Themes and Trends in Regulatory Reform - Regulatory Reform Committee Contents


Memorandum submitted by Andrew Tyrtania

SUMMARY

    — Avoid rules—stick to principles.

    — Concentrate on competence.

    — Competence must extend from those who advise clients, to those in administration and ultimately and most importantly to those in control of the firms.

    — Competence must also be applied to those in regulation.

    — Regulators must monitor, communicate with and advise firms.

  I would like the committee to bear in mind the following when considering any proposed amendments to financial services regulations:

1.  RULES OR PRINCIPLES

  1.1.  The financial services market is by nature dynamic and inventive. London and to a certain degree therefore, the UK, relies on its dynamic nature to attract financial services firms. This same characteristic however, makes it extremely difficult to regulate by means of a system of written rules and regulations.

  1.2.  The principles-based approach is therefore, likely to be most effective in controlling and restraining risks in the sector, as principles do not need constant revision. To be effective, a principles-based system requires competent individuals within firms and within the regulator. I believe the current FSA training & competence rules to be lacking in ensuring that this is the case within firms. I also believe the current crisis to be the first real test of principles-based regulation and a wake-up call to the senior management of financial services firms that they have not properly understood and acted on their obligations under the Principles.

  1.3.  In some areas, rules are entirely appropriate. But they will only be effective where they are recognised, understood and enforced. The more rules we have, the less likely they are to be recognised. The more complex the drafting of the rules and the larger the rulebook becomes, the less likely they are to be understood. Where rules exist the regulator must be capable of interpreting rules, understanding the firms they apply to and of giving appropriate guidance to those firms.

  1.4.  I recently heard Vince Cable speaking at a debate organised by the Securities and Investment Institute, at which he called for "more rules". As one of the examples he gave to support his argument he cited the ludicrous multiples of income that mortgage lenders have been offering in the recent past.

  1.5.  Since the regulation of mortgage sales by the FSA in the UK there has been and remains a requirement (a rule) for the adviser to consider, and evidence, affordability.If this rule had been adhered to, no unsuitable mortgage offers would have been made in the UK. It doesn't matter what multiple of income is offered, or even whether the applicant is "self-certifying" their earnings. It's either affordable, or it isn't. Having the rule alone doesn't make the system work.

  1.6.  The existing FSA Handbook is enormous, complex, impenetrable and ambiguous.

  1.7.  I believe the Committee should encourage FSA to maintain the principles-based approach. Work should commence on a new rule book, structured in-line with the activities that firms must seek permission to carry out, rather than the "type of firm" approach that we have ended up with at present.

  1.8.  As firms develop and adapt, they change type, they adopt or develop new products and their risk profile changes.

  1.9.  There are so many rules that each firm must adhere to that the individual compliance officers rarely understand which rules apply to their firm, or to which individuals within their firm. As a consequence, employees are presented with huge and complex in-house compliance manuals—which they never read.

  1.10.  In creating a new principles-based and activity focussed set of rules, the new handbook must be simple, concise and precise.

  1.11.  Principles can be applied to any situation, but they require intelligent application. Intelligent application should be cited as best practice and set as a benchmark for others to aspire to or exceed.

2.  ADOPTING A COMPETENCE-BASED APPROACH

  2.1.  The present FSA Training & Competence regime focuses almost exclusively on those individuals advising Retail clients. Examination standards are set and must be attained. Competence must be regularly monitored and assessed.

  2.2.  Unlike threshold examinations, there is however, little guidance provided to firms on what makes an effective competence monitoring system. Some firms do it well—others poorly. So standards of competence vary. Some people may be technically competent, some may be consummate salesmen. Guess which become whistle-blowers and which get listened to.

  2.3.  Retail products tend to be less complex than those available between professionals, yet those who advise professionals, or those buying investments on behalf of professionals are subject to less or even no competence requirements.

  2.4.  As we go on up towards the ultimate management of a firm—they move further away from clients and further away from competence requirements. Is it any wonder we get directors who don't understand how their firms have got into difficulties, when below them are managers who don't understand what the whizz-kids in the front office are really doing.

  2.5.  Talking to the senior management about the risks in their firms we have a Regulator staffed by a body of largely lawyers and accountants, rather than experienced financial services practitioners.

  2.6.  The committee should encourage FSA to adopt a competence-based system of management controls, and to extend that system to all employees of the firm. The regulator itself should adopt those same principles, develop best practice and disseminate that throughout firms.

  2.7.  There are competence models that can be followed and they can be applied to anybody, at any level within any firm. They could even be applied to health service professionals or possibly even to those charged with child-protection issues!

3.  THE ROLE OF THE REGULATOR

  3.1.  As mentioned previously, the current crisis is a wake-up call to the senior management of financial services firms within the UK. Enforcement action may be necessary, but a witch hunt will be of little value.

  3.2.  The regulator asks firms to adopt "open and honest dialogue" with its regulator. Unfortunately the obligation is not mutual. When firms seek guidance on the interpretation or application of rules they are too often told "I'm sorry, that's for you to determine". As one grows old, hopefully one also matures. A mature approach when faced with a question you cannot answer is to admit that you do not know the answer. But the obligation doesn't end there.

  3.3.  Regulatory staff must be prepared, trained for and empowered to jump to the aid of firms asking for help. They should visit and work alongside firms to develop a mutual understanding of their business, the risks within it and to formulate systems and practices that the firm can adopt to meet the Principles and control their risks.

  3.4.  The incentives are mutual. If firms are better controlled, crises like the present one are less likely and businesses with better risk controls become less risky businesses and therefore attain a higher market value.

IN CONCLUSION

  Senior management often fail to understand how to control the risks within their businesses. They see rules as barriers and that culture trickles downwards from the top. Compliance is still too often viewed as a necessary evil and unwarranted expense.

  So compliance officers, many highly skilled and competent, sit between a workforce burdened with too many rules and a management that views them as an unwanted overhead.

  The FSA should use the current ARROW system to engage with management at all levels within firms. They should champion the empowerment of their own staff to help firms seek solutions to the industry's common problems.

  We do not need a radical solution or thousands of new rules, we just need the methodical application of common sense. If you do not understand something—don't sign it off!

My background and interest in the issues are as follows:

  I have been a practitioner in UK financial services since 1989, having operated under all of the regulators since the 1985 Financial Services Act, namely LAUTRO, FIMBRA, SFA, IMRO and FSA. I am poacher turned gamekeeper, now working as a compliance consultant to the asset management industry.

  Early on in my career I was exposed to the pre-regulation hangover of poor sales practices in the provision of retail financial advice and found these objectionable. This included being guided by the firm I first entered the industry with, to transfer a senior accountant away from his firm's employer pension scheme to a personal pension plan.

  I therefore, migrated to firms operating at a higher level of professional standards and acquired relevant industry qualifications along the way.

  I moved from personal financial advice into investment management, acting as both a private client discretionary investment manager and as fund manager for collective funds (broker funds and unit trusts).

  Prior to the problems in the split capital investment trust sector in the UK, I worked for a large regional stockbroker that was one of the top three players in split-capital investment trusts. One of my last activities within the firm was to edit and produce "The Investor Guide to Investment Trusts", a title taken over from S.G. Warburg. Within the firm my investment analyst, our investment director and myself had developed a system of analysing the shares of the split-capital trusts that properly illustrated their risks and potential returns and allowed us to provide predictable returns and to avoid the high-risk shares. We were invited to join the "magic circle" that existed within the industry, so that we would get the shares we wanted for our clients as long as we also took the shares that the issuers wanted to sell to us. We declined. No-one from that firm was ever called to assist the FSA with its investigations.

  At my previous employer I designed and implemented a risk-based system for controlling the investments entered into by portfolio managers on behalf of clients. It is not rules based, it does not limit risk by using numbers, it relies on assessing the competence of the portfolio manager to understand his client's needs, objectives and tolerance of risk, and to understand and properly utilise the investment he is considering. It allows for creativity and changing products. To date—it works.

  I have met and worked alongside investment managers and financial advisers both good and bad. Very few have been inherently bad people, but some have been ill-informed, uninformed or misguided.

  I recognise that you do not create a low-risk product by combining together many hundreds of high-risk mortgages. The best simile I can muster is that it's like trying to increase your chances of winning the National Lottery by buying lots of tickets, all with the same numbers.

February 2009







 
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