Long Finance: Implications For Compliance

By Professor Michael Mainelli
Published by www.powerchex.co.uk

[An edited version of this article appeared as "Long Finance: Implications For Compliance" in Powerchex, within their articles at www.powerchex.com]

Comliance or Collapse?

The two big themes of our times are globalisation and sustainability, space and time. Globalisation makes you think about equitable dealings across the world. Sustainability makes you think about future generations. Commercial transactions and money are inextricably linked to trust in the community. Each transaction with another person links us just a little bit more to the other person’s societal mores, them to ours, and both of us to the future. This leads to my Zen koan - “If you have some trust, I shall give you trust. If you have no trust, I shall take it away from you.” Shouldn’t the ultimate goals of compliance be to help ensure equitable dealings and sustainable commerce? Does compliance balance trust across space and time?

Less than two score organisations were at the centre of the Credit Crunch - all of them with compliance officers. In a global economy of approximately $55 trillion GDP Professor Niall Ferguson notes: “By the end of 2007, 15 megabanks, with combined shareholder equity of $857 billion, had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion - an aggregate leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion - more than a third of the total.” [“There’s No Such Thing As Too Big To Fail In A Free Market”, The Telegraph, 5 October 2009] All 15 served by four auditing firms and three credit rating agencies. Yet there was a point in 2008 when it was rational to believe that the global wholesale financial system might fail. The US mortgage market, an intensely concentrated market focused on Fannie Mae and Freddie Mac circulating around AIG, had collapsed. In turn, three highly concentrated retail financial markets, those in UK, Iceland and Ireland, were on the verge of collapse late in that year. Then Bear Stearns, then Lehman Brothers disappeared.

The UK has a special set of problems, not least because it wants to continue to be a vibrant international financial centre. Our firm has been studying global financial centres since 2004, most notably in our Global Financial Centres Index, where London’s decade long lead has been shaken. What queers UK debate about the crisis is that when people talk about the Credit Crunch and the City, they confound the global investment banking near-collapse with the systemic UK retail near-collapse that took down Northern Rock and HBOS, and later Lloyds TSB, with RBS a casualty of both global wholesale and UK retail. London seems a tragic hero - it lost its own principles of open markets in oligopolistic pursuit of quick bucks that the rest of the UK has been all too happy to spend.

So, were compliance officers doing their job? Would better compliance have helped? Before we leap to self-serving conclusions that more compliance would help, as well as create more compliance jobs at presumably higher pay (no need for bonuses), let’s move on a bit.

Too Big To Fail Is Too Big To Regulate

Politicians have, naturally, been caught between sophistication and simplism, and often fallen for the latter. Early on Gordon Brown blamed the foreigners. It must have been the unprecedented collapse of the US housing market that unfairly affected UK banks, starting with the run on Northern Rock. However, that explanation quickly faltered when it became apparent that, not least because of poor supervision by the Financial Services Authority, Northern Rock had an unsustainable business model relying on capital market funding rather than capitalisation. Politicians then tried to blame the offshore centres. These culprits too failed to deliver as it became clear that core investment banking had melted down, and that little of RBS’ or Lloyds TSB’s failures could be blamed on offshore tax havens. If Washington DC were declared an offshore haven that would at least explain the collapse of Fannie Mae and Freddie Mac. Within the EU blaming foreign speculators is still a popular, though transparent, political tactic. Now bankers bonuses and hedge funds take the brunt, while the three credit rating agencies’, despite their total failure to do their job, shuffle in, and then out, of the frame, quickly followed by four global auditing practices scuttling along behind who conveniently shrouded their waste of time and money on financial services firms’ audits with an over-the-shoulder cry for more auditing.

We have cries for “more regulation”, of nearly every, and often contradictory, sorts - never mind the quality, feel the width. However I contend that no institution should be allowed to become “too big to fail”. One can add “too interconnected to fail” and, in the case of a couple of the investment banks, probably “too influential to fail”. Too big to fail is too big to regulate. In the UK, Northern Rock was 20% of new mortgages, and Lloyds TSB a mighty 32%. Today just six lenders are 78% of mortgages while just three banks are 65% of personal current accounts. In all the UK has around 100 active retail financial institutions. If the UK had a retail financial market with numbers comparable to Germany or the USA, it might have anywhere from 1,200 to 1,800 retail financial institutions. Ironically, in 1910 the UK had 1,723 building societies. Today the UK has 52.

There has been a tendency to blame “free markets” and perhaps this has some strict justification, but the truth is that we had markets that were neither free, nor open, but encouraging oligopolies. From the beginning Adam Smith recognises that markets must be open and competitive, not just free. Anti-monopoly and anti-trust legislation exist to keep size under control. Yet the legislation is either unenforced or poorly applied when we have a dozen banks controlling global wholesale markets and handfuls of banks in some countries controlling local retail and commercial markets. How demeaning that it fell to Neelie Kroes, the EU competition commissioner, to decree that RBS and Lloyds TSB ought to shrink a little as a punishment for state aid to the sector, not to the UK Competition Commission or Office of Fair Trading. In fact, onerous compliance requirements impede better competition in finance.

Professionally Advised Into Collapse

There are numerous professionals whose very profession means that they are almost wholly involved in finance - accountants, actuaries, risk managers, securities traders, investment professionals, chartered financial analysts - all with their professional bodies and letters. There are numerous professionals from lawyers to engineers who have chosen to work in finance. As people involved in compliance, we should be asking whether these professionals reduce risk or increase risk.

Long ago I developed an intelligence versus integrity balance test. In a dodgy or seemingly hypocritical situation, such as “I was not fully aware I was taking a bribe”, the subject can either be very intelligent in the way he or she wriggles, and thus demonstrate a complete lack of integrity; or people shall assume the subject has high integrity though innocently strayed, but clearly lacks intelligence. It’s tough to balance in the middle. And Graham Greene knew which was worse: “Our worst enemies here are not the ignorant and the simple, however cruel; our worst enemies are the intelligent and corrupt.”

Her Majesty, Queen Elizabeth II, visited the London School of Economics in November 2008, and inquired why had nobody noticed that the credit crunch was on its way? The British Academy felt compelled to respond to Her Majesty and create a little hole of calm reflection:

“Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. What matters in such circumstances is not just to predict the nature of the problem but also its timing. And there is also finding the will to act…” <align="left">
[British Academy public letter to the Queen, 22 July 2009 - http://www.britac.ac.uk/templates/asset-relay.cfm?frmAssetFileID=8285>]

Just doing our job. It’s fairly clear that the professions either failed to see it coming or individuals within the professions saw the credit scrunch coming and took the money while they could. Yet, leaving Bernard Madoff to one side, I know of no professionals in their professional institutes’ dock for the credit scrunch. No disciplinary hearings on the credit scrunch. No professionals struck off their institutes’ registers. So then the institutes must be at fault. Their members are innocent, having followed their principles and codes of ethics along with executing their professional skills perfectly. Leading to an uncomfortable implication that, perhaps, the great edifices of accounting, auditing, actuarial science (ahem), risk management and financial analysis are the shams. The professionals are following mystical alchemical rituals that have failed to bring the rains or revive the blighted crops.

In my opinion, if the professions don’t want to be weighed and found wanting on an intelligence versus integrity balance, then each one of them needs to conduct a review of the fundamentals of its own professional practices. Accountants to challenge fair value. Auditors and actuaries to study confidence accounting. Risk managers to incorporate leptokurtosis or quit. Financial analysts to remove their biased interests. Lawyers to see why all this expensive governance hasn’t recompensed a single loser. Perhaps we professionals lack the imagination to rethink our professions. Or perhaps we just don’t know our place. In my opinion, if the City-based professions don’t want to be weighed and found wanting on an intelligence versus integrity balance, then each one of them needs to conduct a review of the fundamentals of its own professional practices. And compliance people too need to ask why they didn’t seem to do much for the longevity of the system in which they worked.

Get A Sense Of Long-Term Perspective

It surprises me that despite the biggest crash in our lifetimes I’ve heard few good questions. Indeed I hear the worst one repeated again and again, “When will things return to normal?”. The question I think we should all be asking far more stridently is “When would we know our financial system is working?” The answers might be like this: “When a 20-year-old can responsibly enter into a financial structure for his or her retirement”, or “When investors can safely fund a 75 to 100 year forestry project.” On this basis, the financial system has never been working. Such a question raises a host of related issues. The question draws in actuaries, accountants, life insurance, savings, investments, security, fraud, risk, returns and firm defaults.

What to do? Workers in the City of London do have a conscience. A number of us started a Long Finance (www.longfinance.net) initiative which has already published reports on the Eternal Coin and long finance mortgages. We have other reports in train, for example on pensions and present value analysis. Present value and discounted cash flow are perfectly sensible concepts, yet often have horrific unintentional consequences - so how do we replace it or improve upon them?

One straightforward reform for financial services, obvious but lacking political energy for unexplained reasons, is to break up the big four audit firms. In consequence, audit may become more expensive, though it would be interesting to then require audit firms to provide an indemnity for these expensive opinions. A second straightforward reform would be to remove any special status from credit ratings in regulation, e.g. Basel agreements, with the consequence that the big three may wither away. The third, and biggest, obvious reform is to create competition in wholesale and retail banking, to which end breaking up the banks is a fundamental step.

Incredibly, despite major failures, the Credit Crunch has not been crisis enough to jolt radical reform of finance, yet. In the popular parlance, we seem to be ‘wasting a good crisis’ rather than restructuring financial services to serve society. We need to think more boldly about bold reforms. Along the way, we need to reform compliance to work for the long finance.

[An edited version of this article appeared as "Long Finance: Implications For Compliance" in Powerchex, within their articles at www.powerchex.com]