Positive action, but slow progress

The accountability proposals follow the Financial Services (Banking Reform) Act 2013, which created a criminal liability for managers where they are responsible for contraventions that occur within their area of responsibility that cause a financial institution to fail. Given the depth of the financial crisis and its seriousness, it has been a frustration for government that no one has been sent to prison.

The new proposals from the regulators extend the area of regulatory scrutiny and the need for prior regulatory approval beyond the board to executive committees and to heads of important business areas. Beyond that, other senior individuals whose responsibility could lead to “significant harm” will need to be assessed by the employing firm each year, to ensure they continue to be fit and proper for that role.

Senior individuals whose responsibility could lead to “significant harm” will need to be assessed by the employing firm each year

Most financial institutions make their investment or lending decisions subject to the approval of a committee that usually has a wide membership designed to use the range of skills and experience within the organisation in the decision-making process. So the regulator will now be able to target these individuals for regulatory action, as well as directors. The board has ultimate responsibility including for the investment committees, but now the regulator has to approve them both.

On bonuses, the regulators are proposing to extend the deferral period. The key problem with a bonus is that it incentivises the individual to put his own interest ahead of the firm’s. The American phrase, “you eat what you kill”, describes this approach succinctly – it’s all about the individual. The firm merely provides the context or environment in which the individual can hunt.

To discourage the individual from acting in a way that jeopardises the future of the firm, a proportion (40 per cent to 60 per cent depending on seniority) of the bonus is delayed – the current requirement is a period of three to five years, although most firms opt for the minimum of three years. The new proposal is to extend the minimum to five years for “major risk takers” and to seven years for senior managers. This will mean a substantial proportion of bonus will always be outstanding for the individual, thus encouraging them to ensure the firm does not fail.

Loopholes

One way round this problem is for an individual to move to another firm when the new employer buys out the unpaid bonus with the old firm – defeating the purpose of the deferral arrangement. In fact, the individual almost has an incentive to move employer, especially if there is a concern over future viability of the old firm. The regulator is addressing this problem by suggesting some alternatives: a ban on buy-outs, maintaining the deferred bonus or clawing back the bonus if a problem subsequently emerges. The FCA must outlaw buy-outs in order to make the deferral mechanism effective – then the incentive for the individual to ensure the firm does not fail will work.

None of these proposals will be welcomed by banks, although they are hardly unexpected. Whether this new regime would have prevented the financial crisis is not easy to judge — let us hope it is not tested.

Will anyone ever go to jail? If an individual caused the bank to fail then he should certainly be prosecuted, but probably so should the board for allowing that person so much power to put the institution at risk. It might even be suggested that the individual had been approved by the regulator, suggesting it, too, should assume some responsibility. The one thing that is certain is that there will be another scandal and a major bank will suffer a major loss — that’s when these new rules will be tested.

The FCA has reported on its investigations into best execution, in which the regulator visited certain firms and discovered both good and bad practices. The best execution rule requires brokers to get the best price for their customers – it’s a very obvious requirement, otherwise what are brokers for?

The numbers can be very substantial: the Investment Management Association estimates that its members manage some £2.2 trillion in equities. If all investors could save a basis point (0.01 per cent) in terms of price or other dealing costs, this could translate into £264 million in additional client returns each year (based on average turnover levels), which over 30 years could represent an additional £37.5 billion of value.

Failures

The FCA’s review highlighted examples of poor practice – firms not delivering best execution, because they did not believe the client was relying on them, or that the firm assumed that the client had already shopped around for prices. Meanwhile, certain firms thought that some instruments (for example, fixed income) were not included.

All these represent such serious levels of misunderstanding that they are risible. The basic or default presumption is that best execution applies unless it can be established otherwise.

Firms are required to monitor their execution performance in order to ensure that they are delivering a good service. This is no more than simple quality control, which is required whatever product or service you provide. One firm was monitoring by comparing prices achieved with a benchmark, but only where the difference represented a value of at least £500. So if your transaction was £1,000, but you had lost £450 by virtue of poor execution, the monitoring of execution quality would not have picked up the problem.

The examples of poor practice indicate how difficult it is for clients to check on the performance of their brokers – this is why clients need brokers. If the client had the resources or expertise to be able to judge the broker’s performance, he probably would not need the broker.

Payment for order flow is a strange arrangement, which has been seen in the LIFFE options market. The basic idea is that the broker may charge the client a fee or commission for execution (including the provision of best execution) and then finds a price by ringing several market makers (as is the obvious way to demonstrate that the best price has been obtained): once the transaction is finalised, the broker charges the market maker an additional commission. This essentially means the market maker paying for the order. This second commission amounts to an inducement under FCA rules and is not compatible with the best execution rules. There is an incentive to direct the order to the market maker paying the most commission. The second commission is something the market maker has to factor into his price, so it is in effect a cost hidden from the broker’s client.

The practice was addressed by the FSA in 2013, when it published guidance stating that payment for order flow breached its rules. However, its recent report states that some firms are continuing to collect payments from market makers by describing the service they provide as “arranging” rather than “execution”.

This recast service enabled the brokers to argue that best execution did not arise — an interpretation that the FCA has rightly rejected. Apparently, the FCA has informed the four firms concerned of its conclusion and they have ceased this practice. This is progress, but it has taken the publication of guidance and a visit to stop this practice — and not all firms were visited.

Andrew Hampton is a former investment banker