Sunday, 22 April 2012

You are guilty until proven innocent...at 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.

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