Why Regulate?

I recently watched the movie “The Big Short” which is about a few traders who actually predicted that the US housing bubble was going to burst and that the collapse of the sub-prime mortgage market was inevitable. These traders used financial instruments (mainly credit default swaps) to bet against the market and the major banks – which as we all know now, was a very profitable thing to do in the end.

The reason I opened with a reference to this movie is not to get into the merits of how they profited from the situation but to highlight a point that struck me the most while watching it. In the move the actor Steve Carell plays hedge fund manager Mark Baum who appears to be on vendetta against the big Wall Street banks who he describes are nothing but crooks. At first the character thinks that the big banks do not have a clue what they are doing and that they are being naïve by not recognising the problem and continuing to deal in sub-prime mortgages which are literally worthless. But at the end he finally comes to the realisation – which now with the benefit of hindsight is quite obvious to see – that the big banks knew exactly what they were doing and what’s more, they knew that they would have to be bailed out since they were too big to fail. So they deliberately made as much profits as possible until they would reach the point of no return and have the tax payer bail them out.

This notion that the banks know that they are too valuable to the financial system and that bank failures would be devastating on any economy puts them in a particularly advantageous position. In more technical jargon we would say that it creates a moral hazard situation. This is the main reason why the financial sector is so highly regulated. Thus, many would agree, especially many small investors who do not trust the big banks and believe they need to be protected from them, that regulating the banks and other financial services practitioners is very important. The more regulated they are, the better they would argue.

But…

Could too much regulation actually leave investors worse off?

More specifically, could the small retail investors that the politicians and policy makers so heroically swear to protect against these big bad financial practitioners, end up worse off?

Let us start with reviewing a bit the EU investment services rules since in Malta we are subject to the same/similar regulations & directives. So in 2007 we saw the introduction of the Market in Financial Instruments Directive (MiFID) which introduced much more pro-consumer rules and put much more onus on the service providers. What this means is that investment service providers had to start recording much more data in order to ensure that they were abiding by the many more procedures and regulations that had been introduced. This in turn lead to much more forms to be filled in and checks to be put in place to ensure that the sales staff were actually adhering to the rules and not putting the company they work for at risk of breaching any of them.

On the whole this is obviously a good thing since it ensures further that the investment service providers are acting fair and responsible in carrying out their business. At the same time, this increased regulation comes at a cost in the form of time and money that investment services firms have to spend per transaction. Furthermore, such firms also have to assess the risk and reward of entering into transactions with clients. Are the various risks of selling this product to this client worth the compensation that the company is earning?

In most cases the highest risk is when dealing with the smaller less knowledgeable investor, who is also the same investor that will generate the lease return for the service provider. So it is quite common for investment firms to exclude certain investors from certain products based primarily on the higher risk such investors pose. This in turn will leave these investors with lesser choice and higher concentration risk since they will only be offered a small choice of investments. So regulations that had the aim of protecting investors could actually be leaving them worse off by excluding them unnecessarily from certain investments. What is even worse is that such investors, who are the ones who would need investment advice the most, could be shun away altogether from investment advice due to the higher risk of offering investment advice to them.

You may think that I am exaggerating a bit here – which firm would reject business just because a product is classified as complex and presents more risk to the investment service provider? Let us look at real examples of how this is actually happening. Any HSBC Bank Malta Plc (HSBC) customer had been informed that a few years ago the bank decided that it would only be offering execution only transactions and would absolutely not be offering investment advice. Furthermore, the same bank has recently informed its customers that it would no longer be allowing its customers to hold investments on their nominee accounts. That is to say that HSBC would no longer be holding the custody of clients’ investments and has actually written to clients to transfer their holding to other providers (which are competitors of the same bank).

Some may argue that this is a one off case and that it is a direct result of directives by HSBC’s parent company to reduce risk as much as possible across the many subsidiaries, especially in the smaller jurisdiction such as Malta. So let us look at another example – the subordinated bond issued by Bank of Valletta Plc (BOV) late last year which is basically a Contingent Convertible Bond (Coco). Due to the nature of the bond it was rightly so rated as a complex instrument by our regulator. Under MiFID rules such instruments must be accompanied by more paperwork to ensure that it would be appropriate for an investor based on such investor’s knowledge and experience.

What happened in practice? A bond which from a scale of 1 to 10 in its complexity would be rated at less than 1 in my view, was made subject to more scrutinising procedures by the listing authority. It had to be sold in two tranches – tranche 1 imposed a minimum of €5,000 which had to also be accompanied by investment advice, thus putting the highest level of onus on service providers, while tranche 2 imposed a minimum of €25,000 and had to be accompanied by an appropriateness test. Our regulator argued that due to the vast network of retail clients that such a bond would have appealed to, such clients needed to be protected even further than MiFID suggests. The result – many investment services providers including other banks simply did not bother with the issue. The bond was sold by a smaller amount of firms which got back logged in the paperwork and the issue had to be prolonged until all the work by the investment firms had been carried out. Looking at the trading of the same bond on the secondary market – virtually non-existent. I went into much more detail in a previous post which focused specifically on the bond issue. Here I simply wish to highlight the negative aspect of too much regulation.

So how do you strike a balance?

I started the post by pointing out why regulation of this industry is such an important aspect. We then saw a few examples of how regulation could leave investors worse off by marginalising the smaller less knowledgeable ones. So how can regulators and policy makers stick a balance between these two opposing forces? In my view, the answer lies in being more pragmatic in the imposition of the rules and regulation governing investment services. The one size fits all approach of putting all complex instruments into the same basket is redundant and disruptive. While firms that are found guilty of negligence and misconduct should be properly dealt with, regulations should not be acting as an impediment to business.

Another very disruptive and damaging practice is having an ultra pro-investor approach when regulating investment services firms. As I have just stated, when found guilty of purposeful negligence and unethical behaviour the regulator should be given as much ammunition as possible to deal with such perpetrators. However, feeding the idea that if someone loses money when investing in a financial instrument they have a good chance of getting compensation creates a misconception that investment firms are guaranteeing every instrument that they sell. This is a very dangerous situation which will only lead to a negative situation for both the investors and the firms selling the investments.

Could there perhaps be a solution whereby staff that work with the regulator must spend a certain amount of time working with an investment service provider? Thus they would attain hand-on experience and would ultimately be able to implement the directives more effectively and efficiently. Moreover, this would have to be an ongoing exercise and not a one time thing. Just because someone worked in the industry 10 years ago and has been working for the regulator ever since does not qualify as still being in touch with reality.

On the other hand, should compliance officers and Money Laundering Reporting Officers (MLROs) be given training by the regulator on a regular basis for example? This would help to get the perspectives of both the regulator and the practitioners more in line. Here I am not talking about the usual boring courses that just present what is in the regulations. Anyone can read the regulations on their own and no presentation is needed for that. What I am speaking about here is offering real life examples of what the regulator is dealing with in order to create a more understanding environment between the regulator and the practitioners.

The Bottom Line

At the end of it all, it is always going to be a difficult task to find the ideal level of regulation. What is important is that both regulators and practitioners work towards the common goal and try to understand each other’s perspective. Both can learn from each other and both need each other whether they would like to admit it or not. Regulating by empowering is far more effective then regulating by imposing. Thus, I truly believe that more effort and resources need to be channelled towards the education of the investing public. After all education = power since by educating people you will empower them to be able to regulate the financial practitioners themselves.

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