One of the great lessons of the last ten years has been to remind us that positive consumer outcomes support long-run, sustainable prosperity
Today’s theme is not an easy one, frankly, in the sense that forecasting the financial future is notoriously complex. ‘Nobody,’ as the old stock trader adage goes, ‘rings a bell at the top of the market’.
However difficult it may be though, there’s no doubting the importance of prediction to modern business. Indeed, in a world that seems to continually stress test the ability of leaders to adapt to change, the value of looking forward has only ever magnified over time.
And this is certainly true for global regulators, who are now making projections about the future on the basis of a rapidly changing economic and social context.
So, gone is the existential crisis of survival that dominated in 2007, 2008 and 2009. The seizure of global credit markets. Institutions levered 40 to 50 times. Lack of liquidity. Network risk, and so on.
Replacing it, a new growth imperative. So, you now have a domestic focus in areas like employment, productivity, pensions and investment.
There’s the European agenda on Capital Markets Union, SME lending and infrastructure. And of course, there’s the global, macro-economic agenda.
Now, in this significant shift of context, it’s difficult for regulators to continue to define activity solely in terms of its capacity to respond to crisis. There must also be an attempt to speak to societal ambitions for the next five, 10 and 15 years. To forecast how regulation should adapt to a more positive future.
So, we are at a key inflection point in the economic cycle, where the question isn’t just: how do you clean up finance and restore faith in the sector?
It’s how do you achieve this remediation - yet also make sure that London and the UK don’t become seen as hostile places to do business?
Now, of course, we’ve been at similar inflection points before. Moving from crisis to confidence.
But if you look back 23 years, towards the end of the last recession, regulators were operating in a very different context.
Few in global finance then were arguing for anything as ‘transgressive’ as greater accountability or transparency. Market forces were seen to perform these functions without the need for regulatory intervention.
And the debate tended to be centred largely around questions of left or right, rather than up or down. Regulated capitalism versus neo-liberalism and so on.
Today, by way of contrast, there’s a much broader acceptance of the importance of effective regulation to the City. Not just as means of dispensing justice, but as a mechanism by which you create sustainable growth. The quantum of rules remains important to business leaders – particularly in the context of Europe – but it is not the only debate in town.
In fact, for a majority of leaders – in government and regulation, as well as in business – one of the great lessons of the last ten years has been to remind us that positive consumer outcomes support long-run, sustainable prosperity.
Now, for the FCA and others to achieve that ambition, there are a couple of core conditions that need to be established.
Effective policy and supervision is the first.
So we’ve seen significant work over the last few years on key political and societal priorities: accountability; pension policy; insurance; market integrity; benchmarks; reward incentives; and so on.
The second priority, and the one I want to focus on today, is the broader importance of supporting vibrant markets.
So, as you look forward, you want profits for good firms without the envy and unrest that’s created in the past. But that means you also need exits for poor firms. And you certainly need a context that supports useful innovation.
And this leads to the two, linked themes I want to look at this afternoon. Competition and financial innovation.
Competition
How do regulators have a more telling impact on competition today, than we’ve seen in the past?
On the former, the core questions – around issues like market concentration, price, product quality and the like – are ones that have dominated financial services for many years.
There have been successes during that time, certainly.
Optimists can point to the opening of investment markets in 1986 - as well as the abolition of trade controls - as a period that significantly increased efficiency in the City, cementing its position as a global hub.
But there have also been some frustrating challenges.
UK retail banking, in particular, has been the subject of special attention. More than a dozen competition reviews and studies over the last 15 or so years.
Yet even now, you’re statistically more likely to divorce your wife or husband, than to separate from your current account provider.
Now, this might reflect the UK’s attitude to marriage. More likely though, given the fact some 80% of customers bank with just four providers, it speaks to the general complexity of promoting competition in financial services, which has a tendency to wax and wane.
Certainly, pre-crisis, there were at least signs of progress.
So, although big banks tended to be interested in their existing customers, there was always a sense that challenger firms – who were hungrier for market share and growth – could poach disaffected customers from larger rivals.
Indeed, the Herfindahl index of market concentration, which measures the size of firms in relation to their industries, saw a positive, albeit modest, reduction in UK banking concentration from 1,470 to 1,290, between 2000 and 2008.
Crucially, however, within just two years, these gains had been reversed by financial crisis. The index now stood at 1,830 – the higher number representing greater concentration – and the challenger fringe had been significantly reduced, with the disappearance of high street names like Northern Rock.
No surprise then that what’s followed since has been a resurgence in political ambition to prise open the UK’s financial markets.
Indeed, in April, the FCA gained competition concurrency powers that allow it to investigate breaches of the Competition Act. To refer cases to the Competition and Markets Authority. And to open its own market studies.
The key question, however, has been: how do regulators have a more telling impact on competition today, than we’ve seen in the past?
And for me, there are a couple of pressing priorities here.
The first has been reducing barriers to entry in areas like banking.
So, for example, there’s now enhanced pre-application support for firms that want to apply for banking licences.
In fact, the FCA and (Prudential Regulation Authority) PRA have trebled the number of meetings we now hold with prospective banks, following a structured process of walking through their business models and setting out expectations.
On top of this, capital and liquidity requirements are lower. So, for entrants that are judged to be resolvable or who have no systemic impact, the absolute minimum is now £1m.
And importantly, we’ve also seen the introduction of the so-called ‘mobilisation option’. Authorisation is granted to firms with sufficiently developed business plans, liquidity and capital, key senior managers and so on, but with restrictions on their activity.
So, where businesses used to enter the process with no guarantee of authorisation – making it more difficult to attract capital, to recruit, to set up premises, engage with third parties and so on – today authorisation is granted at a much earlier stage.
For firms, this has the great benefit of bringing certainty. The risk becomes a business one rather than a regulatory one. And the impact has been significant.
In total, some 14 new banks have been authorised in the UK since 2013. Another 20 are in the pre-application stage.
And, importantly, this is supporting the emergence of genuine and diverse alternatives. Major brands, without legacy issues, like M&S, Post Office and Tesco.
We’re seeing new or revived brands. Metrobank, Paragon, Williams & Glynn and so on.
And we’re also now seeing the emergence of new models of intermediation – crowd funding, P2P and other forms of non-bank lending (shadow banking) that have quickly become an important source of funding for small and mid-cap firms.
Indeed, Allen & Overy last year released figures, based on some 200 firms, suggesting shadow banking is now almost as important to many European companies as bank debt, with 41% of corporate funding coming from ‘alternative’ sources. Compared to 43% from banks.
So, there does seem to be some sign of significant progress here.
But of course, for competition to work, you need to not just help people on to the pitch – you need to referee.
In other words, there must be some mechanism by which you make sure competition plays out in the interests of both market and consumers.
Behavioural economics and competition
And this bring me on to the second core competition policy area here for the FCA: the growing influence of areas like behavioural economics. Particularly as the value of traditional policy instruments, like unsophisticated disclosure, have been tested by economists.
So, in the financial sector, more than perhaps any other industry, we now know the addition of more data is not always reflected in the mark-up or quality of retail services.
In other words, prices don’t always respond efficiently to new information. Yet in the past, the assumption was the opposite. That prices do respond efficiently (or if not efficiently, that they do at least respond); and that decision-making is rational, not always, but certainly rational for sophisticated decision-makers with access to data.
An important question for the FCA was to understand ‘why’ this doesn’t happen. Effectively, why did so many consumers make the wrong decisions, or at least ‘sub-optimal’ decisions, when selecting financial products? Why did they sometimes reward poor products with their custom?
In the UK, the classic example of that asymmetry was payment protection insurance (PPI).
Now, clearly taking out insurance against future loss of income is not, in and of itself, indicative of any competitive failure or breakdown in economic models.
But the key is this: PPI as a product should never have been as successful as it was: generating £45bn premiums or a 490% return on equity.
In a perfectly rational market, it would have been both too expensive to succeed, with premiums adding 20% to the cost of a loan, and too ineffective to succeed. The claims ratio only averaged around 16%.
So, the lesson here, as well as in relation to other products like mini-bonds in Hong Kong and subprime mortgages in the US, is that consumers often struggle to make rational decisions when faced with the ‘black box’ of finance.
Now, in this context, numbers of participants can become a crude measure of competitive effectiveness. Price discovery, by way of example, is not necessarily more effective in Italy, which has something like 700 banks, than it is the UK, which has far fewer.
So effectively, if you want an increase in numbers on the pitch to translate into an effective increase in competition, there must be demand-side reform. Consumers must have the power to discipline the market.
To achieve this, we’ve seen the FCA leading global work, particularly in retail banking and insurance, in areas like teaser rates and disclosure, as well as complex pricing strategies - reference pricing, under-emphasised fees and the like.
On top of this, we’ve also begun work in the wholesale space, last month launching the terms of reference for an investment and corporate banking market study.
So for example, we’ll be looking at the adequacy of information presented to clients and transparency of allocation, as well as whether or not there are issues around bundling or cross-subsidisation.
The basic question here, however, is a simple one. Is there a competitive landscape?
Innovation
And this brings me on to my second point on innovation.
Now, it is, as I said at the start, very difficult to predict how the increased mechanisation of financial services will play out over the coming years.
At the moment, we are seeing the emergence of a pretty disparate group of innovators that are looking, in the fintech space in particular, to deliver ‘one-click’ standards of customer service.
Quite what effect this will have on the market place we don’t know – but there seem to be two competing visions.
Pessimists argue that lower product value here might just reduce the incentive for incumbents to offer differentiated products - and point to an array of potential issues in areas like cyber crime.
The optimists, who are more vocal and numerous, talk of the potential here for innovation to solve problems that have not even been imagined. They talk of its potential to strip away product value on the supply side and add it to the buy-side. Benefitting consumers.
They also, of course, point to the rapidly escalating significance of financial innovators to the domestic economy. The UK’s alternative finance market has been close to doubling in size, year on year. Providing close to £2bn of funding last year alone.
Now, it should be said, it’s not the job of the regulator to pick winners here. Nor to tilt the playing field. The FCA does, however, have a responsibility to ensure that excitement over potential is tempered by principles of consumer protection. No-one wants a repeat of PPI or the like.
So, the FCA is responsible for regulating both loan-based crowdfunding platforms, as well as investment-based platforms.
And there are certainly important questions here for leaders. Questions around standards of disclosure for example, but also the analysis of credit and default rates on loans, sharp sales patter, over-confidence among investors and so on.
But it is very difficult to dismiss the social and economic potential for new technologies in financial services.
Already, corporate clients at some of the biggest banks are conducting billion dollar payments through their mobile devices. Non-cash payments outstrip cash payments.
And the UK and Ireland are today the fastest growing fintech incubators in the world, developing at an annualized rate of some 74% since 2008. Albeit from a much lower baseline than Silicon Valley.
What we certainly don’t want to do in this context, is create that environment I spoke about, where innovators see the UK as an unhelpful place to conduct business.
So, from October last year, the FCA’s ‘Innovation Hub’ has been giving direct support to innovators, as well as looking at how you might adapt the regulatory regime to support useful innovation.
On the first, there’s support for firms around the navigation of regulation. These do not tend to be businesses with monumental compliance departments.
There’s also support for them in terms of authorisation, with significant face-to-face engagement to support firms through to formal application.
Finally, we’re working with firms to test approaches to customer engagement. Disclosure being the first key area, where we have been working closely with some of the big banks to develop more effective means of reducing information asymmetries.
On the second strand of work, so looking at the regulatory regime itself, we’re using this engagement with firms to actively identify the processes or policies that might need to change.
At the moment, key areas here include questions over how innovators access finance; uncertainty around regulation in areas like digital currency, and the FCA’s own paper-based processes, which clearly don’t fit the innovator model of iMacs, cloud-based computing, selfie-sticks and the like.
Conclusion
The right approach, is to pursue sustainable growth on the basis of positive outcomes for clients and consumers. Both retail and wholesale.
And this, perhaps, is the key point here. It is an imperative for regulators to keep in step with the economic and social cycles around it.
A decade is a long time in finance, and this inflection point we have now arrived at – where analysis of the past has given way to hope for the future – requires a regulatory response.
It also, however, requires positive engagement from industry.
The wrong approach, as we are now only too familiar with, is for firms to unpick principles in the pursuit of profit with no apparent social utility. A form of ‘enchanted wealth’, as Thomas Carlyle described it after the industrial revolution.
The right approach, is to pursue sustainable growth on the basis of positive outcomes for clients and consumers. Both retail and wholesale.
Regulation, as we have now learnt, has a profoundly important role to play in that equation. It can, and should, be friend to both business and consumer.