The Financial Services Action Plan: overrated, oversold and over here

By Keith Boyfield

Introduction

The title of this paper borrows from the old jibe aimed at American GIs during the Second World War- ‘over-paid, over-sexed and over here’. However, their involvement was probably considerably more beneficial to the UK than the Financial Services Action Plan (FSAP) may prove to be, even if they did lure away some of our best and brightest across the Atlantic.

Just as the US involvement in the Second World War was well intentioned, so is the FSAP – or at least as originally proposed. It seeks to complete a single market in financial services throughout the EU. Altogether the plan comprises 42 separate detailed measures and is the product of many years acrimonious haggling in Brussels.

The laudable aims include the promotion of competition, the removal of barriers barring such competition, greater consumer protection, improved transparency and the ability to offer services throughout the EU, so long as one is regulated by one of the 27 Member States. In industry jargon, this is known as ‘passporting’.

However, in practice, EU regulation of financial services may well disappoint its proponents. Progress is likely to be frustratingly slow as Member States seek to interpret the FSAP in such a manner as to protect their domestic financial services industry from foreign rivals. Some of them, for example, may resort to one of the 71 recitals or reserve powers bolted on at the last minute to the Level One version of MiFID, ¹ which allows them to impose a wide range of costly obligations on firms offering financial services in their domestic markets. What is more, there is a widespread view in the City that the Commission’s Internal Market Directorate, responsible for enforcing FSAP, harbour a misplaced confidence in the ability and willingness of all 27 Member States to implement the 42 measures that constitute the Plan.

Significantly, Commissioner Charlie McCreevy is beginning to share their concern. The Financial Times reported on 21st February that Mr McCreevy had warned an audience gathered in London that, "I fear that there is a real risk that the dream of a single new rule book replacing 27 existing rule books could be turned into a real practical nightmare. This will certainly happen if we end up supplementing the single rule book with the handiwork of a dozen or more gold-platers, with manuals of interpretative guidelines, with a multiplicity of different types of numbers of reporting fields - demanded by 27 different regulators." ²

In reality, the FSAP as presently framed may greatly hinder the creation of a single market in financial services while at the same time handicapping the EU’s financial centres, notably London, by making them less competitive through excessive regulation.

Furthermore, it is worth asking whether one can really ever achieve a single EU market without a single legal system, a single tax system and a single EU wide financial services regulator?

The Global Challenge

We now live in a global world. Looking ahead, the major growth opportunities in financial services may well focus on rapidly liberalising markets such as the BRIC nations and even the N11, ³ the group of rapidly growing economies that Goldman Sachs has identified as a source of new demand and sustained growth that could, in time, surpass existing major markets.

To take a specific example, it is worth looking at how the Indian insurance market is in the process of liberalising – it is opening up a competitive market where foreigners can take substantial equity stakes in firms offering a raft of services to a burgeoning middle class.

In China, the savings stock is estimated at $4 trillion while the total capital raised from issuing shares amounted to around $25 bn, yet this figure is dwarfed by the $200 bn raised from bonds. And on the insurance side, China Life has emerged as the world’s second largest quoted insurance company after AIG worth $130 bn, and that’s only four years after it was launched on the Hong Kong and Shanghai stock exchanges.

Furthermore, only at the end of July, the China Development Bank along with Singapore Temasek have invested €13.4 bn in a share purchase deal with Barclays to support its bid for ABN; interestingly, this deal was engineered by Blackstone, the private equity house in which the Chinese government has a 9.9 per cent stake following its flotation in New York last month. As Sir Callum McCarthy, head of the FSA, points out, “It is clear that the development of Asian capital markets to anything like their full potential will transform the landscape for global capital flows.” ⁴

Nor should we ignore the emergence of new financial centres such as Dubai, which has attracted over 100 international companies to its new international financial centre, which only opened in 2005. Morgan Stanley is just one of the large ‘bulge bracket’ investment banks that have opened their doors with 40 professionals now transacting business. The contribution from financial services is expected to quadruple by 2015 (that’s a leap from today’s figure of $3.4 bn to $15bn).

In the insurance sector, Bermuda is now the principal domicile of captive insurance companies with a 20 per cent of all captives formed, according to the Captive Insurance Company Directory. And Bermuda is doing a roaring trade in reinsurance. In the months following Hurricane Katrina, while traditional sources of insurance capital left the market, it is estimated that just under $20 bn of hedge fund capital flowed into existing or start-up reinsurance companies, many of them domiciled in Bermuda.

Here in London we have enjoyed spectacular growth as a financial centre following the Big Bang 20 years ago. A few vital statistics demonstrate this success: 75 per cent of EU companies who choose to list on a foreign stock exchange do so in London; 40 per cent of the world’s foreign equity market is traded in the City; 43 per cent of OTC derivatives are traded in London; 20 per cent of international bank lending is arranged in the UK; and 70 per cent of international corporate bonds are traded on secondary markets here in Britain’s capital, which is the world’s largest market for international insurance. London is winning plaudits for its ability to attract business from other financial centres worldwide, not least New York.

New York is worried. Earlier this year, a report was produced by McKinsey for Mayor Mike Bloomberg and other leading political figures in the Greater New York area. It is an excellent analysis of the thicket of complicated rules which currently shackle New York’s financial services industry. Significantly, in their joint introduction to the report, Mayor Bloomberg and Senator Chuck Schumer stress, “The flawed interpretation of the 2002 Sarbanes-Oxley Act, which produced far heavier costs than expected, has only aggravated the situation.” We should take note and act on their wise words because the FSAP threatens to tie London in similar set of regulatory handcuffs.

The McKinsey report sets out four main contributory factors to this loss of competitiveness:

• Over-regulation, notably the Sarbanes Oxley Act passed in the wake of a number of high profile corporate scandals such as Enron and Tyco. The deterrent effect of this regulatory excess is reflected in the dearth of recent IPOs on the New York Stock Exchange.
   
• Highly litigious culture, as Conrad Black must now appreciate.
   
• Post 9/11, real difficulties in obtaining visas for highly skilled talent from abroad.
   
• The sheer expense of operating in New York, reflected in real estate prices both in Manhattan and the Hamptons.

Worryingly, one is beginning to see the same types of constraints threatening the growth of London’s financial services industry. And the FSAP may jeopardise London’s ability to exploit new opportunities to win business in the developing world.

What is more, Paris and Frankfurt would like to win back some business from London. So would emerging centres such as Malta, home to an increasing number of captives, and maverick centres such as Latvia (described by some as a centre of excellence for money laundering) and offshore centres such as Gibraltar.

Last December our consulting firm – Keith Boyfield Associates - published an in-depth study of the impact of the FSAP for the think tank, Open Europe. This report was based on an extensive survey of City firms and professionals together with a series of face-to-face interviews with leading players at a wide range of financial services firms and professional advisers, notably lawyers. We compiled a table setting out the estimated costs that would be incurred in the UK with regard to the implementation of the regulations that comprise the Plan. Our estimates also drew on work undertaken by regulatory bodies and government departments, trade associations and firms of economists such as Europe Economics and Oxera. As you can see from the table, these combined costs may amount to as much as £23.5 billion.

Table 1: Estimated costs for the UK of key FSAP measures

Source: Keith Boyfield Associates. For further details see Selling the City Short? Open Europe, December 2006 13.7-23.5bn

You will also observe from the table that considerable uncertainty surrounds the precise implementation costs associated with some directives. For example, the costs associated with implementing the Capital Requirements Directive may cost anything between £2.5 bn to £7bn by 2010, the symbolic deadline for the completion of the Lisbon Agenda, which aims to create a ‘more dynamic, innovative and attractive Europe’. Meanwhile, a heated debate surrounds the eventual cost of implementing MiFID throughout Europe. The most conservative estimate suggests a total cost of £1.2 bn for the UK alone, but our own Open Europe forecast does not rule out the eventual cost amounting to as much as £6 bn, depending on the precise compliance routes adopted.

This uncertainty over costs as well as benefits was highlighted by Sir Callum McCarthy, Chairman of the FSA, who told the Commons Treasury Select Committee, “It is deeply unsatisfactory that UK financial services firms face major changes, with the associated costs, for an initiative which has been subject to no comprehensive EU cost benefit analysis.”

Although I have not done any detailed work on the FSAP as a whole since the beginning of this year, I have been monitoring what has been happening in certain areas, namely MiFID and the Solvency 2 Directive which regulates the European insurance sector. While developments with the formulation of the latter have proved comparatively promising, the former is a worsening headache.

Beginning with the relatively good news, the Solvency 2 draft directive published earlier this month by the Commission was undoubtedly a win for the lobbying campaign led by the City, ABI and Treasury. It is the first directive within the insurance sector to follow what is termed the Lamfalussy procedure, ⁵ whereby details are hammered out once broad principles are agreed.

The proposed regime – known as Solvency 2 – will replace the existing Solvency 1 rules adopted in the 1970s that govern how much capital insurers must keep in reserve to underwrite business. Broadly speaking, the draft directive appears to have adopted the risk based approach promoted by the UK.

Solvency 2 will streamline the number of regulators firms report to and harmonise standards for measuring their ability to pay claims. Who will benefit from this revision exercise? "The big and diversified players,” says Bryan Joseph, the head of PricewaterhouseCooper’s London actuarial practice. ⁶ Everyone I have talked with in the City agrees with him.

Essentially, the new standards will favour the industry's major firms because companies that sell a diverse range of risks will be allowed to keep less money in the bank to back their policies. Solvency 2 is therefore likely to act as a catalyst for further consolidation of the industry. The big players will prosper; those with a specialised niche will probably still find a market for their services, but existing mid-sized firms will need to identify a competitive advantage to survive. The jury is still out on how all this will pan out, particularly as the directive is not likely to be implemented fully until 2012 – two years behind schedule, and Member States will continue to haggle over the implementation of the measure for the next five years.

While Solvency 2 appears to be a step in the right direction, there are continuing concerns over the way in which MiFID is being implemented, or not as the case may be. This hugely ambitious initiative will end the obligation to trade securities on domestic bourses and will seek to create a level playing field in securities transactions across Europe. It is due to be fully implemented by 1st November.

MiFID Monitor reports that as of June 2007 only 10 out of 27 Member States have notified the Commission that they are likely to meet the target deadline of 1st November. Spain and the Netherlands will not be ready to implement in November and a number of Scandinavian countries look as though they will join them. The Commission is beginning infringement proceedings but this will take a long time to complete. This begs the question, will firms regulated in MiFID transposed countries be able to passport their services to non-transposed Member States; and will firms in non-transposed countries be able to compete in those markets such as the UK that have transposed MiFID? As things currently stand, this move to establish a single market in securities trading is riddled with problems, and expensive problems at that. Jon Moulton, the founder of Alchemy Partners, argues that MiFID “will drag stuff out of London”; in particular, “It will tend to result in people with large amounts of money going somewhere else.” ⁷

In The Business recently it was reported that a survey conducted by the consultants OEE & Cosonovo revealed that with the exception of smaller stock exchanges and trading platforms, the majority of fund managers and stock brokers polled believe the costs of complying with MiFID will exceed the benefits. ⁸

And over one half of them reckon that the FSA has underestimated the cost of implementing the MiFID directive. In particular, the IT costs associated with MIFID requirements are likely to soar. Accenture reckons EU-wide costs may total €2bn while Sun Systems predict it may be as high as £8 bn. ⁹

But perhaps the key point about MiFID is the catalytic role it may play in consolidating share dealing throughout the EU. The larger integrated investment banks will probably prosper at the expense of the smaller - but often highly innovative - houses. This was a crucial point that was made over and over again when we conducted our wide ranging programme of interviews for the Open Europe study. Significantly, the major investment banks, dominated by the US houses such as Goldman Sachs, Morgan Stanley and Lehman Brothers, are comparatively relaxed about MiFID as well as FSAP as a whole.

The smaller banks and financial institutions are likely to find MiFID an onerous and expensive regulatory burden. As Jon Moulton points out, it will represent “a wall of inefficiency for Europe relative to other countries”. He adds, “It will result in the comparative advantage of London as a financial centre being eroded”, and he is particularly concerned about “what it will do will be to hamper our smaller, livelier market players.” ¹⁰

The beneficiaries from MiFID will tend to be suppliers of IT services and the regulatory consultants and accountants that are required to ensure compliance. Robert Walters, a headhunting firm, reports that, “salaries have continued to rise. In some specialist areas, particularly within investment banking, senior compliance officers have enjoyed a dramatic pay hike”. ¹¹ Global heads of general compliance can now confidently expect to earn more than £220,000 a year. However, all these resources spent on regulatory compliance ultimately threaten our long term global competitiveness.

Judged overall, the FSAP threatens to saddle London with an unnecessarily rigid regulatory grip really designed for retail markets, not the City’s sophisticated wholesale markets.

New York Gets Ready to Prune the Regulatory Thicket

The problem of excessive costs imposed by heavy-handed regulation is a factor now fully recognized in New York, London’s main rival. More to the point, the authorities are beginning to reverse the regulatory tide. Following the publication of the McKinsey report and a welter of articles in the financial press and media reports on the costs and dislocation associated with regulatory overkill, the current Administration has decided to tackle the issue of regulatory red tape. Hank Paulson, the Treasury Secretary and a former head of Goldman Sachs, announced on 26th June that the US government would be reviewing the regulation of capital markets. ¹²

The US Treasury is due to make its recommendations on how to reduce legal and regulatory burdens that business leaders along with Mr Paulson recognise are handicapping US competitiveness. One specific initiative is the request Mr Paulson has made for the hedge fund industry to develop its own self-regulatory best practice code – instead of a statutory one.

Recommendations

So, what should we do to defend and enhance London’s role as one of the world’s major financial centers? Here are six suggestions, some more radical than others.

1. The European Commission is due to conduct a review in 2008 to assess the progress made with the FSAP and whether there is a case for tackling specific instances of overzealous regulation. This review will be led by Charlie McCreevy, whom many people - including me - think is one of the champions of free markets within the EU. Nevertheless, there is likely to be a limit to what can be achieved; so we must be realistic. Trade bodies such as the BBA, LIBA and the ABI, as well think tanks such as Global Vision will have a crucial role to play in submitting well researched submissions on the shortfalls and costs associated with the FSAP.
    
2. The radical option I would support is to amend and simplify some of the detailed regulation contained in the FSAP. For example, we need to address Articles 9 and 11 in the Takeover Directive, which enable companies in certain countries, notably France, to adopt ‘poison pill’ defences against hostile bids. Another example would be to redraft the UCITS III regulations pertaining to fund management so as to avoid the present national divergence in implementation. A third example would be tackle the suitably named MAD Directive, designed to address market abuse and insider trading, which is unnecessarily burdensome and prescriptive. For more details on what needs to be done it is best to read our Open Europe report.
    
3. We only need minimal but effective regulation of wholesale markets; this is the key lesson to be drawn from the Sarbanes-Oxley debacle. The onus should be on a principles based approach. As Sir Callum McCarthy says, “There are many, and better, means of solving problems than new regulations.” In this context, it is worth reading and digesting the Ten Principles of Better Regulation set out by the International Council of Securities Associations.
    
4. Maintain an open door approach with visas available for specialised talent. This welcoming attitude is what made cities such as Venice, Amsterdam, New York and London prosper in the past. They were much the richer in every sense because they embraced oppressed groups such as Jews, Armenians, and East African Asians.
    
5. As well as excessive regulation the UK must review its tax regime. The Treasury and Revenue & Excise are already doing so with regard to private equity, partly in response to a trade union campaign, and also because of the sheer size and clout of mega funds such as Primera and Blackstone. We would do well to take notice of the strategy adopted by Macedonia, which is clearly keen to attract new business to the country.
    
   Macedonia is currently promoting itself as the ‘new business heaven in Europe’. In an advertising campaign that ran in the Financial Times earlier this year (see advert below), it highlights the fact that as from 2008 it will offer investors a flat tax on profits of only 10 per cent (the lowest in Europe); income will be taxed at only 10 per cent while the authorities promise it will only take three days to register a company. The inducements in the free economic zones and technology parks are even more attractive to the investor.
    
   A little closer to home Ireland has slashed taxes on business – corporation tax was cut from 38 per cent to 12.5 per cent in 2002. The results have been remarkable: inward investment has risen strongly, economic growth has surged and Ireland now boasts the highest GDP per capita within the EU. With tax competition between Member States becoming more aggressive, the UK would do well to think hard about its tax and regulatory regime (this recommendation applies to George Osborne’s team just as much as to the current Treasury team under Alistair Darling).
    
6. More gloomily, yet perhaps more realistically, one suspects that real action will only be sparked when one sees a mounting number of losses – which means more businesses deciding to follow the example set by Hiscox, which recently relocated a significant part of its insurance business to the welcoming shores of Bermuda. We are already witnessing some hedge funds and a number of investment banks conducting more and more work in other parts of the world, such as Budapest and Mumbai. In this context it is striking to see the number of traders and analysts from the Indian sub-continent working for investment banks in the City. Already, Morgan Stanley has a sizeable office in India; Goldman Sachs has just established a wholly owned business in India. I believe such moves may be signaling something profound.

However, the danger remains that a radical review of the FSAP may not be possible because our EU partners would oppose such moves, which strengthens the case for an ‘a la carte’ Europe, as advocated by Ruth Lea, Global Vision’s Director.

Notes & References

1. The Markets in Financial Instruments Directive.
2. ‘McCreevy warns that EU states risk creating MiFID 'nightmare'’ by Tobias Buck in Brussels, Financial Times, 21 February 2007.
3. The N11 group of counties consists of Bangladesh, Egypt, Indonesia, Iran, South Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey and Vietnam.
4. IOSCO conference speech, 16 November 2006.
5. The Lamfalussy Process, named after Professor Lamfalussy, is composed of four ‘levels’, each focusing on a specific stage of the implementation of EU legislation.
6. ‘New EU Insurance Rules Could Free Up Capital’, Wall Street Journal Europe, 10 July 2007.
7. Interview with Jon Moulton, 14 August 2006.
8. ‘City counts the true cost of MiFID compliance’, by Helen Dunne, The Business, 11 July 2007.
9. Source: Financial Times, 16 February 2006.
10. Interview with Jon Moulton, 14 August 2006.
11. Quoted in Selling the City short? A Review of the EU’s Financial Services Action Plan, Open Europe, December 2006, p. 95.
12. ‘Paulson Details Plan to Review US Regulatory System’, Wall Street Journal Europe, 27 June 2007.
13. IOSCO conference speech, 16 November 2006.

Notes on the author:

Keith Boyfield is a leading economist specialising in marketing, competition and regulatory policy. He has built up a reputation as a writer on economic and financial issues, having written over forty studies for several leading think tanks, including the IEA and the CPS, and has written extensively on the Financial Services Action Plan. He has also served as a consultant to the European Commission, having recently completed a major study on the economic effects of secondary slot trading at congested airports for the Competition and Energy & Transport Directorates. Keith is currently editing an International Guide to M&A Tax for Acquisitions Monthly and sponsored by KPMG as well as writing a market intelligence study for International Financial Review (IFR) on the Global Insurance Sector and its influence on international capital markets. Keith is a regular contributor to the press, television and radio. He writes for the Wall Street Journal Europe, Financial Times, The Business, The Daily Telegraph and The Independent. He also writes for a number of specialist journals and magazines. He is a Director of Leriba Risk Services Ltd., a company he recently co-founded with Jonathan Clayton, The Times correspondent in Africa and Buchizya Mseteka, who served as Reuters correspondent in Uganda, Kenya, Tanzania and South Africa. He is also a member of Global Vision’s Economic Advisory Panel.