Bank Off Scotfree

See Chapter 5.

Numerous questions tumble out of the cracks of the FSA's report on the destruction of Bank of Scotland: where is the review of the FSA's ARROW visits (as for Northern Wreck)? who were the key participants and their highly paid flunkies? Were any of them also responsible for the bank's £20m worth of bad attitude to complaints, by any chance?

For the tuppence it's worth, the report says that from 2006 to 2008:

"(1)  there were serious deficiencies in the control framework, which meant that it failed to provide robust oversight and challenge to the business;
(2) there were serious deficiencies with the framework for the management of credit risk across the portfolio which meant that there was a lack of focus on the need to manage risk across the portfolio as a whole;
(3) there were serious deficiencies in the distribution framework which meant that it did not operate effectively to reduce the risk in the portfolio; and
(4) there were serious deficiencies in the process for the identification and management of transactions which showed signs of stress which meant that they were neither identified promptly nor managed effectively."

And there were:

"targets which incentivised ...:
(1) prioritising the development of relationships with and the facilitation of customers;
(2) increasing the appetite to lend;
(3) increasing the appetite to take on greater credit risk;
(4) fostering an attitude of optimism at the expense of prudence; and
(5) regarding risk management as a constraint on the business rather than integral to it."

Furthermore, there were:

"significant issues as to the quality, reliability and utility of the available management information which directly affected the effectiveness with which the risks of the business could be assessed, managed and mitigated."

And, finally:

"(1) Group Risk failed to conduct effective oversight and control of Corporate; and
(2) there were issues with the quality and scope of assurance work undertaken by Group Internal Audit."

The FSA's solution?

"In these exceptional circumstances, the most effective way in which to balance the need for deterrence and act in the wider public interest is to issue a public censure."

Desperate times call for desperate measures!

Strength in Diversity

Following the discussion on the concept of a Social Finance Association, it was interesting to read the guest post on Zopa's blog by Rob Garcia, Senior Director of Product Strategy at Lending Club, attempting to classify types of social finance as 'crowdfunding', 'microfinance' or 'peer-to-peer lending or investing'.

Having had to spend far too long studying the distinctions between US and UK regulation in this area, I must respectfully disagree that 'crowdfunding' necessarily involves 'pooling' or a lack of nexus between 'funder' and 'fundee'. Similarly, any of these models should be capable of operation on either a for-profit or not-for-profit basis, or for any purpose, social or otherwise. The essence should be that each facilitator enables people - rather than the facilitator itself - to determine the allocation of their own funds directly to other people, businesses or projects, whether the businesses or projects are operated for-profit, social purposes or otherwise). In other words, people remain in day-to-day control of the management of their money, not the facilitator.

While precise distinctions between the various different social finance models may be important at one level, and a diverse range of business models is certainly good sign for the strength of the sector, the sector must also be ready to differentiate itself from traditional financial institutions and models - unless it wants to be regulated in the same way.

Social finance models were vital alternatives before the global financial crisis, let alone now and for the foreseeable future while traditional institutions adjust to new capital and regulatory constraints. But the existing regulatory framework makes it painfully slow and expensive to launch social finance platforms. To help foster confident innovation and competition, and enable the new sector to flourish quickly enough to provide much needed funding, financial regulators should clarify what is permissible within or outside the scope of regulation.

Image from the Trade Association Forum.

A Social Finance Association?

The past 5 years have seen the launch of many innovative business models aimed at enabling people to provide funding directly to other people and businesses via online finance platforms, rather than 'traditional' financial institutions. The terms 'crowdfunding' or 'social finance' seem to encompass most models out there.

The 'social' element is critical to the success of these models, because there are very real social and economic benefits to people - rather than financial institutions - sharing most of the margin between savings/investment rates and funding costs.

But I've witnessed firsthand how social finance platforms and their members tend to wrestle with the problem that social finance does not fit neatly into our financial regulatory framework, which is designed, ironically, to force recalcitrant 'traditional' providers to deal fairly with consumers. We are also currently victims of the delay and uncertainty caused by reforms to that regulatory framework. Because when they aren't rescuing banks or attending to 'business as usual', the key regulatory staff are understandably taken up with figuring out the new regulatory regime rather than vetting the legality of innovative business models that may remain outside the regulatory perimeter.

These problems add a huge amount of time and expense to starting and developing a social finance business, precisely at the time when banks are both lending less and paying lower savings rates.

Of course, it's common for the participants in new market segments to jointly discuss the development of the sector, including the characteristics and boundaries of regulatory 'safe harbours' and if/how they ought to be regulated. An appropriate forum for such discussion makes it easier to innovate and compete. But it also creates an efficient contact point with regulatory officials and opinion formers for discussing policy and regulatory concerns which individual participants wouldn't otherwise voice for practical reasons of time and cost, or for fear of inviting adverse attention.

There is no need for incorporation or office space. Trade associations often begin on ad hoc, unincorporated basis in response to a threat or opportunity that presents to all the participants.

Has that moment arrived for social finance?

Image from the Trade Association Forum.

The Leadership Crisis Is Ours To Resolve

Paul Moore's recent evidence to the Treasury Select Committee reveals the kind of top-down culture in the UK financial system that explains not only rampant over-expansion and the financial chicanery that went with it, but also arrogant, self-interested foot-dragging over such things as slow payments, mis-selling of PPI, acceptance of falsely self-declared income on mortgage applications and allegedly excessive bank charges. Intensive regulatory activity, checks and balances aimed at preserving the banks has not been enough to save them. For this, the very taxpayers who are poorly served as consumers must now pay.

After a string of CEO departures, the resignation of Sir James Crosby from his post as Deputy Chairman of the FSA, and with the "blame" now lying at the door of the man who was Chancellor through it all, there is no doubt we are in the midst of a leadership crisis.

But what lies in store for us once the "old guard" has gone? Who are the new leaders? Will their leadership improve?

Leadership is a rather nebulous concept. Over centuries, people have literally died trying to define it by reference to specific character traits, sundry personal qualities, types of behaviour, situational responses, functional responsibilities and so on. But regardless of whether or not leadership features all or some of these characteristics, it is ultimately a very complex, contextual, dynamic, inter-personal relationship between the purported leader and those he/she is trying to lead.

In other words, leadership is what the participants in the relationship make it, and we get the leaders we deserve.

But we know this, and we're acting on it. Our decline in faith in our institutions over the past 30 years, and the corresponding surge in political awareness, participation in informal politics, and personalisation of previously mass consumer experiences all reflect our growing individual pragmatism and our confidence in acting on it from the bottom-up. We have learned that great leadership is within our control because we are a fundamental part of that relationship. In essence, we are the leaders.

That is why, when Chris Skinner issued an apology to 98% of bankers for his rather apt criticism of banks, I suggested that in fact they should take his remarks personally. Because we know that as people they are not powerless. We know that great leadership will emerge when the 98% respond to the criticism, bottom-up, by forging a decent relationship with their customers, putting those customers first, ahead of their managers, executives, board directors or shareholders. Only then will we see decent, sustainable profits from the finance services industry.

FSA Needs Help to Shut Northern Wreck's Stable Door

Hopes that the FSA's internal audit report into the (mis-)handling of Northern Wreck would quietly close the stable door have been dashed.

Not only do the recommendations in the report imply major shortcomings in the way "high impact" firms are supervised, but the fact that the revelations have come 8 years and so many scandals into the agency's existence also suggest that the FSA is incapable of closing the stable door on its own.

But the FSA is not so much to blame, as our expectations.

It does seem unrealistic to expect the FSA (any more than every bank it supervises) to hire enough people of sufficient calibre and to keep them sufficiently trained and informed to detect every significant hole in firms' evolving business plans/models that may be exposed by the latest financial wheeze. Even if the FSA could solve that staffing and data challenge, the chances of the FSA actually persuading bank management to accept that a particular hole exists and to plug it quickly enough seems very unlikely to work every time. After all, participating in financial markets inherently involves the assumption of risk, not completely eliminating it.

I guess there's no harm in the FSA continually striving to improve the likelihood of meeting these expectations - or aspirations - except for the ever-increasing budget that will be required.

One thought is for the FSA to rely more on third party firms to do the specialist business and economic analysis, leaving the FSA to focus more tightly on commissioning, reviewing and reacting to their reports and managing the regulatory relationship with firms. That would allow for clearer segregation of the detectives from the prosecutors. The profit motive might enhance the economic efficiency with which the analysis is done, and also enable deeper expertise to be built over a longer period than the FSA's career ladder might allow.

I hear howls about more money being spent by government on consultants, and that too needs a good overhaul for sure, but it's no argument for depriving the government of private help.

Whatever happens, the private and public elements of the financial services industry will have to work better together if more Wrecks are to be avoided.