Financial Services are never far away from the news at present, whether in the context of Brexit, banking or regulatory issues. However I took part in two events last week which focused attention on the sector, and which may both find their origins - along with the 2008 financial crisis - in the so-called ‘Big Bang’ over 30 years ago, in 1986.
The first of last week’s events was a presentation by Mark Littlewood, Director General of the Institute for Economic Affairs. The second was Capital Economics’ UK Forecast Forum last Thursday.
Paul Hollingsworth at Capital Economics was talking about the long-term outlook, and he has analysed the sectors which made a particular contribution to the fall in average UK productivity between the years 2000-2007 and 2009-2015: in other words, before and after the crash of 2008. His chart shows that financial services are responsible for more than half of that fall: a central challenge for the UK economy (to which the Chancellor drew attention in his November Budget).
Mark’s presentation looked particularly at trust in financial services, and how to set about re-building it. He drew attention to the vital importance of the sector, which employs c. two million people and generates £71 billion each year in taxes, and he argued for better communication of its role - not only in providing services for all, but also in pooling risk to enable their access to those services.
Both speakers drew attention to excessive regulation: in fact Mark pointed out that whereas in 1979 there was one regulator for every 11,000 people employed in the sector now, there is one for each 300 people employed.
Regulation, however, does not come out of nowhere. It comes in response to a problem, and in my mind it is crystal clear where that problem started: it was in the dual capacity ‘Big Bang’ in October 1986. Prior to that date there was a rigid definition between the roles of principal (dealing for your own account) and agent (acting in the sole interest of your customer). After that date a spate of mergers and acquisitions took place, blending the two ‘capacities’ and creating massive conflicts of interest which, in my view, financial service firms have never been able to control . Dual capacity flooded into banks, investment companies, mortgage providers, everywhere ..
I have been a pure agent since setting up Barclayshare (now Barclays Stockbrokers) in 1986 and, in the early days of Share Radio, I discussed this issue with Brian Winterflood, the legendary stockjobber who has been a pure principal all his working life. The link to our discussion is above.
To illustrate the conflict of interest challenge, I recall some years ago a research analyst from an investment bank setting out at a public meeting the sequence of priority for recipients of his research. First it went to the proprietary trading book, secondly to the firm’s corporate advisers (M&A etc..), and third and last to the investment clients. What a revelation!
So what are the consequences of this? For the businesses themselves, dual capacity means an ever-present temptation for misbehaviour and a huge increase in systemic risk, as businesses seek to sell off their own book to their more gullible customers – the sale of sub-prime mortgages triggered the 2008 crash, and directly resulted from the mixing of retail supply with institutional product trading.
And for customers as a whole, it breeds an atmosphere of distrust: think PPI and other mis-selling scandals. The result is a continual push for ever more regulation, and that’s what we’ve seen.
The 2008 crash can therefore be traced directly back to ending the separation of the principal and agent roles, and its seismic shock ended a whole raft of high margin, high risk products. As Paul Hollingsworth pointed out, this may explain the impact on productivity before and after the crash: we can see both the step change in 2008 and the lower growth rate since then.
What’s to be done? Difficult, because dual capacity is now so deeply ingrained in financial services. It’s in banking (there was an opportunity to address it there, but unfortunately the Bank of England made the split into ‘retail’ and ‘casino’ banking rather than agent and principal), investment services, insurance - it’s everywhere.
My preference is that businesses should be required to disclose their capacity when advertising their services. Those which only act in their customer’s interest should state ‘100% agent’; those which also trade from their own positions or products should explain how this affects their customer proposition. Then at least people would be able to make their own judgement: trust would have more the chance to recover. And as it did, the burden of regulation should be reduced on ‘single capacity’ firms.
The financial services sector is too important to the UK economy to be consigned indefinitely to this half-life: over-regulated and under-performing. We must work with business models that people can understand and trust: and we must remove chronic appeal of misbehaviour.
Thanks to Capital Economics and the Institute of Economic Affairs, at least we can now see the consequences when we don’t take action.