Sunday, February 10, 2013

The Failings of Regulators - Why the UK is so bad at regulating the financial services industry

When, in 1984 as a New Scotland Yard Fraud Detective, I went to study financial regulation as it was carried out by the Securities and Exchange Commission and other agencies in Washington, I was introduced to a group of regulators that had a culture and an uncompromising track-record of taking on the biggest financial criminals and bringing them down.

I had gone to study with the SEC because I had become only too aware of the tidal wave of new financial crimes we were having to deal with in London, crimes which were being predicated by Mrs Thatcher's policies of opening London up to a far greater degree of financial competition. 

Having repealed exchange controls, thus opening up the channels of financial free flows, and having encouraged a policy of enabling foreign financial companies to set up business in London, she was determined to put London firmly in place as the third staging post of a 24/7 trading market, which could facilitate the global dealing in financial products, so that when the Tokyo market closed, the UK market would be open, and the US market would open before we closed.

This era of free-flowing financial operability brought with it a whole new range of financial criminals who were willing to hitch a ride on the coat-tails of the major players, and their activities were landing on the few desks of the small specialist squad of detectives of which I was a member. It was quickly proved to be useless to seek to involve the civil servant regulators at the DTI, very few of whom wanted to get their lily-white hands dirtied by dealing with these new offences.

I quickly became aware that we were dealing with crimes, the likes of which we had not hitherto experienced and which would cause British juries difficulties if we, the detectives, were not capable of presenting our cases in ways which a British jury would comprehend. In many cases, these types of scams were making use of American trading methods and language, about which we knew very little, and I discussed this problem with my boss at the Fraud Squad. An incredibly farsighted man, he asked me to put together a position paper, which he used to lobby for some budget, and then told me to organise a visit to America to go and study with the SEC and the other US regulators, from whose experiences and skills we might learn.

Thus it was that I ended up studying financial regulation in Washington, Philadelphia, Chicago and New York, a lengthy period of immediate and direct study which I doubt few modern financial regulators have been able to, or indeed, wished to replicate!

This visit taught me a large number of truths, but chief among them was the realisation that those who handle other people's money, for which they get paid commissions, brokerage, bonuses, or any other kind of financial reward, have to be looked upon as potential criminals, and dealt with accordingly!

I say this because that is how the SEC viewed them and dealt with them, and they reserved some very draconian penalties for those who broke the rules. In order to bring order and discipline to their financial markets, the different financial regulatory agencies,  worked very closely with the Department of Justice, investigating cases in tandem, and sharing the evidence so that criminal charges could be brought in step with regulatory wrongdoing.

Yes, it would be nice if we could think that the financial sector was a well-ordered, good-mannered, lawful, transparent and ethical environment, peopled by men and women who paid more than just lip-service to the concepts of integrity and honour, But it isn't and that is all there is to it. These employees get paid big money to take the big risks, including the risk of getting caught. They are there to insulate their executives and main board directors from direct involvement in the crimes they commit, so that the upper echelons in the management food chain can always claim they were unaware what was going on when rampant wrong-doing is uncovered. They will always benefit from the outcome of the criminal conduct, but as long as they do not need to be dragged into the day-to-day debate, they can continue to operate on the basis that they were deaf dumb and blind to what was happening on the floors below.

We cannot whinge and whine for something we shall never see, and we should not be surprised when the inhabitants of the Square Mile behave in the way we all know they will. If they commit crimes of every financial kind, which they do, then we only have ourselves to blame for allowing them to do so.

So we have to recognise them for the kind of animal they are, which is potential organised criminals because the other lesson of overriding importance that I learned was that the only thing that financial services practitioners fear is being prosecuted for criminal offences. If they are convicted, then that is the end of their careers, it is the one way street to the door marked 'Exit', and it means ejection into social and commercial outer darkness.

It is the only way, and I mean the 'only' way to regulate financial practitioners, to instil in them such a fear of committing a crime, which they know will be prosecuted, that they will toe the line. It is a draconian, uncompromising penalty, but it works, and that is what I cannot seem to get into the thick heads of the British regulatory galère, who are all imbued with the 'Good Chaps' syndrome and oozing with the desire to soft-pedal on the wrong-doings of those whom they regulate. People who work in the banking and finance industry have one ambition in mind and that is to make as much money for themselves as they possibly can in the most unreasonably short space of time. Therefore, to assume that they will want to do this ethically, honestly, reasonably, transparently or honourably, is to be a complete prat!

Like the SEC do, they must be assumed to have the capacity to behave like criminals, and the regulatory regime must be geared towards that end-game. You don't regulate these people by doing nice, you find out what they are doing through intelligence-led detection; you focus on the weak links and turn them, you get the evidence against the top players, and you go in hard and bring them down. It isn't pretty, it isn't nice, and it takes a special kind of professional to carry it out, former properly trained detectives, and Customs and Revenue investigators. All the while we employ these charming young commercial solicitors, chartered accountants, ex-DTI staffers and former financial services sales people in these roles, we are never going to be able to knock the skin off a rice pudding.

The young regulators who worked at the SEC, and particularly in the Enforcement Division were young, dynamic criminal lawyers, yes, criminal lawyers, who had a good understanding of how regulatory law and criminal law interlinked. They had careers to build, and they wanted to go after the biggest targets they could and bring them down hard, so there was no pussy-footing, and being nice to the regulated sector. Above all, there was no regulatory capture obvious in their relationships.

Regulatory capture is what happens when regulated industries are able to gain influence over their regulator, so that regulation that ostensibly serves the public interest actually supports the interest of the industry concerned. As confirms;

"...Some economists argue that regulatory capture is inevitable, most that it is a significant risk. It occurs because those who are regulated have a high stake in influencing regulation to favour them. Each firm's profits are heavily influenced by regulation, so they will each put a lot of effort into influencing the regulator, whereas few individual consumers will have a sufficiently large stake to expend much effort.

Another advantage that the regulated industry has over consumers, and often over the regulator, is expert knowledge of the industry. This allows the industry to marshal the facts and arguments needed to influence the regulator, far more easily than consumers, and often more easily than regulators.

Conflicts of interest among individuals who run the regulator may also lead to regulatory capture. It is not uncommon for people to move between working for the regulator and working for the industry: for example working for a financial regulator and then in a compliance role in a bank...."

Let us consider the case of Hector Sants if we need any more proof of the accuracy of this last assertion. Now, I am not saying that Hector was carrying a candle for Barclays Bank while he was a regulator and was responsible for ensuring that their regulated activity was all it should be. I am advised by friends of mine who worked at Barclays under the benign regime of Roberto 'The Don' Diamante, that they were regularly getting hauled in to account for their actions of which the FSA did not approve. They turned up and got their wrists slapped, but nothing ever happened to them.

So, what can you say?

Well, the Treasury Select Committee has said a great deal about the way in which the FSA has handled their role, and much of what they have had to say has not been pleasant. You have to understand the way in which Government agencies speak publicly about other agencies within their ambit. The normal practice is not to be seen, publicly, to be disparaging of the other's actions. Carefully worded phrases are usually adopted, which contain vague allusions, recognisable to those familiar with the argot, and which indicate a sense of displeasure. It is unusual for a Government agency like the Treasury sub-committee to be very outspoken.

Back in October 2012, The Treasury Select Committee published a devastating report ( on the failings of the Financial Services Authority’s oversight of RBS. The MPs on the committee were unimpressed, concluding that the FSA could and should have intervened in the bank’s takeover of ABN Amro. Its members believe the regulator should have stopped the takeover, and they criticise the FSA for failing to investigate the failure.

The report says:

‘In December 2010 the FSA initially felt that a 298-word statement about RBS’s failure was explanation enough. This reflects serious flaws in the culture and governance of the regulator. It also reflects a fundamental misunderstanding of its duty to account for its actions to the public and Parliament.

‘In view of the vast amounts of public money committed to propping up RBS, Lord Turner’s comment that a Report into the demise of RBS “would add little, if anything, to our understanding of what went wrong” was inadequate. He should have grasped the need for a public explanation of how that situation had arisen, something which he has subsequently acknowledged. We would not expect the new chairmen of the regulators to repeat the error.’

The Committee’s report says the the FSA’s own report, which describes ‘failures and inadequacies in the regulation and supervision of capital, liquidity, asset quality and a failure appropriately to analyse the risks relating to the ABN Amro acquisition’ is a serious indictment’ of the senior management and leadership at the regulator.

"...The FSA Report describes failures and inadequacies in the regulation and supervision of capital, liquidity and asset quality and also describes a failure appropriately to analyse the risks relating to the ABN AMRO acquisition.

This is a serious indictment of both the senior management and leadership, and in particular the Chairman and Chief Executive, in place at the time, and their predecessors, regardless of the prevailing assumptions and political pressures..."

Subsequently, the Treasury Select Committee has made its displeasure about the FSA felt in another more recent report.

When defining the new role of the CEO of the Financial Conduct Authority, the Select Committee has said;

"...He must restore the credibility of the conduct regulator. The FCA is the successor to a body which failed consumers. Although it devoted a great deal of time and effort to conduct matters, it left consumers exposed to some of the worst scandals in UK financial history. It created a 'box-ticking' culture whose benefits were far from evident and which still failed to pick up major failures in the making. We will expect Mr Griffith-Jones and his board to ensure that the new organisation adopts a radically different approach. We note that the PRA, which has assumed responsibility for most prudential aspects of the FSA's work, has done this, with its adoption of a move to judgement-based regulation.

The board of the FSA also appeared to fail in its oversight of the work of the Authority. He and his new board colleagues will need to demonstrate stronger strategic leadership than their FSA predecessors..."

This is truly outspoken stuff,  and in a hard-hitting piece published at  Michelle McGagh has asked;

"...Should the financial regulator be fined for its mistakes...?" :

She writes: "... It’s a pretty shocking legacy that the FSA will leave behind when it is superseded by the Financial Conduct Authority (FCA) later this year. Since the FSA was established out of the Securities and Investments Board (a previously failed regulatory agency) in 1997 it has dropped the ball on many occasions.

The most notable is obviously its failure to prevent the banking crisis that hit in 2007 which ended in taxpayer-funded bailouts and a re-organisation of high street banking. And let’s not even talk about the most recent banking debacle surrounding Libor.

Scandals that were smaller, but of no less importance to the individuals involved, that the FSA failed to spot can easily be reeled off: Arch Cru, Equitable Life, payment protection insurance (PPI) claims, split-cap investment trusts, precipice bonds, self-certified mortgages, endowment policies, Keydata. The list goes on.

The Treasury Select Committee was right to admonish the FSA over its ‘box-ticking culture’ which meant it failed to spot the scandals in front of its nose. So concerned was the FSA with filling out the forms that it didn’t bother investigating what was happening at the heart of organisations, or more importantly how consumers were being treated. (They didn't do anything because they didn't know how)!

The comments in the Committee’s report are an embarrassing attack for the FSA and you could say its punishment is being abolished and replaced by the FCA.

But is this really punishment enough for those at the top of the tree who oversaw the organisation's failures? "
"The FSA has made some meek admissions to being in the wrong. In October Lord Turner, FSA chairman, said ‘bad rules’ were allowed to remain in place and ‘a lot of very clever people got it very wrong’ – what an understatement. (What a farce, these people may have been very clever, in terms of possessing degrees and being accountants and lawyers, but if common sense were dynamite, most of them wouldn't have had enough to blow their noses!)

The fact is the FSA didn’t bother to put the rules right because the people at the top wouldn’t have to be accountable for it. In fact, they’re so unaccountable that they can be rewarded for their failures; take the recently knighted FSA chief executive Hector Sants."

"Maybe a series of penalties for those at the head of regulatory failings would provoke a change of attitude, a change from box-ticking to real investigation, and ensure that the FCA doesn’t just become a rebranded FSA."

At last the Treasury Select Committee seems to be showing some teeth. But why has it taken so long? And will it change anything? I very much doubt it, but at least the word is spreading - and who knows, maybe one day pigs might fly ..."

As an afterthought, it is worth remembering that most of the staff who are in post at the discredited FSA, and whose actions have been so deeply criticised, will still be in similar posts at the FCA! Just thought you might like to know!


Hawkeye said...

Well, with prosecutors like Martin Wheatley on the case, who needs to waste money on a Defence Counsel??

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