Regulation Taylor

The bookshelf in Michael Taylor’s office is brimming with tales of scandal and intrigue in the City. From BCCI and Maxwell to the latest thriller documenting the crash at Barings, the titles reveal his interest in the steamier side of the financial services industry, in particular its disasters.

Taylor’s background tells you he is an insider. As a former policy adviser at the Bank of England he could see behind the shroud of secrecy that still cloaks much of the goings on in the City.

But he refused to turn native. Last week, Taylor, who is now the director of a course in financial services regulation at London Guildhall University, published the third instalment of his proposals for a new regulatory scheme for the City. He argues that the Government should overhaul the so-called self-regulatory bodies that have overseen the building societies, insurance companies, securities houses and other financial services firms enshrined in the 1986 Financial Services Act.

He believes the changes brought on by the Act have made regulation by a large number of discreet organisations almost impossible. The blurring of traditional business lines that followed Big Bang makes it impossible for any one regulator to deal with a problem. Several are often called in, making it impossible for the case to be dealt with quickly or consistently.

In his publication for the Centre for the Study of Financial Information, Peak Practice: How to reform the UK regulatory system, he sets out why he thinks they should be rolled up into two units: one given the job of protecting investors, while the other safeguards the financial system. At the moment, each regulator attempts to perform both jobs, which often leads to conflicts of interest.

For instance, an investor might want their money back from a struggling bank and care little about its survival. The collapse of the bank, however, might pose a risk to the whole financial system.

There are also growing risks within the wholesale financial system that stem from the mergers following Big Bang, Taylor explains. ‘These days you have a set of institutions that are inherently less stable because they now have subsidiary businesses that are less liquid and find it hard to sell quickly when they are in trouble,’ he says. ‘A securities house that is running a large swaps book can sell its shares quickly, but might not be able to unwind this business before real trouble strikes.’

It seems obvious from the various reports in the Barings case, when debts in the securities business overwhelmed a blue-chip bank, that the risk to the system was taken into account long before the concerns of the bank’s depositors.

Taylor’s views have already gained some notoriety. His old employer, Bank of England governor Eddie George, has argued the proposals have fatal flaws. He defends the ‘complex matrix structure where, broadly speaking, financial businesses are regulated institutionally for prudential purposes and functionally for purposes of business conduct’ as the best way to manage the situation. Following Taylor’s proposed structure, he says, ‘there would still be a need for close practical co-operation between different regulatory interests’. And that, he adds, would be inefficient.

The Government has also shunned any attempts to push forward reforms this side of an election.

Nevertheless, a flurry of activity in the last month, principally from the regulators themselves, has kept the debate moving forward.

Securities and Futures Authority chairman, Richard Farrant, has openly backed Taylor’s proposals. He argues that it makes little sense for the Bank of England, the DTI, the SFA and the Building Societies Commission to cover the same ground.

Andrew Large, the chairman of the Securities and Investments Board, says he is also eager to reform the system. He said last week he is examining ways of rewarding financial firms that establish good controls, such as effective internal auditing procedures. The point he wants to make is that regulation has not failed so much as the City firms, which have refused to put in place adequate protection within their own organisations. The regulator’s role in a revised system drops its reliance on the big stick in favour of a little carrot.

Jonathan Jesty, a partner in KPMG’s Regulatory Services Practice, says: ‘An evaluation of the degree of risk and therefore regulation required for an individual entity is part of routine monitoring. What is new is for the regulators to differentiate more radically the compliance burden between those where significant investor protection issues are, or are not, likely to arise. How radically we await to see.’

However it is worked out, firms that can prove they have good internal controls will get a pat on the back and a lighter regulatory load.

It is the point at which accountants are drawn into the picture. Both as internal and external auditors, accountants are increasingly being asked to take on a fraud detection role that builds on their auditing knowledge. There is a wide spread of opinion in the profession over how much accountants should get involved and whether they should trade off an increase in responsibility. Gerry Acher, head of audit at KPMG, has suggested a trade off that exchanges an increase in responsibility for a legal limit to an audit firm’s liability. The SIB hasn’t said whether it wants to go down this road, but the need for stronger internal controls is definitely going to involve accountants. The decision by Morgan Grenfell to appoint Robert Smith, the current Scots ICA president, as head of its troubled asset management arm is no coincidence.

Taylor says this change of attitude by the SIB is consistent with his desire for a regulatory system based on an economic system of rewards and punishments, rather than a legalistic system that simply adds clauses to a ever expanding rulebook every time someone finds a loophole. But this move, which has the backing of the Treasury, is not enough for Taylor.

He believes the scandals of the past reveal too many conflicts of interest within the self-regulatory bodies. Each one decides how tough they are going to be on firms. They also obscure the battle between the consumer and the firms that owe them money.

Taylor’s criticism of the financial services industry is best illustrated by the pensions mis-selling scandal of the late 1980s. The saga is like a running sore that still draws a wince of embarrassment from the firms and regulators involved.

At issue is the advice given to millions of employees who had joined, or were eligible to join, a company pension scheme. Unfortunately, most of them were persuaded to sign up for a personal pension that would be worth less than the company scheme when they retired.

Eight years have passed since the first questions were asked about the conduct and professionalism of the financial investment community, whose members stood to gain massive bonuses for every personal pension sold.

The tortuous, drawn out investigation has been conducted by no less than four regulatory bodies – Fimbra, Lautro, Imro and the PIA.

They have argued over the conduct of the investigation and what kind of punishment should be meted out. According to Taylor, they have also refused to recognise a conflict of interest that comes with their brief.

They exist to protect the financial companies and the systems they operate under, alongside a duty to protect the consumer.

Consumer groups have been scathing in their criticism. They believe the regulators’ concern is for the future of the firms which produced, in this case, pensions advice, which overrides their consideration for the investors. Most spectacularly, Britain’s largest pensions company, the Prudential, escaped disciplinary action after an 18-month investigation.

Lautro, the Life Assurance and Unit Trust Regulatory Organisation, said the insurer had done enough to avoid fines because it had ‘acknowledged’ Lautro’s concerns.

Lautro has subsequently been merged with Fimbra by the Securities and Investments Board in an effort to toughen up the regulatory regime. But its new offspring, the PIA, has struggled with its parent, its members and its investors ever since. To the outside world the struggle for supremacy between various regulators looks more like a farce and only goes to obscure the issues.

Meanwhile, the Maxwell and Levitt cases, Barings, Asil Nadir’s Polly Peck and Barlow Clowes all revealed the need for robust consumer protection.

But to say there are contradictions is heresy. Imro, for instance, is certain that its brief has been clear from the beginning. ‘There is a fundamental misconception here,’ comments Martin Davies of Imro. ‘The investors come first. If the investors are best served by suspending a firm and ultimately sending it out of business then that is what we’ll do. The only reason we would keep a firm going is if other investors would be adversely affected by the firm crashing.’

To give Imro its due, it has been more aggressive in this area than most of its peers. It has begun the process of punishing its members involved in pensions mis-selling with hefty fines. But Imro has also, in the past, helped muddy the waters of regulation. Last year it had an ill-tempered row with the Securities and Investments Board, which oversees the activities of the PIA and Imro, among others. It accused the SIB of meddling in its affairs and declared that it neither wanted nor needed another regulator to check what it was doing. SIB argued that it was the only regulator in the field accountable to Parliament and therefore, meddling was an essential part of its job.

What would happen if we had two regulators? For one thing, scrapping the multitude of regulatory organisations would split regulation along very traditionally English adversarial lines.

On the one side would be the defender of the consumer and investor. On the other would be an equally large beast protecting the financial system.

Taylor has called it the Financial Stability Commission (FSC), which would authorise and supervise all financial institutions. It would be set up following an Act of Parliament and probably answerable to the Treasury.

The Bank of England would then concentrate on money management (exchange rates and interest rates) and the Stock Exchange would spend more time drumming up business for the main London securities market than dreaming up new regulations.

The Consumer Protection Commission (CPC), on the other hand, would watch over business, primarily in the retail markets, for the consumer. ‘In time, it might also take over the administration of the Consumer Credit Act and would subsume the various Ombudsmen schemes,’ says Taylor.

The Labour Party, in contrast, has backed the idea of an enhanced SIB, says its City spokesman Mike O’Brien. This overcomes one of the main weaknesses in Taylor’s argument – staffing. Experts in the building societies sector, that currently all live under the umbrella of the Building Societies Association, would be split between the FSC and CPC.

Peter Sime, head of regulatory practice at securities house CS First Boston, agrees that one super-regulator modelled on the SIB is the most efficient solution, though he believes there may be a case for splitting the roles played by staff within the organisation.

‘There is a lot of logic to splitting the roles, but whether you need to have two separate bodies is another matter.’ Sime’s case for getting the best staff relies on the US model. ‘The Securities and Exchange Commission has got it right because it is a good career move. Two years at a regulator in the US is a career boost.

But none of our regulators have got the same reputation.’

Taylor believes systems of co-operation can be constructed between his two commissions and whatever policing body succeeds the beleaguered Serious Fraud Office. He may be hair splitting, but he is adamant the conflict of interest between the City and the people who buy its products should be recognised in separate commissions, despite the inefficiencies.

It is still a million miles away from the current mess of self-regulation, and the SIB, SFA and Labour Party are all clearly heading in that direction.

Most of the others are still in a rut. They claim they can perform both functions to the satisfaction of both consumers and City folk.

Sime and most of his peers agree that radical change is on the way. After all, there are enough threats to the supremacy of London as a financial centre from foreign competition and Britain’s attitude towards European Union, without another Barings. But who will protect the City and the consumer in equal measure? What is certain is that the current system cannot cope.