Last night I attended a vigorous roundtable hosted by AQMetrics, a risk and compliance software provider, which argued over how MiFID II, the incoming regulations covering European Union financial markets from 2018, can change culture and conduct in financial Institutions. The debate seemed to conclude that MiFID II relies on producing and monitoring far more data across a range of asset classes to encourage transparency but there are many aspects of culture which cannot be measured.
Anat Admati, finance and economics professor at Stanford and co-author of the book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, said the financial crisis exposed the ineffectiveness of regulations at that time and that they are still inadequate and flawed. In a paper this year, It Takes a Village to Maintain a Dangerous Financial System, she said: “Most of the time, however, the harm from excessive risk in banking is invisible and the culprits remain unaccountable. They rarely violate the law.”
As a result managers and financial institutions, who have access to cheap funding, enjoy magnified profits and bonuses during prosperous periods but suffer little on the downside. In addition auditors, credit rating agencies, law firms, consultants and lobbyists can profit from overly complex rules.
Admati also said that fund managers tend to benefit on the upside and have little to lose if they take risk for which their investors or clients are not properly compensated. So asset managers may not be run fully in the interests of the small investors whose money they invest.
The UK Financial Conduct Authority agreed in a 200-page report on UK asset management last week which concluded that limited price competition means that investors often pay high charges and on average, these costs are not justified by higher returns. The limited price competition means that fund management has enjoyed sustained, high profits over a number of years, despite clients not making their desired returns.
The FCA illustrated the impact on costs on a £20,000 investment over 20 years to show the impact of charges. An investor in a typical low-cost passive fund would earn £9,455 (24.8%) more than an investor in a typical active fund, and this could rise to £14,439 (44.4%) once transaction costs have been taken into account.
The regulator said most active equity funds charge fees of between 1% and 0.75%, which has not changed over the last decade. Fees do not fall as the fund size increases so economies of scale are captured by the fund manager rather than being passed onto investors. As a result, asset management firms have consistently earned substantial profits across the FCA’s six-year sample, with an average profit margin of 36%.
Admati compared banking regulation to the safety standards in the aviation industry, where everyone involved fears being directly responsible for deaths, and does their best to maintain safety. “In banking, the public interest in safety conflicts with the incentives of people within the industry. Because the harm is difficult to connect to specific policy failures and individuals, it persists,” she added.
MiFID II introduces new rules and both the buyside and the sellside have to report far more data, supposedly so that like the aviation industry, regulators have better radars to prevent accidents.Yet this does not mean there will be culture change if firms treat MiFID II as a form-filling exercise and continue to believe they can do anything as long they are not breaking a specific rule – rather than acting, first and foremost, in the best interests of their clients or investors.
Regulations on their own are not enough. As Admati pointed out, it will take a village to change the financial system. This involves everyone from executives and individuals in the financial system, governments, central banks, academia, auditors, credit rating agencies, law firms, consultants, lobbyists and the media as well as the regulators. So if MiFID II and all the other incoming regulations just serve to increase costs, rather than change culture, it will be a wasted opportunity.