8 Financial Services Policy Requests - Election Edition

If you've been lumped with the job of writing your party's General Election Manifesto, here are 8 financial policies to simply drag and drop:

1. Remove the need for FCA credit-broking authorisation just to introduce borrowers whose finance arrangements will be 'exempt agreements' anyway - it makes no sense at all;

2. Remove the need for businesses who lend to consumers or small businesses on peer-to-peer lending platforms to be authorised by the FCA - again, it makes no sense, because the platform operator already has the responsibility to ensure the borrower gets the right documentation and so on; an alternative would be to allow such lenders to go through a quick and simple registration process;

3. Remove the requirement for individuals who wish to invest on crowd-investment platforms to certify that they are only investing 10% of their 'net investible portfolio' and to either pass an 'appropriateness test' or are receiving advice - it's a disproportionately complex series of hoops compared to the simplicity of the investment opportunities and the typical amounts at stake;

4. Focus on the issues raised in this submission to the Competition and Markets Authority on competition in retail banking, particularly around encouraging a more diverse range of financial business models;

5. Re-classify P2P loans as a standard pension product, rather than a non-standard product - the administrative burden related to non-standard products is disproportionately high for such a simple instrument as a loan;

6.  Reduce the processing time for EIS/SEIS approvals to 2 to 3 weeks, rather than months - investors won't wait forever;

7.  Reduce the approval time for FCA authorisation for FinTech businesses from 6 months to 6 weeks; alternatively, introduce a 'small firms registration' option with a process for moving to full authorisation over time, so that firms can begin trading within 6 weeks of application, rather than having to spend 3 months fully documenting their business plans, only to then wait 6 to 12 months before being able to trade - others entrepreneurs and investors will stop entering this space;

8. Proportionately regulate invoice discounting to confirm the basis on which multiple ordinary retail investors can fund the discounting of a single invoice - it's a rapidly growing source of SME funding, simple for investors to understand and their money is only at risk for short periods of time.

Towards A Diverse, Sustainable Financial System

It's not every day you get to brainstorm ways to bring diversity and sustainability to Britain's ailing financial system amidst a broad cross-section of officials, economists, entrepreneurs, think-tanks, technology suppliers and advisers. And yesterday's Finance Innovation Lab workshop was a golden opportunity to do just that.

While the Lab will report the output in due course, I thought I'd share a summary of my notes from the breakout sessions in which I participated. These looked at regulatory barriers and lack of financial awareness. Others explored the unfair advantages enjoyed by estalished providers and ways to encourage innovation. We operated under the Chatham House Rule, hence the absence of names or affiliations.

The UK financial system is neither diverse nor sustainable. 

There is plenty of evidence that the UK's financial system is suffering from a lack of innovation and competition, and is unsustainable in its current form. Rates of market entry and exit are low, relative to other industries. Few customers switch and customer trust is lowest for financial services on several leading surveys. The unit cost of intermediation remains high in financial services compared to other retail markets, while management and staff have reaped the benefits of any increased operational efficiencies (even while legacy systems remain prevalent). Banks rely on a huge back-book of deposits on which they pay little or no interest to finance loans to fund trading in financial assets rather than loans to productive businesses. After all, a single giant property loan does more to grow the bank's numbers than lending the same amount of money to thousands of small firms. 

Regulatory barriers

 

Against this background, we concluded that the current regulatory framework, including subsidies and incentives, is essentially designed to both protect the 'financial system' and 'customers' - i.e. to minimise the risk that consumers and small businesses, in particular, will be mis-sold 'products' by unscrupulous suppliers. 

In effect, however, that framework obliges policy officials (Treasury) and regulators (FSA) protect the system as it is, rather than to ensure that it evolves to encourage and accommodate innovation in line with customer requirements. That's because the framework and those who police it are organised in silos according to existing product types and types of suppliers, and not according to types of customers' and their day-to-day activities. 

The customer protection regime mirrors this approach, being organised according to limited sets of product types and types of suppliers, as well as types of promotional and business activities in which suppliers are engaged (not their customers). As a result, the impact of regulation, complaints and potential for changes are all viewed through the lens of existing products and firms, and any actual changes reinforce those lines of distinction. 

The perverse nature of this can be seen in the fact that, if I want to allocate £100 to a project that I'd like to support, it's easiest for me to donate the money, a bit more complex if I want the money repaid with interest (as a loan), very complex if I want to be able to freely trade that right to be repaid with interest (a bond) and the most complex thing of all is to receive an equity share in the project. This discourages diversification and the search for opportunities to get a decent return on surplus cash; and limits the availability of funding to new businesses, on which most new jobs depend.

Hard-wiring the markets according to types of products, suppliers and ways of dealing with them also artificially limits the number and range of suppliers, product types, and the corresponding markets. In addition, taxpayer guarantees and subsidies in the form of savings and pension incentives are aligned with existing regulated suppliers and product types. Therefore, the regulations and incentives work together to enable the suppliers in the regulated markets to charge higher fees, make higher margins, reward staff more generously and pay more for marketing - resulting in less innovation and competition.

The overall result is a financial system that is not designed to evolve in line with the requirements of consumers, small businesses or even big business. It is designed to suit incumbent suppliers - those who play well with the system, regulators and policy officials. Yet there is no single set of policy officals or regulators tasked with understanding how the regulations, subsidies and incentives actually work together as a whole or whether they distort any aspects of the financial system within or outside the regulated areas.

A broad range of solutions were suggested, as you can imagine, and the Lab will report on these shortly, and include them in a submission to the Parliamentary Commission on Banking Standards. However, suggestions included: 

• creating a Parliamentary Select Committee to focus on encouraging financial innovation;

• limits on market share by product type;

• controls on gross leverage; 

•  separate banks' credit creation process from financial intermediation (the process of allocating that credit);

• central bank guidance to banks on how much to lend productive firms;

• levelling the playing field on subsidies and tax incentives/allowances;

• a target of 200 new local banks by 2016;

• publishing details of national banks' regional/local banking activity;

• making it easier to get low risk financial businesses authorised;

• publishing the amount of the subsidies to major banks and oblige them to set aside a proportion of their subsidy for future crises;

• treating payments systems and credit reference data as utilities (i.e. public goods).

Lack of financial awareness

The scale of financial mis-selling across many different types of products and lack of diversification by investors suggests a widespread lack of understanding of financial services. This was seen to be caused by a lack of financial education, on the one hand; and by product complexity on the other. In turn, product complexity is driven by both regulatory complexity and an unwillingness to invest the extra effort required to simplify products and better align them with customer requirements.

The lack of financial education is essentially a failing of our education system. Yet there is little faith that the Department for Education accepts any responsibility for delivering a sound financial education. It's also clear that no other government department sees this as part of its mission. Rather, financial education seems to be a specialist area confined to universities and business schools or professional bodies. It was felt that this will only change with a determined effort by the Department for Education to measure financial 'literacy', collect best practice for teaching it and including those measures in the national curriculum. Measures of success would include improvements in financial literacy exam results, fewer complaints to the Financial Omudsman Service and improved diversification amongst savers and investors.

Removing product complexity requires a commitment to reducing regulatory complexity, the removal of the regulatory barriers to innovation and competition discussed above, as well as incentives that drive both simpler products and diversification, rather than the concentration of funds into a few regulated asset classes.

In short, more pragmatism and less politics should go a long way.

The Enemies of Growth

The Economist article on The Question of Extractive Elites certainly resonated with me last week, as it did with those involved in the subsequent discussion on Buttonwood's notebook. It's another way of looking at the difference between 'facilitators' and 'institutions'.

In “Why Nations Fail: The Origins of Power, Prosperity and Poverty”, Daron Acemoglu and James Robinson, suggest "extractive economies" experience limited growth because their institutions “are structured to extract resources from the many by the few and... fail to protect property rights or provide incentives for economic activity.”

"Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will be ulimtately short-lived."

Acemoglu and Robinson place certain 'third world' economies into the "extractive" category, but place the developed world into an "inclusive" category on the basis that their institutions tend not to be extractive. But as Buttonwood notes, there are elements of developed economies that fit the description of extractive economies, citing banks and the public sector as the most likely candidates - although I would add the institutions that comprise the pensions and benefits industry as another example. And we should define "public sector" quite broadly to include political parties, unions, quangos and so on.

These extractive institutions tend to be linked, since the public sector is not only capable of extracting resources in a way that starves business or crowding out private investment, but it is also responsible for regulating the private institutions that are themselves extractive.

As previously discussed, high levels of public spending and national wage bargains are partly to blame for throttling the UK economy and preventing the development of manufacturing, particularly in regions which struggle to capitalise on the lower cost of living to keep wage costs down. The tax and regulatory framework favours banks and regulated investment institutions over new entrants. 

The current UK government is trying to spend less, but it's refusal to regulate means extractive frameworks are not being overhauled. Of course there is a danger that the new entrants seeking a level playing field may be tomorrow's "extractive institutions". But that would at least imply significant creative destruction in the meantime. Ideally the rise of "extractive institutions" would be kept in check by more dynamic regulatory intervention, but future overhauls may be required.  

That is the politicians' job. But they, too, have a tendency to be the enemies of growth.

Are ISAs "Safe"?

I'm having lots of discussions with mainstream policy folk at the moment, and it's striking that they perceive money invested via tax-free Individual Savings Accounts as somehow 'safe'.

This is somewhat true, up to the limits of compensation scheme protection. But only if you ignore the enormous direct and indirect costs of the bailouts required to deliver that protection, not to mention the fact that ISA cash earns 0.41% interest after 'teaser rates' expire, and investment returns after management and dealing fees may be slight (as we've learned in the pensions market). 

Even worse, your ISA money can't be properly diversified because you can only invest it in a limited range of regulated asset classes. So the government is both incentivising you to invest narrowly, and disincentivising you from putting your eggs in the full range of potential baskets.

But worst of all, like much of the money in the regulated system, the £350bn in total ISA money is 'dead' - propping up bank balance sheets and generating mutual fund fees - rather than working capital in the hands of creditworthy people and businesses who need it.

So it's high time that policy makers re-aligned the ISA tax incentives with the day-to-day activities of people and businesses. We urgently need to expand the range of asset classes within the ISA scheme, using proportionate regulation where appropriate.

Image from the Building Societies Association.

No Mandate To Offer Better Public Pensions

Where is Cameron's mandate to offer public sector workers better pensions than the private sector?

Gordo raided the private sector pension pot years ago, as the Tories rightly pointed out in their election campaign. The unions, of course, had no problem with that, since they are the beneficiaries of Labour Party porkbarrelling. And economic crisis has mean that private sector workers have known for the past few years they can never retire.

The public sector needs to understand they can strike all they like. The world has changed.

Referenda seem popular at the moment. Perhaps we should have one to decide this issue?

Never Retire

Pensions are underwater

It will be fascinating to see if we get real transparency and competition in pension provision, now that the vast horde of public sector staff can no longer rely on the taxpayer to fund a nice, cosy retirement.

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...

The corporate pension deficit stands at £362bn, directly affecting 12m people. And while all sorts of indexing and accounting tricks changes will be used to reduce the impact on company balance sheets, that won't translate into pension incomes for employees.

And there's no reason that the public sector will fare any better, absent the taxpayer safety net.

Image from Early Retirement Today.

Sunlight On Pensions

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.

Add that level of transparency to the focus on improving administration and record-keeping, and we should see some more pension scandals come to light in 2011.

What fun!

Next job: fill the black hole.