Unintended Consequences!

I admit it is easy to criticise the great and the good who are trying regulate the financial markets and the practitioners within them! see my last blog. I'm not certain that the route these bodies are taking is the most likely to get the desired results. The task to me is akin to Canute's self imposed challenge of turning back the tide but adds a couple more dimensions; firstly instead of setting a throne at the water's edge and commanding it to stop, the throne is set on a floating barge in the middle of the sea; secondly that sea is shark infested, a not too tortured analogy! The imposition of new rules and amendments to the old rules smacks of desperation to me. Whichever way you interpret it the legend of Canute is allegorical, either a self-effacing acknowledgement that Kings are mortal or a egotistical folly fuelled by the adoration of his subjects. The actions of the regulators are not allegorical they are real, imposed (admittedly after parsimonious consultation in some but not all areas) and real drivers of change. At the risk of the last sentence being interpreted as a positive it should be noted that change is not always benign it can be destructive or at least unintended and avoided at all costs just for it own sake.  Equally so, I would hope that the initial blame culture prevalent at the beginning of the crisis where governments blamed financial institutions,  regulators blamed distributors, journalists and consumers blamed everyone has been replaced by that most "illusive" of cultures, collective responsibility.

The following statements I would hope are not controversial and sum up the majority of the major issues that changes to the the regulatory environment are attempting to address.

1. The liabilities of major Financial institutions must be underwritten by assets with a surplus for sustained periods of stress.
2. Advice and remuneration for it must be transparent, fit for purpose and economically appropriate.
3. Retail consumers must be protected to a higher degree than Professionals and Institutions in their dealing in the financial markets.
4. Market practitioners must exhibit high standards of Professional integrity and accountability if they do not.
5. Consumers must be more educated in their understanding of the Financial markets and the relationship between risk and reward.

 I will be first to admit that the five statements are broad and the devil is in the detail, however if you could start again you would  not build the current models of Regulatory oversight that we see in the developed world. Stepping back my single biggest issue is that when you breakdown the value chain of most financial transactions you will identify a very real and material cost of regulation. Regulatory cost comes in various shapes and sizes whether it be Capital Adequacy ( the requirement to hold very liquid assets on balance sheet equal to a proportion of the liabilities of a business in the future, even if only to run down the business without client detriment; to the cost of armies of Compliance professionals tasked with keeping the business within the rules and the first line of protection for retail clients or the cost of reporting regularly to clients telling them how much they have made or lost in the experience. I am not advocating that the cost of regulation should be nil as this is clearly a nonsense, I am however concerned that the materiality of it is misunderstood. I work in a simple world where the measurement of the validity of a transaction or product can be assessed by the risk and reward profile inherent in the final return. Therefore if costs; manufacturing, distribution and regulatory are passed onto a client in the transaction they inevitably inhibit reward as a drag on return.

All to often the antidote to make the product or transaction more attractive will manifest itself as an increase in risk. Products and the underlying transactions in the whole are a provision of services, whether it be a combination of professional management aimed at growing or preserving wealth, matching an outcome to a need through advice or valuing, reporting and safekeeping. In the regulated world there is also an element of Fiduciary oversight and redress. As with any manufacturing industry the provision of such service comes at a cost which in turn covers the cost incurred by the service providers plus a realistic margin of profit. It is my contention that the regulatory cost and hurdles that exist before any product is launched creates a burden that influences the quality of the product and ultimately by extrapolation the choice of potential product available to the market.

Finally and at the risk of becoming a latter day Canute myself I am firmly becoming an advocate of a return to "Caveat Emptor", the principle of buyer beware! It is probably the wrong time to suggest that protection should be relaxed in Financial services given the relative excesses and failings exhibited over the last decade and frankly back to the late 80's when the regulatory framework as we know it began, however the very real cost of regulatory intervention will become prohibitive if it is not already for most consumers seeking choice. Leviathan funds may be the only choice for those seeking investment or savings products, since the sheer size does give the benefit of scale efficiencies accommodating costs at a relatively low ratio to  principal investment. All good you may think but only if the fund does what it says on the tin! As we know there is more than one FSA struggling with this issue and we certainly don't want retail investors seeking low volatility investment return and getting Horse meat instead!

HRP February 2013