What is the right approach to financial regulation?

Better regulation - Guillaume Prache

We will not restore investors’ confidence unless they can be indemnified in case of fraudulent and damaging behavior from providers.

Following the 2008 financial crisis, an impressive series of new EU regulatory projects is now flowing through to the European Parliament: in 2011 alone, it should debate on new regulations on short selling, on the review of the Markets in Financial Instruments Directive (MiFID) and of the Insurance Mediation Directive, on investment funds depositaries, on investor compensation schemes, and so on.

Is this good or bad for individual investors and savers throughout the EU? It is now very clear that the two parties mainly responsible for the financial crisis that started in 2008 were the banks and the financial supervisors. It is therefore logical that the EU is trying to tackle these deficiencies. The problem for financial services users is whether these new regulations will restore their confidence and improve their protection or not.

Our experience and analysis tells that these regulations too often rely on weak evidence, miss their key objectives, and are poorly enforced.

A vivid example of poor evidence is the European Commission (EC) consultation on the review of the MiFID rules on capital market structures. Evidence produced by the EC is so thin that it does not even seem to know the extent of the so-called “OTC” share of the equity markets (sources vary between 15 and 50 per cent!).

If only for that reason, the EC project to create yet another category of market venue (“the organised trading facilities”) seems flawed from the start. Moreover, it will complicate further the equity markets for end users (investors and non-financial issuers).

The new EU regulatory projects also too often miss their objectives. For example, the “Prips” (Packaged Retail Investment Products) project, which rightly aimed at harmonising investor information and conduct of business rules for all retail investment products, is now focusing only on a small share of those, excluding for example all personal pension products.

Also, we will not restore investors’ confidence unless they can be indemnified in case of fraudulent and damaging behavior from providers (as it is already the case in a few member states such as the Netherlands). But despite a “coherent collective redress framework in Europe” green paper issued this month, actual EU rules on collective redress still seem unfortunately very far away.

Lastly, new regulations per se will not make a significant difference for investors if they are not properly enforced. The four year old MiFID rules on investor information and on the justification and disclosure of “inducements” (commissions paid by the providers to distributors – often labeling themselves as “advisors”) have not been properly enforced. The “Consumer guide to MiFID” from the European supervisor itself does not even mention the “inducements” rules !

In the end, the severe imbalance between the power and influence of the financial institutions lobbies and those of the “buy side” at the EU level seems to be the main reason for such disappointing results. After all, customer protection is only the sixth and very last objective of the new EU financial authorities.

Less regulation - Kim MacFarland

Financial regulation has two true objectives at heart: firstly, it seeks to protect consumers and investors, and secondly, it aims to preserve systemic stability, which ultimately can again be distilled down to the basic level of providing protection for consumers and investors.

But there is what could be described as an “efficient frontier” between the goals above on the one hand and the efficient flow of capital in the global economy on the other. It could be argued that in the past the bias had been skewed towards efficient capital flow – to the detriment of investor protection and stability. However, if the bias were to swing too far in the other direction it could be equally, if not more, problematic.

Crucially, while complex legislation may lead to better consumer protection and systemic stability, it won’t come for free. Instead, there may be significant long-term costs to consider. Firstly, capital will inevitably flow less efficiently. Secondly, as the industry prices in greater operating complexity and risk oversight, there may well be increases in the price of financial services and consumer protection.

This is particularly the case in those instances where major economies start issuing duplicative – or even worse, conflicting – legislation. The effect on the industry will not only mean increasingly difficult operating processes, but also an ever-growing provision allocated to compliance and risk oversight resources. There needs to be the question whether the benefit to the end consumer outweighs the costs that they will inevitably pick up. This increase in regulation, compliance and risk oversight will get priced into the consumers investment solution.

Finally, for businesses aiming to work efficiently across several different territories, the growing regulatory burden is in some senses one of the biggest challenges post the 2008 financial crisis. The speed at which the regulatory process is moving is unprecedented. The growing weight of legislation is not a characteristic of selected individual territories but a growing global trend. What is more worrying is the apparent shift toward extra-territorial jurisdiction as demonstrated in the recent roll-out of US regulation under Dodd-Frank Act as issued by the US Securities and Exchange Commision in 2010, as well as the Foreign Account Tax Compliance Act.

These pieces of legislations are historic and will result in significant changes to the regulatory framework and will undoubtedly impact the global financial services industry. In the past it was reasonable for money managers or sellers of investment solutions to ensure compliance with local regulation to citizens within its borders. However, the US has now cast its regulatory net outside of its borders, obliging investment businesses to comply with US regulations wherever they manage money for US citizens outside of the US. Their reasons – tax evasion and reaction to the credit crisis to name two – may be reasonable, but their methods and their consequences may be excessive. Extrapolate this to a situation where several countries instigate similar processes and the result risks being both complex and inefficient.

From an investment management perspective, it is possible that over the coming years the industry will suffer the regulatory backlash from the recent failure of the banking system. It is questionable whether policy makers understand in enough depth the distinction between capital-hungry banks and capital-light managers of third party assets. In this case, like using a sledgehammer to crack a nut, it is hard to remain convinced that regulators and policy makers are fully aware of the downstream impact and cost of the regulations they are putting in place.