The financial system and a structure for growth

THESE DAYS, increasing economic growth and improving financial stability are two of the most important issues facing policymakers across all developed economies. The financial crisis has forced a reappraisal of the regulatory architecture and around the world, policymakers are proposing significant changes to rules governing the financial sector, with the goal of making the financial system more resilient.

Given the large and visible costs of financial instability for Europe, it is natural for European policymakers to make the avoidance of future financial crises a high priority. But it is also important to recognise that regulation carries a range of costs that can dilute the considerable economic benefits of a competitive and dynamic financial services sector.

Financial development is not only the consequence of economic growth but also a driver. If the EU is to achieve the ambitious goals for unleashing private enterprise and creating jobs set out within the Europe 2020 agenda, then it cannot afford to overlook the role of the financial system in fostering innovation and growth.

In presenting the twin goals of growth and stability as conflicting, a false dichotomy has arisen in the policy debate. In fact they are entirely interdependent: financial stability will give businesses in the UK and across Europe the confidence to invest in new jobs and growth; while economic growth is essential for companies and citizens to build the income and wealth that is needed to sustain a stable economy and financial system for the long term.

As supervisory authorities consider a broad set of proposals to strengthen the regulatory infrastructure, an important question that arises is how to assess the aggregate impact of these various measures. Although each may look sensible in isolation, they could still impose a larger-than-expected burden on the financial system when taken in the aggregate.

The focus of policy reforms should be on forcing financial institutions to internalise the social costs of their risk-taking decisions rather than suppressing financial innovation.

Credible policies to allow the controlled failure of financial institutions would encourage market monitoring of risk-taking, reducing the need for additional prudential regulation while minimising costs to the taxpayer in the event of bankruptcy.

Policymakers should aim to put in place an objective, sustainable and flexible regulatory regime, as the design of the regulatory framework will play a significant role in the future development of both the financial industry and the wider economy.

International consistency in the regulatory reform agenda is also important so as not to risk fragmentation of global capital markets, which bring significant economic benefits to companies and consumers alike.

I welcomed Commissioner Barnier’s announcement in April this year of the programme under the Single Market Act “Twelve projects for the 2012 Single Market: together for new growth”.

The Union and its member states must remain an attractive destination for companies, investors and entrepreneurs, and a magnet for the skills needed to develop the jobs and income on which Europe’s future prosperity depends.

The private sector, given such a framework, can be empowered to deploy Europe’s potential to deliver smart, sustainable and inclusive growth. There should be recognition by policymakers in Europe that the financial services sector has an important role to play in facilitating that growth.

A stable financial system will help to restore confidence, but financial institutions must be free to continue to take the risks which are inherent in financial intermediation so long as they bear the consequences of any failure, and do not rely on a ‘safety net’ of taxpayer’s money: providing capital and risk management to European citizens, companies and governments; and in financial innovation: developing new financial products which support the development of new industries and markets.

This in turn creates the conditions in which savers, companies and taxpayers regain confidence in the stability of the financial system. The economic and social purpose of financial markets is the efficient allocation of capital, and the regulatory agenda must be framed around this goal. At a time when the economy is struggling to recover lost ground, changes to the regulatory regime should not unduly restrict the potential of the financial sector to create the environment for business – commercial undertakings, employers, employees, and the skills they harness and develop – to succeed and to make the profits that must, ultimately, provide the catalyst for future growth.

Chris Cummings is CEO of TheCityUK, an independent body promoting UK-based financial and related professional services