Slide 1

Wholesale Parliamentary Group on Wholesale Financial Markets & Services

Futures & Options Association Event, House of Commons
Breakfast Roundtable Discussion, Wednesday, 26 November 2014

Text of Professor Michael Mainelli, Chairman of Z/Yen Group

My daughter would like to be a design engineer.  She shared with me this morning a humorous poster - “The ark was built by amateurs; professionals built the Titanic”.  In professional services surrounding the financial crises since 2007 we've had our fair share of Titanics, and professionals, bankers, accountants, actuaries, analysts, just to get started.  

And our responses have been of two kinds.   One set of responses has been a set of speeches, nay sermons, on ethics and culture, often by bankers who seem to have found God at the same time as finding their pensions.  These speeches plead for more time to change culture, rather than dare to touch the industrial structure of banking, for example this week's report by Cass Business School and New City Agenda, "A Report On The Culture Of British Retail Banking", that pleads for just another generation to change.  No problem, we'll be done in 30 more years.  

Our second set of responses have followed the Titanic metaphor as we unleash a tsunami of rules and regulations. We have followed a path from 'too big to fail' to 'too big to manage' to 'too big to regulate'. We are trying to manage large, overly complex organisations through bureaucrats and lawyers.  The most recent similar experiment is possibly the economic mis-management of the Soviet Union.

We continue to miss the need to inject real competition into the industry of financial services.  We haven't done it in audit, in rating agencies, in wholesale banking, or in UK retail banking.  Adam Smith pushed for competition in banking back in 1776.  In “The Wealth of Nations”, he urged real competition: “By dividing the whole circulation into a greater number of parts, the failure of any one company, an accident which, in the course of things, must sometimes happen, becomes of less consequence to the public. This competition, too, obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away.”  I would draw your attention to my suggestion to this same APG back in February 2008, less than four months after RBS's collapse, and now some five and half long years ago.  In response to your questions about reform, I suggested completing the nationalisation of RBS, then privatising it in slices, e.g. RBS in 100 slices.  These slices could be restricted and go back a bit to mutuals or building societies, e.g. a portfolio of Newcastle loans and mortgages, a portfolio of Somerset loans and mortgages.  The early slices should be keenly priced, encouraging take-up, as was done in the mid-1980 privatisations.  The later slices would be equivalent to a "bad bank" or "toxic loan guarantee".  The resulting competition and change would have transformed the situation for consumers and taxpayers.  I dare you to tell me today that was poor advice.

However, there is also the need for competition in quality and standards in financial services.  Voluntary standards markets, such as the International Standards Organization (ISO) system, are found in many industries, from oil rigs to shipping to aircraft to fire extinguishers to lighting to computers.  A voluntary standard market is “a commercial system in which actual and potential buyers and suppliers of products and services rely on conformity assessments”.  Standards markets are very British, going back to the formation of the BSI during the need for standardisation of the railways.  Long Finance brought out a report last November, "Backing Market Forces: How To Make Voluntary Standards Markets Work For Financial Services Regulation", on how this approach could help financial services regulation, along with the BSI and the Chartered Institute for Securities & Investment.  We note that successful voluntary standards markets exhibit three characteristics:
  • there must be an open standard available to all;
  • standard development must be an open, structured, inclusive process involving interested stakeholders, a co-creation if you will;
  • conformity assessment - self-certification, second party or third party verification and certification - is essential, and the more rigorous the audit the better.

Note as well that there must be competition among the auditors, beneath a system of accreditation for the auditors.  Voluntary standards markets are a 'third way' between regulation and unfettered greed.  In our report we noted that the global shipping industry uses some 285 ISO standards, the complex food supply industry some 813, but financial services only 51, most of which are in SWIFT and other data transmission standards.  

The report notes three types of standards - people, product, and process.  On people standards, these are, in our opinion, already well-covered by various institutes and professional bodies.  That said, the Banking Standards Commission and Lady Susan Rice are doing more.

Our focus was on product and process standards.  There have been some good initiatives on product standards, such as FairBanking, already a United Kingdom Accreditation Service accredited mark for properly run financial products.  Other sensible initiatives include the Hedge Fund Standards Board trying to develop codes of conduct, or the Climate Bonds Initiative trying set out standards for what makes a bond truly 'green'.

On process standards, the regulators and we are missing some obvious ways of increasing competition yet ensuring quality.  For example, 'know your customer' and 'anti-money laundering' rules could as easily have been placed in more flexible and evolutionary voluntary standards markets, rather than codified into dusty regulatory volumes.  More technical areas such as modelling and stress testing standards are easily placed into voluntary standards markets rather than law.

Current discussions on index and benchmark processes are ideal for moving into voluntary standards markets.  A benchmark is an index (statistical measure), calculated from a representative set of underlying data, that is used as a reference price for a financial instrument or financial contract or to measure the performance of an investment fund. An increasing number, if not the majority, of financial indices and benchmarks rely for their creation on opinion, perception, and judgement of people in the market.  This is in contrast to indices compiled from analysis of historic transaction prices.  Some examples of “informed judgement indices” include LIBOR, the Baltic Exchange indices, potash or coal markets.  An index for such markets needs to find ways of ‘normalising’ a diversity of product and short-term adjustments, for example a lack of underlying trades at a point in time, or diverse product sources and destinations.  Such indices are important in helping to structure long-term contracts by providing a reference price around which trades can determine the apportionment of risks and rewards.  In an increasingly inter-connected world, these indices are relied on more intensively for both trade and finance.  In fact, one of the major public benefits of markets is presumed to be their ability to set prices.  Yet these indices are drying up as players don't want to risk providing a public benefit, so the gold fix is retreating and many other price providers are reconsidering what they do.  Without these prices many people suffer who are not participating in the core market.  They depend on a market setting prices for their reference prices around the world.

Informed judgement indices have weaknesses, ranging from the fallibility of human perception to the temptation to manipulate indices for financial gains.  In 2013, in the wake of LIBOR scandals, the European Commission proposed legislation and regulation to help restore confidence in the integrity of benchmarks.  ESMA has led on this.  However, little thought seems to have been applied to working out what distinguishes “informed judgement” indices from “historic transaction” indices, and how reforming them might be better conducted.  I contend that injecting the idea of using voluntary standards markets rather than regulation would help this debate enormously.

In closing, I urge you to consider more use of voluntary standards markets in financial services.  They have worked well in every other industry.  The special pleading of the uniqueness of professional services does not apply.  In fact, this third way between untamed behaviour and regulated oblivion is exactly what we need, and is a free market response to regulation.  I sought to close on a quote that combined politics and professionalism, so I'll leave you with these thoughts from Tina Fey, "Politics and prostitution have to be the only jobs where inexperience is considered a virtue.  In what other profession would you brag about not knowing stuff? 'I’m not one of those fancy Harvard heart surgeons.  I’m just an unlicensed plumber with a dream and I’d like to cut your chest open.'”  Voluntary standards markets are worth your considered examination.  Thank you.