Mud on both faces

City regulation

Jan 20th 2005
From The Economist print edition

Britain's FSA and the firms it regulates need to clean up their act

LEGAL & GENERAL (L&G), a big British insurer, has been quick to declare victory over its regulator. On January 18th, the independent tribunal that hears appeals against enforcement decisions by the Financial Services Authority cleared the company of the widespread mis-selling of mortgage-linked endowment policies that the FSA had punished with a £1.1m ($1.9m) fine. But mis-selling on any scale is bad; and the Financial Services and Markets Tribunal did find L&G guilty of some.

The case is one of many thrown up by the bear market in shares in Britain from late 1999 to early 2003. During the years of heady share-price growth that preceded it, individuals were inspired to buy endowment policies intended to pay off their mortgages at maturity. Many were not sufficiently warned that share prices fall as well as rise, and that investment performance might not be good enough to pay off the debt. Several large firms have been fined for mis-selling endowments, although L&G is the only one to have challenged the FSA. David Prosser, L&G's boss, took a risk, and although his company did not escape unscathed, he has reason to be pleased with the result.

The regulators emerge with the blacker eye in part because this is not their only recent mishap. On December 24th, the FSA announced details of a settlement in which the sellers of “split-capital” investment trusts (closed-end funds with several classes of shares) agreed to pay £194m to investors who had not been properly warned of the risks and management methods. As the regulators had indicated earlier that they were seeking some £350m, they were publicly bashed for not getting it. This week, the revelation that the Bank of England was boosting the number of staff devoted to sniffing out bad practices in the City suggested that it did not think the FSA was doing all that it could.

At issue is whether the FSA, which regulates the most sophisticated financial markets in Europe, is up to the job. This matters, not least because the European Union is moving quickly towards defining the shape of pan-European financial regulation and this, once set, will be hard to change. It matters too because the FSA has recently added to its enormous portfolio two more whoppers: mortgages and non-life insurance.

In its roughly five-year existence the FSA has achieved an enormous amount just by bringing Britain's formerly fragmented system of financial regulation under a single roof. But there are flaws, and the L&G case has highlighted them.

Procedurally, in trying to provide fairly swift justice the FSA failed to do its homework. It relied too heavily on a small sample of transactions, reviewed by PricewaterhouseCoopers, an accounting firm, and hardened suggestions of potential mis-selling into proven breaches. The tribunal roasted the regulators for these errors.

Structurally, the system is seen to lack fairness. The FSA's enforcement arm makes recommendations to its Regulatory Decisions Committee (RDC), which is staffed by outsiders but chaired by an FSA employee. The RDC in turn sets any penalties. L&G is only one defendant to protest that it cannot get a fair hearing. Sir Philip Watts, former chairman of Royal Dutch/Shell, is another. His appeal to the tribunal is pending.

The good news is that the FSA is likely to learn from all this. John Tiner, its chief executive, says that the decision provides a “positive stimulus” to look at where the FSA can improve its procedures, “to do what we probably should have done anyway”. A change of faces will help. The RDC is to have a new chairman—Tim Herrington, now a partner in Clifford Chance, a law firm. Andrew Proctor, the FSA's head of enforcement, left two weeks ago.

This fresh look may include using more often the FSA's statutory power to require firms themselves to appoint outside experts, with a duty of care to both company and regulator, to trawl through their records and identify wrongdoing. The FSA claims that L&G was unhelpful in providing information; the tribunal says the regulator should have been more aggressive.
Back on the other side of the street, L&G too has some housekeeping to do. The tribunal found that its procedures were patchy and that it did not do enough to ensure that buyers were well advised. Interestingly, though L&G challenged the fine, like other insurers it has paid compensation to some customers.

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