Much of the UK’s financial services industry does not need to be overseen by a single state regulator, and only banks linked to the payments system should be under such surveillance, according to a new report by the Institute of Economic Affairs, a free market think tank.

The report, called Does Britain Need a Financial Regulator?, challenges much prevailing opinion that has argued for tougher, more comprehensive rules and regulations to prevent a repeat of the recent market turmoil, affecting sectors including family offices. The US has recently signed into law sweeping regulations of banking and financial services; in the European Union, the bloc is moving to tighten oversight of hedge funds. (To read a recent item about the scale of such rules, click here).

However, the IEA argues that the UK regulatory regime, under which the Financial Services Authority oversees the entire sector, is unwieldy and can in some ways make financial problems worse. On banks, the regulation should focus on protecting the payments system, while individual banks should be allowed to fail in an “orderly fashion”, the IEA said. Since 2001/02, the FSA, which then had a budget of £195 million ($311 million) and 2,030 staff, has expanded to 3,260 staff with a budget for 2010/11 of £454 million.

The IEA's report also argues that hedge funds, investment banks and other private investment funds should not face statutory regulation. It argues that traditional Common Law rules dealing with fraud, theft and other offences are adequate for handling the problems that have arisen in these sectors.

Already, the new Conservative/Liberal Democrat coalition government is moving to transfer some of the banking supervision powers from the FSA to the Bank of England. However, the FSA – set up in the late 1990s – will retain many other supervisory roles, over sectors such as investment management and mortgages.

“The market mechanism is enough to guarantee effective regulation: the number of financial scandals has not reduced in the era of statutory, bureaucratic regulation. Other than in the case of banks dependent on the Bank of England for deposit insurance and lender of last resort facilities, the financial system should be left to self-regulate,” Philip Booth, editorial director at the IEA and author of the report, said.

“If the coalition genuinely wants to create better regulation in the financial sector, along with more competition and cheaper capital for companies, they should scrap the FSA and the vast majority of its functions and leave the financial sector to itself as far as possible,” Booth said.

The UK Treasury department did not discuss the specifics of the IEA report, but told WealthBriefing: "The coalition government believes that sound regulation is vital to protect consumers and ensure financial stability. Good regulation creates the transparency and accountability that produces trust in the system and the confidence to invest and allows the financial services to flourish. The financial crisis demonstrated the impact of failed regulation on the wider economy. That is why we have set out a clear set of reforms to ensure those mistakes are not repeated."

The FSA has stepped up its enforcement actions in recent months, mounting an aggressive campaign to catch and prosecute alleged insider dealers, for example. And yesterday, the FSA fined members of the Royal Bank of Scotland Group £5.6 million for failing to have adequate systems and controls in place to prevent breaches of UK financial sanctions.

However, the financial turmoil has been an uncomfortable experience for the watchdog: in 2007 and 2008, the FSA was criticised for allegedly failing to act quickly enough over the near-collapse of UK lender Northern Rock, or for not identifying the scale of potential problems that eventually hit banks such as RBS and HBOS.

In its report, the IEA pointed out that the current regulatory landscape is relatively young. For example, statutory regulation of the stock exchange and other investment markets started as recently as 1986.

“Self-regulation of exchanges works better, as exchanges have a strong incentive to develop the best regulatory systems possible in ways that reduce the cost of capital to companies. Exchanges need to attract both companies that wish to raise capital through them and investors. They therefore need efficient but effective systems of regulation. Investment markets should therefore be allowed to regulate themselves,”  the IEA report said.

“Both history and economic theory show that the statutory regulation of investment markets leads to bureaucratic rule-writing attitude instead of effective regulation. Investment markets are now regulated by an incomprehensible combination of EU and UK statutory regulation which is unnecessary and costly,” it continued.

The think tank said statutory regulation of investment markets and exchanges should be scrapped, supporting a recent government proposal to allow regional stock exchanges to be set up exempt from financial regulation.