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Friday, 10 August 2012

More Early Warnings - Now!

Last year I cheekily suggested we should allow financial regulators to short-sell the stocks of companies that are subject to the slow grind of enforcement action. Refreshingly, the Treasury seemed to acknowledge such concerns and the Financial Services Bill includes a power for the Financial Conduct Authority to disclose that a warning of enforcement has been issued to a firm - a so-called 'early warning notice'. The Standard Chartered 'wire stripping' saga provides an excellent illustration of the issues.

Radio silence on enforcement actions is explained as investor protection. Yet it leaves innocent investors to continue piling into stocks they might have avoided had they known of the alleged misconduct. Instead, enforcement action should merely be about regulatory penalties, and the fact an action has been commenced should be disclosed as a material fact about which investors (and customers) can draw their own conclusions. Short-selling has a similar effect. Generally speaking, short-sellers go looking for mismanagement and/or misconduct and back their suspicions with a market price. I gave the example of Greenlight's campaign against Allied Capital (and later Lehman Brothers), and noted that DE Shaw had a £100m short position in Barclays in February 2011. That at least acts as timely opportunity for long-only shareholders to consider selling, and would-be investors to steer clear.

Our banks, in particular, continue to present examples of long term operational misconduct that show why early warning is a good idea, the latest being the saga of Standard Chartered Bank's alleged 'wire stripping' activities. A key issue is whether $250bn or $14m in US dollar transactions were rendered invisible to the US authorities, preventing scrutiny to establish whether they breached sanctions against Iran. SCB claims that it's been working with various US federal authorities to settle allegations about its practices for some time - precisely the sort of cosy arrangement that leaves everyone else in the dark. But the New York State Department of Financial Services has decided to go it alone. In April it notified the federal authorities in April that it would pursue SCB more widely than the $14m in transactions that SCB say are in issue. The resulting allegations were published on Monday - perhaps not exactly an 'early warning' to the market, but it will do for argument's sake. SCB's share price dropped significantly on the news, later recovering somewhat, so these are clearly matters of concern to investors.

SCB has naturally reacted defensively in the face of the NY State regulator's broader allegations. It's running the traditional defence of cosy enforcement activity, saying its reputation with investors has been harmed before all the facts are out, and people have lost money 'unfairly'. It claims the NY State regulator is wrong on the merits of the case, and should thrash it out in a settlement quietly like the Feds. But the fact that the share price recovered somewhat from the initial fall might suggest that investors are still making up their minds. In other words, the 'early warning' has not been the unmitigated disaster some might claim. Similarly, short-sellers often need to incur the cost of holding their positions for many months - even years - before they're ultimately proved right or wrong.

Personally, I think the merits of whether or not the relevant transactions were affected by sanctions and should have been subject to scrutiny pales into insignificance beside SCB's apparent approach to that issue. It's one thing for the bank to take the view that the transactions are out of scope and argue the toss with the authorities while complying with scrutiny procedures in the meantime. There are also instances where regulation is clearly outdated, flawed or unduly awkward and a pragmatic 'fix' is acknowledged by the authorities as acceptable. But would be quite another thing to apparently make a judgement call privately and then deliberately alter transaction data - or require it to be altered - to shield the transactions from scrutiny. That sort of attitude to compliance risk makes you wonder what other risks are being run and at what scale. And the initial impact on the share price shows that at least some investors are just as interested to know that such risks are being run as the regulators. Neither investors nor regulators like surprises.

Interestingly, the City's propaganda machine has chosen the SCB saga as a point from which to launch a counter-attack on behalf of banks generally. The Financial Times, 'reports' a "backlash against naming and shaming of banks" - a kind of backlash against a backlash, if you will. The FT cites a proposal by Lord Flight to amend the Financial Services Bill to prevent the Financial Conduct Authority being allowed to give early warning notices. Interestingly, Lord Flight has introduced an extra note of moral panic that pension funds have lost money as a result of the NY regulator's disclosure of its allegations against SCB. Any time you see a gratuitous populist reference like that you should smell effluent. 

Let's be clear: investors have lost money because they didn't realise that SCB was running a risk of enforcement activity on a grand scale. That kind of problem seems to be particularly rife in banking. We need more early warnings - now!


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