And so the second centralised regulatory system was introduced. The Financial Services Authority was created (FSA) a singly all-embracing regulator. Again no attempt was made to identify the cause of the Baring Bank failure and address the cause in the legislation. All the legislation did was great a massive expensive regulator with the belief that somehow the regulatory will know what to do. Banks the cause of the problem, were merely lumped together with other financial institutions to be regulated by the new massive centralised financial services regulator.
Twin Peaks regulation the “solution” to the second failure
The 2008 world banking crisis demonstrated the extent of the failure of the FSA. Not only did the FSA never get round to the prudential regulation of banks (which in any event had been abandoned to the failed Basel II system), the FSA was manifestly ignorant of prudential reduction of banks. Pandering to public opinion the FSA had morphed into a market conduct regulator. The 2008 crisis made it clear that it was a mistake to remove the banks from the Bank of England and so the Twin Peaks regulatory system was born. The FSA would be restricted to do what it was in any event doing – become a market conduct regulator and the prudential regulation of banks would be sent back to the Bank of England were it belonged. For good measure prudential regulation of other financial institutions was also sent the “Bank” of England – it now ceases to be what it always has been a bank. The Bank of England of course has no experience in prudential regulation of these other institutions. The belief is of course it will somehow acquire these skills – the same belief which existed that if the regulatory staff of the Bank of England was transferred to the FSA the FSA would acquire the skills. It never did.
The Twin Peaks regulatory system was created to correct the mistake of sending banks to the FSA.
In any event since 1986 all the has happened is new complex expensive regulatory systems have been created under the mistaken belief, or in any event parliament has been persuaded to believe, that once created these regulators will somehow know what to do. Experience has shown that this belief or confidence is greatly misplaced. The newly created regulatory systems have never even came close the identifying the underlying causes of the financial failures. The costs of this system in South Africa at least, is imposed without constraint on the private sector but borne ultimately by the public. Thus the Bearings Bank failure led to the FSA which morphed itself into a Market Conduct regulator never solving the very problem it was created to solve, bank failures. The 2008 world financial crisis demonstrated clearly the FSA was a failure which has now led to the Twin Peaks Regulatory System. Once again there is no indication at all what in fact it will do to prevent another banking crisis. As before it is created with the forlorn belief the regulators will know what to do. They do not and they will not. They never have.
Economists view on regulation
EH Carr the distinguished historian pointed out that in the past history was set against different backdrops, such as religion. He pointed out that more recently it has become understood that history is being and should be interpreted against the backdrop of economics. Economics provides clear insight to regulation.
It is commonly believed regulation takes place because it is in the public interest. Having said this there is no clear idea at all what in the public interest means. Logically it should have the meaning assigned to it by John Locke that the state will protect life, liberty and property using laws passed in the public interest. In this sense then the test for in the public interest is; is the goal to protect life, liberty or property and if so are the specific measures in the public interest. If this is correct then parliament would pass the laws. It should be noted it is not the regulator which acts in the public interest, it is parliament which passes laws in the public interest. This ancient interpretation of in the public interest is largely ignored today. It is usually said regulation is in the public interest where it improves resource allocation. That is, should be clear, largely meaningless. In any event economists have found virtually no empirical evidence to support the contention the regulation is passed in the public interest.
George Stigler (1971), Nobel laureate, did a great deal of work on the economics of regulation and in 1971 gave to the world the concept of regulatory capture, a term which now forms part of the vernacular. Stigler is correct regulation is not in the public interests but in the interests of the parties who manage to capture the regulation. Stigler argued industries could capture regulation. However it is clear that it is not the financial industries which have captured financial regulation since 1986. The Twin Peaks legislation, costing an estimated R3.8 bn/a is not in the interest of the financial industry. The industry does not benefit from it. As indicated above no one has been able to list any benefits for the legislation. It is possible to argue that the regulation will raise costs raising the barriers to entry and thus the financial large institutions may benefit from the legislation by driving out competition. This clearly will happen and has happened smaller firms cannot survive in this market. This of course prejudices emerging black firms but since the SA financial market is already a concentrated market it is unlikely the large institutions will want to pay R3.8 bn/a to secure something they already have. In any event there is no evidence that the financial market has been promoting or wants the Twin Peak Regulatory System. The motivation comes from existing bureaucrats. The System cuts across the entire financial market – the promotion of the system is not coming from the market but from the existing regulators, the National Treasury and the FSB.
It should thus be clear that although promoted as being in the public interest, it is not. It is however in the interest of the recipients of the R3.8 bn/a – the regulators and the large number of persons who will benefit financially from the system.
No justifiable reason for the Twin Peaks Regulatory System has been advanced. That somehow it is necessary because of the 2008 banking crisis has no substance. There is no reason to believe it will not fail as the 1986 UK system failed and the FSA has failed. It is nothing other than a complex expensive bureaucracy, funding (probably unconstitutionally so) by a direct levy on the private sector, imposed without consent or constraint. It is created with the forlorn belief that somehow once created it will solve some unidentified and unspecified problems. This forlorn belief underpinned the other failures.
A much more plausible explanation for the Twin Peaks comes from economists – regulatory capture. These self-funded aimless institutions exist for their own sakes, the R3.8 bn/a wasted expenditure is the reason for the Twin Peaks system.
A safer financial sector to serve South Africa better 2011 National Treasury
Annual Report – 2015 Financial Services Board
Carr, EH What is history?
Ferguson, Niall (2012) The Great Degeneration – how institutions decay and economies die Allen Lane
Implementing a twin peaks model of financial regulation in South Africa 2011 Financial Regulatory Reform Steering Committee
Insurance Banana Skins 2013 PWC
Insurance Banana Skins 2015 PWC
Momoniat, Ismail (2012) ‘Rules of Insurance’ Financial Mail
The Financial Services Board within the Supervisory Regime Financial Services Board (undated)
Stigler, George (1971) “Economic theory of regulation”, Bell Journal of Economics & Management Science 2(1)
 Regulator is indicated in inverted commas because it is not clear that the regulatory is the FSB. Regulation is via Acts of parliament. Each industry has its own Act which defines the regulator. To the extent that anyone can be called the Regulator it is probably the Registrar appointed in terms of the legislation. The FSB and the Registrar are of course not the same thing. The one is juristic person and the other a natural person. Technically the FSB can be abolished and the regulatory system could continue. There is also confusion regarding the relationship between the FSB and National Treasury which reached such proportions of confusion that the FSB putout and explanatory document in an attempt to clarify issues, The Financial Services Board within the Supervisory Regime (contained in a file entitled Understanding the FSB Better)
 Even in this regard matters are not that simple because other “regulators” have been created such as the National Credit Regulator, the Consumer Protection Act and so on all of which can to an extent be said to be regulating. There are no end of regulators. I have previously remarked, never before in the history of mankind has such a might expensive armada been assembled purportedly to protect the consumer.
 Annual Report 2015 Financial Services Board
 Insurance Banana Skins 2013 PWC; Insurance Banana Skins 2015 PWC
 It was estimated that the regulatory examinations, alone, cost the industry R1.28 bn; The Cost of Financial Advisory Business Compliance in South Africa 2012.
 Ismail Momoniat “Rules of insurance” Financial Mail July 20, 2012; A safer financial sector to serve South Africa better 2011 National Treasury; Implementing a twin peaks model of financial regulation in South Africa Financial Regulatory Reform Steering Committee
 The National Treasury’s document A safer financial sector to serve South Africa better Basel’s solution is to force banks to hold more high quality capital. There is no critical analysis at the failure of banks. It is nothing other than the uncritical acceptance of a failed system, continuing with the failure. In any event if the solution is Basel III the twin peaks system is unnecessary. All that would be necessary is for banks to implement Basel III.
 Nine separate agencies were combined into the FSA.