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Regulatory Consulting’s Insight & Foresight Newsletter – 2012 Review

Dear Readers Our December review always contains our annual assessment of regulatory developments in financial services. It is a regulatory risk outlook on a page or two. 2012 will likely be viewed in a few year’s time as one where turbulence in regulation was not the immediate result of turbulence in markets. Rather it was a year of self-inflicted change as Parliament set about reforming the regulatory framework and architecture and the regulator completed the latest iteration of reforming retail investment markets while splitting itself in two. There are several strands to the outlook The Financial Services Act 2012  The Government whips did reasonably well to get this messy piece of legislation through all its parliamentary stages. It was messy because the situation really called for a ground up repeal and re-enactment as the Treasury select committee called for. The resultant legislation is very hard to follow. It was also messy because various people had scores to settle. The FSA has not handled its relationship with Parliament well. So to keep to timetable the compromise for the Whips was to allow rather more changes to the Bill than the Government might have wished. It is not often that the basic objectives of a statutory body are changed after introduction of a Bill. But the FCA will have a new objective to facilitate consumers gaining access to financial markets. It is too soon to know how this objective will be translated into action. It is not uncommon for statutory bodies to be set contending objectives so that some sort of balance is required in the overall result. In this case Parliament seems to have believed that this sort of objective would exercise restraint on the FCA causing it to reflect on such questions as social exclusion when it adopts strategies which might improve the quality of outcome but reduce its availability. In practice the FCA will probably be able to dodge the bullet given the high level nature of the language but it will give parliamentary scrutineers a peg on which to hang some awkward questions. A similar fate probably awaits the objective of promoting competition. There has been a fair degree of conflation between the idea that competition improves the outcome for consumers and one about competitiveness, particularly the international kind. The architects of the legislation seem to think that competition has much more to give the consumer despite the fact that 25 years of financial services legislation has been directed at the consequences of the market failure that competition does not work in this market. Competition analysis requires careful definition of markets. Promoting competition at the national level could have disastrous consequences internationally. A balance of harms test is needed to work out what to do for the best. There is no sign that the new regulator has this on board and the Act is silent about it. It will be some time before the twin peaks model of regulation can be judged. In practice much will depend on the environment in which it operates and how the governing bodies decide to interpret their roles and responsibilities. If the Bank of England does not embrace accountability under its new leader it will run the risk of serious reputational harm if exogenous events tax its ability to provide solutions. The FCA has a much enlarged conduct brief and will not be much less complex than the FSA before the split. It is early days but the FSA’s “Journey to the FCA” document did not inspire confidence. Too many policy options have been closed off by the personalities leaving a choice between failing regulatory approaches. A significant performance improvement is sought and it is not clear if it will be forthcoming. Banking  Banking covers a very broad range of activities and people so generalisation is problematic. However, the sector served up another spectacular year of compliance failures. Perhaps the least compelling of the authorities’ complaints were those around sanctions busting, particularly in regard to Iran where the rules change regularly and the authorities are ambivalent to some transactions. So Standard Chartered probably have a valid reason to begrudge their yellow card. The money laundering in Mexico and LIBOR scandals are harder to show any compassion for. The authorities do seem to have some way to go in communicating what they expect, what society expects, from those supplying banking services. However, the problem appears immense. Our banks are so big that neither their compliance departments nor the regulator is really equipped to get on top of what happens in a bank branch in a dusty border town just across the Rio Grande. In that context Hector Sants appears to be putting his head in the lion’s mouth by accepting the role of group compliance head at Barclays. But a more fundamental problem is that to break banks up into manageable chunks (a potential regulatory solution) would probably prolong and intensify global poor economic performance. The problem highlights the dilemma about competition and at what level to pitch the analysis. What hurts consumers most; prolonged triple dip recession or a few drugs barons laundering a few billion dollars? Is LIBOR fixing more important than money laundering? Some would say these are false dichotomies but efficiency arguments force choices. RDR  One final comment on RDR written before the fact is irresistible. The saga began is 2006. The previous initiative to remove the polarisation rule also took seven years. So the wheels grind very slow and at great expense (which the consumer pays) not a lot changes. It is not obvious why it takes so long and so little is achieved. No doubt the FSA would ask us to suspend judgment until some experience under RDR conditions can be analysed. The trouble is that the regulatory regime operates exclusively on the supply side of the market. But extensive research including that sponsored by the regulator shows in various degrees of clarity that the market failure is on the demand side of the market. One wonders how long it will be before this state of affairs can no longer be ignored. Martin Wheatley speaks of learning the lessons that behavioural economics can teach. That could mean many things. Our prediction is that unless the regulatory regime is adapted significantly to cope with consumer behaviours not much will happen. For example it is not clear how the regulator thinks that making the cost of advice transparently clear will improve consumer outcomes. Transparency is a means to an end, not an end in itself. On the FSA’s own analysis, which the FCA will inherit, adviser charging ought to give rise to greater take up of paid advice and other forms of engagement with the industry because levels of trust have risen. If that doesn’t happen, what then? Europe  If you thought the FSA was slow consider the EU institutions. In 2002 a committee reported on the Solvency 1 Directive recommending a drastic overhaul and the introduction of risk based capital for insurers. It now seems likely that the Solvency 2 Directive will be delayed until 2016. 14 years is a long time. Few of the originators will see completion and that is inefficient as too many people join projects and take time to get up to speed. Moreover, Solvency 2 has become a monster. Banking is just as slow. Since the Solvency 2 project began the Union’s institutions have been reformed and the Union enlarged. With the three EEA countries 30 national delegations have to agree changes. The co-decision procedure has given the European Parliament significant powers to propose and reform. This is all good stuff in its own way but it causes delay. Markets grow used to governmental inaction. Ways need to be found of speeding things up or Europe will be consigned to the slow lane. 2013 will probably not see much change and in consequence disenchantment with Europe will likely grow. Where will we be in 12 month’s time? If the Middle East gets no worse and there is no market catastrophe such as a Euro meltdown, which we think is not very likely on this watch, attention will remain focused on the domestic scene. The regulators seem likely to go live in the second quarter after all which is much quicker than our expectations. We expect the Bank to become quickly locked in a battle waged on two fronts. It will remain heavily involved in international fora trying to hammer out agreed standards for capital and resolution for global banks. Domestically, it will try to lever up capital buffers and try to regulate insurers as if they were banks. The continued non-availability of Solvency 2 will be an irritant for insurers and regulators alike. The FCA will be heavily burdened down trying to prepare for regulation of consumer credit and payday loans. It will have a significant body of knowledge from RDR thematic work to show that their approach is too complicated and is being got round to produce commission like effects. This will result in son of RDR which will become embroiled with MiFID2 and PRIPS. The prognosis is not overly brilliant. We nevertheless wish our readers a very prosperous New Year! Best wishes The Regulatory Consulting Team