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.

What's The Beef?

Isn't it fascinating how quickly the FSA reacted to the faintest whiff of horsemeat, yet it's namesake was prepared to leave dodgy banking products lying around the shelves for years? 

And what a remarkable difference in crisis management there is between the average high street food retailer and the finance shop next door!

Seems to me the Treasury's hoping most Brits will prefer the taste of a beaten favourite. 

Dead Simple Financial Products

Little wonder that the UK Treasury is still trying in vain to persuade financial institutions to supply 'simple' financial services. The recent report shows that the government is relying on the same old players and the same old view of the marketplace to come up with the same old result. The challenge for new entrants will be whether they will be able to cut through the wall of spin and marketing noise to reach consumers with truly cost effective services that are adapted to their day-to-day activities.

The Simple Products Steering Group's recent interim report continues to view the financial services market through the lens of traditional products, providers and consumer segmentation. Its working groups are drawn exclusively from existing providers. The report refers to the so-called "mass market" and believes that simple products "should not be tailored to individual needs". It equates 'choice' with complexity. It seeks to balance “a fair deal” for consumers with “a viable commercial proposition for [existing] providers". Perhaps worst of all, for simple financial products to succeed the Steering Group believes “it is essential to improve the awareness and financial capability of UK consumers.” The report recommends two types of savings accounts (at-call and 30 days’ notice) and life cover. Apparently, millions of us will pile into these things on the basis of a little consumer education, a kite-mark, feel-good messaging and… certain choices embedded in default settings.

Hello?

If retail banks and life insurers were capable of delivering cost effective, useful financial services, there would be no need for the Simple Products Steering Group.

When will the authorities realise they’re flogging a dead horse?

As explained here, the route to simplicity and transparency lies in first understanding the complexity of the consumer problem being addressed, then figuring out the simplest, most consumable service that will solve it. That's the role of a facilitator. By contrast, those producing complex products are unlikely to be focused on the consumer's problem in the first place, let alone understand it - they're focused primarily on solving their own problems at consumers' expense. Trial and error, testing and learning, flexibility and adaptability are vital steps in this process. Yet our financial services framework is intolerant of them. A new service should be able to launch and undergo several iterations in the time it takes to get through today's authorisation process. Tiny factual differences have seismic regulatory implications in the type of permission or licence needed, and this adds to the time-lag and legal advice involved.

We must figure out how to make the process of decent innovation easier.

Image from Worth1000.

The Politics of Cash

Over on Tomorrow's Transactions, Dave Birch quite rightly questions the assertion in the NY Times that cash is somehow important to "protect our civil liberties by preserving some untraceable payment method." Few people are obsessed with anonymity. But at the same time Dave applauds the notion that "Cash-based economies harm the poor by heightening the risks they face when carrying money and fueling government corruption and inefficiency."

I should declare at the outset that I'm a great fan of electronic money and online financial services, and I advise various clients in the payments and online peer-to-peer finance space.  But I also believe that innovation doesn't 'kill' anything - the new must coexist with the old. Calling for the abolition of old services brings the laggards out in force, sometimes to comic effect. That's one reason you won't hear me calling for the end of fractional reserve banking.

But the 'death of cash' is not a question of civil liberties or somehow liberating the poor from a cash economy. Many people - the so-called 'unbanked' in particular - still see cash as the best mechanism for maintaining control over their finances. What some people see as higher prices for not paying online or by direct debit etc, others see as a wise investment in a payment method that prevents them spending money they don't have.

 

Research commissioned by the Financial Inclusion Taskforce found that the 3 million British adults without a bank account (the 'unbanked') do not consider themselves as disadvantaged by not having bank accounts, cheque books and debit cards. They do not see much use in an ATM, cheque book, credit card or debit card because they don't tell you your balance until it's too late. A text message confirming a payment you just made is laughable.

And if you don't find your bank or its services trustworthy or useful in the first place, why would you give them all your personal details so they can text your bank balance to your phone?

Most importantly, the same research found that most of the so-called 'unbanked' are actually in control of their finances. They put cash in specific jars to cover certain expenses. They can readily see at any time how much is in the jar, so they 'always know where they are' in setting money aside for energy bills and so on. 

I agree that loan sharks and others may prey on this form of financial control. But it's not as if access to a bank branch, internet banking or direct debit has saved the rest of us from financial charlatans or the erosion of civil liberties...

Long live cash, I say.

The Complex Job of Producing Simple Financial Services

There has been a futile tendency amongst regulators to view 'simple' retail financial services as merely 'basic' or 'vanilla' versions of existing products. And the Treasury's aspirations in this area have not improved, at least as of February 2012.

Perhaps ironically, the route to simplicity and transparency is much harder than producing a complex product that no consumer really understands. To produce a simple retail financial service involves first understanding the complexity of the consumer problem being addressed, then figuring out the simplest, most consumable service that will solve it. That's the role of a facilitator. By contrast, those producing complex products are unlikely to be focused on the consumer's problem in the first place, let alone understand it - they're focused primarily on solving their own problems at consumers' expense.

The path to simplicity involves disruptive innovation and critical thought to remove not only the complexity but also the intermediaries ('institutions') who've failed to solve consumers' problems cost-effectively to date. Trial and error, testing and learning, flexibility and adaptability are all key characteristics of this process. Yet our financial services framework is intolerant of them. In fact, a new service could launch and undergo several iterations in the time it takes to get it authorised by the regulators in the first place. Tiny factual differences have seismic regulatory implications in the type of permission or licence needed, and this adds to the time-lag and legal advice involved. We must figure out how to make the process of decent innovation easier.

Having waded through all this treacle to actually produce an innovative, simple product, there is then the challenge of explaining very simply how it works - and on a low budget. I recall Richard Duvall saying that £60m was spent on the launch of Egg, while the marketing spend dedicated to the launch of Zopa was £35k (though the phenomenal PR benefit from launching something truly new was priceless). But perhaps that isn't as much of a disadvantage as you might expect. While we see plenty of pointless, fluffy TV ads for expensive banking products, we don't see much marketing effort devoted to the 'basic' versions. As Professor Devlin found in his research for the Treasury, low fees and ease of switching has dampened traditional institutions' enthusiasm for creating and marketing simple stuff when there's so much money to be made from complexity and inertia.

At any rate, we need to celebrate the really simple, clear and transparent explanations of how our new financial services work. I've set out some examples below from my own experience. Some relate to services that are in beta or brand new, some established. To demonstrate the ability of TV journalists to explain things incredibly simply, I've also included just one piece of excellent coverage that removed the need for the business concerned to produce videos of its own.

Other top-tips on great explanatory clips are welcome.

Nutmeg




Abundance Generation




Elexu



Zopa



Funding Circle




PeopleFundIt

Who's Greg Smith and WTF is a "Structured Product"?

Another mysterious product warning

Yesterday came the 'news' that sales of "structured products" by investment banks to retail and small business customers have soared, in spite of FSA warnings about them. Today, in perhaps unrelated news, came Greg Smith's resignation letter from Goldman Sachs, where he was executive director and head of the firm’s US equity derivatives business in Europe, the Middle East and Africa:

"I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact." 

Which begs the question what a "structured product" actually is, and whether small business customers and their advisers had any idea what they were buying - or that they weren't supposed to be buying them.

The explanation of "structured products" at the official MoneyAdviceService is not terribly helpful (a general comment on the site that I've made before). We're told these products involve a 'note' and a 'derivative'. But under the bold heading "How Your Capital is Protected" it says rather ironically that:

"Even if a product offers ‘capital protection’ it can sometimes fail, causing you to lose some or all of your original money."

Oh come on, you say, the Money Advice Service?! Surely the global investment banks aren't going to be selling to 'Moms and Pops'!

But that's exactly the concern. I'm sorry, but just how sophisticated do you believe the average owner/director of an unlisted business really is when it comes to finance deals involving derivatives? One chap said his firm was sold "a £601,000 amortising, enhanced collar swap" and thought it had the same effect as a household mortgage. Yet businesses are being told to go to court against investment banks if they think they've been ripped off, rather than look to the regulator.

But does the regulator really understand these products well enough to be of any help? It seems to be speaking another language altogether. The first footnote to the FSA's industry consultation paper on the subject purports to explain structured products, but somehow I doubt the average banker would understand exactly what qualifies and what doesn't, let alone its customers:

"This publication deals with structured investment products (capital-at risk and non-capital-at-risk) and structured deposits.

We define a structured capital-at-risk product (SCARP) as in our Handbook i.e. as a product, other than a derivative, which provides an agreed level of income or growth over a specified investment period and displays the following characteristics:
(a) the customer is exposed to a range of outcomes in respect of the return of initial capital invested;
(b) the return of initial capital invested at the end of the investment period is linked by a pre-set formula to the performance of an index, a combination of indices, a 'basket' of selected stocks (typically from an index or indices), or other factor or combination of factors; and
(c) if the performance in (b) is within specified limits, repayment of initial capital invested occurs but if not, the customer could lose some or all of the initial capital invested.

A non-SCARP structured investment product is one that promises to provide a minimum return of 100% of the initial capital invested so long as the issuer(s) of the financial instrument(s) underlying the product remain(s) solvent. This repayment of initial capital is not affected by the market risk factors in (b) above.

We define a structured deposit as in our Handbook i.e. as a deposit paid on terms under which any interest or premium will be paid, or is at risk, according to a formula which involves the performance of:
(a) an index (or combination of indices) (other than money market indices);
(b) a stock (or combination of stocks); or
(c) a commodity (or combination of commodities)."

All clear then?
 
Image from HappyPlace.

Why The GIB Should Be P2P

In this month's Financial World, Michael Mainelli helpfully explains why the Green Investment Bank "supporters get a hard ride from City anlaysts." The problem, he says, is lack of independence from the government, especially since government policy on alternative energy is "capricious".

I like the "slightly subversive" suggestion for an index-linked carbon bond with the coupon set to the government's performance against its green energy targets. Although if the City won't gamble on government policy, we probably shouldn't let the government bet taxpayer money on its own performance either.

However, there is a way to encourage both broad-based retail investment and widespread household commitment to alternative energy without direct government support. Allow individuals to directly finance each other's alternative energy projects via a dedicated channel on any peer-to-peer finance platform - or, indeed, on dedicated peer-to-peer platforms. Credit risk would sit with individual lenders who are able to diversify across many projects and limit the amount allocated to each one, while earning a better return on their surplus cash than bank savings rates. The initial and ongoing capital requirements for each platform operator would be nominal, compared to the £3bn currently being contemplated for the GIB. And the transparency of online P2P platforms would enable easy measurement of the capital dedicated to alternative energy. In effect, the government would be leveraging its subsidies towards feed-in tariffs etc., not by borrowing on its own account through the bond markets, but by attracting surplus personal savings that currently lack a decent return.

As I've previously explained, this would also avoid the primary risks associated with the vertical credit model of existing bond structures, namely:

1. The separation of lender and borrower, and fragmentation of the original loan note makes it harder to adjust loans when borrowers get into trouble (as highlighted by the 'fraudclosure' and 'forced repurchase' problems in the US also explained in Confessions of a Subprime Lender).
2. The process of transforming 'maturity' (changing the date when loans or debt instruments are due to expire) creates balance sheet risk for the intermediary.
3. It is unclear whether ratings, accounting and audit functions really do remove information asymmetry between borrowers and lenders. Do we have "credible" ratings agencies, when only three dominate the market and they are paid by the issuers of the securities they grade? Similar problems exist in the accounting and audit markets - hence the calls for reforms in these areas.
4. There are huge challenges for subsequent bondholders to undertake adequate due diligence on large volumes of original loans long since disconnected from the bonds and often not even under the bond issuer's control.
5. Pressure to reduce the amount of capital required by each operator in the vertical chain of intermediaries results in a game of regulatory, tax, capital and ratings arbitrage that spans the globe and creates endlessly complex corporate structures.
6. Various factors lead to underestimation of the capital required for the private and implicit public sector guarantees required to support it. This is further complicated by the fact that "...the performance of highly-rated structured securities... in a major liquidity crisis... become highly correlated as all investors and funded institutions are forced to sell high quality assets in order to generate liquidity."
7. The knowledge that the market can ultimately 'put' problem securities on the taxpayer (whether this is explicit, implicit, direct or indirect) creates a moral hazard that seems to increase in line with the demand for the securities until the system irretrievably melts down.

Horizontal credit intermediation, is a feature of peer-to-peer finance platforms - like Zopa, Ratesetter and Funding Circle - where each borrower's loan amount is provided via many tiny one-to-one loans from many different lenders at inception.

The one-to-one legal relationship between borrower and lender/loan owner is maintained for the life of the loan via the same loan origination and servicing platform (with a back-up available), allowing for ready enforcement. The intermediary has no balance sheet risk, and therefore no temptation to engage in regulatory, tax or other arbitrage. Loan maturities do not need to be altered to achieve diversification across different loans, loan terms and borrowers. The basis of the original underwriting decision remains transparent and available as the basis for assessing the performance of the loan against its grade, as well as for pricing the loan on any resale or refinance, making due diligence by subsequent owners easy. To the extent that credit risk were to concentrate on certain borrowers or types of borrowers, those risks would remain visible throughout the life of the loan, rather than rendered opaque through fragmentation, re-packaging and re-grading. Similarly, the transparency of the initial underwriting and subsequent loan performance removes the scope for moral hazard.

Image from Carnation Canada.

Credit Where It's Due

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.


Image from Midnight Poutine.

Policy Fail? Simple Products And The UK Treasury

The UK's regulated financial services providers have failed to co-operate with various government initiatives to encourage the offering of simple financial products, according to a recent report by Professor James Devlin for the UK Treasury. He found that:

"The combination of a relatively low fee cap [1 to 1.5%], free movement in and out of products without penalty and the relatively low level of funds invested by many users together represented a formidable barrier to enthusiasm from the industry for previous “simple products” (Devlin, p.4)

The lack of simple regulated financial products affects virtually the entire UK population. The primary target may be those people earning low to medium incomes, and those with little financial services experience/expertise/interest and/or limited savings (Devlin, p.10). But people earning higher incomes (over £30k) include themselves in the target market because they would most welcome "standards which show when a financial service offers customers a reasonable deal" (Devlin, p.14). The Treasury also notes in the accompanying consultation on simple financial products, that 48% of UK households have less than a month's salary in savings, and 27% have none at all (para 2.13).

When launching the Retail Distribution Review of financial advice in 2006, the FSA claimed that "insufficient consumer trust and confidence in the products and services supplied by the market lie at the root of what we are seeking to address." And while Professor Devlin cites recent research to the effect that trust in financial service providers is "not significantly below" supermarkets, mobile phone providers and the NHS (Devlin, p.16), that's not saying very much. Investments, pensions and securities are the least trusted consumer services across the EU. Only 34% of consumers think they deliver what's promised, 26% of us are as likely to trust investment providers as used car salesmen, yet 76% of us don't bother to switch providers. What would be the point?

Faced with regulated financial services providers' continuing refusal to supply suitable investment, pension and savings products at reasonable prices, you'd think the government would directly question the structure of all the providers and their products. After all, similar proposals for 'vanilla products' are afoot in the US (and meeting strong resistance from providers, of course (Devlin, p.31)). Instead, however, the UK government has meekly decided to avoid simple investments altogether and focus solely on simplifying "deposit savings accounts" and income protection insurance:

"Although the Government believes that the principles of simple products are widely applicable, it also believes that, initially, simple products should focus on products that do not carry risk to capital, i.e. that are not investment products. Risk would add an extra level of complexity to the product design, as the design would have to weigh up how much risk individuals are willing to bear, both in terms of capital risk and risk to gains."

Hello?

This astonishingly narrow focus fails on at least four counts. First, and most obviously, it shies away from the key challenge facing the consumer: the lack of simple investment products. Second, it means the government won't enable us to diversify at a reasonable cost. Third, it encourages us all to put our money in the banks for little or no interest, leaving us exposed to inflation that continues to hover well above base rates. Fourth, given the banks' reluctance to lend their deposits due to capital constraints, these proposals inhibit the efficient allocation of our surplus cash to creditworthy people and businesses.

While initiatives to improve financial advice are helpful, good advice does not equate to simple products. The glacial Retail Distribution Review, launched in 2006, will only alter compensation for financial advisers from the end of 2012. Full advice will be fee-based and beyond most people. While advisers are "considering" developing a simplified advice model that might provide a "limited sales route", they're worried that if the investments do not perform customers may claim they thought they were given full advice which proved to be wrong (Devlin, p.26). I wonder why?!

In response to the sound of dragging feet, the government recently commissioned the Consumer Financial Education Body to develop a "free and impartial national advice service":

"It will not give regulated advice, but it will provide people with information and advice on all major areas of money and personal finance. A key component of the national financial advice service will be a financial healthcheck, that will provide people with a holistic review of their finances, highlight areas to prioritise, and give people a personalised action plan to take forward. The service will move as close to the regulatory boundary as possible to ensure that people have a seamless journey between the national financial advice service and regulated advice, should they need it. To this end, CFEB is exploring the possibility of providing generic product recommendations, for example 'you should consider purchasing home contents insurance'." (HMT, para 4.3; see also Devlin, p.29))

You mean home contents insurance is an investment? In what, burglaries?

That little gem aside, the "Moneymadeclear" web site may help improve the knowledge of someone who already has a basic understanding of the various types of financial service. But it won't help anyone to actually decide on a suitable product, or render products 'simple'. Which is surely the point.

A little sunlight may penetrate via the "key investor information document" introduced at EU level to enable easier comparison of the key terms of multiple products. Professor Devlin also suggests that strong warnings on products that do not meet "simple product" criteria (Devlin, p.5) and a traffic light system to declare the risk associated with products (Devlin, p.27) would help people choose suitable products. He has urged the government to retain rule RU64 that obliges a financial advisor to explain why any alternative product being recommended is at least as suitable as a simple product. He found that this rule led product providers to reduce fees for more complex products to make them at least as suitable (Devlin, p.22).

For now, however, we're stuck with expensive, complex regulated financial products.

Like... the Kickout bond! ;-)