Opinion

Regulation in the time of COVID: a weekly round-up

Gavin Stewart Gavin Stewart

It's been a challenging year for financial services regulation. Gavin Stewart has been documenting the ups and downs and summarises his daily updates for the week.

Last year, I began writing daily blogs about the impact of COVID-19 on financial regulation. Other issues - notably Brexit and digitisation - have featured as well, but the recent situation remains the dominant driver of regulation as we enter 2021.

Here's a round-up of this week's insights into financial services regulation:

Bounce back loans

Ever since HM Treasury (HMT) opened the gates on Bounce Bank Loans (BBLs) in the early days of the coronavirus situation, the debate around how much of them would be repaid has been growing.

As the duration of the crisis has extended (the days when the Bank of England was pushing a V-shaped recovery seem like ancient history), the likelihood of government pushing for a conventional repayment process has receded. As early as the start of January, it was clear the emphasis had swung from repayment to supporting businesses.

So the Chancellor's shift to a "pay as you grow" approach to repayment isn't a surprise. It does, however, raise important questions for both the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) that will be hard to resolve with any real degree of satisfaction.

On the prudential side, there will be an overhang of 'zombie debt', highly unlikely to be repaid but only partially provisioned against. This could easily have a knock-on impact to other lending and may lead to all sorts of unpalatable trade-offs and inconsistencies.

As regards conduct, it could effectively universalise the FCA's vulnerable consumers approach across small businesses, which has some attractions in principle, but is almost impossible to apply consistently.

Meanwhile, there will still be noise around collection practices, with both banks and regulators reputationally fragile from not having done a great job in this area after the financial crisis.

Against this background, both regulators will want to give coronavirus time to pass before starting serious review work. This, at least, gives firms time to put together a comprehensive strategy; one that should also factor in complaints and the important role the Financial Ombudsman Service will play.

Loan collections

Speaking of the BBLs, which began at the outset when banks were asked to cut right back on their due diligence checks, there has been concern (led by the National Audit Office) about the potential for taxpayer losses up to £27 billion. And this had led to talks about setting up an industry-wide debt collection service. These have now stalled.

The reason they stalled seems to have been disagreement over the scope envisaged for the new shared utility; whether it should handle the end-to-end process or just the basic groundwork, leaving collections themselves to the banks.

From a regulatory perspective, a shared utility would raise a series of issues around outsourcing, control and overall responsibility. These issues exist in both cases but would probably be more acute in the 'basic groundwork' model, with the point of handover between the utility and the banks likely to be contentious. They potentially still exist if the banks create stand-alone units to deal with the collections' process.

There is no simple way through these problems, and banks and supervisors will need to work hard to understand each other's approaches. And a different version of the same problems also exists on the personal side, around the FCA's 'temporary' regulations on mortgages and consumer credit. Some version of these regs is likely to become quasi-permanent - there's never really been an exit strategy - and supervisors are likely to struggle to interpret to resulting policy consistently.

Andrew Bailey at TSC (1)

On 8 Feb, Andrew Bailey, Bank of England (BoE) Governor and, for this purpose, ex-CEO of the FCA, gave evidence to the Treasury Select Committee (TSC) on its inquiry into the FCA's regulation of London Capital & Finance (LCF) following the Gloster Review

One of the main themes of the report and of the TSC hearings is the extent to which the FCA should focus on risks and issues that arise beyond the perimeter of regulated activities.

This is an old issue, going back at least to the split capital trusts' scandal of the early 2000s, and work on an approach to the perimeter was also done at the inception of the FCA. In both instances, the regulator backed away from it, preferring to focus on activities that were regulated. Perhaps reacting to LCF, the FCA has now begun issuing a perimeter report.

The issue is genuinely difficult, with no simple answer. Back in 2004, an FCA Board member observed that many of the most-difficult issues they had seen originated outside the perimeter, and some of the events that subsequently caused the financial crisis support this analysis. But it would be a brave regulator who argued that it was right to focus on unregulated activities to the detriment of the regulated. And there are legitimate concerns from firms and politicians that the distinction between regulated and unregulated should mean something. The balance has been wrong but it's always a lose/lose trade-off for regulators.

HMT's current consultation on the Future Regulatory Framework (FRF) after Brexit is an opportunity to make these choices more visible and more palatable. Part of the solution is embedding greater transparency - about what issues the regulator is not prioritising; about the unregulated activities conducted by regulated firms (the 'halo effect'); and about how and why regulators will use their powers in respect of unregulated activities.

Another part is about simplifying the perimeter, currently horrendously complicated, which should be tackled incrementally over time. And finally, this is an obvious area where consistent parliamentary scrutiny would help all concerned.

Andrew Bailey at TSC (2)

Some highly charged phrases were used at Monday's TSC hearing, including that the FCA was a "broken machine" and that Andrew Bailey had inherited a "troubled legacy".

What is really at stake here is the ability of the FCA, to be successful when it has some 60,000 firms to regulate and they range from the biggest and most complex in the world to a very, very long tail of small firms, a significant proportion of which are - like LCF - far from simple themselves and capable of inflicting considerable harm on consumers.

There has always been scepticism within the regulator, going back to at least 2009, about whether taking on responsibility for consumer credit (which was already being talked about) would 'break' the risk-based approach.

Because this is based on size - the bigger the firm the bigger the potential impact when something goes wrong - it is ill-equipped to manage a long tail of small firms unless they are low risk. Even before the FCA took on consumer credit, this was a problem. The report on Connaught, issued at the same time as thee LCF review, is a good example.

There are, of course, ways to mitigate the resulting risks, but overall, the story of the last 20 years is one where proportionately less and less time has been spent supervising small firms. Some of this has been resource driven, but mistakes have also been made.

In the LCF context, the 2014 strategy - much criticised in the PA Consulting report quoted in the review - is the biggest culprit. Any long-term solution will involve digitisation and a greater recognition - political as well as within the FCA - of the importance of effective small firm supervision to the overall soundness of the system.

Andrew Bailey at TSC (3)

One of the most-interesting questions during these hearings was whether the FCA had been misleading retail consumers.

This was in the context of the acceptance that, under the 2014 strategy, many of the longtail of smaller firms in the FCA's "flexible" portfolio - all but about 100 of the 60,000 total - were not being actively supervised (ie, no named supervisor, no regular meetings).

As I've discussed before, finite resource dictates much of this, but the 2014 strategy took it to an extreme, and effectively moved the FCA away from a firm-based to a market-based approach based on c.7 sectors.

This might have worked better if the firms were low-risk, had similar business models and could be categorised relatively neatly, but, in reality, the spectrum within each sector is too wide to support such an approach. And there is also a tension here between the FCA's consumer protection and competition objectives, with the latter cheerleading for innovation and, by extension, increasing financial complexity.

There will be other firms like LCF, not because they have the same business model, but because they sail close to (or cross) regulatory red lines, and they continue to present significant risk.

In the absence of either significantly more resource or a reining in of innovative business models - both vanishingly unlikely, digitisation offers the only real prospect of improving the standard of regulatory coverage in a sustainable way. But we shouldn't kid ourselves it will be a cheap option - if it works, and identifies more LCFs earlier, it will still take time and money to clean them up.

To discuss these issues further, contact Gavin Stewart.