The economic considerations of Twin Peaks

The Financial Sector Regulation Bill, the so-called Twin Peaks Bill, has been circulated for comment. A Socio-Economic Impact Assessment (SEIA) for the Bill has also been published, but the SEIA is however wholly inadequate, (Vivian 2016 Insight).

Why should a piece of regulation be put in place? A single answer can be given; because it is in the public interest. This is the public interest theory of regulation. That answer is too broad because the phrase in the public interest itself is too broad. We suggest the formulation by John Locke is closer to the truth; “Political power then [is] the making of laws for the regulating and preserving of property only for the public good [ie interest]”.

Regulations must be made to protect life, liberty and property and only made when it is in public interest to do so. Each law, including regulation, must be examined and two questions must be asked. Does this law protect property; and if so, is it in the public interest that this law be passed? Do note that it is the law itself which must be passed in the public interest.

There is no theoretical basis for saying a bureaucrat must act in the public interest; that would be granting to the bureaucrat arbitrary discretion which would be against the rule of law. The bureaucrat must act according to the law which in itself was passed to protect life, liberty, and property, and also be in the public interest.

Looking back

This clear Lockean position became confused by the American experience which can be traced back to the so-called Progressive Era from 1890 to 1920. It was during this era that some of the most far reaching regulatory changes took place which still impact matters to this day.

In 1890 the Sherman AntiTrust Act was passed, which forms the basis of competition legislation around the world, arriving much later in other Western Countries.

Whether competition regulation protects property is not at all clear, nor is it clear that passing said law is in itself in the public interest. Because of the legacy of the Progressive era, American literature takes a broader view of when legislation is needed. It merely states that competition law is in the public interest, or competition regulation is necessary to correct market failure.

It is argued that markets led to monopolies or markets failed to prevent monopolies. Thus, governments must intervene to correct this market failure. Monopolies, it is said, lead to economic inefficiency. Markets fail to be efficient and thus government intervention is necessary to correct this market failure. It should be clear that American literature on economics of public interest can be confusing. When actual cases involving completion law are examined the loss of property is hard to find and so eventually some say the purpose of competition law is to protect competition itself.

Regulatory capture

It is easy to claim the Competition law was in the public interest but what did the empirical evidence show? In 1954 Arnold Harberger attempted to measure the adverse effect of competition failure in the US and concluded the dead-weight loss was a mere 0.08% of national income. This was so small that it prompted Nobel Laureate George Stigler to observe in 1956 that “economists would be better employed fighting termites than combatting monopoly”.

Passing monopoly laws would not be in the public interest. The cost of policing a problem which hardly exists would not be justified by spending amounts thousands of times greater than the problem itself. Nevertheless Stigler went on to spend a great deal of time developing an economic theory of regulation.

In 1970 Stigler published his findings in The Theory of Economic Regulation. Looking at a wide range of regulations which existed in the US he could not find evidence that regulations were made in the public interest. Harberger’s finding with respect to competition regulation was not unique. It was a general principle. There is very little evidence that the public benefit from regulation. The public pays for it but does not benefit.

Who then benefits? He approached the problem from the standard economic perspective, supply and demand. Regulation was supplied by the state, who then demanded the regulation? He reasoned it was demanded by the regulated entities themselves. He argued that the regulated had captured the regulator – and that is how the idea of regulatory capture was born.

A balancing act

There are a number of reasons why an industry would want regulations, especially if the industry can benefit from being regulated. One reason is that the industry wants to be shielded from competition. In the case of short term insurance this in fact is the earliest example of an industry wanting regulation. For any company to be viable, including insurers, it is important that the income exceeds expenditure and this requires adequate premiums be charged. If the premiums are inadequate then the company will run into solvency issues. However, in a highly competitive market it may be difficult to raise premiums.

Insurers, so the argument went, face destructive competition. It may well be that insurers would like premium regulations since they could then set the premiums at rates higher than those set by the free market. At an early date American insurers were reasonably happy to submit to regulation. Their rates were set higher than the market rates.

Over time Stigler’s regulatory capture theory explaining the existence of regulation gained acceptance. What he did not explain was why regulation would be supplied. The factual position was that regulation existed, and a rationale for it could be found in the idea of regulatory capture – but what remained is an explanation for the supply of the regulation.

SA’s Twin Peaks

With this theoretical background in mind; why then is the twin peaks legislation going to be introduced? The Twin Peak system will cost the public about R6bn per annum. This is an expense to be extracted from the financial industry which will be pass on to the public. Is it in the public interest? The public will pay but will the public get any benefit for the money it will be paying out? From an insurance perspective it does not look as if the public can get any benefit. Two main reasons have been given for the Twin Peaks; a stable financial sector and an inclusive financial market.

The stable financial sector refers to the 2008 world banking crisis. Obviously the twin peaks legislation can produce no benefit to the insurance industry as the crisis originated in banking and other countries and not in South Africa. South Africa can pass all the laws it likes and impose all the costs it wants to and it will make no difference as to what happens overseas.

For South African insurance clients to spend money trying to prevent another world banking crisis is merely to waste money – the money spent is a deadweight cost. It will not produce a more stable short term insurance market because the existing system has produced that already. Short term insurance customers will not benefit from the twin peaks market conduct either.

Of the nearly two million short term claims, which are submitted per annum, no evidence at all exists that the market is not treating its customers fairly. Clients will get virtually no benefit for their contribution to the R6bn per annum.

Empty contributions

As in the case of previous studies on economics of regulation there is no evidence to suggest the twin peaks legislation, as regulatory legislation, is in the insuring public’s interest.