MiFID II: End of the road or just a bend?

For those working in European financial services the MiFID II (Markets in Financial Instruments Directive) legislation, which came into effect on 3 January, potentially marks one of the biggest shifts in the business since Big Bang in 1986. The latter marked the liberalisation of financial services by deregulating many of the practices which had previously characterised the City of London (notably the abolition of fixed commission charges and the demarcation between market makers and the brokers selling stocks). For a time in the late-1980s, the City felt a bit like the wild west as companies with deep pockets rushed to expand into new business areas against a backdrop of relatively lax regulation. More than three decades later, if MiFID does not represent a 180 degree turn it is certainly a long way around the dial.

The objective of MiFID II is to strengthen the degree of investor protection by improving the functioning of financial markets. This in turn implies increasing the degree of market transparency and resilience. The law puts a much greater onus on counterparties to accurately report trades and the prices at which they take place (the transparency part). Enhanced reporting structures are also required to ensure that the products which are sold by financial institutions are appropriate for the client, thus reducing the likelihood of a bust (the resiliency aspect). It is thus far harder these days to flog inappropriate products to unsuspecting clients in order to make a fast buck. About time, of course. We have heard too many stories of misselling over recent decades to avoid the conclusion that some parts of the industry cannot be trusted to regulate themselves and that they will have to be forced into it by the power of the law.

The scope of the products to which all these regulations apply is also being expanded as MiFIR (Markets in Financial Instruments Regulation) comes into force. Not surprisingly, the costs of implementing the procedures required to comply with the new regulations are enormous. And nobody knows how the regime will work in practice. The whole process is based upon the application of “best execution” – the duty to get the best price in the shortest possible time. But this is open to a great deal of interpretation. There is also a risk of regulatory arbitrage across the EU if the MiFID II rules are implemented differently across legislative regimes. Moreover, whilst it is impossible for business conducted in the EU on behalf of EU-based clients to avoid the scope of the law, there is no reason why business conducted in the EU on behalf of extra-EU clients need be subject to the same rules. Accordingly, this could drive some activity out of the EU towards more light-touch regulatory areas.

From a research perspective, the biggest issue is that the costs of research now have to be unbundled and can no longer be hidden within trading commissions. The law now says that financial institutions managing money on behalf of clients are no longer allowed to receive unsolicited research from those providing investment advice. Thus, asset managers now have to enter into a contract with a sell-side institution to ensure that they are compliant with the law, in order that those whose funds they are managing can see how much they are being charged for research advice. We have known for some time that this issue would hit us eventually and many firms have been thinking about its implications for at least two years. What is particularly interesting is the process of price discovery that has since taken place.

Initially, firms providing financial research aimed high but as asset managers baulked at the charges, so they have been dramatically reduced. Much of the anecdotal evidence suggests that research costs will not be covered by the fees paid by the buy side which is going to change the face of financial sector research. An article in the FT last week asked us to “spare a thought, friends, for Julian Bonusworthy. North of 40, he works for a respectable if second-tier global bank with towering offices in London. He is an equity analyst, advising fund manager clients what to buy and sell. His base salary is £350,000 and in a good year he takes a big performance award at year-end. His twins are in private school, the Land Rover is paid for and his £4m house is not.” He may be an imaginary character but research analysts earning that kind of money are about to become a much rarer breed[1].

The largest company by market cap in the FTSE100 is HSBC. According to Bloomberg, it is covered by 33 analysts of which 12 have a buy recommendation; 5 a sell and 16 a hold. One thing is for sure: the buy side of the industry simply does not have the budget to pay 33 analysts to cover this single stock, and they certainly do not need to shell out huge amounts to be told to hold. Therefore a lot of winnowing is about to take place. Firms which can offer a wide range of client services will continue to find a market for single stock research and offer it at competitive prices. Those continuing to offer good investment ideas should also be able to continue making a living. But for many people in financial services life is about to get a lot harder. Big Bang may have heralded the start of the financial research industry; MiFID II might sound its death knell.

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[1] As for economists who, I can assure you, earn much less the MiFID legislation defines investment research as “financial analysis or other forms of general recommendation relating to transactions in financial instruments.” Technically, that means we are largely exempt since much of our analysis does not relate to transactions in financial instruments.

Justin's case

Justin Gatlin’s win over the great Usain Bolt in last night’s 100m final at the World Athletics Championships is a reminder that life does not always run to the script that the majority of people might wish. For those of you not athletics aficionados, Gatlin has twice been banned by the IAAF for doping offences. As one person tweeted last night, once is a mistake but twice is a choice. There are lots of allegations surrounding Bolt himself: Maybe he has doped, maybe not. But he has not been caught let alone banned (TWICE!!). Without wishing to turn all moralistic, there is a serious point about credibility here. Unless the rules are applied effectively and sanctions imposed which make cheating an unattractive option, there will always be a temptation to push the boundaries.

The same could be said of any organisation which knowingly breaks the rules. An obvious example is the conduct of banks, many of which have been heavily fined for transgressing sanctions rules (German automakers who falsified emissions data find themselves in the same position). In the UK, the FCA has levied fines totalling £3 billion since 2013 (of which only around 0.6% has been levied on individuals). Over the period since 2008, banks globally have paid $321 billion with the US regulators particularly adept at forcing banks to pay up by threatening to curtail access to the global dollar payments system. Depending on which side of the divide you sit, the actions of regulators to extract large sums of money from the banking system either represent an extortion policy of which Al Capone would be proud, or it is a genuine attempt to hit banks where it hurts in a bid to force a change of behaviour (I suspect both are true).

However, behaviour is changing. Banks are much more careful these days about the kinds of business they undertake as the compliance burden rises. According to Boston Consulting, the number of regulatory changes per year more than tripled between 2011 and 2016. Each individual regulation effectively represents a tax on activity, because it requires additional oversight with an associated implementation cost and failure penalty. Regulators are currently particularly keen to clamp down on money laundering in a bid to combat terrorist financing, and as a result banks are actively turning away customers if it means that the potential risks exceed the potential gains. Mis-selling risks are another area of particular scrutiny, and given the concerns surrounding the accuracy of Libor submissions in recent years the FCA recently announced that the system whereby Libor is set by quotations will be replaced by a transactions-based system (a sensible move, even if it is not quite clear how this will work in practice).

It is interesting, however, to note that the period of punitive regulation appears to be drawing to a close. BoE Governor Carney warned in March about regulatory fatigue and in its latest Financial Stability Report, the BoE noted that “given the progress made and the lessons from work to date, the FPC is now moving to the next stage. Its focus is on systemic risk, rather than risk to individual companies or consumers.” Carney also warned last week that there should be no rolling back of regulation. In other words, a lot has been done in recent years and banks need time to adjust to the higher costs of regulation which have done a lot to shore up banking sector stability.

In the case of financial regulation, it thus appears that the regime of punitive sanctions has had a significant impact on banks’ behaviour and they will emerge stronger and safer. This is akin to the situation in which Justin Gatlin finds himself. He broke the rules, was caught and banned for a total of five years but has since run “clean.” Like the banks, Gatlin profited from cheating and indeed his current physical condition, which means he is still able to run world-class sprint times even at the age of 35, may have something to do with the drugs he took earlier in his career. But there are differences between the two situations. Gatlin’s actions were those of an individual who took a conscious decision to cheat in order to benefit his career. Whilst there were individuals within banks who made similar decisions, it is fair to say that institutions did not (to my knowledge) engage in systematic cheating, though they can be accused of turning a blind eye to certain actions for which they have been punished.

I don’t like the fact that Gatlin won last night and many people (of which I am one) believe he forfeited his right to compete at the highest level following his second drugs offence. He demeans his sport and sets a bad example for others to follow, especially younger athletes. In this sense the IAAF fails to police its sport adequately. At least the financial regulator will come down hard on individuals which it finds guilty of breaking the rules as new regulations come into play. Indeed, over the last three years more individuals have been fined by the FCA than firms. In this area, IAAF President Sebastian Coe perhaps has something to learn from financial regulators.

Location, location, relocation

Remember the EU Financial Transactions Tax (FTT)? Back in 2011, European Commission President Barroso presented a plan to make sure that financial institutions would “pay their fair share” following the bailouts which banks received in the wake of the financial crisis. Predictably, it led to an outcry with a small but vocal minority, led by the UK, intent on blocking its introduction. Having originally been intended to come into operation in 2014 it has yet to come into law – and probably now never will. Yet as recently as January, the EU Parliament suggested that a draft text could be ready by mid-2017. We are still waiting.

The irony is, of course, that many EU countries already had a form of FTT in place. Even the UK levies stamp duty on equity transactions, having done so since 1694. But with much of the evidence suggesting it would have an adverse effect on certain types of business, with derivatives transactions likely to be the worst hit, the push back was so great that it has been quietly kicked into the long grass. I have long held the suspicion that this would be the case, though when I made this point in a panel discussion in 2013, I was told I was wrong. Unfortunately, I will likely be proved right for the wrong reasons.

It is Brexit that has changed the nature of the debate. On the assumption that this will mean an end to financial services passporting, it is going to become a lot harder to conduct international financial services from London. With Paris and Frankfurt keen to attract business from the City, the chances of the FTT being introduced have gone below infinitesimally small. Although both the French and German governments continue to publicly support the principle of the FTT, it is hard to see either being very supportive at a time when they are scrabbling for London business. With Frankfurt apparently ahead in the business relocation race, the German government is unlikely to push the FTT high up the priority list. And without their support, the FTT is as good as dead in the water. This, of course, makes life rather more complicated for Britain, some of whose politicians assumed that the UK could continue to operate as a low-tax offshore haven.

Abandoning the FTT will certainly make it easier for firms to relocate to other EU locations. Indeed, some business lines simply might not have been profitable in the face of its introduction which could have resulted in them being cut altogether. Now, however, they may be able to continue operating elsewhere. However, abandoning the FTT alone is not going to be enough to persuade business to relocate. Given the pick of European cities to live, many bankers might opt for Paris. After all, it is sufficiently diverse to match the “charms” of London and is certainly one of Europe’s more beautiful large cities. But France is perceived as a more difficult place to do business than the UK and ranks 29th in the World Bank’s Ease of Doing Business index behind other EU members such as Poland and Portugal.

Anglophone bankers might have a preference for Dublin but Ireland may be reluctant to host some of the riskier parts of banking activity, following the problems which it has had to overcome in recent years. The Irish authorities would welcome asset managers, insurance companies and back office functions but may be more cautious about taking on big balance sheet risk given the relatively small size of the economy. It is thus partly due to the lack of alternatives elsewhere that Frankfurt has emerged as the front runner. Germany’s Ease of Doing Business ranking (17) is higher than Ireland (18) , although lower than the UK (7). Frankfurt is also home to the ECB and a well-defined financial cluster has been established in recent years.

One downside is that Frankfurt is relatively small compared to Paris and London, and is already operating at full capacity following the transfer of euro zone banking supervision to the ECB which has pushed up business and residential property prices. The latter in particular is not insurmountable. Anyone who travels 20 miles into central London on a daily basis will find they can do a longer commute rather faster and more cheaply than they can in south east England. Speaking from my own experience, I can testify that the quality of life is also rather better in the Rhein-Main region. If you like a beer, Germany is a good place to be, though if clubbing is your thing maybe you will find Frankfurt a bit tame.

From an industry perspective, however, the real concern is that the integrated European financial services sector will begin to fragment. London will remain the dominant player for some time to come but as business begins to relocate elsewhere it will be replicated on a smaller scale. It will be very difficult and highly costly to build the full infrastructure which the modern industry needs across a number of different European locations. Whilst Frankfurt will probably gain a lot of London business, my long-standing conviction remains that the centre of gravity will inexorably shift towards Asia. This trend may have happened anyway but will certainly be hastened by Brexit. Some politicians might cheer such an outcome for it will result in the de-risking of European financial services that the FTT was designed to achieve. But the British government may come to regret the dismantling of an industry which plays such a crucial role in the knowledge economy that it claims to support.

Banks: Safety in numbers

I have spent much of the last week involved in banking issues, either talking with banks about their business plans or about them in the context of the Money Macro & Finance Research Group annual conference. One of the takeaways from the week is that insiders and outsiders, not surprisingly, view the sector’s problems differently. Banks are concerned to restore profitability and have outlined their business plans contingent on the current legislative environment, which they believe is sufficient to strengthen their institutions. Many academics and policy makers, on the other hand, want to make banks even safer in order that the integrity of the financial system is maintained and to ensure taxpayers are protected in the event of further problems. Either way, it is a sign of the times that we spend so much time on regulation issues today. A decade ago, financial stability was both a business and intellectual backwater.

Looking at the big picture, there is still a lot of debate on whether the banking system is safe enough. Sir John Vickers, who chaired the Independent Commission on Banking, does not believe it is. Earlier this year he strongly argued that the ICB’s recommendations on capital adequacy had been largely ignored and that banks do not have nearly enough capital to withstand shocks. This is a view which the Bank of England does not share. Vickers’ argument is that although holding equity capital is costly for banks, because investors expect high returns, “high returns make sense only if they compensate for risk ... which is best done by more equity, not less.” In his view, the BoE argument that leverage ratios were ten times higher before the crisis means only that banks today are too risky versus stratospherically risky prior to 2008.

But whilst the argument is sound enough, John Kay points out that efforts to measure bank leverage, as required under the Basel III legislation, represent “bogus quantification.” We cannot adequately measure bank ‘riskiness’, and efforts to put a precise number on it give us a false sense of security. In any case, it is not as if banks were not regulated previously, as anyone who tried opening a bank account even prior to the crash of 2008 can testify. It is more the case that bank regulation was previously misdirected.

This highlights that there is a trade-off between the safety and usefulness of regulation. As Kay points out, the rising numbers employed in compliance represent a heavy tax on banking activity, and banks themselves are being forced to make costs savings in other areas to ensure they can meet the regulatory challenge. Ironically, we will only know that the outlays on additional compliance are being well spent if they prevent banks from incurring the wrath of the regulator. So the less they are in the headlines, the better. But since the actions of regulators on the other side of the Atlantic appear more as a capricious attempt at extortion, it may not matter how much banks spend if they are operating on a far-from-level playing field.

It is interesting when talking to banks about their business plans to note that they are taking a highly pragmatic approach. So long as they have a clear view of what they have to do, and the timeframe under which they have to operate, they seem broadly happy with where we are heading. Indeed, there appears to be a lot more certainty today than there was a year or two ago, when bankers complained that the regulatory goalposts were being moved far more quickly than seemed necessary. It would thus appear that, in the UK at least, the field of bank regulation is beginning to mature. In its early stages, bank regulation was focused on emergency balance sheet repair and there probably was an element of on-the-hoof policy making. Today, we are able to look forward with a bit more certainty, and I am also left with a sense that banks and regulators talk to each other more than they once did.

Macroprudential policy has thus become a key element in the policy armoury. There are some concerns that it may become a substitute for monetary policy – at least in part. For example, the regulators might prevail on banks to change lending practices, thereby operating on the credit supply side, rather than using interest rates to regulate credit demand.  In future, when (if) interest rates return to more ‘normal’ levels, that might be a cause for concern – particularly if the current creeping trend towards the politicisation of monetary policy gathers pace. But this is not exactly a new problem: indeed, for a long period after 1945, the UK operated a form of macroprudential policy in the form of credit rationing. Given what we know happened to the banking system prior to 2008, I wonder why we gave it up.

Stressful times

This morning’s financial pages are full of coverage of the European bank stress tests, which were released yesterday evening. The good news is that with two exceptions, the regulators were broadly satisfied that the 51 European banks under scrutiny would be able to withstand severely adverse market conditions, in the sense that they would be able to hold their common equity tier one (CET1) ratios above the absolute minimum of 4.5%. In plain terms, this means that banks should be able to maintain a sufficiently large capital cushion in order to continue operating during times of market stress and thereby remain solvent.

In the wake of the problems resulting from the Lehman’s bankruptcy in 2008, it makes sense for the authorities to pay greater attention to the risks posed by the banking sector. Indeed, the lack of regulatory oversight magnified the extent of the post-Lehman’s distress so it is a positive step that problems are being addressed. But previous efforts to stress test the European banking sector were criticised for not being stringent enough, and the same familiar refrains are being heard again this morning. It is true that the risks appear to have intensified in the wake of the Brexit referendum and it is also true that different countries face different degrees of macro risk, which makes it difficult to compare the impacts of the adverse scenarios across countries. 

But these criticisms are to miss the point. We can never know exactly what kinds of shock will materialise and the best that we can do is give a hypothetical benchmark against which to judge a range of possible outcomes. Like any forecast, they will probably prove to be wrong but if we get the broad direction of travel right, we can be satisfied (though we can only hope that we never have to find out).

In any case, as the European Banking Authority pointed out, banks are far better capitalised today than they were five years ago. The CET1 ratio at the end of 2015 across the panel of 51 banks was 13.2 % versus 8.9% at the end of 2010 (albeit on a slightly different definition). The rules have been tightened up and banks have done their best to comply with regulators’ demands for a broader capital base. There is little doubt that banks were under-capitalised pre-Lehmans and it is only right that they should be forced to build a better stable door, even though this has forced them to pull out of capital intensive businesses which has had a notable impact on profitability. 

However, this does not excuse the fact that regulators were far too complacent about the risks which banks were running prior to 2008. Public calls to send bank chiefs to jail were never matched by calls to jail regulators for neglect! Indeed, whilst disgraced RBS chairman Fred Goodwin was stripped of his knighthood, former BoE Governor Mervyn King was ennobled and, it was noted this morning in the FT, “has quietly taken up a role as a senior adviser to Citigroup.” Lest the irony of that should escape anyone, Lord King argued in his recent book that the structure of the financial system in flawed and that “without reform of the financial system, another crisis is certain.” 

Back in 2011, former Barclays chairman Bob Diamond argued that it was time to end the criticism of banks over their role in creating the recession of 2008-09. He was ahead of his time: There were many problems with the banking system in 2011 which needed to be resolved, and there is still a lot to do today. But banking recovery is not being helped by the fact that interest rates are at all-time lows, making it harder for banks to generate profits and rebuild their capital base. With the Bank of England widely tipped to cut interest rates deeper into all-time low territory in the course of next week, that is an issue to which I will return,

That's the way to do it

Although large chunks of the British institutional framework appear to have collapsed in the wake of the Brexit referendum result, the Bank of England can continue to hold its head high. Governor Mark Carney has offered leadership and a clarity of message which has been absent elsewhere. The irony is, of course, that Mr Carney is not even a Brit but he is showing the natives of his adopted country how crisis management should be conducted. He has obviously learned lessons from his predecessor, when Mervyn King was initially slow off the mark in identifying and then tackling the wave of problems which washed over the UK banking system in 2007-08, although he subsequently proved to be a very safe pair of hands. 

Indeed, the fact that the UK banking system has held up pretty well in the face of the Brexit uncertainty shock is partly the result of the system put in place during the latter phase of Mr King’s tenure. Where Mr Carney has scored has been his willingness to lead from the front: His presentation today of the Financial Stability Report was his third significant public appearance in the 12 days since the referendum. The tone of the FSR was cautious and highlighted many of the things which could go wrong. The BoE warned of the risks to the commercial real estate (CRE) sector which might be triggered by Brexit, noting that “foreign investors accounted for around 45% of the value of total transactions since 2009.  These inflows fell by almost 50% in the first quarter of 2016.” 

Right on cue, two more companies today announced they were suspending trading in property funds following yesterday’s announcement by Standard Life. It does appear that overseas investors are getting their money out while they can. The ban on withdrawals might appear dramatic but it reflects the fact that the funds can only repay investors by selling their property holdings, but since property is an illiquid asset this takes time. Whilst this might cause investors to panic with regard to their ability to get their money back, this is not like 2008, although it will cause jitters to ripple throughout the market. The BoE also points out that the collapse in the CRE sector could feed into the wider economy because property is often used as collateral to secure bank lending, and less collateral might result in a lower level of bank lending. In a bid to ensure that lending is not restricted by policy actions, the BoE announced it would reduce the bank countercyclical capital buffer (CCB) from 0.5% to 0% with immediate effect. In effect, the funds which banks otherwise would have been required to put away for a rainy day can now be used for lending purposes. It is now raining! 

But the BoE knows that it can only operate on the supply side of the credit market. As Mr Carney noted in a speech last week “one uncomfortable truth is that there are limits to what the Bank of England can do. In particular, monetary policy cannot immediately or fully offset the economic implications of a large, negative shock.  The future potential of this economy and its implications for jobs, real wages and wealth are not the gifts of monetary policymakers. These will be driven by much bigger decisions; by bigger plans that are being formulated by others.” 

The markets are taking their own view on UK prospects with the pound at 31-year lows against the US dollar. Despite the central bank’s best efforts, there exists a vacuum at the heart of policymaking. Until we have more clarity here, the pound is likely to remain under pressure. Still, it’s good news if any foreign tourists fancy a holiday break in the UK. The economy needs all the support it can get.