A lot of the concern (and indeed anger) over income inequality has focused on the spiralling remuneration of senior executives, particularly in the financial sector. Although bankers and financiers have not been the only ‘top’ people to see their pay shoot up, the pace has been set in financial services, with executives in other sectors running to catch up. If we are to reduce income inequality we need to understand how it has been engineered. My central contention is that high levels of reward in financial services result from extensive innovation that has benefitted the innovators themselves more than their clients. The new regulatory regime therefore needs to focus on the source of the returns that allow big bonuses to be paid and on interventions to secure better value for the customers.
The purpose of regulation of any industry is to mitigate market failure. In theory, efficient markets meet the needs of well-informed consumers. In practice, markets are not always efficient and consumers are often not well informed. Some kinds of regulation are generally accepted, for instance to ensure the safety of electrical appliances, where consumers lack the expertise to discriminate. Regulation is also accepted where there are natural monopolies, such as the gas, electricity and water supply systems, or where there are barriers to entry and economies of scale that result in few suppliers, such as in telecommunications.
The financial services sector is subject to many kinds of market failure, more so than other sectors of the economy. Exploitation of market failure across a sector leads to public scandal, with payment protection insurance and Libor-fixing only the most recent instances of illegitimate behaviour. Even where conduct rules are not breached, a culture of exploiting market failures and inefficiencies for gain exists, some of which is legitimate (arbitrage) and some dubious (proprietary trading based on private knowledge gained from clients). The culture of exploitation exacerbates the impact of market failure, which might otherwise be quite modest.
Of course, when financial intermediation contributes to wealth creation in the wider economy, by channelling savings into productive investment and by helping individuals and businesses to manage their risk, high rewards can be justified. And there have been many innovations in financial services in recent years, a few of which have played a significant role in fostering economic growth, such as the contribution of venture capital to the commercialisation of new technologies.
However, as famously recognised by Adair Turner, chairman of the Financial Services Authority (FSA), many other innovations have been ‘socially useless’ (although he subsequently said that ‘economically useless’ would have been a more precise description). For example, financial innovation in bond markets has been a cause of instability and wealth destruction. It has also allowed for ‘economic rent’ extraction at the end customer’s expense. Rent generation and extraction leads, on the one hand, to excessive remuneration for agents and market-makers and, on the other, to higher transaction costs and thus lower returns for investors and pensioners.
Moreover, most hedge fund activity is zero-sum arbitrage that rewards fund managers for taking short-term positions, at the expense of both investors in those hedge funds and the generality of long-term investors. A similar cost to the economy arises from proprietary trading by investment banks and from investment in ‘new asset classes’ such as commodities and foreign exchange. In principle, there can be benefits from such activities in the form of deeper liquidity and price discovery, but in practice these benefits are subject to diminishing returns. To the extent that new investors do in fact make money, it is at the expense of long-term investors, consumers of commodities, and those needing foreign exchange for travel and trade.
The market failures that led to the financial crisis in 2007 have been extensively analysed and a range of responses have been identified; these are being developed under the umbrella term ‘macro-prudential regulation’. Eric Beinhocker and Tony Dolphin, in a recent contribution to Juncture, identified large-scale rent extraction by financial services as a serious problem. However, relatively little consideration has been given to tackling the misconduct which makes such wealth extraction possible. This will be the responsibility of the new Financial Conduct Authority (FCA). We need now to focus on the causes of and remedies for misconduct in the financial services sector, so that the FCA can perform better than its predecessor, the FSA, on this score.
Britain has witnessed a series of major, industry-wide, retail mis-selling scandals on the FSA’s watch, including endowment mortgages, personal pensions, split caps, precipice bonds and payment protection insurance. Eventual suppression by the regulator of one kind of mis-selling results in the appearance of another kind – the ‘waterbed effect’. We have also seen ‘creativity’ in wholesale markets, with more knowledgeable investment banks selling structured products – many of which failed to perform as predicted – to less-well-informed investors, including the pension and investment funds to which consumers entrust their savings. And there has been illegitimate manipulation for gain, of which the Libor scandal may prove to be the tip of the iceberg.
This shameful litany indicates that misconduct is systemic, not inadvertent. Its root causes need to be identified if a regulatory regime is to be effective. My contention is that the personal enrichment of employees though salaries and bonuses – which typically amount to half the profits of an investment bank – is likely to be the key driver.
Of course, high remuneration can be a legitimate measure of success in an industry whose business is money. And exceptional earnings provide insurance in the event of job loss from a crash, contraction or even personal misconduct. But the pay in the financial sector in recent years cannot be justified by these considerations. The financial services industry has locked itself into a feedback loop whereby excessive profits justify disproportionate remuneration that in turn demands yet bigger profits in order to meet expectations of yet higher remuneration – all at the expense of clients and shareholders.
A new regulatory regime
The regulatory response to market failure in financial services must therefore address the origins of the excessive profits. These arise in markets that are insufficiently competitive, as a result of opacity, myopia, complexity, oligopoly, asymmetry of information, and problems associated with principal/agent relationships. The consequence is rent-seeking behaviour, in particular the devising of economically useless products that serve no wider wealth-creating function, the unnecessary churning of portfolios to earn fees, and the marketing of useful products but with excessive charges. As an example of the latter, the UK Competition Commission reported that the 12 largest distributors of payment protection insurance made profits that yielded a return on equity of 490 per cent.
Top of the to-do list for the new FCA will be ‘promoting effective competition in the interests of consumers’. Some parts of the financial services sector self-evidently suffer from insufficient competition. As a result of a series of mergers over time, retail banking in the UK is dominated by just four major firms. The regulator needs to foster new entrants or, at the very least, not impede unreasonably those willing to offer consumers an alternative service.
Other areas of financial services have a larger number of firms but, even so, competition is ineffectual in achieving better outcomes for consumers. There are more than 2,000 investment funds available to UK retail investors; nevertheless, most put the bulk of their money into actively managed funds, which in general do no better than passively managed funds after allowing for higher charges. So another regulatory response is to require firms to disclose all costs borne by investors, as this would help consumers, advisors and commentators to understand ‘performance after charges’. More generally, there is a need to require greater transparency, for instance by requiring regulated businesses to publish information about their performance and shortcomings.
Regulators face a dilemma: whether to write extensive, detailed rules or to rely on high-level principles. In the past, the FSA has employed both approaches, and both are liable to evasion by rent-seekers. One principle that could be usefully incorporated into the regulatory regime is that of ‘fiduciary duty’. A fiduciary has a number of duties including: not to be in a situation where personal interests and duty of care to the client conflict; not to profit at the expense of the client; not to take advantage of information gained from the client; and generally to give undivided loyalty.
The fiduciary principle is a deeply rooted common law concept, although it is difficult for consumers to gain redress for breach because of the costs of going to court. One approach to ensure that consumers can avail themselves of their rights is to include the fiduciary principle within the regulatory regime. The US Dodd-Frank Act provides authority for the Securities and Exchange Commission to impose regulations requiring the application of fiduciary standards to advice and recommendations by broker-dealers and investment advisers to their customers. The Kay review of UK equity markets recommended that all participants in the equity investment chain should observe fiduciary standards in their relationship with clients and customers. The new legislation that will govern the FCA includes the general principle that those providing regulated financial services should be expected to provide consumers with a level of care that is appropriate, having regard to the degree of risk involved and the capabilities of the consumer. While this is a step in the right direction, it would have been better to refer explicitly to fiduciary standards.
More attention also needs to be paid to the regulation of wholesale markets. The general view has been that the professionals in these markets do not need protection. However, recent experience of the ‘alphabet soup’ of innovative offerings in bond markets indicates that those purchasing have less understanding of the risks involved than those selling – that the less astute ‘stuffees’ get stuffed by the more astute ‘stuffers’. The concern is that the former include the pension and investment funds where consumers’ long-term savings are placed. Indeed, Adair Turner has admitted:
‘In the past, it’s fair to say that the FSA did tend to assume that relationships in wholesale markets, for instance the sale of products to apparently sophisticated institution investors such as pension funds, should be governed largely by a caveat emptor, market discipline approach. But increasingly we are aware that at the end of the chain of wholesale institutional relationships there will typically lie a retail consumer – the pension fund policyholder for instance. And that shoddy wholesale market conduct is certainly not a victimless activity.’
Given the opportunities for fund managers to capture rents, rather than apply these to clients’ accounts, there is a good case to address the need for fiduciary relationships among customers, fund managers, advisors and product originators at a level which would better protect the consumer interest than the usual arms’ length approach by regulators. If there is a significant mismatch of capabilities between the parties to a given class of transaction, then the imposition of a fiduciary duty on the more capable party would enhance market efficiency and good conduct.
The fiduciary principle should also be of use to the regulator in ensuring ‘market integrity’. In the past, insider dealing in equity markets was not seen as objectionable; market participants provided each other with ‘tips’ on forthcoming price movements, on a reciprocal basis. Such insider dealing based on private knowledge is now a criminal offence. In contrast, however, it has not been an offence for investment banks to engage in proprietary trading in bond markets where they are both product originators and market-makers. The success of such trading depends in large part on private knowledge gained from transacting business for clients. The gains from such trading, in what is a zero-sum situation, are at the expense of clients with long-term needs, both as investors and as recipients of capital. In the US, the Volcker rule, enacted by the Dodd-Frank Act, is intended to restrict proprietary trading by commercial banks and is a particular application of the fiduciary principle.
If the interventions discussed here – increased competition, improved transparency and the application of a fiduciary principle – are insufficient to constrain rent extraction and excess remuneration, then the regulator needs a reserve power to act to limit charges if necessary to prevent detriment to consumers. The prospect of such ‘economic regulation’ would likely elicit shock and horror from the financial services sector. It is, however, employed in utilities regulation, both over the long term, in respect of charges for use of the distribution networks which are natural monopolies, and also initially, in respect of supply by the original, formerly nationalised industries, until the entry of competitors allowed price control to be abandoned.
The FCA’s strategic objective is to ensure that the relevant markets function well. To make prompt and effective intervention when market failure is suspected, the regulator needs to have a deep understanding of the business models of regulated firms, based on insight into the economic fundamentals of each market sector. An important analytical approach is to ‘follow the money’ through the food chain, both upwards from the fund management charges paid by investors and savers, and downwards from large bonuses, to see where excessive returns appear. Analysis of source and application of funds by market sector will suggest potential root causes of conduct risk. Such economic and business analysis has not been a feature of the FSA’s past approach, which focused on the symptoms of misconduct, rather than the root causes. The FSA used to say explicitly that it was not an ‘economic regulator’; it carried out little economic analysis, and indeed never appointed a board-level chief economic advisor, unlike other regulators and government departments. This was a serious mistake that the FCA needs to rectify.
Any regulator with the objective to ensure markets function well must address outcomes, including charges levied in relation to the costs of transactions. If charges are excessive then the regulator needs to act to constrain returns to shareholders and employees to a level which would otherwise be achieved by efficient firms in an effectively competitive market. The industry would object that constraining remuneration would result in firms moving to more permissive regulatory jurisdictions. On the other hand, such intervention would enhance the attractiveness to investors of the UK market by reducing transaction costs.
The financial services sector has grown substantially in recent years, with adverse consequences for the economy at large – too much talent has been taken up devising socially useless products that extract economic rent from short-run trading at the expense of long-run investment. The excessive rent-extraction has led to excessive profits that have in turn led to excessive pay. This is bad enough in itself, but top pay in the sector has also set the pace for top pay elsewhere, resulting in the growth of societal inequalities more widely. Better regulation of the sector is needed to bear down on market failure and on rent extraction and to restore financial services to its proper role of facilitating wealth creation and risk management in the economy at large. Success would lead to lower transaction costs, which would attract larger flows of funds from investors and savers, from both the UK and overseas.
A new regulator is shortly to come into being. But it is essential that this regulator is much stronger and more fearless in tackling the abuses of the sector it oversees than was the previous regime. The ‘Journey to the FCA’ consultation document recently published by the emergent agency points in the right direction, particularly in respect of the need to address misconduct in wholesale markets, but the extent of the FCA’s ambition is as yet hard to gauge. Announcing a comprehensive review of wholesale markets would provide a defining early initiative; this could build on the experience of the FSA’s retail distribution review, which was one of its more successful undertakings.
If the financial sector is to be brought to heel then it needs to be regulated by a watchdog that has real teeth. And for that to happen there needs to be strong political backing for serious reform. Political sentiment has shifted from unqualified admiration for the pre-crisis financial services sector to a much more jaundiced view currently. The FCA needs to recognise this shift in perception and act accordingly.