House of Sad

Every now and then I like to go off-piste and look at issues in the world of football, partly because it interests me but also because it is an area ripe for economic analysis (bear with me on this, there is some economics in here). A couple of years ago, I looked at the financial position of Newcastle United, the club I support. I reluctantly concluded that although the financial model adopted by the owner Mike Ashley was condemning the club to mediocrity, this was consistent with a strategy in which the owner had no incentive to spend huge sums of money for no guaranteed reward. However, this was inconsistent with the demands of fans who want to see the club spend money in order to challenge for trophies, rather than simply making up the numbers. Perhaps the relationship between owner and fans can be seen as a principal-agent problem in which the owners’ actions on behalf of the club impact directly on the fans. 

The news earlier this year that a Saudi Arabian consortium was interested in buying the club was welcomed by fans who hoped that it would allow Newcastle to challenge for trophies on the domestic, and perhaps even European, stage. The group included Saudi Arabia's sovereign wealth fund PIF thus making a direct link to the Saudi government whose record on human rights is, to say the least, questionable. This posed an ethical dilemma for me. Obviously I want my club to be successful which would have been enabled by the funds PIF has at its disposal. Against that I am uncomfortable with the links to a government deemed by Amnesty International as repressive. As it happens, the dilemma was resolved yesterday when the consortium withdrew its bid for the club.

It appears that the Premier League (PL) had dragged its feet in applying the “fit and proper person” test to the prospective owners and 17 weeks after the bid was submitted, the consortium simply lost patience. Quite rightly the PL wanted to determine the precise links between the consortium and the Saudi government. It needed assurances about who would have control (who is the beneficial owner), where funding would come from and who would appoint the board. In the absence of clarification, the PL’s rules prevented it from sanctioning the deal. On the surface, you might think that this was a case of good governance in action. But the PL – and indeed the English Football League, which governs lower leagues in England – has a murky record. Consider these examples:

1. In 2003 the PL welcomed Roman Abramovich's takeover of Chelsea FC with open arms. Not once did they publicly ask how he obtained his money. Nor did they raise the issue of money laundering, despite the fact that any business funded by funds of dubious provenance is a classic money laundering risk.
2. In 2005 the PL was quite happy to allow the Glazers to purchase Man Utd, despite the fact they loaded the club with huge debts in the process. Those debts are currently valued at £0.5bn – almost 0.8% of the annual gross value added generated in Manchester.
3. The PL welcomed Thaksin Shinawatra as the buyer of Man City in 2007. Thaksin, being a former PM of Thailand who was deposed in a coup, is the sort of politically exposed person whom people in finance are warned to treat carefully in any financial dealings. Thaksin then sold the club to the Abu Dhabi Investment Group, owned by a member of their royal family. The club was recently charged with breaching UEFA's financial fair play regulations (and dubiously acquitted), yet we did not hear anything from the PL on the issue.
4. If it is Saudi involvement the PL is concerned about, there seem to be no worries that Sheffield United are owned by a Saudi prince who recently won a court ruling that he could purchase a 50% stake in a club reputedly worth £100m for just £5m. 
5. Lower down the leagues, the football authorities claim to have a 'fit and proper' person test. Yet Wigan Athletic was last month declared bankrupt just four weeks after it was sold to a Hong Kong based consortium.
6. The travails of recently-promoted Leeds Utd can partly be laid at the PL's door. They raised no eyebrows when in the early-2000s the owner borrowed against future revenues to load up the club with debt, predicated on the basis it would regularly qualify for the Champions League. It didn’t and predictably Leeds went bankrupt. It then went through a series of owners which culminated in the farce whereby Massimo Cellino took control in 2014 only after winning a challenge to the Football League's attempt to block him. Cellino was later banned for financial irregularities before being allowed to return to his post. You almost couldn’t make it up.

I could go on. Fans of football clubs with long pedigrees such as Blackpool and Portsmouth can tell similar tales of woe in which unscrupulous owners managed to take over clubs before subsequently ruining them. On the basis of their past record of "anything goes" there are calls for the PL to be more open about why they put obstacles in the way of the Saudi takeover, without ever explicitly saying they failed the ownership test. Has it discovered a moral conscience, in which case I fully expect that this won't be the last occasion that club takeovers are blocked? Or is it because the Saudis have blocked the PL from taking legal action against the broadcaster beoutQ for illegally streaming matches whilst simultaneously blocking the PL’s licensed broadcaster in the Middle East?

In effect, football is being run along casino capitalism lines: The very behaviour which voters condemned banks for undertaking prior to the Lehman’s bust is alive and well in football. It has been well established in finance that self-regulation does not work – there is always an incentive for someone to game the system to their advantage. The same is true in football club ownership. To the extent the owner is running a business, there needs to be a systematic set of rules which proscribe what owners can do and penalties which are consistently applied in the event they are broken. Football’s regulators could do worse than learn from the financial regulators, which have been open and transparent about what institutions can and cannot do, and which crack down hard on miscreants. There should also be a separation of the financial incentives of the PL and those of the top clubs. Regulators are there to regulate, not to get rich on the back of those they are meant to oversee.

My favourite quote from the book by Simon Kuper and Stefan Szymanski Why England Lose … (aka Soccernomics) is “just as oil is part of the oil business, stupidity is part of the football business.” But it should not be this way. If football people want to be treated as the professionals they say they are, the sport needs to be regulated properly. Not run in the capricious manner which benefits the rich owner at the expense of the less well-off fan.

More sabre rattling

In recent weeks I have posed a number of economic questions of Brexit. My issues are never addressed head-on. Instead, the usual response is for supporters of the policy to meet my question with another question which is irrelevant to the issue at hand. I probably shouldn’t be surprised: This has been the modus operandi of Leavers throughout the past four years who have never been able to successfully answer any questions on the economic benefits of Brexit. But we cannot run away from the issues forever, and the latest salvo from Chancellor Sajid Javid in an interview with the FT suggesting there will be no post-Brexit regulatory alignment with the EU raises questions that need to be answered.

To quote directly, “there will not be alignment, we will not be a ruletaker, we will not be in the single market and we will not be in the customs union - and we will do this by the end of the year.” He justifies this stance by arguing that companies have had three years to prepare for a new economic relationship. But they haven’t really. Theresa May’s administration was concerned to minimise trade frictions with the EU and it has never been clear what regulatory arrangement the government was aiming for. It is even less clear today. The fact that the government has postponed EU exit three times in the last ten months means the business community is increasingly unsure which deadlines it has to meet, which has added to the confusion. Following the government’s cancellation of regular meetings with industry groups there appears to be a widening gulf between the needs of business and the government. No wonder that business investment has barely risen in the past three years.

Digging deeper only reveals the flaws in Javid’s thinking. His suggestion that “Japan sells cars to the EU but they don’t follow EU rules” is to ignore the fact that Japan has invested heavily in the UK precisely in order to have production facilities which allow it to comply with EU regulations. His hope to boost annual GDP growth to “between 2.7% and 2.8%” a year also sounds like a big stretch when you consider that the slowdown in population growth appears to have reduced the potential growth rate to something closer to 1.5%. His belief that “Once we’ve got this agreement in place with our European friends, we will continue to be one of the most successful economies on Earth,” was pure hubris. How an economy which neither grows particularly quickly nor has exceptionally high incomes per head, let alone one with a debt-to-GDP ratio close to 90%, can be considered “one of the most successful economies on Earth” strains credulity. The economic situation is not terrible but his is not a description of the UK economy I recognise.

As I can attest from my own experience, just because Javid has worked in a trading environment does not mean he necessarily knows anything about economics and I have no idea whether the man entrusted to looking after the nation’s finances believes this nonsense. I rather suspect he does not, as this gem taken from his Brexit referendum literature in 2016 confirms (see graphic above). Consequently, his comments can simply be seen as a bargaining ploy to get the EU to take seriously the UK’s threat to walk away with no deal at the end of 2020. However, I maintain that such an approach is counterproductive. Nobody doubts that a no-deal Brexit will cause some hardship for the EU but it will only have a problem with one trading partner whilst the UK will have a problem with 27. This type of posturing was tiresome three years ago – today it appears deluded.

There is a clear sense that the government is trying to reboot the economic model, in much the same way as the Thatcher government did 40 years ago. The difference is that the economic failures of the 1970s justified trying out new policies. By the early 1980s, the old industries on which the UK had depended for the better part of a century were no longer globally competitive. One of the ways the UK moved forward was to focus on new sectors, particularly in services, and new markets, particularly the nascent EU single market. The case for such a radical economic change is absent today (though you can argue about the need for political change). If the UK is, as Javid believes, “one of the most successful economies on Earth” what is the argument for such a radical structural change?

Over the last four years, many Brexit supporters have consistently failed to acknowledge the importance of regulatory harmonisation for trade. Industries with cross-border supply chains, for example, do not have to worry whether their products meet local requirements if they are sanctioned for use within the single market. Industries such as pharmaceuticals have to meet stringent requirements before their product is certified for use by the general public. Having the same set of rules across different markets makes it easier to sell across borders, and ultimately reduces costs from which the consumer benefits. Regulatory harmonisation is even more important in service industries where it is so much easier to impose little obstacles that can derail trade. Sajid Javid might believe the UK is no longer going to be a rule taker in international trade rules but he is wrong. Trade rules are what underpin the system and if you want access to the Chinese, Indian or American market you have to abide by the rules in those markets.

I have been upfront about my concerns regarding leaving the EU over the years. Even though I was on the wrong side of the Brexit decision, I can live with the referendum result so long as the economic disruption can be minimised. But I remain opposed to the decision to leave the single market, not only because it was not on the ballot paper in June 2016 but primarily because it threatens to impose higher costs which will lead to a reduction in economic welfare. The Brits do have legitimate concerns about the extent to which the UK may be forced to adhere to future changes to EU law on issues such as the environment, and I will deal with this problem in a subsequent post. Indeed, this may be one of the motivating factors behind Javid’s comments. Nonetheless, for too long politicians have been allowed to get away with economically illiterate arguments to support their political case. This is another such example, and there is a serious risk that one day the EU will call the UK’s bluff.

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.

Regulate but don't suffocate

Some time ago I was sitting in a meeting in which the discussion turned to administrative and procedural matters, none of which affected me. I realised that if I left the room I would not be missed and I could use the time to do something more productive. This is, of course, an experience familiar to many millions of people. Once we add up the amount of person hours wasted in processing apparently trifling administrative matters, we begin to understand the magnitude of the economic costs imposed by red tape.

Like many people, I tend to think of this problem as one which others should deal with. After all, I am not paid to be a bureaucrat – surely there must be someone else to take care of this. But so long as we are operating on the company's time, our employer has a right to ask us to deal with processes which make the company's life easier. In any case a lot of regulation is necessary. We cannot hope to operate in a complex economic system without a set of detailed rules governing the underlying processes. Indeed, without a lot of these rules, we would experience market failures far more frequently than we do. But that does not mean we should accept all regulation as good, or even necessary.

An example of "good" legislation is that designed to tackle the problem of environmental damage. It has a transparent aim of reducing the wider social costs associated with pollution, which yields obvious benefits to society. Of course producers have to adapt their production methods which can act as a spur to innovation but it also raises costs which are ultimately passed on to the consumer. Society thus has to carefully weigh the costs and benefits of regulation. One of the problems we are now beginning to understand is that as circumstances change, much of the regulation that sits on the statute book becomes outdated.

To this end, President Obama signed executive orders requiring federal agencies to review existing legislation to “determine whether any such regulations should be modified, streamlined, expanded, or repealed” with the purpose of making the “regulatory program more effective or less burdensome in achieving the regulatory objectives.” Consider the situation we are in today in which governments are increasingly concerned about the nitrous oxide emissions caused by diesel engines – the very same technology which was once seen as the solution to the problem of CO₂ emissions. That solution is increasingly being seen as a problem and regulation is being amended accordingly, with the likes of the UK and France planning to ban the sale of new cars powered by the internal combustion engine within the next 25 years.

Financial regulation is another case in point. Much of the legislation implemented in the past decade is designed to reduce the risks to society from the socialisation of a private sector problem (i.e. governments do not have to bail out banks) by preventing the emergence of banks which are too big to fail. Globally, banks now have to hold bigger capital buffers and are subject to much greater regulatory oversight. We will only see how effective the legislation has been over the longer term if it reduces the frequency of banking crises. What we do know is that the short-term adjustment costs are high, as banks increase the size of their compliance budget whilst getting out of, or being forced to turn down, business which was once extremely lucrative. In effect, a tax is being imposed on banking activity whose incidence falls mainly on the banks themselves: The wider social costs of this legislation are minimal and it satisfies society's demand for justice in the wake of the crash of 2008 by clamping down on banks’ activity.

But is it all good or necessary? The US Dodd-Frank Act, for example, comprises almost 14,000 pages and 15 million words. Nobody can possibly know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically the US Constitution, upon which a nation was built, contains just 4,543 words. Consider also the EU’s MiFID II legislation due to come into effect next year which is designed to offer greater protection for investors and inject more transparency across the financial services industry. EU financial instruments which fall within its scope will have to comply with the new regulations, irrespective of where they are traded. One of the other aspects of the regulation is that it forces sell-side institutions to charge money managers for their research, rather than bundling it in with transaction fees, in order that money managers’ clients have greater transparency over the fees they are charged (a topic I will deal with another time).

Suffice to say this is a big deal for the European financial services industry and has cost a lot of time and effort as banks and asset managers gear up for it. But according to a recent Bloomberg report (here), a lot of countries are struggling to be ready to implement the law in January. It will potentially change the nature of the industry – never mind Brexit – and before anyone suggests that the UK will benefit by leaving the EU, may I remind you that the UK was instrumental in driving through large parts of the MiFID II legislation.

I confess that I have a vested interest in this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry anyway, it reinforces my view that large elements of the non-EU financial services industry may simply expand their businesses in less heavily regulated areas. Frankfurt may grab a piece of the London pie but in the longer term it may well turn out only to be crumbs compared with what eventually relocates to Singapore and Shanghai

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.