Good regulation will be one of the most important drivers of long-term growth and prosperity.
As we all know, the British Bankers’ Association (BBA) has been an important advocate for reform in banking over the year, with Anthony Browne making the point that financial growth and professional standards are essentially two sides of the same coin.
In UK and European banking, this link is particularly strong and has been for many centuries. The centre of influence may have shifted backwards and forwards over the years – from Amsterdam, to Paris, then London and so on and so forth – but the broad theme of delivering to the highest professional standards has always been there.
And it’s that focus on integrity – its link to profitability – that I want to explore this afternoon. So, how does the FCA encourage a positive connection between the two? What mandate, if any, should the regulator have to contribute towards wider economic prosperity?
At the centre of this debate: an understanding that the architecture of modern regulation in the UK, the FCA and PRA, is profoundly different from that of the past.
One of the dominant themes of financial governance in the twentieth century was the idea the official sector was effectively a ‘handbrake’ on progress. Ronald Reagan used to say: ‘Government’s view of the economy could be summed up in a few short phrases: if it moves, tax it. If it keeps moving, regulate it. If it stops moving, subsidise it.’
And over the course of time, we have seen the ‘handbrake’ become the enduring metaphor of regulatory activity.
I want to argue today this characterisation is wrong. Or at least, wholly wrong in its application to the FCA and PRA.
In fact, I want to argue that good regulation will be one of the most important drivers of long-term growth and prosperity. That a strongly consumerist conduct regulator will act in the broad interests of our banking industry.
To understand how, you first have to look back to some of the most significant events that shaped our banking sector over the last five years. Issues like LIBOR, payment protection insurance (PPI), card protection products, Interest Rate Swaps and so on.
Three key themes emerge.
First, from the supply side, we see problems associated with mis-selling. Not just in the UK of course, but around the world. In Asia, the mini-bond crisis. In the US, mortgages. In Spain, preference shares.
In the UK, we had PPI, with the sale of policies to people who did not need them. CPP − large profits on products costing 60p to produce. And interest rate swaps, where complex hedging products were sold to small business owners who did not understand the downside risks.
These mis-sales were often accelerated by the manner of presentation – the framing if you like. So PPI, when set against the full cost of a loan, might seem a relatively small addition to the main transaction. Or the sale might follow a lengthy pitch for the primary product – making the decision less clear for customers.
Second, from the demand side, we see the ‘hopeless mirage’ – as behavioural economist Daniel Kahneman put it – ‘of the logical consistencies of human preferences’.
Simply put, we do not live in a world where everything and everyone behaves entirely predictably. So what follows is an increasing susceptibility to issues like framing.
The third key theme to emerge, the focus for my remarks today, was one of a regulatory framework that was too retrospective, with an excessive reliance on rules versus culture.
Taken in aggregate, these three themes – difficulties on supply side, demand side and official side – created a perfect storm.
It reduced the regulator to the role of judge dispensing justice. It chiselled away at public confidence in financial services.
And it had a considerable cash impact on UK firms – CPP was fined £10.5m. PPI is now an £11bn problem. The total contingency fund for interest rate swap compensation is around £3bn.
It’s in the interests of everyone for regulators to move things forward. Protecting consumers more effectively, certainly, but actually also making a positive economic contribution.
Perhaps predictably everyone has interpreted the challenges presented by these events differently.
For some it was all about greed, some pointed to structural reform and incentives, for others it was all about financial education and caveat emptor. Everyone agreed that oversight – management, regulation, supervision – was lacking but disagreed on the share of responsibilities and so on.
For me, the key issue in this debate was a relatively simple one: a financial crisis, whether conduct or prudential, sinks all boats.
So it’s in the interests of everyone for regulators to move things forward. Protecting consumers more effectively, certainly, but actually also making a positive economic contribution.
If this sounds counterintuitive in the context of Reagan’s comments – it is worth reflecting on the fact that PwC this year estimated a well-regulated financial sector could add between two and three percentage points in GDP terms by 2020 – creating 218,000 jobs in the wider UK economy.
Assuming these figures are broadly correct, the challenge then becomes one of delivery. In other words, what are the characteristics of effective regulation?
For me, there are two key areas.
First, and foremost, we need a regulatory structure that is firmly forward looking. That anticipates and tackles issues before they become multi-billion dollar problems.
There was a deep-rooted problem of retrospection in regulation leading up to the crisis, with too great a focus on near-term data versus long-term trend, rules over principles, enforcement over prevention.
What we have now is a very different regulatory infrastructure, with the PRA and FCA mandated to promote stability. To make markets work well over the long run.
For the BBA and its members, this means the focus is broader. So instead of just zeroing in on individual firms – the regulator scans markets to see where the issues are, increasingly using thematic reviews and market studies to signpost direction.
Over the last seven months, we have seen this work moved forward in several key banking-related areas, including: competition work on cash savings – so investigating issues like ‘teaser’ rates and consumer inertia – and our review into mobile banking.
So, on the latter we’re interested – as the European Union is – to see where the consumer protection challenges may lie in future:
What is the impact on the banking experience of our reliance on smartphones and tablets?
What are the fraud and security risks coming through from technology?
Do advances like bank account apps, mobile payments and contactless technology present long-term challenges?
And it’s worth observing, in passing, that this is not a retail-only issue.
Ten years ago, the idea of your chief financial officer moving huge amounts of capital on their mobile may have sounded fanciful. But today you hear of corporate clients at major UK banks authorising over a billion dollars of payments at a time on mobile devices.
The FCA approach is always to take a long-term view on these issues.
Rule-based oversight has, effectively, been the dominant model of governance since Henry IV banned alchemy – putting quill to parchment on the Act of Multipliers.
The second key criteria for effective regulation is good judgement.
The question being posed in the years following 2008 was, understandably, one of how the system permitted culture to slide south on the scale it did.
For the first time, people started to seriously debate whether it was enough to only focus on compliance and rules – as opposed to pinning down broader expectations of behaviour in financial services.
Clearly there was a balance to be struck then – as there is now. Rules and check lists are important but they do not guarantee good conduct.
That is why the gestation period for cases like PPI, interest rate swaps and CPP all occur during an escalation in rules, with FSA guidance expanding by 27% between 2005 and 2008.
In preventing a repetition of these conditions, the first step for regulators has been to look beyond legal compliance. To exercise judgement more authoritatively.
And there are three key areas where the FCA is achieving this. First, we are developing a deeper understanding of the sectors we regulate, and what the consumer is experiencing.
Second, we are more probing about sources of revenue – how does a firm make its money? As an example, under the current structure, the alarms bells would have rung over the high margins in PPI versus the product’s low claims ratio – around 16% of gross written premiums.
Third, we are interested in how the business model delivers versus the expectations of consumers. Looking at areas like behavioural economics for the first time.
If these sound like modest steps, it’s worth remembering they are unprecedented in UK conduct regulation. Rule-based oversight has, effectively, been the dominant model of governance since Henry IV banned alchemy – putting quill to parchment on the Act of Multipliers.
Clearly this does not mean the official sector can prevent all shocks to the financial system. But the broad shift in emphasis – from check lists to judgement – moves us in the right direction.
Two examples of this from the UK.
First: the interest-only mortgage issue.
The numbers here were not reassuring. 2.6 million interest-only mortgages due for repayment over the next 30 years. 260,000 without an associated repayment strategy. Around 48% of borrowers underestimating their financial challenge.
The important point is that instead of sitting back and waiting for a problem to unfurl, the banking community has worked with the FCA to nip this issue in the bud. Contacting borrowers to check repayment plans. Giving homeowners the opportunity to plan for the future.
Second: the retry system.
Again, we see a collaborative venture with banks – a positive touch point between the official sector and commercial sector.
On the face of it, it was a relatively minor improvement. The numbers are not vast in financial service terms, £200m potentially.
But as a statement of intent, there is no doubt this was a significant ‘step up’. Identifying a basic problem for consumers: penalty charges incurred from the time gap between money coming in and out of personal accounts.
Implementing a relatively straightforward solution: banks agreeing to retry later in the day to see if the money has cleared.
It would be churlish not to recognise the efforts many in the sector are making. This is, potentially, one of the most significant steps forward for the UK banking industry since 2008 in terms of repairing its relationship with retail customers.
The key issue here is that the act of moving things forward is a joint one. Banks and regulators – we have a clear responsibility to replace, or repair, the structures that encouraged self-destructive tendencies in the past.
A major priority: the issue of financial reward, which is being tackled at the domestic level, as well as the international through CRD IV, discussions around UCITS V, and the work of the European Supervisory Authorities.
Whether or not we all agree on the outcomes of these workstreams – and the bonus cap is one we do have significant concerns over – there is no doubt this is important work.
In The Big Short, Michael Lewis uses the example of different US hospitals removing more appendixes than others because they get paid more for doing so, to underline a basic point that: ‘If you want to predict how people will behave, you look at their incentives.’
So a few years down the line it is reassuring to see evidence of a culture shift taking place. Complaints data – still one of the best yardsticks of public confidence in financial services – shows the number of complaints against banks fell by more than a quarter over the year – a 26% drop.
And the FCA’s ongoing investigation into the financial incentives offered to sales staff, specifically bonuses and variable pay, suggests UK banks are making strides in reforming reward structures.
The early analysis – and I think we have to stress this is early analysis – shows three of the biggest lenders have removed the direct link to sales in incentive arrangements for front line staff – both in retail branches, as well as call centres.
On top of this, there’s good evidence to suggest the major players are increasing testing of customer outcomes in face-to-face sales. In other words, the requirements of the consumer appear to be more clearly represented by the back office operation.
Time will tell if this is a corner turned – and it’s important to say the FCA has not looked at how firms use targets or performance management. Nor is the progress uniform – we are picking up cases where less headway has been made, particularly in areas like investment and protection sales.
But it would be churlish not to recognise the efforts many in the sector are making. This is, potentially, one of the most significant steps forward for the UK banking industry since 2008 in terms of repairing its relationship with retail customers.
Finally, a word on international regulation.
In recent years, the pace and volume of global reform has been unprecedented – an extra 13 million words of EU regulations and directives since 2010, according to the press this week.
Post-crisis, many of those words relate to financial services – as you’d expect – with major reforms in areas like: standards for retail investment; provision of personal current accounts; CRD IV; re-structuring; and, MiFID.
For me, the key challenge is two-fold. First, to make sure the rules strike a sensible balance. Clearly you want to move things forward, encourage economic activity. But you want to achieve this without increasing the risk of instability.
Second, by all means encourage a global approach to the regulation of international markets – reducing opportunities for regulatory arbitrage and the like – but not at any cost.
So, in areas like derivative reform and benchmarking, where we’ve been working closely with the Commodity Futures Trading Commission (CFTC) and colleagues at the European Securities and Markets Authority (ESMA), it makes obvious sense to work towards common rules and standards.
But it is also an imperative that national regulators – including the likes of the FCA, SEC, BaFin and SFC – have a sensible degree of autonomy so they can influence major reforms affecting their own customers, their own firms.
On all these issues, the key challenge is to provide regulation that is effective enough to both protect consumers, as well as to lay the foundations for economic growth, prosperity and renewed confidence.
The UK is several steps along this road but there is no room, or reason for complacency.
We operate in a sector that is still haemorrhaging bad headlines – the latest in the wholesale markets.
Until this flow is reduced to a trickle, until the change is real, you cannot hope to deliver stability, prosperity, confidence and trust in what is – it should always be remembered – one of our great industries.
Banking in the UK has suffered but it remains a huge net contributor to our economy. Generating £37bn surplus from overseas trade. Providing around one in every eight pounds of government revenue.
Behind these sums, the fact that attention to customer service has been one of the great trademarks of our banking sector over the years. Directing business and investment to the UK. Transforming the capital into one of the world’s most innovative economic centres.
In Anthony’s words: to get back on its feet, London must reclaim this moral high ground.
It is the FCA’s job to provide the footholds to this success. To be a net GDP contributor. Not a handbrake.
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