Blunt tools must be replaced with more responsive solutions
THERE is celebration in the air now that the UK has come out of recession strongly. However, is it too soon to get out the bunting? Yes, lessons have been learned from the financial crisis, and we are looking healthier as an economy. But there could be trouble brewing. Has financial regulation armed itself effectively enough to ensure we don’t see a repeat of the crisis, or should we accept that another financial collapse is inevitable?
The crisis reminded us that we are in a truly global economy. While the benefits are massive, the risks are perhaps higher, and the domino effect of markets collapsing is still clear in our minds. As a result, regulation is now set at an international level and this is what makes it complex.
Regulatory changes have had a major impact on financial services, and this is the central talking point of the Association of Chartered Certified Accountants’ (ACCA) soon-to-be-published paper How regulators changed the world. At the apex of this new-look regulatory armoury sits Basel III, the implications of which are far-reaching and costly for financial institutions and business in general. Banks will need to hold more high-quality capital and liquid assets. So they will need to invest in assets that generate less income, reducing their return on equity.
Regulation has long been seen by many as an evil, and will always face criticism as being a brake on progress, competition and profit. But rather than having too much or too little, could it be that we have instead yet to get regulation right? The risks have not passed; indeed threats remain, including high levels of sovereign debt, insolvent banks in some European countries, and significant unemployment. The mechanisms put in place to guard against them may not be as solid as they should be.
Over the past few years, there has been a cultural shift within banking. Banks have recognised that they need to do things differently, while compliance teams are putting in place frameworks to measure and address banks’ failings. But it will take time to shift behaviours. Banks need to see regulation as an opportunity to change their business models, rather than as a compliance project. It’s a chance to review their people, processes and systems, and look at where they want to be in the market in five years’ time.
No one is saying don’t take risks. Risk is a key feature of financial markets. However, genuine safeguards also need to be in place. Many are now too simple for what is an intricate suite of risks.
Ring-fencing is one proposal intended to make retail banks safer and failed banks easier to resolve. But the challenge is that it could create a lack of liquidity and affect the services banks offer to small firms, which may find it particularly difficult to hedge or to take out forward swaps to protect their profit margins. Ring-fencing should help make banking more robust, but unfortunately it is being applied as a single, blunt instrument across the sector, rather than tailored to individual banks. Given that both retail and investment banks have collapsed over the past few years, it is hard to see why one side of a ring fence would be safer than another.
GOOD ON PAPER
Many regulatory responses to the financial meltdown have emerged from good intentions, and on paper look strong. In practice, however, they are far from perfect. A good example is derivatives reporting. Losses arising from credit default swaps almost brought down US insurance giant AIG. The firm ended up being bailed out by the US government at a cost of $182bn to taxpayers. The G20’s response was to enforce trade reporting of all derivatives globally.
The European Market Infrastructure Regulation (EMIR) has required financial institutions and companies to report their derivative trades since 12 February 2014. Every derivative transaction – whether it’s an over-the-counter interest rate swap or FX forward, or an exchange-traded future or option – must be reported to a trade repository. Both the buyer and seller need to report the derivative transaction. And as there are 85 data fields that need to be filled in for each trade, derivative reporting is a massive data-gathering exercise. For both financial and non-financial companies, the burden of reporting is onerous, and regulators have been badly organised about implementing the new rules. So businesses are bearing the cost in both time and money.
Derivative reporting in practice offers no transparency about companies’ positions in the market and the exposure of their counterparties; it just collects trades. Ultimately, it just creates a list of transactions, and there are so many trades taking place (about 100m per week) that regulators will be unable to make sense of them. Not all the consequences of reporting derivative trades have been thought through, and it is unclear whether regulators will achieve their objectives. Trade reporting on its own would not address what went wrong with AIG.
Beyond the banks, the security of the financial system rests on proper controls to promote the safety of organisations within the “shadow banking” industry – for example, payday lenders, peer-to-peer lenders and hedge funds. This needs to be done in the right way to avoid the creation of unnecessary barriers to entry, while at the same time protecting the customer. Payday lending is a good example of where there must be a very specific balance between customer protection and avoiding crippling the industry. ACCA’s recently published report on payday lending business models shows how lenders rely on repeat lending to a customer for profitability. Ethical questions emerge from a model that relies on people falling deeper into debt. But payday loans can also serve a purpose and new entrants should not be put off by over-regulation.
Corporate governance is another area that has a more prominent role to play if we are to make the post crisis world safer. In the past, non-executive directors often didn’t have the time, influence or desire to challenge chief executives. So non-executive directors must get the right management information so they can challenge effectively, and they need to have appropriate forums in which to facilitate debate.
ACCA has launched a consultation, Creating value through governance – towards a new accountability, which shows that there is little consensus about what corporate governance is for, making it difficult to assess whether it is doing a good job. The thinking behind our attention to corporate governance is that its purpose should be to ensure companies create sustainable value and that governance practices should be evaluated on how well they achieve this.
It’s no surprise that ACCA’s business-focused finance professionals are looking at this. Governance, Risk and Ethics is a core element of the ACCA qualification. Without strong governance and risk management, organisations will fail. Governance and regulation covers everything within a finance remit – from future business strategy to tax and audit and beyond. Without a firm grasp of the regulatory and compliance issues in all areas of the business, accountants cannot effectively act as guardians against a future crisis. But governance is a corporate-wide issue and should not be confined to finance teams, although their leadership is vital.
There is a bigger picture here. Greater financial literacy among the public is often overlooked, but it is critical that governments invest in it. If people are more financially literate, they are less likely to buy inappropriate products. The current government has already begun that process and financial education will appear in the curriculum from September. However, there is a long way to go until we are anywhere near a financial regulation regime that is as close to bullet proof as is possible without jeopardising the need for banks and businesses to remain competitive.
The debate around whether there is too much or too little regulation has moved on, arguably by force, as a consequence of the crisis. If anything, the meltdown in financial markets taught us that we need regulation, but it needs to be the right type. And to achieve this, regulators must be more engaged with the global financial services fraternity. There may be an era of trial and error.
Sarah Hathaway is head of ACCA UK.