Wednesday, 5 September 2012

Libor as a 'public good'? No, thanks...

So here we go...again. Crisis have always been the perfect excuse to step up government control over private affairs. This time it is the Libor crisis and the consequence could be a Libor rate set up by a public organism. The European Union has published today a consultation paper which asks for market participants’ views on the possibility of public control of vital indices and benchmarks such as Libor.

With flamboyant questions like “do you consider some or all indices to be public goods?” the EU mandarins ask for views on “what role should public institutions play in governance and provision of benchmarks?” and “What indices, if any, would be best provided by public bodies?” My answer of course would be: ‘none’.

The European undemocratic apparatus seems to believe that public institutions may have fewer conflicts of interest in the production of these indices and be better position to control them if they arise. Dream on, I say! Truth be said, public bodies have less incentive to knowingly alter the indices for a monetary gain as most banks do. However, money is not the only reason or cause of a conflict of interest. What money is to the private sector votes is to the public. Votes are the lifeblood of governments and public bodies that depend on them. Furthermore, you also have prestige, power, and a long etcetera of other potential incentives for public officials to meddle with the production of indices. Private hands are not perfect and the rotten eggs are always present in all baskets but the same can be said from the public hands.

God save us if the mighty Leviathan is given more control over our private sphere!

Wednesday, 15 August 2012

Money, dirty money...

Standard Chartered and the New York Department for Financial Services (NYDFS) have rushed a settlement agreement over the weekend which will see the British bank paying $340m to the regulator for alleged illegal transactions with Iran. The Wall Street Journal reports that The settlement took the form of a term sheet signed by Mr. Sands that spelled out the key points in the agreement, including the monetary penalty” and that “because the deal was struck so quickly, the final settlement agreement is yet to be drafted in its full legal format”.

We certainly understand the reasons why Standard Chartered would want to strike a quick settlement, even if expensive and unfair. From their perspective they need to get the issue out of their way as soon as possible and move on with business as usual in order to avoid further uncertainty and support the share price. What we do not know for certain is why the regulator has agreed to such a quick and cheap deal. As Zerohedge reports the NYDFS has settled for a ridiculous 0.14% per each allegedly illegal transaction. If the NYDFS is really acting to protect Americans and to avoid dealings with terrorist regimes around the world, as the strong language used in last week’s order against the bank seemed to suggest, it should have not settled the case or, at least, should have imposed a far greater fine in line with the alleged crimes committed and also to set a clear example to other banks.

However, this time around it is not a banking scandal that we are witnessing. This is a regulators' scandal. A “rogue” regulator pushing the limits, acting with impunity and aiming to elevate its status and public image as well as cashing in some additional funding. After all, in the public sector, as in the private, it’s all about status, reputation, power and money, a big bunch of dirty money...

And by the way, do not believe the BBC and other left leaning media headlines. The fact that in the settlement Standard Chartered acknowledged that the fine covers all the transactions that the New York regulator claims were illegal does not mean that the transactions were actually illegal. Nothing has been proven so far and therefore I believe Standard Chartered is innocent until proven otherwise. Standard Chartered is simply protecting itself for future legal proceedings by covering all transactions the NYDFS claimed to be illegal. That is how settlements work: nothing is proven or admitted and the defendant tries to close the loop to avoid further proceedings. Only fools or extremely biased people could confuse these concepts.

Tuesday, 7 August 2012

What are the real reasons behind US authorities vs. Standard Chartered?

The US authorities have recently hit on HSBC and Barclays with hefty fines for breaching anti money laundering laws and massive settlement payouts for alleged Libor rigging. But this week the spotlight turns to Standard Chartered which has been beaten up by strong language and accusations from US officials. Share price was tumbling today.

You may think that this is just a coincidence or perhaps you are a bit suspicious like me and think that possibly there is something else behind these fines. If I know something about regulators and politicians is that behind every action they take there is always a broader intention, a priority. Regulators focus their limited resources in certain priorities as we all do. Priorities are decided regularly at the top level and these top officials expect results. According to the results, these couple of years it seems that UK banks were a priority. The question then is, why UK banks? Following an easy logic the answer would be that US authorities are attempting to destroy the financial powerhouse that is the City of London and bring all that business (and revenue) to New York.

Perhaps too simple to be true and perhaps I am making too many assumptions some may argue. But don’t be fooled. Politicians and regulators are very simple and  unsophisticated men trying to appease normal folks, so do not expect over-engineered intentions or actions in whatever they do. 99% of the time it will be a simple action to obtain a simple and visible (especially visible to voters) result. In this case, it may be a hike in revenue to pay for crazy Obamanomics spending or possibly to improve the general economy indicators ahead of next year’s presidential election.

Whatever the motive is, I betcha  stopping the Iranian regime to move funds across the world is the facade and the least of their worries.

Friday, 27 July 2012

The hand that rocks the cradle.

It is 2007/8. The world financial system is melting and about to collapse. Everyday headlines are about massive losses, banks' collapses, jobs losses, etc. Everyone is shiting their pants. Out of fear and survival instincts management at certain troubled institutions begin lowering their submissions to Libor in order to contain fear and contagion and keep afloat. Other banks, that have easily realised of the strategy, join the party and do the same as soon as their own hull begins cracking and water coming in. The first time you do it you hold your breath, the second and third are easier and so on. Subtle and indirect calls, meetings and emails between management of these institutions and global regulators touch the topic of the apparently lower submissions. However, their apparent indifference and even promotion of the Libor rate for their own purposes strengthen your believe that they don't care or even support your behaviour. And then is when the party really begins.

So far the submissions have been made in controlled manner and for a specific purpose of saving your own ass, however after a while it seems that the behaviour is perfectly legitimate. Naturally, traders seeing that their positions are collapsing call the Libor submitting employees and ask them for a small favour: a submission, let's say, 0.3 lower or higher. It is not that much really, both think, and anyway we have been doing this for a few months now, everyone else is doing it and we cannot get behind, moreover regulators are aware but not getting nosy about it, etc, etc, so why not? Shortly, the practice extends almost to everyone and staff from different institutions begin commenting on the fact that it seems free buffet when it comes to Libor. The look at the dark and gloomy economic horizon and think: "why not I scratch your back and you scratch mine". It may not be the right thing to do, but regulators and management are behind us, thousands of bankers are being fired here and there and my time might come soon so let's pack our pockets now. You can blame the traders for their horrible behaviour, and they are certainly guilty, but when the rout of hungry wolves kill the goat regulators must ask themselves what level of guilt they share for having turned a blind eye to the slaughter feast.

Of course this is just a imaginary scenario and we do not know yet all the details (we will never know, probably), but it is very easy for politicians and regulators to blame the banks and get away with it. Regulators and governments undoubtedly have some level of guilt in this affair however, so far, no one has raised their hands yet and say sorry. This fact shows what kind of integrity and honesty most regulators have: none. If they truly have some moral fibre they should apologise and be more carefully in the way they criticise banks.

Friday, 6 July 2012

The FSA double standards.

The Wall Street Journal reports today (see the article here) that the FSA missed warnings and signs in relation to the Libor scandal and did not act to prevent the rigging. Curious, I would say the least, that I can recall many FSA enforcement actions where a key argument held for launching an investigation and eventually imposing hefty fines was (yes, you guessed it!), that the individual should have known better or should have acted earlier.

For example, Barclays, in relation to LIBOR fixing:

“Barclays should have ensured that the systems and controls around its submissions processes were adequate”

Or Mr. Einhorn, in relation to Greenlight Capital and Punch Taverns:

“Given Mr Einhorn’s position and experience, it should have been apparent to him that the information he received on the Punch Call was confidential and price sensitive information that gave rise to legal and regulatory risk.”

There are many other examples where the FSA took action based on expected behaviours and not on clear breaches of rules. It has become normal for regulated firms and individuals to live in an regulatory environment where behaviours need to comply not only with the letter and spirit of the rules but also with the conduct expected by the FSA. However, the FSA asks for integrity to financial sector players and forget to act with integrity itself.

All this should make some politicians and the public ask themselves a few chilling questions: Does the FSA have any accountability? Is it hypocrisy, recklessness, dishonesty or arrogance what makes the FSA ask the financial sector to comply with certain standards of conduct it does not apply to itself?

Thursday, 5 July 2012

In defence of Bankers.

I work in bank and I can proudly say that the vast majority of individuals working in banks are honest, hard-workers, strive for success and personal improvement, do their utmost to provide the best possible service to their clients, follow the highest standards of professionalism and a code of ethics that permeates everything they do in their work. Most of us at banks are just normal blokes who like to enjoy a pint after work at our local pub with some friends or spend time with our families. Most of us don't earn massive salaries and bonus. London Tube drivers earn more than many of us. Most of us are not greedy, or at least not more greedy than most people is. Of course I want a bigger salary or bonus, but everyone does. Whoever is free of sin cast the first stone. Most of us do not break basic ethical principles and morals to get a quick buck.  And no, not all of us go out every night to Gentlemen clubs drinking expensive Champaign and smoking fat cigars. Personally, I'm happy to go back home every day after a long day of work to see my family and read a good book.

And yes, certainly there are those who are a bit cheeky and try to push the boundaries. I am a compliance officer and I have to deal with them every day, but it makes me proud that most people I have ever worked with always come to reason and realise that it is beneficial for everyone to play within the rules. Finally, you have the rotten apples. Although I have never met anyone of them I'm sure they do exist. They do in any country, any sector, any industry and any company and they should be punished to serve as an example for others with crooked intentions. But there is no relation or link between a small group of criminals and discussing culture change in a organization like a bank that employs thousands of people where most of them are good intentioned individuals.

But some may argue that it is the bank's culture that nurtures the appearance of these criminal minds. Well, so far I have worked in three City banks in the last 5 years and all of them inculcate a top down approach to ethics and culture, have strong internal codes of ethics and treat very seriously any breach of them. It may well be a smokescreen you may think but most of us know very well that if we do not act according to the highest level of morals, ethics and professionalism, clients will go to our competitor or ruin our career. I have seen many disciplinary cases during my live as compliance officer.

So, when Tories and Labour, journalists, regulators, central bankers and the public in general claim that banks and bankers need a cultural change, I do not understand what all this furore is about.  The 90's are long gone and banks' culture has improved significantly since then. Nowadays, most banks promote and are involved in social activities and care about their neighbour. My employer organises regular days out where a bunch of us participate in social activities, matches our personal contributions to charities and supports working experiences for children from less well off schools. So, again, I don't understand. You may think I'm blind because I'm an insider and this rant is just self-interested. Perhaps it is, but it is undeniable that culture in banks or the culture of most people working at banks is not rotten, regardless of the empty demagogy of politicians.

What is even more distressful is that most of those people claiming a culture change do not have any authority to talk about morals. When government, parliament, the press, regulators and central bankers have all been tarnished by scandals rooted in low ethics and a rotten culture I personally laugh at their authority to even mention banks culture. It's like a drunkard telling me off for having a beer. It is hypocrisy. In my humble view, what this country needs is a culture change starting from politicians, regulators and other top public officials who should sort out their own house first and set the example to follow.

Monday, 2 July 2012

On banking scandals.

1. Banking culture:

I don’t buy the clamour for changing culture in banks as a panacea for banks’ wrongdoing. There are, there have been and there will always be immoral individuals committing crimes and defrauding others. The role of the State is to police these individuals and prevent their actions but not interfering with the culture of private organisations. The idea behind changing banks culture in essence means more government control over private activities. It is reminiscent of the culture shaping exercise initiated by the Nazis. Striving for the Utopia by indoctrinating the grassroots. Creating the perfect mix for the dictator to arise.

2. Libor scandal:

Scandals like the Libor rigging are nothing new. Similar scandals happened in any country, in any sector, in any industry, and in any company. If someone commits fraud or breaks the law, judges and tribunals should punish them. But we do not need more regulation or government intervention. No regulation, even the strictest one, can ever stop collusion. Nothing can guarantee that fraud will not happen again. It always will.

The real interest rating rigging scandal is the Bank of England and other Central Banks continually manipulating interest rates and therefore making worse off or better off specific sectors of the population. That is unrestricted, centrally planned, biased and unjust rigging of the general economy and so our individual pockets. Furthermore, politicians and regulators force and manipulate the entire economy to make it behave in predetermined ways which, again, benefit some and punish others. I have not yet seen politician, regulator or central banker resigning over such scandal.

3. Interest Rates Swaps scandal:

We need to reform the concept of miss-selling. The details are not clear yet but if, as it seems, some bankers within some banks did indeed force, lie or misled their customers in order to sell them an Interest Rate Swap, they must be punished. However, the concept of miss-selling is generalist, imprecise, far-reaching and misleading. It induces to blaming an entire sector instead of the actual wrongdoers.

IRS are not complex products. If interest rates go up banks pay you, if they go down you pay the banks (or vice versa). A quick look to Google would easily explain that.

Buyers need to assume responsibility for their decisions. Nanny State cannot and must not remove from individuals decision making and the responsibility it brings. This removal of individual responsibility for decisions is done directly in authoritarian states and subtly and indirectly in neo-socialist states such as the UK. The State must not save us from our own ignorance.

Wednesday, 20 June 2012

The end justifies the means? It does in financial regulation.

F.A. Hayek, “The Road to Serfdom”:

"The principle that the end justifies the means is in individualist ethics regarded as the denial of all morals. In collectivist ethics it becomes necessarily the supreme rule; there is literally nothing which the consistent collectivist must not be prepared to do if it serves 'the good of the whole,' because the 'good of the whole' is to him the only criterion of what ought to be done. ...collectivist ethics... knows no other limit than that set by expediency—the suitability of the particular act for the end in view."

Speech by Clive Adamson, Director of Supervision, Conduct Business Unit, FSA, 14 Jun 2012:

The strategic objective of the FCA is to ‘making markets work well’.

Our previous supervisory approach was too focused on disclosure at the point of sale.

The new supervisory approach will comprise of five main elements:

1. To be more forward-looking in assessment of potential problems: We will continue to move towards challenging firms about whether their business models deliver good outcomes for consumers and, where we disagree with management have the confidence in our judgment to require firms to change their business models.
2. Intervene earlier when we see problems.
3. Address the underlying causes of problems that we see, not just the symptoms.
4. Secure redress for consumers if failures do occur.
5. Take meaningful action.

No words need to be added.

Tuesday, 12 June 2012

Governments' Moral Hazard.

“Too big to fail” and “moral hazard” are not new concepts at all, although many politicians and regulators seem to have discovered or re-discovered them in recent times. Since the firsts bank bail-outs occurred during the onset of the global financial crisis in 2007 and 2008, governments and regulators have been working very hard to find a solution to the “too big to fail” and the “moral hazard” dilemma in order to protect taxpayers’ money from any future bail-outs. However, I wonder, should we not be looking at “too big to fail” governments instead and the “moral hazard” created by bailing-out governments?

In relation to banking, the “too big to fail” problem is essentially the conundrum that if a large bank fails, the ripple effects it will have in the economy will be much worse than the costs of rescuing it and therefore taxpayers, instead of shareholders and bondholders, end up picking up the bill of broken institutions. Consequently, if banks or other financial institutions know that they will be rescued instead of let fall, “moral hazard” emerges, and sometimes becomes entrenched in the system, because these institutions will be willing to take on greater risks under the comfort that if the situation turns for the worst they will be bailed-out by   governments (taxpayers).

Because of those nasty consequences, politicians and regulators of most developed countries are looking into possible solutions which minimise the cost for taxpayers. So far, some of the ideas put on the table are good intentioned and not so far from a basic capitalist’s principle commanding that broken, unsuccessful, companies should be allowed to fail and that owners, and not unconnected third parties,   should carry the burden and the costs of such failure. However rules produced by politicians and regulators are intrinsically flawed and the current proposal are becoming, as usual, a lobbying and a political fight. It would have been a better idea to allow the market to come up with its own solutions, but that is a separate point.

In terms of specific techniques currently being implemented, for example, in the US the Dodd-Frank Act in effect creates a two tier system: financial institutions categorised as “too big to fail” and therefore forced to fail in a coordinated manner, including, for example, the regulator forcing bail-ins (creditors becoming shareholders) and other financial institutions which do not pass the filter and therefore will be allowed to fail. On this side of the pond, the Independent Commission on Banking has produced the Vicker’s report suggesting that retail operations of banks should be ring-fenced from the more exotic investment banks activities, especially proprietary trading, in order to avoid damaging spills on depositors and the more traditional lending business. In parallel, proposals are also being formulated to create “living wills” in order to allow for the orderly dismantling and failure of trouble banks. Some even argue that banks should be forcibly split up and reduced in size altogether. 

However, it is hypocritical and shocking, that some politicians are so keen on making rules and new legislation related to the financial system but forget to look at themselves in the mirror. How can these politicians blame banks for taking risks under the safety of the taxpayers net when their own politically driven bets are made directly using taxpayers’ money? Why is it so benevolent and altruist to do so in the latter example but morally repugnant in the former? Taking into account that these politicians are proposing measures against banks’ bail-outs while, at the same time, supporting government bail-outs, the inconsistency is even more painful. We do not need to look further than the recent Spanish’s banks bail-out to see an example of this inconsistency.

Although it is true that sometimes banks’ behaviours can be riskier than usual based on the security net provided by governments bail outs, any losses are most of the time borne by private investors. When the private sector takes risks this is always done using private funds. On the other hand, any governmental action, for good or for bad, is always backed by taxpayers money. Governments are the uttermost   example of “moral hazard”. Furthermore, in today’s world, states have become so huge and interconnected that their failure will create devastating flows destroying domestic and international economies. Even relatively small states such as Greece are a risk for the entire world economy. For that reason, millions of pounds have already been poured into Greece, Portugal, Ireland and Spain, effectively creating the same “too big to fail” and “moral hazard” conundrum but this time at the sovereign level. Taxpayers from Euro-zone countries and taxpayers from other countries (through the IMF) have shouldered the rescue of these governments who got ran out of cash after spending it lavishly.

Therefore, as with the private sector, we need similar free market measures for governments. Bail-outs must stop and sovereign states must be allowed to fail and default. Creditors, and not taxpayers, should carry the burden. And most importantly, real actions need to be taken to limit the size and interconnectedness of governments as well as ensuring that precise techniques are designed to avoid “moral hazard” and taxpayers’   money being used to perpetuate “zombie” countries. For a start, cutting taxes will be a good beginning since less tax revenue means less to spend and therefore it is the best possible limit to the size of governments. Also, taxpayers need to realise how morally   repugnant the “moral hazard” heralded by governments is and they should demand tighter controls in the way governments spend their money.

Saturday, 26 May 2012

Banks as puppets of politicians must end.

It is very common nowadays to hear politicians and regulators claiming that banks are only interested in profits and greedy bonus and that banks do not give enough importance to their customers’ interests and relegate them in favour of their own interest and profit. It is fascinating to see how easily politicians argue that the whole system is flawed every single time a bank behaves (according to these same politicians, but still arguable) below the level they consider adequate.  

However, asking banks to put their customers’ needs before their own is superfluous. Banks know very well that they need to satisfy clients’ demands if they are to survive. Clients’ needs and they protection of the bank's reputation are always present in the minds of anyone working at a bank, from top managers to junior employees. In this sense banks are not much different from any other company in any other sector. In a properly established market system banks and financial institutions would, most of the time, behave in such a way that both parties are satisfied: banks provide a product or service for a price and customers are willing to pay for it because what they receive is worth the price. Banks are very aware of this trade off.  However, we do not live in a free market system, and if sometimes banks do not deliver for customers, it is mostly due to government interference, in one way or the other, and not in the willingness of banks to please their customers.

Banks, as any other company, know very well that if they do not provide value for money customers will stop purchasing from them and will go to another bank across the road. All companies compete for customers and strive to provide good products at attractive prices. The financial sector is no different in this regard. If politicians really want a financial system where banks produce what customers really need and want, there is no better way than implementing a purer market system where banks that do not deliver value for money will be disregarded and disappear. Of course, as in any other sector (including governments), there are certainly some individuals who may sometimes behave in a way which is not in their customers’ interest and which is solely in their own personal benefit, even if it implies committing illegal activities. However, these are sporadic cases though attracting huge attention. Politicians normally neglect that banks are naturally inclined to care about their customers and will use any wrongdoing as an excuse to ramp up control. 

But it does not stop there. For some politicians, the financial sector is also “strategically important”, “essential”, “special” or whichever other terminology they think of to argue that it has an additional function well beyond that of providing for their customers. It is not uncommon to hear politicians and regulators saying that the financial sector has a “social responsibility” that it cannot neglect. Some go even further and say that banking must pursue the ghostly “public interest”. However, these are not a simple concepts. Public interest is not just one but many, as different groups of individuals always have different and sometimes opposed interests. In reality, every time a politician or regulator claim that banks have a social responsibility to pursue the public interest, what they really are saying is that more intervention and control is needed. What politicians really mean is that banks should act in a way which supports their particular view of the “public interest” or their particular level of care for their clients. And then is when real intervention begins.

In some countries governments will simply seize banks and take the steering wheel themselves. However, in so-called developed countries politicians are more sophisticated. First, governments will pass laws to put the banking system on a specific track so that certain activities are discouraged while others are promoted. Secondly, a powerful regulator will be created to supervise and direct individual firms, or the system as a whole, in a specific direction determined beforehand. Hence, the financial sector becomes a puppet of the government. Politicians in developed countries know very well that direct control of banks is not an option. The country will be seen as an authoritarian regime and therefore discourage investment. Also, they know that private companies are better run privately and without political intervention. Therefore, they favour using this stealthy and indirect control instead of explicit intervention.

It is always good intentions that cause the worst catastrophes. Simply, look at the recent financial crisis created by the noble intention of providing affordable housing for everyone. However, regardless of how honourable politicians’ intentions are we cannot use the financial system as puppet for politicians to pursue their political agenda. If we are to avoid banking failures and promote a healthy financial system where customers receive what they want at affordable prices we should stop political interference and furtive control of banks. Unfortunately, the world is moving in the opposite direction.

Thursday, 24 May 2012

Mis selling of current accounts? Let's get a Happy Meal!

Mr. Andrew Bailey, from the Bank of England claims that free in-credit banking may lead to mis selling and therefore he argues that the regulator could intervene and push banks to charge for these types of products.

There is something that really strikes me in his argumentation: can anyone explain me how, for example, the simplest of the simplest banking product, a current account, can be mis sold? Or how, and why, providing free current accounts could, in Mr. Bailey's words, "encourage" mis selling? Mr. Bailey argument that the "unclear picture" of how free banking products work may have led to mis selling of other products (like "payment protection insurance" or PPI) simply does not have any logical basis. Certainly there is some truth in the argument that some banking products are complex and hide the true costs but that is not a current account or a PPI. According to his logic, every time I'm given a free gift if I buy a Happy Meal, that could also be mis selling. In that case McDonalds has run the biggest and longest mis selling scandal ever. 

Surely, the best protection for consumers is to make sure that products are as transparent as possible, including transparency of any costs associated to them. However, if the Bank is really prepared to intervene in the sector and require banks to charge for current accounts, it will be the most ridiculous idea ever. And definitely not the one the priorities the Bank should have in mind right now. If Mr. Bailey is serious about tackling mis selling he should forget about intervention. It should not be up to a regulator to decide how banks charge their clients. The regulator’s role is simply to ensure that banks provide clear, easy to understand and transparent information about benefits and costs of the products they offer as well as to ensure benefits and costs are presented fairly and evenly to the consumer who, eventually, has the responsibility for taking the decision. Intervening in this market would not only be irresponsible, it would be a lack of respect to the intelligence of UK people. 

Tuesday, 15 May 2012

Risk taking is a necessity.

The prestigious American Economist Allan H. Meltzer once said that "Capitalism without failure is like religion without sin. It doesn't work". 

Anyone who believes in Capitalism will agree that individuals and corporation need to fail. If we are to create a healthy and competitive market place that is able to bring the maximum possible degree of development and progress for all, we need to allow bad companies, ideas or strategies to fail in order to give way to better and more efficient ones. However, it is not only absolute failure (e.g. bankruptcy and liquidation) what Capitalism need. A healthy form of Capitalism also needs to allow market players to make mistakes. There is no doubt that mistakes are good for Capitalism in two ways: first, they allow market players to learn and therefore is an optimal way of improving performance; and, second, if we are to commit the same (or different) mistakes repeatedly, it will more likely lead to an ultimate failure of inefficient propositions.

However, “failure” is just the consequence. The cause is “risk”. If we fail in our objectives, or if we achieve them, the reason will be that, at some point, we have decided to take a particular course of action without knowing for certain what the result will be. In other words, we have taken some degree of “risk”. For example, when Christopher Columbus set off for the East Indies, he took a risk. So did the Catholic Kings of Spain who funded the expedition. And certainly, so do companies in every decision they take. Therefore, risk is an essential human necessity to achieve success, although it has a negative downside: “failure”.

Yet, it seems that some financial commentators and politicians are unable to grasp this elemental fact. And accordingly, when JP Morgan announced last Thursday that it had a $2 billion loss from a trade going sour in its Chief Investment Office in London, they seemed to have been taken aback by the fact that the bank was taking a risk and are now decided to push forward a change to the regulatory framework so that it cannot happen again. 

Individuals and companies have an intrinsic incentive to control the risk they take if the are to achieve success instead of failure. Yet, this incentive can be distorted (read here anti free markets policies such as government support of failed institutions) and hence there still may be a case to promote rules that will protect unconnected third parties, such as taxpayers or clients of the institution, when everything goes awfully wrong. Nonetheless, if we are to cultivate an advanced and developed society, individuals and companies should be allowed to take risks, and hence fail, or make mistakes regardless of how painful the can be for the maker. Responsibility for the decision taken and its consequences (failure or success) are a key element of capitalism that regulators and politicians should always bear in mind. For that reason, law-makers and regulators should abstain from pushing through politically driven and impulsive regulation and simply ensure that any rules protect innocent third parties while permitting companies and individuals to take risk.

Friday, 11 May 2012

Quick post: A view on the JPM embarrassment.

JPM’s loss of capital as a result of the London Whale bad trade is a mere 0.2%. Even if it was larger, the bank is very well capitalised to stand bigger shocks. There has been no harm to clients. The real damage is simply in the reputation of the institution and a bad quarter. Many people will use this incident to press on for the implementation of the Volcker rule in the US and the ring-fencing of retail operations in the UK. However, this incident shows that good capital buffers for unexpected blows are the best precaution. If things get even worse, recovery plans and living will do the rest. Although incidents like this are undesirable and there should be controls to avoid them, we need to allow risk taking if we want progress and development. We just need to ensure that if it goes sour, third parties are protected and it hurts only the risk taker.

Wednesday, 9 May 2012

A critic to the FSA's approach to regulation, supervision and enforcement.

The functions of any financial services regulator steer around three basic pillars: regulation, supervision and enforcement. However, there are many different approaches to each one of these pillars which the regulators can choose from to create the regulatory framework. This article attempts to explain how the FSA’s chosen combo poses serious risks to the freedom of individuals and corporations in a market economy and exacerbates the potential for abuse of power by the regulator, creates legal uncertainty and compromises the values of the rule of law.

In terms of regulation (i.e. writing rules), the FSA has always favoured a ‘principles based’ and ‘outcomes focused’ methodology. In this sense, although UK’s financial regulation comprises an extensive handbook with detailed and specific rules, the jewel crown that underpin the entire framework is the 11 ‘principles for business’ that financial firms must observe. Moreover, individuals registered with the FSA as ‘approved persons’ (normally senior managers and client facing bankers) must comply with a set of 7 ‘statements of principles for approved persons’. Most of these principles for firms and individuals are extremely general and can embrace almost any activity. For example, some of these principles state that individuals and firms must act with integrity and due skill, care and diligence. This approach, which is diametrically opposed to the box-ticking, ‘rule based’ system, implemented in other countries such as the US, has also an upside as it is, to some extent, believed to be more beneficial for the financial sector as it allows a degree of freedom and flexibility for companies to decide how to achieve those outcomes and comply with the principles. However, for this methodology to work efficiently, any interference from the regulator should be kept to a minimum.

In relation to supervision of financial markets and firms, The Big Fish already explained in a previous post (in fact the very first one) how, since its inception, the FSA’s attitude has steadily changed and become a major threat to freedom of enterprise in the UK. The old FSA system of ‘light touch’ regulation is now a thing of the past and the trend is moving rapidly to the ‘more intrusive supervision’ approach spearheaded by a more powerful and determined regulator than ever before. This entails making ‘judgements on judgments’ and taking a more pro-active and pre-emptive view of regulated firms’ internal affairs.

Finally, and in parallel with the ‘more intrusive supervision’ approach, the FSA has also intensified its enforcement activity and made its ‘credible deterrence’ attitude the flagship element of its approach to enforcement. This ‘credible deterrence’ enforcement style involves the stated intention by the regulator to pursue high profile cases in specific areas of concern.

By nature, any ‘principles based regulation’ system is to some extent imprecise and has vague borders. Consequently, any action taken by a regulator on the basis of generic principles is likely to rely heavily in opinions rather than facts. On the contrary, in a rule based system, either there is a breach of a rule and it is proven so or there is not. In a principle based system it is possible that prosecution occurs if the expected outcome of a particular principle is not met up to the level the regulator wants. Indeed, if one looks at the rationale behind most enforcement actions the FSA has taken in 2011 and so far in 2012, it is palpable how the reasons supporting these fines and sanctions are increasingly based on the breach of principles only, as opposed to specific rules, or on behaviours which fall short of what the regulator expected in order to meet its desired outcomes.

Therefore, it is not surprising that, when such a vague and borderless system of principles is combined with an intensive and intrusive supervision and a prejudiced enforcement, the likelihood of the regulator to exceed and even abuse its powers increases significantly. The consequences are a potential for limitations of freedom as well as the presumption of innocence. The rule of law is likely to be strained and tainted because of sudden changes in the interpretation or implementation of these principles, normally based on the needs or interests of the regulator instead of objective factors. In other words, ‘principles based regulation’ gives companies more leeway in dealing with its private affairs but it also gives regulators more leeway in judging the actions of a company and as a result it may create unnecessary and unfair legal uncertainty.

However, the problem is not ‘principles based regulation’ in itself which, as explained earlier, has some benefits. The problem is the way this system of regulation is applied by the regulator. On the one side, a gentle and balanced application of a ‘principles based’ system has potential for smarter regulation that helps the markets work more efficiently. On the opposite side, an intensive, intrusive, impulsive and biased application of the principles is very likely to distort the legal system by creating uncertainty about the application of the rules and has potential to produce unjust and abusive results. Unfortunately, the latter is the route the UK FSA is taking.

Sunday, 6 May 2012

The hypocritical regulator.

Governments and Regulators are the least trusted institutions by the general public. Yet, in a stunt of either arrogance or naivety, the regulator shows, once again, his hypocritical side by criticising the lack of trust on the financial sector and forgetting his own. Furthermore, when regulators are less trusted than banks, an attack to the financial sector on the basis of low levels of trust lacks any legitimacy.

Last Friday, Martin Wheatley, current Managing Director of the FSA’s Consumer and Market Business Unit, gave a speech at the Chartered Institute of Bankers in London titled: “Rebuilding trust and confidence in banks and bankers”. Mr. Wheatley, who will soon become CEO of the Financial Conduct Authority (FCA), maintains that it is only in recent years that banks, like other financial services, seem to have lost people’s trust and confidence. and, as a consequence of this distrust by the general public (and the occasional misselling scandal), Mr. Wheatley goes on to argue that the regulator is entitled to continue cracking down on the sector and watching it even closer.

The idea that Mr. Wheatley intends to transmit in this speech is an old one: that the regulator will use its more 'intrusive supervision' approach in the fighting against practices which put profits before customers. The line of attack will be three-fold:  a) product banning and product regulation; b) greater attention on the business model and whether it can deliver good outcomes for consumers; and c) the role and engagement of boards and senior executives.

As a factual basis to his argument that the public trust in banking and financial sector is at record lows, Mr. Wheatley mentions the “annual barometer of trust” put together by the PR firm Edelman. Specifically, Mr. Wheatley explains that “financial services came bottom this year with just 45% of survey respondents saying they trust the industry to do what is right.” To be fair with Mr. Wheatley, it is true that Financial Services comes at the bottom in the trust ranking for the business sector, with technology right at the top. However, what Mr. Wheatley conveniently hides is that governments, government officials and regulators are trusted a great deal less than the financial sector.

So, let’s have a look at the following slides taken from the same survey (apologies for the quality of the slides, but please follow the link above for the original presentation):

1) Trust in government enjoys, by far, the lowest level of trust among the four broad sectors analysed (NGO’s, Government, Business and Media):

  2) The decline in the trust people have in governments hits record lows and is significantly lower than the trust in businesses: 

 3) The credibility of government officials and regulators is right at the bottom of the table, being the biggest decline in the barometer’s history.

Tuesday, 1 May 2012

Can Europe return to its glorious liberal past?

The dream of a liberal society, respectful of freedom and individuals is, unfortunately, becoming more and more uncertain every day. However, the wishful answer to the question of whether Europe can become again a liberal society as it was in the past, is that yes, it can. Sadly, the only certainty is that it will take us a long time to get there and the road ahead is a mine-field full of uncertainties and difficulties. The change, if it happens, will most likely be a slow and stealthy, almost unnoticed, transformation and will require at least two more generations as a best estimate. There are of course, potential accelerators such us revolutions, wars or other calamities which may well trigger a faster change and a rethinking of the world we live in, however, History teaches us that most changes take long time even if, when we study them, specific events are recognised as speeding up the adjustment. 

Since the middle of last century, Europe has been the witness of the entrenchment of a social welfare economy and mentality which will take some time to disappear and give way to a more liberal system of managing countries and their economy. Since the big wars, social security systems and big governments were implemented across Europe and the trend continues to be “bigger” governments instead of leaner ones. However, the crucial problem lays in the very minds of individuals, their past and their culture.

The generation of individuals who grew up in these “social” states were provided with free education, free health system, job security, unemployment benefits and many other, apparently free, gifts which they saw as the achievement of a long-awaited aspiration by their parents and grandparents. Their offspring were born in a world were most countries (bar couple of sporadic reactions to unsustainable models such as those led by Lady Thatcher or Ronald Reagan) were accustomed to certain living standards that were no longer negotiable and did not want to give up at any costs. Not even a catastrophic event such as the financial crisis that started in 2008, and which is a clear proof that the model is broken, has been enough to awaken that second generation, now mostly in their late 30’s and 40’s. Similarly to drugs, social welfare systems have hooked millions of individuals and has consequently allowed the entrenchment of governments which are willing to keep the patient sedated in order to maintain their power and own privileges. However, Europe is running out of this drug and very soon the next generation will begin to wake up to an uncomfortable hangover. I cannot read the future, but it is not a wild guess to imagine that this generation will feel the “cold turkey” in its crudest form and the reactions are absolutely unpredictable. Certainly they will be upset and will fight back to recover their parents’ benefits and living standards, but the reality (i.e. unsustainability) will render them to find new ways and innovate, as humans have been doing for centuries. Slowly, they will learn to survive on their own, and so will do their children. And this is the time when liberalism can triumph again.

At some point in the near future, upcoming generations will need to make a choice: to return to the “granny state” (whereby slowly and painfully Europe will decline and die while being overtaken by developing countries) or to embrace a completely different system by which individuals re-invent themselves and are reborn as a different thriving country and economy. No one knows what that system will be and the former option seems more likely to this pessimistic author, but if the seeds are correctly planted now, the chances for a more liberal world with smaller governments may increase. As Hayek put it, “we must make the building of a free society once more an intellectual adventure, a deed of courage. Unless we can make the philosophic foundations of a free society once more a living intellectual issue, and its implementation a task which challenges the ingenuity and imagination of our liveliest minds, the prospects of freedom are indeed dark. But if we can regain that belief in power of ideas which was the mark of liberalism at its best, the battle is not lost.”

On the bright side, we are witnessing changes in the political, social and economical landscape. The rise of political parties on the right and left of the established centre are a living proof of movements in the tectonic plates of the society. The strong comeback of liberal voices like Hayek and the Austrian School are also a good sign, as is the fury and rage against politicians and governments that in a diffused way permeates many different layers of society.

On the dark side though, we can foresee how politicians will manage to maintain their “status quo” and even expand their powers. As Hayek irrefutably said, “’Emergencies’ have always been the pretext on which the safeguards of individual liberty have been eroded.” Governments can still manage to muddle through and provide individuals with a softer drug enough to debilitate their will and keep them calm until the good times return.

Almost 70 years ago, in his masterpiece “The Road to Serfdom”, Hayek said that “the first need is to free ourselves of that worst form of contemporary obscurantism which tries to persuade us that what we have done in the recent past was all either wise or unavoidable. We shall not grow wiser before we learn that much that we have done was very foolish. If in the first attempt to create a world of free men we have failed, we must try again. The guiding principle that a policy of freedom for the individual is the only truly progressive policy remains as true today as it was in the nineteenth century.” This remains as true today as it was in his time.

The Big Fish in the news.

The Big Fish Blog and Twitter (@TheBigFish­_UK), which have been running for just over a week, were born with the aim of providing a serious and expert analysis, commentary and critic of financial regulation developments in the UK and worldwide from a free markets, free enterprise and personal freedom perspective. Secondarily, we also intend to comment mainly in relation to relevant news or developments in the Economy, Business, Financial Markets and Political sectors in order to denounce any attacks against freedom and propose sensible and workable solutions. Therefore, we seek to reach the general public and become a point of reference so we have our say in the debate and our voice is heard. 

We have already engaged with multitude of Twitter users and specialised blogs, news sites and think-tanks, in order to spread our opinion, and although it is just a small step in our journey, we are very proud and honoured for having been selected three times already in the Cityam Forum "Rapid Responses – Top Tweets" section. Here they are:
  • 1st May 2012: The FSA are the worst enemy of free markets. Why is everyone so passive about this?
  • 27th April 2012: The Leveson Inquiry is becoming a political ballgame. It should have ended long ago and the job left to the police.
  • 24th April 2012: Sarko socialist, Hollande far-left, Le Pen extreme right. Is there any real pro business party in France?

Please, keep following us on twitter (@TheBigFish­_UK) and on this blog. Meanwhile we will keep updating this space with further developments in the future.

Many thanks,

The Big Fish team.

Friday, 27 April 2012

Mr. Sants will not be missed.

Every time I listen (or read) a speech by Hector Sants, I can't help but smiling at the naivety and childish tone it has. At the same time, I get annoyed at the paternalistic nature of it and scared of the consequences of his words. Mr. Sants, who will be leaving the FSA at the end of June, delivered his final speech as CEO of the FSA on the 24th of April with the grandiose title of: "Delivering effective corporate governance: the financial regulators role". Although the speech is mostly concerned with the role of boards and the governance framework, I would like to focus on several, more general, statements in this speech which I think clearly reflect the mindset of Mr. Sants and the philosophy he has brought to the FSA, and which are becoming a major threat to financial services freedom of enterprise.

Firstly, Mr. Sants, in a statement that can be interpreted as a defense of the 'more intrusive supervision' approach, declares that "we cannot rely on markets alone or on individuals doing the right thing all of the time. What is needed is a strong regulatory framework and a determined and knowledgeable regulator willing to intervene". I agree that financial markets need, as any other sector, a strong regulatory framework which sets the 'rules of the game'. I also agree that individuals and markets are not perfect, and sometimes end up creating a big mess. But I utterly disagree with government interventions in the private affairs of individuals or companies. The main role of a regulator is to watch and punish those trespassing the limits, not to tell financial markets entities how to act of behave. Any action or intervention that the regulator takes will simply be 'what the regulator considers to be right' at that time, and will be based on the regulator's interest, which can never be legitimately said to represent the interest of all players and stakeholders in the financial markets or in the society as a whole. Therefore, it cannot be argued with any convincing claim that the regulator's actions are the 'the right actions' and all other are wrong. Cleverly, and to avoid critics, Mr, Sants is quick to remark that regulator's intervention "will not guarantee failures are avoided.  Neither would that be desirable". So, if it does not guarantee avoiding failures and, as explained below, it can create other failures in itself, what is the purpose and benefit of this intervention?

Regulator interventions in the financial sector are those of a self-interested player who instead of playing by the rules is exerting unjustified coercion and can intentionally alter and direct the natural forces and interest present on any human relationships, including those present in the financial markets, for its own benefit or interest. The most daunting consequences of this is that, as the Public Choice theory exposes, these actions are very likely to lead to 'government failure' (read here 'regulatory failure') with consequences even more catastrophic than those created by the markets (e.g. we just need to observe the chaos in the Eurozone to see a current example of this). As Eamonn Butler's extremely interesting book 'Public Choice – A Primer' explains, "the market may be unable to deliver certain things, but government not necessarily an ideal way to deliver them either. Indeed, the problems that government intervention creates can be even more damaging than those it is intended to correct."

Secondly, a paternalistic statement by Mr. Sants in support of the 'credible deterrence' philosophy: "history tells us that we cannot rely on the motivation of individuals alone and that we need credible enforcement to require individuals to be driven by principles rather than just commercial expediency. Commercial success should not place an individual above the law." Although, in essence, I agree with the basic concept Mr. Sants is trying to express, there is a single word I fully disagree with and which exposes what the regulator really means: 'credible'. The meaning of 'credible' implies an element of publicity. It denotes that the crucial element is not whether enforcement actually punishes the wrongdoers, the important element is that the punishment is made public and consequently introducing a sense of fear on individuals. Therefore, the risk is that enforcement activities are pushed too far and sanctions are pursued merely to achieve that fear factor instead of for genuinely punishing of offenders.

Finally, Mr. Sants argues that "ultimately, the purpose of financial markets is to serve everyone not the personal interests of individuals." This is the scary bit. This comment is the kind of meaningless and contradicting rhetoric of an authoritarian politician in a banana republic who is ramping up his populist speech before intervening in a specific sector or seizing a 'strategic' company 'for the benefit of the country'. When Mr. Sants talks about 'everyone' he means that ghostly concept of 'public interest' that we know from a practical point of view to be a fallacy. As Eamonn Butler cleverly vindicates: "we live in a world of value-pluralism and, as far as economic decisions taken by government are concerned, people value different goods and services differently. Inevitably, the different interests of different  people will clash and agreement on what constitutes the 'public interest' is impossible".

Mr. Sants was a successful investment banker at Credit Suisse First Boston before he joined the FSA and as such he has done a fine job. He has implemented an aggressive culture and has expanded the powers and resources of the regulator to levels never seen before. Since he became CEO, the FSA's budget has gone up from £323m for 2008/9 to £543.5m for 2012/13 and the number of staff boosted to around 4,000. His blueprint has been deeply rooted in the culture of the regulator and so far there are no indications that the imminent dismantling of the old FSA will have any impact at all. This was his last speech but his long shadow will remain for a long time. For many working in the industry as well as for those that believe in free enterprise and free markets, Mr. Sants will not be missed.

Wednesday, 25 April 2012

Quick post: FSA's banning hunger.

The FSA is cracking down on the sale and marketing of Traded Life Policy Investments of "TLPI" to Retail Clients. Although it is clear that TLPI are not suitable products for everyone, this attack on the freedom of individuals (including all sides: clients, intermediaries and providers) looks like another move forward in the more intrusive attitude that the FSA has been implementing recently. The Big Fish, in a previous post, warned of the risks and the consequences of the "more intrusive supervision" approach by the FSA.

The FSA has been continually warning (even as recently as last 18th of April) of its intentions to begin banning products if it considers them to be unsuitable for the public and this is just another step in that direction, although instead of using a straight ban, the FSA seems to be testing stakeholders reactions by performing a veiled veto. It is difficult to read the future and see where all this will end, but this is certainly fulfilling its purpose: to send a clear message to everyone that the FSA is not joking, it is going to restrict the freedom of financial sector players and therefore you should either change profession or leave the UK.

The FSA's lost case.

The UK's financial sector watchdog, the Financial Services Authority or FSA, has lost its case against a former head of UBS Wealth Management UK, John Pottage. The FSA's original decision to fine Mr. Pottage £100,000 in 2009 for systems and controls failures was rebutted by the Upper Tribunal for Financial Services. Now, this is good news! But before my euphoria takes me over, let's analyse the case.

It strikes me that the main argument used by the FSA to support that Mr. Pottage is guilty of "misconduct", was that he inadequately supervised the business on the basis that "he should have instigated a 'root and branch' review of UBS's operations and compliance procedures sooner". In particular, the FSA argues the following:

"The [FSA] considers that as CEO, and being responsible for the operation and management of the Executive Committees, [Mr Pottage] should have performed an adequate Initial Assessment. He failed to do so. As a result, he failed to identify the need for the Systematic Overhaul." Mr Pottage had been "too accepting of the assurances he received that there were no fundamental deficiencies with the design and operational effectiveness of the 30 governance and risk management frameworks". Mr Pottage "should have questioned more vigorously the assumption that the frameworks were fit for purpose and that they had been implemented properly locally."

The legal basis for the FSA's action is found in Sections 66(1) and 66(2) of the Financial Services and Markets Act and, more specifically, in the Principle 7 of the statements of principle for approved persons in the FSA's Handbook which states that: "an approved person performing a significant influence function must take reasonable steps to ensure that the business of the firm for which he is responsible in his controlled function complies with the relevant requirements and standards of the regulatory system." The crucial element is therefore whether Mr. Pottage took reasonable steps to ensure that appropriate systems and controls were properly implemented in the business. 

Mr. Pottage, as admitted by the FSA, had had meetings with members of the Management Committee, with senior staff in Legal, Risk and Compliance, with the COO, with his predecessor and with the Firm's Business Unit Head. Therefore, considering that Mr. Potter took some steps to understand the business circumstances, its risks and the work in place to address them, it seems that the FSA's expectations go too far and the argument wielded ("should have questioned more vigorously") sounds very weak if not childish (and certainly by that logic the FSA should also be prosecuting its own senior managers who have presided over catastrophic failures in recent years). Yet, we have seen lately a growing number of cases where the FSA's decisions and arguments to prosecute firms and individuals are increasingly based on what the FSA believes the individual should have done (and did not do) instead of whether the individual or firm actually did do something wrong. I must admit, that this reasoning is recognised by the current legal framework. However, instead of being fully based on facts, this kind of argumentation is prone to be dominated by presumptions, opinions, interpretations and hindsight. Accordingly, it could potentially give too much leeway to the FSA and its apparatus.

So, as I said earlier, this ruling is certainly good news for people who believe that the public sector should be restrained and should be able to exert coercion on individuals only to the extent permitted by the legal framework. Of course, I am slightly biased, but in all seriousness, the UK needs more rulings like this. In the UK's system of regulation and supervision, where an almost almighty regulator is beefing up its "credible deterrence" strategy to the point of taking it almost to the extreme, this is a much needed evidence that the checks and balances structure works and is good news for those who believe in the rule of law and the presumption of innocence. Furthermore, such punch in the face to the FSA will hopefully help to hold down the FSA so that it will need to think twice before pursuing a similar case again.

Unfortunately, perhaps I am being delusional. The reality points in the opposite direction and the FSA keeps on looking for its high profile cases in his exercise of washing its image with the UK public. For example, just today, Hector Sants, the soon-to-leave chief executive of the FSA, has made it clear in a final speech that "tougher action is needed on senior management". People like, me who works in the industry, know very well how the pressure is, slowly but steadily, mounting on senior management and board members, including NEDs. The aim, it seems to me, is to ensure that board members and senior managers get involved and are knowledgeable of the day-to-day running of the business as if they were doing it themselves. Obviously, everyone agrees that board members and senior executives need to know, and understand, what is going on in their business, but practically it seems near impossible to do both roles. That is the reason why honest delegation and supervision together with appropriate flows of key information are the crucial tools for senior managers and board members. The day-to-day is left to managers and employees down the chain.

Monday, 23 April 2012

The Anti-Innovation Regulator.

Last week Adair Turner, Chairman of the Financial Services Authority or FSA, gave a lecture at the School of Advanced International Studies (SAIS) John Hopkins University on the topic of “Securitisation, shadow banking and the value of financial innovation”. In it, Lord Turner argues that when financial innovation and shadow banking are “concentrated on activities central to or closely related to the money and credit process”, this innovation creates “macro instability” and “negative externalities” that the regulator must tackle.

Lord Turner admits that the regulator should not be concerned with trying to achieve an optimal result (in his own words: “regulators cannot and should not pursue some precise target of social optimality”). However, Lord Turner claims that regulators “should seek to constrain the instability potentially created by credit and money creation processes, by credit and asset price cycles." In other words, the proposal is to hit the brake pedal of the financial sector to ensure that innovation in a specific area chosen by the regulator is, at least, slowed down if not brought to a complete halt, while allowing innovation in other areas.

It is remarkable that Lord Turner himself admits that “measuring with any precision the value of innovation is difficult in all sectors of the economy, but particularly so in finance”, however, in a moment of enlightenment, he is keen to share with all of us his own (and hence the FSA’s) measure of the social value of a particular innovation. It is understandable that he has a view on this point. But so do most people familiar with the subject. Yet, we sense in this speech by Lord Turner a feeling of anxiety to wield some sort of supervision and dominance over an area which has grown too free and untouched from the long hands of the central planner. The intentions of Lord Turner are even clearer in this statement: “securitisation in itself might have had the potential to be a socially valuable innovation, and might be able to perform socially valuable functions in future if developed in appropriate form”. It is really adventurous how Lord Turner can feel so confident that the regulator will know what the appropriate form is.

The problem is that Lord Turner doesn’t get it. The problem was not financial innovation in itself (such as that kind of innovation that developed in the credit derivatives and securitisation area). What failed was not “innovation”, what failed was the underlying (i.e. bad household and corporate credit decisions) and in this failure financial innovation had no input. The reasons of this failure are still hotly debated, but it seems to me that governments, central banks and regulators also had their part. It is true that innovation can be the cause of unwanted consequences and be socially undesirable, but blaming financial innovation for the financial crisis is like blaming the gun for the murder. Therefore the FSA is off target again and the consequences of this squeeze on the wrong causes of the crisis are yet to be seen. Nonetheless it is understandable that the regulator is so keen to wash his image. Indeed, it was looking to another side when shadow banking and credit innovation were developing in the run up to the financial crisis and did nothing to control such activities now portrayed as creating “negative externalities”. Moreover, shadow banking is the latest area of the financial sector that the regulator has not yet fully grabbed with its long hands and the FSA’s fingers are itchy to regulate it sooner than later.

Innovation is the free development of (better or worse) techniques and application of resources by free individuals in order to maximise their returns within the given legal framework and social customs. But if we want to allow great innovations to flourish we cannot direct their course or otherwise we will be restricting potential innovations and consequently the potential number of successful innovations. 

Sunday, 22 April 2012

You are guilty until proven least, if you are a bank.

So, according to the old logic, it was said that you are innocent until proven otherwise, however, in the financial services world it seems that the balance is moving in the opposite direction…even further.
In the recent FSA’s Business Plan for 2012/13 the Financial Services Authority states the following: “To deliver the consumer protection objective, our policy approach seeks, alongside our intrusive supervisory approach, to address a number of deep-rooted market failures and cultural issues that exist in the market”. So, what does it all mean? In plain words, the UK financial services’ watchdog is saying that in order to protect the UK public at large from a number of market failures and cultural issues which, according to the regulator, create a detriment to the consumer, the FSA will unleash a policing regime that can be tagged as one of the most restrictive of freedom and intrusive of privacy that this country has not seen for many years, if ever at all.

Yes, we all agree that consumers need protection, but I would disagree that the protection is needed only from “deep-rooted market failures”, as the FSA seems to suggest. Protection from politicians and other public officials as well as from consumers themselves (i.e. financial literacy) is also much needed. In any case, how can the FSA be so sure of the “market failures” that need tackling? Have they found a crystal ball that no one else can read? Are all school of thought, economist, politicians and public in general unanimously in agreement that those are the “market failures” that the FSA should be using up its resources for?

However, the most startling part of the statement is that to tackle those “market failures” the FSA will be using a new approach so-called “intrusive supervisory approach”. Actually, it is not so new. It has been steadily and stealthy developing more or less since the outset of the recent Financial Crisis, but what started as a critical reaction to the shocking performance before and during financial crisis, has now become entrenched in the FSA mind and is a reality and a mainstream in the idiosyncrasy of the FSA. If we want to understand this belligerent philosophy we need to put it in context, in historical context. This way, it will be easier to see how the intervention in the financial sector has dramatically increased in recent years.

From general principles to expected results:

The FSA’s pre-financial crisis approach to regulation was something sometimes described as “light touch” regulation. This concept was probably created by an interventionist mind and not by a free marketeer since, from a liberal perspective, there was already a heavy intervention on the freedom of the private/financial sector, including a lengthy set of rules centrally dictated together with a strong enforcement arm easy to flex. Perhaps, it could be argued that the old FSA approach was “light touch” compared with other regulators in other jurisdictions, but definitely it was certainly not light touch in itself.

According to the FSA, the pre-financial crisis approach to regulation evolved around the tenet of “principle based regulation” whereby, instead of writing endless codes of detailed rules, the FSA would outline the principles that it expected regulated firms to follow. Accordingly, the operational implementation of these principles was largely left to each individual firm’s judgment. Naturally, this situation created the emergence of a varied landscape of dissimilar approaches to the implementation of the principles in the day to day activities of each regulated firm which reflected factors such as size, risk appetite, culture and nature of their activities. It created “legal insecurity”. In practice though, firms always tried to benchmark among themselves, especially against the big players and therefore certain uniformity still existed.

However, interventionist systems do not like varied approaches which are not commanded from the top and therefore, the FSA begun to develop a new philosophy called “outcomes focused regulation” (curiously, during this same time there was a sort of bridge period hilariously called “more principles based regulation”). Perhaps, the best example of outcome focused regulation was the Treating Customers Fairly or "TCF" initiative implemented in 2007/8. TCF sets out a series of outcomes the FSA expects to see in the firms’ dealings with their customers. However, it was left to each individual firm to decide how to achieve them. The FSA was content with receiving enough and satisfactory information on how, and what systems and controls, had been implemented in each firm in order to reach these outcomes. A FSA paper in 2007 summarises the regulatory philosophy as follows “We want to give firms the responsibility to decide how best to align their business objectives and processes with the regulatory outcomes we have specified”.

The birth of more intrusive supervision:

More recently, two events happened which further shaped the stance of the regulator: First, the FSA slowly lost its rule writing powers to European Authorities and therefore, since not much could be done in this territory, the shift was toward behavioural aspects: the policing role of the FSA. Secondly, and as a consequence of the catastrophic failure of Northern Rock, the FSA’s launched a full revision of its own supervisory approach.

It all started with a review by its internal audit division of the supervisory methodology and attitude toward the ill-fated institution. This audit identified several key failures which in turn triggered a broader “Supervisory Enhancement Programme” (SEP) which intended to address the principal flaws of the FSA’s general approach to supervision. However, the new philosophy was finally embodied in the Turner Review which was published in March 2009. The Turner Review was prepared by Adair Turner, Chairman of the FSA, as a study of what went wrong during the unprecedented critical days and weeks at the outbreak of the financial crisis. It examines the FSA response to the handling of the crisis and the acknowledged deficiencies in its management of such critical times. More importantly, it also looks at the future and what can be done better. It plants the seeds of the new philosophy of the regulator, including the need for a wider focus which is inclusive of macro economical and prudential factors. The review also deals with the new powers that the FSA should assume going forward and sets the foundations for the "more intrusive supervision" approach.

This new approach is, as described by Lord Turner himself, “underpinned by a different philosophy of regulation”. Lord Turner explained how the new approach would involve "a shift in supervisory style from focusing on systems and processes, to focusing on key business outcomes and risks and on the sustainability of business models and strategies", and it continues: “This shift will imply a greater willingness…to intervene more directly if we perceive that specific business strategies are creating undue risk to the bank itself or to the wider system”.

This is what I want and this is how you do it:

So, the FSA’s attitude is evolving rapidly and is fiddling with a radical new approach: intensive & intrusive supervision. This approach focuses on what the FSA believes to be “inherent risks in a firm’s business model” and features a key element that makes my spine chill: the FSA moves toward having a view on the business risks a firm is taking. In other words, the new approach is proactive rather than reactive. The FSA will be judging firms on the potential consequences of their decisions and will be making ‘judgements on judgements’.

But the regulator is not only trying to frighten banks, it really means what it says. The real and practical consequences of this new approach have been unfolding during the last couple of years and include serious exercise of more inquisitive actions. For example, and I'm just citing a few:
  • Sector wide interventions such as the Retail Distribution Review or RDR and the Mortgage Market Review or MMR;
  • Amplified individual product intervention;
  • Tougher and more frequent enforcement actions;
  • Firm’s permissions variations; and
  • More frequent use of costly and burdensome FSMA 2000 S. 166 (skilled persons review).
In other words, the FSA has already forgotten the carrots and has moved from the stick straight to the chainsaw.

Finally, and looking at the near future, it is worth noting that the proposed re-structuring of the regulator and the break-up of the FSA, unfortunately will NOT have any relevant impact on this new “intrusive supervision” approach. The philosophy will be pushed through and the only measurable impact on firms will be in the costs involved in the running of several regulators. An FSA executive has stated in a recent public speech that the Financial Conduct Authority or ‘FCA’ (which will supervise authorised firms from a conduct perspective) will continue being more intensive in its supervision of regulated firms and will concentrate on strategic approaches and whether business models as a whole deliver the right outcomes for consumers. Also, it will be pre-emptive and interventionists and will increase the engagement between firms and the regulator”

The new new:

So, it is fair to say that a new age of more interventionism in the private sector has been developing in recent years and is here to stay. This is the new new. Forget the presumption of innocence, the right to privacy and the sacrosanct sphere of private freedom. Nowadays, if you run a Bank or a financial institution in the UK you are guilty of wrongdoing unless you prove yourself innocent, or at least the FSA will treat you as such. Basically, if a bank is making too much money it must be because it is doing dirty tricks and so the regulator will not hesitate to be the mighty hammer putting down the nail that stands above the others, as the old Japanese proverb goes.

The recent financial crisis has been the perfect excuse for regulators and politicians to go to the next stage and tighten the screw even harder. This new regulatory stance no longer looks, as it had done in the past, at intervening in the regulatory and legal framework, which requires a lengthy process and is not always fully perceived. This new regulatory stance no longer involves just telling banks what they should do. If that was not enough in itself, the new approach involves “proactively” intervening in the freedom of the private companies and forcing them to do what the regulator wants or expects. It seems as though the old maxim of “the end justifies the means” has been taken to the extreme in this case and you will be frown upon and punished as if you were guilty even before you are proven to have been doing anything wrong.