Regulatory Consulting’s Insight & Foresight Newsletter - February Review 2010

February Review 2010

Although the unannounced General Election campaign kicked off in earnest during the month, few specifics emerged in the absence of the official manifestos. Meanwhile, the FSA went about its business communicating the various ideas it is wrestling with in the post-, or should that be ante-, crisis world. But they were overshadowed by the news that Hector Sants would stand down from the FSA in the summer.

No more Hector’s House jokes

Hector Sants’ decision to execute a previously established plan to leave the FSA a strict three years after taking up the CEO role has been widely reported elsewhere. Throughout his tenure, whenever we met him, generally on matters much less pressing than those on his desk at the time, he never lost any of his charm or sense of humour. This is a remarkable achievement.

The timing, however, even if pre-determined, is lousy. It brings into sharp focus the acute problems that would flow from the Tories winning the election and pressing ahead with the break up of the FSA. In the interim, trying to recruit a successor is plainly futile since no one can say what the job will be. Presuming the Tories do win the election a very awkward period is likely to ensue. Primary legislation to create the powers for successor bodies would take at least a year to pass. Extensive secondary legislation will take at least a further year. Establishing the FSA is itself a good guide to what would happen after the election. The successor bodies would be quickly established but they would have to use the powers of the FSA until the new ones became available. The FSA went live in 2002, fully five years after the 1997 election.

So the question arises who will oversee this project and how many successors to Hector will be recruited? The answer is as many as five since there are likely to be five successor bodies covering prudential supervision, conduct of business supervision, listing, financial crime and financial capability! Possibly a federal approach might be attempted to rationalise back offices, but even if it is, the cost of this will be very considerable. Hector opposed these plans with very good reason. He did not say that this is not the time to heap higher taxes on the regulated community, for that is what this plan will mean through higher fees. He could have. His departure highlights a potentially messy situation and makes it no easier.

Turning the pages of history!

We have commented on several previous occasions that the FSA has a practice of using speeches by its senior people at industry conferences to give quite clear messages about where it is headed. Indeed, they get quite frustrated that too few people read them. Of course, it would help if the speeches did not hide behind such deadly titles as “Asset management regulatory trends and priorities in the post-crisis environment: an update from the FSA.” However, Dan Waters’ speech to the McKinsey Asset Management Conference on 25 January (reported here because it was not posted on the FSA website until 1 February) was one such. It contained a number of significant messages worthy of repetition and comment.

For some time now there has been more than straws in the wind that the FSA is unhappy with the performance of the conduct of business regulatory regime, specifically its fitness for purpose to protect consumers. Process regulation itself has come into question. The Treasury threatened in its July 2009 White Paper on Financial Services to produce a discussion paper on product regulation by the end of 2009 but no such document has been published to date. Dan’s speech refers to product regulation explicitly and goes on to try to define what this might mean and how the regulatory regime could change.

“We want to turn the page on that part of our history” he says to describe the number of mis-selling scandals that routinely occur. “We want to develop a regulatory approach that looks more deeply into the value chain” is the high level description of where the FSA is headed. What does this mean and how could it be achieved? Alas, that is not set out in too many specifics but the broad approach is to hit product provider firms rather than intermediaries by examining their “product governance, design and oversight”. Dan concedes that the FSA looked at this as the RDR got under way but these comments now appear to imply that the FSA already thinks that the RDR as it stands will not achieve what it wants. This is a major message.

Quite a bit of space is devoted to stress testing of new products as a potential way forward. Stress testing is currently in vogue. But the speech points out that “Often, product design seems to be driven by benchmarking against competitor products, so there is a sort of built-in circularity and re-enforcement of entrenched practices.” In other words, there is virtually no product innovation in the retail sector. It is difficult to see how the proposed solution fits with the market failure presented. Possibly, absence of genuine innovation and serial mis-selling points to a different and intractable problem to do with an inverted market. Nevertheless, it is evident that the FSA is not finished with the retail market and RDR is not the last word.

Indeed, the speech goes on to address one aspect of the RDR that has been lagging the rest. This is what to do about wraps and platforms in all their manifestations. Dan hints that the EU Commission’s work on PRIPS and its MIFID and IMD reviews present a fair degree of uncertainty for the RDR. But more explicitly he recognizes that adviser charging does not cope very well with platform charging practices, or rather, vice versa. Finally, FSA it seems will have to front up to this intractable issue too in the forthcoming RDR Policy Statement. We have a long way to go.

Handbags in Berlin

A very strange spat occurred in Berlin. The busy Dan Waters attended a so-called Super Return conference in Berlin. (The idea of a conference using the concept of super returns in its title suggests irrational exuberance is not dead but no matter). It seems that in a panel session of senior regulators including the intrepid Dan, Jon Moulton of Alchemy fame asked why the Alternative Investment Fund Managers Directive (“AIFMD”) was on the stocks and described greater regulation from Brussels as “clinically insane”. In response Dan is reported to have said “It is the arrogance of that statement, that no regulation is needed, that has got the industry in trouble in the first place…”

What is odd about this exchange and its initial reporting by the media is the failure to spot the irony. The FT even noted that Dan was leading the efforts to slow down the legislative process in Brussels so that proper consideration of reservations about the AIFMD’s more extreme proposals could take place. Perhaps Moulton had regulators from other Member States in his sights but the UK regulators should not have been amongst them since they are his best shot at avoiding excessive regulation.

What the alternative fund managers need to do is play the game and develop intellectually coherent arguments, either for no regulation (unlikely), or appropriate levels of regulation. Fortunately, some have understood that imperative and are working to supply the bullets for the likes of Dan to fire. The days of simply railing against the Germans and the French are long gone. Who knows, they might be right!

Oh Pretty Woman!

Adair Turner delivered another of his blockbuster analyses of the banking crisis in Mumbai on 15 February. His reasoning is becoming increasingly sophisticated, although his conclusions grow more worrying in their uncertainty. However, he illustrated his central theorem with Keynes famous analogy (from Chapter 12 of his General Theory for geeks) to a “pick the prettiest girl photo competition”. This posits that the successful competitor was the one who correctly and most rapidly predicted the preferences of the other competitors. In Keynes’ words “It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

The rather dated political incorrectness rather adds to Turner’s point; that limitless financial deepening (or increased financial trading activity and innovation) does not serve society well since equilibrium pricing mechanisms are not assured leading to bubbles in prices. This has been known about for a long time. But his long and elegant analysis comes to a rather abrupt conclusion. “We do not know for sure what the truth is…” He concedes that his nuanced conclusion may make some uneasy but markets just aren’t rational. His prescription is to live in the real world rather than the theoretical. This suggests a pragmatic approach to regulatory responses in future. Pragmatism seems generally to be preferred but if it doesn’t work in a particular circumstance the regulator has little theory to fall back on to justify their action. This could store up trouble for future regulators as well as all of us but it appears to be the world Lord Turner considers we live in.

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