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Regulatory Consulting’s Insight & Foresight Newsletter – September Review 2012

Dear Readers

Back to school after the summer break this year got off to a rip roaring start with Martin Wheatley’s speech condemning certain retail sales incentive practices and foreshadowing how the FCA will intervene earlier in markets when it receives its new powers. Elsewhere, the RDR continued to make its way to a reality of sorts claiming various scalps on the way. In Brussels Solvency 2 appears to be dragging on for another year.

Don’t give them your name Wheatley

One part of the rich tapestry that is the Dad’s Army television series is the relationship between Captain Mainwaring, Sgt. Wilson and Private Pike. It derives from their positions as branch manager, chief cashier and clerk at a local bank. Martin Wheatley’s speech slightly hankered after a time where trust in a bank and its staff was absolute and a paternalistic caution overlaid every decision it made over a customer’s account. However, it was a banking system largely catering for a small middle class and most of the economy worked on cash. The risk is that ridding us of the egregious sales incentive schemes the FSA found in their thematic review will not be easy since there is no way back to a gentler past.

To be clear at the outset, what the FSA found is a disgraceful accident waiting to happen. Many commentators over the years have pointed to the retail banks’ in-branch staff management practices and remuneration as the source of shareholder value destruction. Interestingly, it is not so much about commission as commission like effects producing perverse incentives, i.e. the executives and staff keep the bonuses, the banks’ shareholders pay for the mis-selling redress and administration costs. There is every reason to try to eradicate such practices. The questions are how would that be achieved and what would be the unintended consequences?

A good place to start is to ask the question why would anyone install a daft remuneration scheme in the first place? If we assume that they acted in good faith what did they think they would achieve for their shareholders. It can only be a hypothesis but we suspect that there is a serious disconnect in the operation of free markets which surfaces wherever market imperfections reach a relatively modest level. In other words the market clearing price for a good or service, (i.e. the one that reconciles perfectly in the interests of suppliers and demanders) either cannot be achieved by the normal functioning of the market or it occurs at a price that benefits the supplier excessively. This leads to regulatory intervention which removes the excess profits and may even create a loss for the supplier. So what started as a perfectly rational strategy can be shown to be seriously flawed.

A further defining characteristic of the phenomenon is that there is a profound timing effect. A flawed strategy can work in the short run only to be reversed later, possibly years later. For example, sales of PPI were highly lucrative for many years but now those sales are destroying shareholder value at a very rapid rate. It seems that under conditions of sufficient market imperfection suppliers can extract excessive returns which shareholders accept too readily as final only to find out that the long arm of the regulator claws them back later. Worse, the shareholders may be significantly different. There is a substantial amount of moral hazard in this situation that goes far wider than the FCA’s remit going forward. It is wider than financial services. Whether the review led by Andrew Tyrie can make any inroads into the issues remains to be seen. It is a tall order. The political demand for quick results militates against the likelihood of success. But the stakes are very high. We have a faltering economy post a splurge of excessive private sector credit expansion by the banks. Incentive remuneration systems properly constructed are supposed to make our financial sector more efficient. Making it less efficient does not seem very likely to help. We’re doomed Captain Mainwaring!

If this is the solution what was the problem?

On consecutive days this month two events cast an interesting light on the RDR. AIFA finally bit the bullet and changed its name to become the Association of Professional Financial Advisers. That took some courage and will no doubt be pilloried by a sub-set of the adviser community. The next day the Times ran an article in its money pages along the lines “six things to ask your adviser in light of the RDR”. The first question was to ask the adviser whether they were restricted or independent. On its face this was a worthy educational piece for the money pages and it identified the current key features of the changes. But the yawning gap in the analysis was to ask the question of public policy, “how do the concepts of restricted and independent work in a market place where lack of engagement is the fundamental problem. One would expect the reaction of the customer to be a frown since it hardly addresses any particular need they think they have.

The FSA has been making it steadily harder for the customer to engage with the industry in the name of protecting them better. It is true the less the engagement the less harm can arise but this only works as public policy if financial services are akin to measles, the less of it the better. Under conditions of weak engagement making it harder for customers to understand what they are engaging with and on what terms is a pretty rum approach. For pragmatic reasons, the trade body has had to give up on the concept of independence. That is a direct consequence of regulatory change. The value of independence appears to have been significantly undermined by the regulator. There is no clear explanation for that. Setting the bar high enough to largely eradicate independence, as seems likely, is an odd approach to increasing the overall level of customer welfare. Perhaps the regulator has a hidden agenda. The post-implementation review will be interesting if it is entered into objectively. Perhaps the National Audit Office should be asked to conduct it rather than an in-house review.

The odd thing that joins these two stories is the paragraph in Martin Wheatley’s incentives speech that a strong and successful financial services industry was a pre-requisite of dealing with the problem of getting society to save adequately for retirement and protect for the unexpected. Conduct risk policy has a very long way to go before it can be thought of as serving the interests of society successfully.

Why are we waiting?

An unhappy Michel Barnier, EU Commissioner, announced the likelihood of yet further delay to implementation of the Solvency 2 Directive to 2015. This would leave the UK and the Lloyd’s market in particular even more high and dry after investing what is claimed to be several billion pounds in becoming compliant. In the bazaars some even speak of a planning assumption that S2 may never be implemented in its current form. This seems rather extreme. Were it true the EU law making process for the commercial framework of Europe would be damaged forever. The more likely outcome is a fudge containing more compromise for the unintended consequences of a complex piece of legal engineering. It is a far cry from what the authors of the “London Report” must have hoped for. The idea that buffer capital should rise as insurance liabilities rise (rather than fall) is a simple concept. Unfortunately the engineers took too many risks in trying to hunt down every conceivable outcome. They tried to make a Rolls Royce when a Ford Fiesta would have been adequate. Don’t let the best be the enemy of the good is a Whitehall saying: the 80:20 rule. Alas it seems not to have migrated through the Channel Tunnel yet.

Yours sincerely

The Regulatory Consulting Team