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.