I guess it started out as a reasonable idea - provide card customers with comfort that someone else will help if your credit card is stolen and your card issuer let's you down.
But your card issuer isn't allowed to let you down, unless you do that yourself through fraud or negligence - in which case why would an insurer help? Slow as they are, it's very much in the legal and financial interests of card issuers to invest in anti-fraud protection. And they're usually 'first-on-the-scene' in a card fraud scenario, as you'll be aware if you've ever been called to confirm you weren't standing at a point of sale in both Brazil and Bulgaria in the past few hours.
If you're an ID theft policyholder and you don't agree, are you are among the 0.5% who've actually made a claim?
Cue the FSA probe into CPP, purveyor of fine ID theft protection at £80 a year. The investigation was prompted by Which? who have campaigned against this rort for some time. A glance at the fund managers who backed the IPO tells you all you need to know. Those people have no right to complain. Either they knew the drill or they were gullible enough to think this product had a real future.
As for the attitude of the card issuers: the FT cites at least one analyst's view that:
"You could argue that half the companies on the high street shouldn't exist because the things they sell are vulgar, tasteless or tacky... Which may be true, but it's irrelevant. The point is, there's demand there."
The Ministry of Justice has even produced a helpful guide to Bribery, featuring lots of placatory language and easy talk of "prosecutorial discretion".
They may as well have stood in Parliament Square with a bullhorn shouting: "Get out there and sell UK plc, damn it. We need the spondoolies."
This post is written for information purposes only, and is not intended to be relied upon for any purpose whatsoever, including but not limited to participation in government or corporate procurement exercises anywhere in the universe, either as we currently understand it or as it might turn out to look like following more intensive research involving the Large Hadron Collider and an errant strip of aluminium foil that a cleaner inadvertently left in the chamber after a late night game of cards [er, that's enough disclaimer. Ed].
Auditors, and others interested in the nature of scepticism (feel the irony) will have been interested in recent FT coverage of stock market analysts' reluctance to write "sell" notes on the companies they cover.
In theory, the distribution of sell, hold and buy ratings should be equal. Yet Bloomberg found that 60% of analysts' ratings are "buy", and "buy"/"hold" ratings together outnumber "sell" notes by 9 to 1.
One chief of US equity strategy was brave enough to be quoted as saying, "There is clearly a lack of willingness of management to deal with analysts who are highly critical."
McKinsey research, discussed here, has also found that analysts are "typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined."
It seems likely to be self-defeating to obviously exclude or limit critical analysts' participation in briefings - possibly a sell signal in itself. Or at least a signal that everyone should start asking a lot more questions. But ultimately the research highlights the fact that, for all the law on disclosure and directors duties, the stock market is just that - a sales forum.
"You can even make the case that to guard against the propensity of any British government to waste taxpayers' money or reward friends, you would probably want every page of every outsourcing or PFI contract published on the internet.
Here's the thing. There is almost always a public interest in publishing commercial agreements with governments wherever they sit on the spectrum from parliamentary elective democracy to corrupt military junta. But against that public interest comes the national economic interest, which - whether we like it or not - is occasionally served by allowing businesses to operate under a dank fog of partial disclosure."
The current financial crisis and its causes tell us that the official Western attitude to financial misdeeds is fiendishly inconsistent at best. Witness the irony, for example, of Hank Paulson, as US Treasury Secretary, ramming entire financial institutions together over a weekend, but warning Congress it would take months to renegotiate bank CEOs' compensation agreements. Or the timid enforcement record when it comes to the pillars of the finance world, while the theft of some source code from Goldman Sachs gets you 8 years. No wonder Bernie's bitter. It's like he got everyone else's jail time, as well as his own. But maybe that was the idea. Hang one guy out to dry and hope that's enough for the baying mob.
It makes you wonder whether all the hand-wringing over bribery and corruption was just a Western conspiracy to fool Gaddafi and his ilk into trusting us with his loot.
“While responses to the Discussion Paper demonstrate widespread agreement on the critical importance of auditor scepticism to audit quality, there is less agreement on the nature of scepticism and its role in the audit."
In other words, the accountants aren't really sure what the word "scepticism" means.
Well, for those of you up the back, the Oxford English Dictionary defines a "sceptic" as "a person inclined to question or doubt accepted opinions." So, I'm thinking "scepticism" might be... the inclination to question or doubt accepted opinions. Surely one does not need to be more specific.
However:
"In light of the responses to the Discussion Paper, the APB has decided to distribute copies of the Oxford English Dictionary to all audit practitioners undertake work in the following areas:
* Ensuring that there is a consistent understanding of the nature of professional scepticism and its role in the conduct of an audit.
* Reviewing ISAS (UK and I) for possible ambiguities in relation to the nature and importance of professional scepticism, and proposing such changes as may be needed to make sure the position is clear.
* Reviewing ISQC (UK and I) 1 to ensure that it has sufficient requirements and guidance relating to the need for firms to have appropriate policies and procedures for promoting the competencies that underlie professional scepticism.
* Considering how the application of scepticism can be made more transparent.
* Considering, with other parts of the FRC, whether there is a need for guidance on the approach to be taken by auditors when considering the presentation in the financial statements of matters that have been the subject of significant challenge by the auditors."
The situation is so dire in the audit world, that they have to teach auditors to be sceptical.
What next - teach coppers not to believe everything suspects tell them?
No doubt the unions will fight for a reprieve, but ultimately public sector workers - like the rest of us - will have to focus very carefully on where their pension contributions go, and how much of their return is dissipated in fees, brokerage and dealing costs. No one will have the luxury of assuming they'll actually receive a pension (certainly not a life-sustaining one), just because they pay into one today...
I want to say that "meaning based computing" is the enterprise version of the semantic web, if only to keep 'price comparison' web sites in the technological cross-hairs. But I can't really, as it wasn't even mentioned.
According to Mike, the more fundamental Information Technology challenge is that the world is producing far more human-friendly, unstructured data than structure data (compound annual growth rate of 62% vs 21%). Cloud computing might help scale the technology aspect, but that doesn't help you find the right information. Keyword search, PageRank, meta data and so on all help with the data. But if computers are to search more comprehensively, they must 'understand' the meaning, concepts or ideas you're looking for, and how these relate to one another.
Conceptual search is partly constrained by who is searching, and whether they know what they're looking for. Boolean and linguistic search models in particular require 'training' and lots of maintenance by very smart people who know a lot about what's being searched for. But Mike explained that probabilistic systems are independent of language and investigator bias. Instead, they process the whole data set and look for scenarios where words are 'more likely than chance' to appear together. In this way, a more objective set of search results are returned.
So what?
Well, Mike says the main applications for conceptual search currently seem to be amongst spooks, regulators and major corporations. In other words, it's a mean weapon in major games of cat-and-mouse - one that US financial markets investigators seem to have spent five years perfecting. In fact, the most worrying statement of the evening for some must be that "most of Wall Street's messaging is in the cloud".
Specific uses lie in improving document management, retention and electronic discovery, particularly as an aid to early case assessment and crisis management. A killer app, no doubt, and one where Mike reckons law firms can indeed make a killing - possibly providing outsourced data systems for their clients. But pre-programmed, conceptual search systems are also good enough to enforce corporate policies real-time, preventing 'smoking gun' emails from ever being sent, or corporate bribes being accepted.
If only they could help find decent car insurance, utility and mortgage deals, we'd be shot of price comparison sites as well ;-)
The long overdue move to regulate consumer credit the same way as other financial services has finally been announced.
I've been advising businesses on both sides of the strange divide between the Consumer Credit Act and the Financial Services and Markets Act regimes for the past decade, and I still find the dichotomy as maddening as when I first laid eyes on it.
Gold-plating the Consumer Credit Directive hasn't helped improve the cost and complexity, and transparency is not improved by obliging a provider to register under both the CCA and FSMA regimes for products that are part of the same sales process. Or by allowing banking groups to present themselves as "authorised and regulated by the Financial Services Authority", while in fact sheltering their consumer lending activities under an obscure self-regulatory regime. It defies belief that the banks' consumer lending processes should operate any better than those that have earned them big fines in recent months.
But perhaps the most interesting point, in these troubled financial times, is that the government department that's presided over the CCA regime estimates that we'll save a net £120m annually by repealing it.
The head of the Barclays Business unit is quoted as saying, “It’s the leasing and hire purchase side [where] we found our proposition was not that compelling, comprehensive and competitive. Our market share was small, about 8pc.”
Those are my gob-smacked italics.
According to the same article, the Finance and Leasing Association "said asset finance represents the majority of debt-financed business, and that its members provided £1.7bn of funding to support business investment in December, 5pc higher than the same month in 2009."
Barclays says it can target this £21bn market segment with unsecured loans. But of course it's talking through its hat. The Basel III head-wind blows strongest in the unsecured lending space. So even if Barclays can magic the £1.7bn asset-based portfolio into unsecured loans, it doesn't seem a great alternative use of capital.
But it's an interesting strategy if you're lending some of your own cash on a peer-to-peer platform, instead of leaving it in a savings account.
Today, Lloyds Banking Group announced a provision of £500m in payments to 600,000 Halifax mortgage borrowers who may have been confused over the interest rate that applied to them, with some "missing out on lower mortgage payments." And Barclays Bank confirmed it's withdrawal from asset-based small business lending, explaining that its "proposition was not that compelling, comprehensive [or] competitive" (despite the market segment growing as a whole) and that it wasn't commercially worthwhile to spend money on compliance and other improvements.
In fact there's been a steady stream of poor retail banking stories since August:
One certainly wonders what else might be lurking in the woodpile. It's just a pity it takes so long for the FSA to investigate and announce it's fines. Wouldn't it be better if the data were in the market promptly, rather than leaving everyone to guess?
Or perhaps the FSA should announce when it isn't undertaking enforcement activity against a bank... ;-)
The Treasury reports that it received no support for its proposal for voluntary consumer protection codes for ‘closed loop’ or limited network stored value, which are exempt from European E-money regulation. These include store cards, coffee shop cards, fuel cards, transport cards, membership cards, and meal and other voucher systems - nothing like the collapsed retail pre-payment schemes that have previously lost their customers' money Farepak (Christmas hampers) and WrapIt (wedding gifts).
However, the rejection of the need for voluntary codes arguably opens the way for formal regulation, as the Treasury had seemed to be firmly of the view that more protection is necessary for the reasons summarized below. As a next step:
“The Treasury has asked the Office of Fair Trading (OFT) to provide some advice on the prepaid market, the effectiveness of current self regulatory solutions for protecting consumers, and the interaction between the regulated and unregulated sectors. This advice will be fully considered before the Government decides what, if any, action to take.”
Ominous? Well, it depends on what they mean by "prepaid". If the Treasury means retailers who require people to pay for products weeks or months prior to shipment, then I wonder why it's taken them so long to address a really obvious problem. But if they mean gift vouchers to make sure your nephew spends his birthday money on something educational instead of 5kgs of sweets, then this is over-kill.
I’ve extracted the summary of responses on this aspect below:
"3.10 There was little or no support for voluntary codes as a solution to improving the safeguards for consumers in the unregulated sector.
3.11 Responses fell into two broad categories: those that argued that tougher regulation and enforcement than voluntary codes is necessary to address perceived shortcomings in the unregulated sector; and those that felt that there was no justification for action due to the low risk of consumer detriment. The main reason for the general dissatisfaction with voluntary codes was that, although models vary, supervising and enforcing a voluntary code is often thought to be difficult. There are usually no limits to the number of violations a company might have, no financial incentive to abide by a code, and weak rights of recourse for consumers.
3.12 Some respondents argued that no action was necessary because the perceived risks are low. It was also argued that voluntary codes would be unworkable in practice because the average amounts outstanding on unregulated products (mainly gift cards) are less than £30. These responses concluded that the risk of loss per customer did not warrant a new protection mechanism."
Good to see Michael O'Higgins, the new Chair of the UK Pensions Regulator making a splash in his first interview. He's quoted in Tuesday's FT as saying providers should be obliged to compare their returns against their fees and other charges, including brokerage and dealing costs.
He admits transparency is key to building public trust in pensions, implying there isn't much.
Perhaps the most telling aspect of the battle for electoral reform is that the leading 'Yes' campaigners share great comic wit and timing, while the leading 'No' campaigners merely have surnames that end in 'tt'.
The result should be a triumph of pragmatism over the petty self-interest of has-been Labour politicians.
But the Double-T's will try to make it a vote on t' economy, t' spending cuts, t' cost and t' complexity or some other basis for moral panic.
Personally, I plan to have a lot of fun at their expense.
I spent Monday partly examining the practicalities of treating time as a currency at BarCampBank4.
In essence, 'time banks' for social care are no different to other closed-loop 'alternative' currencies ranging from loyalty schemes to gift card and store card programmes. Hureai Kippu, the Japanese system for earning the right to senior care by caring for senior citizens yourself, is often cited in this context. That specific model, which involves a nationwide clearing system for care credits, is being considered by various local authorities in the UK, though Age UK is among those who question its utility.
However, we need to be cautious about 'open loop' time banks, even though this may bring welcome liquidity and funding to support an aging population with a giant pension deficit. There's a range of practicalities that stand in the way of time - or loyalty points, for that matter - becoming a 'real' or open-loop, freely negotiable currency or E-money. I'll cover these briefly below. But a more fundamental point is that I'm not even sure that opening up such currencies would add any utility to what's already feasible with any real currency, unless the underlying E-money system is somehow cheaper and more cost effective in moving money or other resources to where they are needed. And there are of course plenty of E-money systems that did not need to go to the trouble of creating a new currency to get going.
Other than funding the business itself, perhaps the main practical challenges to time banks becoming open-loop are achieving 'critical mass', enabling immediate redemption in cash, and tax. Issues of trust, privacy, data protection and so on seem secondary and surmountable so long as the upside to participating and disclosing information outweighs any perceived downside.
Achieving a 'critical mass' of people that will ensure adequate supply and demand for the type of time in question is an awesome challenge that deserves a post in itself.
The requirement for users to be able to redeem the time they have 'earned' or 'acquired' in cash at any time would go hand-in-hand with the need to be authorised as an E-money issuer, and to comply with various capital and prudential requirements, including safeguarding the cash corresponding to the outstanding time. Redemption in cash and safeguarding would seem to defeat the purpose of a time bank, founded as it is on the notion that participants deal only in time.
Finally, we are obliged to pay income tax on our earnings, as well as indirect taxes on sales of goods and services. And governments tend not to accept payment in anything other than their own national currency. While in a closed-loop UK time-bank for charitable purposes tax is not an issue, as soon as you enable redemption for cash or goods and services, tax would come into play.
For these reasons, I think time banks are very useful in allocating resources within a specific community, network or scenario, but not as an open-loop currency - at least not without substantial changes to the regulatory and tax framework.
Few people are aware that when you pay using a credit or debit card, your 'issuing' bank charges the retailer's 'acquiring' bank an "interchange fee". The rate is either agreed directly between the banks, or is imposed via a card scheme, like Visa or MasterCard. Nobody outside the banks and card schemes really sees this fee. The retailer receives your money for the purchase price, less a service charge. A little bit of that service charge is kept by the retailer's bank as a payment processing fee, but most is kept by your bank as its interchange fee.
Like any other retail overhead, these charges need to be accounted for in retail pricing. So, even if you aren't paying by card, interchange fees are a significant drag on your personal economy. The European Retail Round Table, a network of large retailers, has found that "the average European household pays €139 per year on interchange fees". And, according to the European Commission, "in the EU, over 23 billion payments, exceeding a value of €1350 billion, are made every year with payment cards." In other words, retailers have no real choice but to accept payments by card.
But who benefits? The ERRT cites a 2006 report found that only 13% of the fees go toward your bank's processing cost, while 44% of interchange fees pay for cards reward programmes - which of course only benefit cardholders. That leaves a healthy profit for issuing banks. In their defence, Visa and MasterCard claim that interchange fees are essential to investment in systems, marketing and anti-fraud efforts. Which is what banks must do themselves, anyway, to meet their own anti-money laundering and prudential requirements. The schemes also suggest that interchange fees may be cost-neutral to retailers if savings on the acceptance of cash and reduced check-out times for card payments are factored in (which has not been accepted in Europe).
Looking at the situation from the consumers' standpoint, non-cardholders get no benefit from card loyalty schemes at all. And even cardholders themselves might prefer the equivalent of interchange fees being spent in ways that directly improve their retail experience.
The card schemes argue that because retailers say they have no choice but to pass on interchange costs to consumers, the measure of whether interchange fees are really too high is whether retailers would actually lower their prices - and they would not. That doesn't hold water. Firstly, all of a retailer's costs are ultimately accounted for in its prices. So it would be wrong of retailers to say that all consumers are not paying for interchange, unless the retailers specifically imposed a specific interchange-related fee only on those paying by card. Secondly, as I commented earlier on Digital Money, the card schemes' assertion rests on the assumption that the only way retailers should reasonably differentiate themselves from each other is in terms of price. So the card schemes would have it that every time a retailer cuts any of type of cost, including interchange fees, the retailer should take the ultimately suicidal step of always reducing prices to the consumer, rather than, say, investing in increased selection, improved customer experience or expansion to achieve economies of scale. That's an unrealistic position in itself, let alone one that would support the assertion that if retailers do not cut prices to consumers on the back of lower interchange fees, they are somehow behaving just as anti-competitively as the card schemes are alleged to be in imposing them. The retail markets are distinct from the market for payment services. Lack of competition in retail markets can be - and is frequently - addressed on its own merits and action taken accordingly.
The battle is also raging in the US, where three bills were put before Congress in 2009 to regulate interchange fees. The Federal Reserve is consulting on proposals to limit debit card fees from July 2011 "one that would base fees on each issuer’s costs, and one that would set a cap of 12 cents per transaction", as explained here by Jean Chatsky, and discussed on Digital Money. Potential implications for bank stocks are discussed here.
I've kept a beady eye on the 'progress' of the Commission on Banking, while holding out little hope that it will result in more than a shuffle of the proverbial deckchairs, rather than any wider solution to our general funding woes.
UK banking, as we know it, would be finished without ongoing taxpayer support of at least £512bn, according to the latest National Audit Office report. And that's assuming the economic headwind doesn't get any stronger.
Instead, the taxpayer safety net allows the Commission the luxury of merely wondering whether good old British banking might be delivered more safely (if still more expensively) via independently funded, ring-fenced subsidiaries.
What difference could this possibly make?
Testament to this bizarre preoccupation with maintaining status quo is the government's determination to ignore alternative models. For instance, the government has just meekly referred to Zopa, the UK's own world-first in person-to-person finance, as a form of "giving" (see page 15). That's weird, because with absolutely no government assistance Zopa has so far enabled over £100 million in person-to-person loans, representing 1% of the UK personal loans market. Lenders are seeing annual returns of 7.9% and a default rate of under 1%, while delivering market leading rates for creditworthy borrowers. Banks aren't offering anything like this service, even with the added government subsidy of tax-free ISA status. Imagine how much of the personal loan market would shift to the Zopa platform if people's lending returns were also tax-free? FundingCircle has already launched a similar model for small business funding. Could the greater liquidity enable mortgage funding in the same way? Such horizontal funding processes also offer a more transparent, low cost and efficient solution than the vertical intermediation model that operates in the 'shadow banking system'.
It's one thing to avert overnight systemic failure, but quite another to prop up exploitative, inefficient business models over the longer term in preference to more efficient alternatives. We should expect a more holistic approach to the UK's financing woes than the Commission on Banking is attempting to provide.
Rather than communing with my laptop, tonight I had the pleasure of discussing the challenges of emerging technology with the inaugural meeting of the SCL Junior Lawyers Group.
The overriding questions seem to be: where will the key trends take the law and lawyers over the next 100 or 10,000 years? And how do we minimise our exposure to the downside - and maximise our exposure to the upside - of the next Black Swan?
Derman's paper helps one get to grips with the financial crisis by succinctly explaining the shortcomings of financial models. Importantly, he points out that:
"Models are analogies, and always describe something relative to something else. Theories, in contrast are the real thing. They don't compare; they describe the essence, without reference."
While Derman gives examples of various theories that can be expressed in mathematical equations, he shows that finance is not capable of such expression. "There are no genuine theories in finance... Only imperfect models remain."
Derman suggests that we "use models as little as possible, and to replicate making as little (sic) assumptions as [we] can," and that we adhere to five rules:
While every financial axiom is wrong, the question is "how wrong, and can you still make use of it?"
"Build vulgar models in a sophisticated way", "using variables the crowd uses... to describe the phenomena they observe."
"A user should know what has been assumed when he uses the model, and... exactly what has been swept out of view."
Models can't be truly right. "You are always trying to shoe-horn the real world into one of the models to see how useful an approximation that is."
"To confuse the model with a theory is to embrace a future disaster driven by the belief that humans obey mathematical rules."
Of course, such limitations could also be said to extend to non-financial models deployed in and around the financial markets, demonstrating the enormous challenge inherent in the regulation of markets for complex products.
Financial models don't operate in a vacuum. The debt markets comprise at least as many models with inherent assumptions about how various aspects of those markets should operate as there are roles, functions, systems and controls, whether they be related to accounting, regulation, underwriting, collections, rating, marketing or audit. Everyone is operating on models - rating models, asset pricing and valuation models, accounting models that assume a company's health is reflected in its financial statements, regulatory models that may be either 'light touch' or heavily prescriptive. And everyone is operating on his or her own model of how these models work together.
The shortcomings of financial models apply equally to all of them.
However, all these models only ultimately 'bite' when a transaction occurs. And since transactions only occur between buyers and sellers (or their agents), only their beliefs about how models 'work' affect each transaction - capitalism keeps the authorities and everyone else on the sidelines. So the 'protective' models deployed by support functions and external actors can only be effective if they are properly deployed and fully understood by market participants. This seems impracticable, given that the likes of lawyers, accountants, ratings agency managers and bond traders have very different views of the same market, and differing attitudes to their employers, clients and so on.
So it's no real surprise that the narrative of the current financial crisis (e.g. "The Big Short") demonstrates the deficiencies in all these models and the manner in which they were deployed, as well as the (sometimes willful) lack of understanding of them amongst virtually all sub-prime debt market participants, regulators, intermediaries and advisers.
This poses an enormous challenge for the future development of markets for complex products. Better financial models, and better use of those models, won't avoid future financial crises. More rules and regulations cannot really be the answer, at least while they remain external to market participants and their transactions - and weakly enforced. Ultimately, we must either improve the knowledge of market participants relative to the complexity of products (through better education and training and/or by reducing the complexity of the products) or give regulators, or some independent creature - a more active role in transactions, if not as outright participants or potential participants.
Regulatory participation in transactions - or the threat of it - could be achieved partly through real-time transaction reporting from all significant financial markets, as is currently proposed in various initiatives around the globe. But that begs the question what the regulators will actually do with the transaction data.
As suggested in my previous post, perhaps adding short-selling to the regulatory repertoire would not only improve transparency and timeliness in dealing with market misconduct, but also provide regulators with a better feel for the limits in the models deployed in and around the financial markets.
As the ebbing economic tide exposes more and more fraud, it's striking to see how long the authorities have been aware of some problems before attempting to correct or publicise them. How are investors protected in the meantime? Shouldn't they be given a chance to cut their losses and switch to better investments as soon as problems are detected? Should new investors be compensated for transactions they would not have entered into had they been aware of the misconduct and/or a firm's diminished reputation?
A review of various accounting, debt and pension scandals suggests that, rather than banning short-selling "to protect the integrity and quality of the securities market and strengthen investor confidence", regulators would be more effective if they were to publicise their ownshort selling as a tool to identify and punish errant firms and companies and to promote market confidence.
Some recent, comparatively trifling, examples closer to home are also instructive. In May 2009, Aegon (then known as Scottish Equitable) informed the FSA of 300 "issues" amounting to £60 million of consumer detriment. Yet this was only presented to the marketplace on 16 December 2010, with a 30% reduction in Aegon's fine, from £4 million to £2.8million. In April 2010 various trading firms were fined £4.2 million, for failing to "provide accurate and timely transaction reports to the FSA." Yet only now are we told that:
"Each firm could have prevented the breaches by carrying out regular reviews of its data. Despite repeated reminders from the FSA during the course of 2007 and 2008, none of the firms did this."
While civil enforcement authorities tip toe around the edges of market problems, things are no better on the criminal enforcement side. UK judges are understandably reluctant to approve US-style 'plea bargains' that result in smaller fines and no admission of illicit conduct. A recent case in point was Mr Justice Bean's reaction to the tiny 'settlement' to emerge from the notorious BAE Systems saga.
Why all this regulatory timidity?
One justification for restraint, co-operation behind the scenes and discounted fines is that it encourages firms to report their own misdeeds rather than hide them - yet the misconduct does remain hidden from customers by the regulators. And informal regulatory discussions can be problematic. Witness the concern around the FT's report that UK banks' auditors may have factored assurances of government support into their opinions as to whether the banks were going concerns in 2008. Worryingly, the FT notes that "auditors are likely to be encouraged to have more private chats with regulators to help prevent another crisis."
"The authorities really don't know what do do about fraud when they discover it in progress... It seems the regulatory thinking... is that shareholders should not be punished for corporate fraud, because... they are the victims in the first place... This thinking may be politically expedient in the short term, but creates a classic moral hazard - a free fraud zone. If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies... If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said [and] allocate their capital more carefully. This sensitivity and other consequences will, in turn, deter dishonesty."
On the flip-side, as Sy Jacobs has observed (quoted in The Big Short) "Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people..." .
Regulators also often cite their own statutory boundaries as the basis for ignoring firms' extra curricular activities. This may be a good technical defence, but feeble given that the financial markets are inter-connected globally, can dwarf the regulated sphere and are populated by subsidiaries of regulated holding companies, as the New York Fed recently admitted in its report on 'shadow banking'.
The literature suggests that, firstly, short sellers think more deeply and critically than the financial authorities about the limits of the various models used in and around the financial markets. Perhaps this is because the short sellers' first instinct is to question the status quo, whereas the regulators first instinct is to support it. Secondly, once short sellers detect a potential anomaly, they investigate it with a view to trading - and so putting themselves at real risk - potentially over a long period of time. Whereas the authorities merely commence an investigation with the vague intention of possibly activating a more formal, lengthy investigation, which might eventually end in a fine or settlement without any admission of wrongdoing. So the short sellers' are driven by a strong sense of anxiety about being wrong, while the authorities are not really 'driven' at all.
Adding short-selling as a regulatory tool may be controversial. But it would enable regulators to learn the same disciplines as the most critical market participants, and remove the time lag and lack of transparency associated with civil and criminal actions. Publishing their short positions would also serve as an instant early warning of the underlying issues - and maybe pay for the ensuing enforcement activity.
It seems the US securitisation market is not the only one in which the purchasers of mortgage debt have enforcement problems. German portfolios are similarly vulnerable.
According to Philipp, the Federal Court of Justice of Germany (Bundesgerichtshof, BGH) has ruled (in XI ZR 200/09) that the Risk Limitation Act 2008 requires the loan purchaser to become a party to the original security agreement between the borrower and the original lender before it can lawfully exercise any immediate right of foreclosure in that security agreement. Merely taking an assignment of the agreement from the original lender is not enough. Unlawfully foreclosing will also render the loan purchaser directly liable for any damage suffered by the borrower.
Philipp suggests that "in most transfers of real estate loans for purposes of refinancing the acquirer has not joined the [original] security agreement."
