Peter Bartram 4 Apr 2018 04:14pm

Restoring confidence in regulators

Regulators are facing challenging times, and they need to rise to the occasion. Peter Bartram examines what they must do to remain an effective force

Caption: Photography: Getty Images

It has been a torrid start to 2018 for Britain’s financial regulators. The Financial Reporting Council (FRC) was under fire for its oversight of KPMG’s auditing work at failed outsourcing contractor Carillion – even though KPMG may ultimately be found not to be at fault. In March the FRC’s chief executive Stephen Haddrill suggested a radical shake-up of the audit industry, calling for an inquiry by the Competition and Markets Authority into whether the Big Four accountancy firms should be broken up in an effort to boost competition and stamp out conflicts of interest.

The Pensions Regulator was criticised for not taking action as the deficit on Carillion’s scheme ballooned to an estimated £990m at the end of 2016. The Financial Conduct Authority (FCA) was lambasted in Parliament for not publishing parts of its report into the scandal at Royal Bank of Scotland’s Global Restructuring Group. (It later agreed to publish the report subject to the consent of those who provided the information for it).

Meanwhile, the Prudential Regulation Authority (PRA), part of the Bank of England, has been out of the spotlight. But its time in the firing line will come if Brexit causes serious instability in Britain’s financial system.

The latest ructions come after years in which critics have claimed the regulators have not been tough enough. Some point to the tougher approach of the US Security and Exchange Commission’s (SEC) Operation Broken Gate. The five-year-old programme is designed to protect investors by providing tighter oversight of auditors responsible for fair financial presentation and disclosure by public companies.

It’s little wonder that a more savvy breed of British regulators are keen to strut their stuff and show their strength. They realise that consumer confidence in matters of finance, not yet recovered from the 2008 crash, won’t be rebuilt if it looks as though they are dozing on the job.

In reality, nothing could be further from the truth. There has been some tough enforcement action in recent months and signs that regulators will be tougher in the future.

But perceptions can be as important as reality. And the main regulators know that they have to raise their game if they’re to win back public confidence. Aside from the Carillion fall-out the FRC’s Haddrill has faced criticism that the world of audit regulation is incestuous. Ex-Big Four auditors regulate the activities of previous colleagues. It’s a bit like auditors marking their own homework, claim critics.

But regulators point out that auditing, especially of large companies, is a complex business. It requires specialised knowledge and, equally important, hands-on experience to spot the critical issues. One way to tackle public cynicism about auditor regulation is to improve the FRC’s transparency. Haddrill says the FRC has taken a number of measures to ensure those taking decisions “are not conflicted in any way”.

“We have published our register of interests, established a wider stakeholder panel, are recruiting board members with diverse backgrounds, and will be more open when possible about the reasoning behind our enforcement decisions,” he says.

The FRC has imposed tougher monitoring and supervisory arrangements for audit. They include changes to auditing standards, which require auditors of public interest entities to report breaches of reporting rules or concerns that there is a material threat to the function of the company. “This is a stronger test than was previously applied,” notes Haddrill.

The FRC would like to see companies become more proactive in raising their audit game. “We’re requiring firms to conduct thorough lessons-learned exercises when quality falls short,” Haddrill says. “We’re also looking at the quality of leadership and support given by the firms to frontline teams.”

ICAEW’s chief executive Michael Izza has a bolder suggestion. Since everyone is agreed that there is not enough competition or choice in the audit market, then perhaps the whole structure must change, he says. “The question is not ‘why do the Big Four have so many Public Interest Entity audits?’ but ‘what is putting other large firms off from entering this market?’ The FRC might be able to shed some light on this – two large firms outside the Big Four have chosen to exit the PIE audit market recently, citing the exponential rise in the cost of FRC regulation, the fact that it now takes several months to review audits, and the disincentive for audit partners to risk their careers as a result of protracted investigation. Audit is evolving, and must keep evolving, in order to meet the needs of society.”

FCA chief executive Andrew Bailey also recognises the need to build public confidence in financial regulation. But he points out that regulating 56,000 very different firms is a significant challenge. “We can’t man-mark them, except with the bigger firms,” he says. “We can’t be all over the landscape with the same level of intensity.”

That means making real choices in the FCA’s annual plan. In making those choices, Bailey and his team are alive to the seismic changes in society, which have an inevitable impact on the profile of financial services regulation. At the heart of the change lies a shift in the lifecycle model of saving, borrowing and investment. There has been a growth in the indebtedness of young people, part fuelled by university tuition fees, while older generations stack up asset wealth in houses and pension pots.

Alongside this, Bailey points to the difficulty in handling issues which push the boundaries of regulation. He mentions the growth of cryptocurrencies. The currencies themselves aren’t subject to FCA regulation but derivative instruments based on them are.

Despite the difficulties, Bailey is confident the relative recent change in regulation structure – the powers of the old Financial Services Authority were shared between the FCA and PRA in 2013 – is working well. Bailey works closely with Sam Woods, current PRA head. The pair sit on each other’s boards and share information.

But the biggest test will come with Brexit. Bailey sees the biggest threat if the final deal doesn’t tackle the “cliff edge” risks to financial services – such as contract continuity and handling of derivatives. The risks are symmetric, Bailey says. They pose a danger for the remaining EU countries as much as Britain.

Haddrill is clear about what he would like to see: “We need to make sure that either the UK regulatory system for audit is regarded as equivalent by the EU and third countries or that there are efficient, rapid mechanisms for securing this.It’s important to provide investors with assurance about work done in overseas companies listed in the UK,” he says. He is also concerned about the talent pipeline in a post-Brexit world. “Audit depends on the UK having sufficient skilled and experienced people,” he says. “As such, recognition of qualifications, and a system that allows auditors to work across different countries, will be an important requirement.”

He adds: “Our key objective is to promote transparency and integrity in business so that the UK remains a magnet for global capital and a centre for excellence for the accounting and actuarial professions.

A principled approach to regulation

Who’d be a financial services regulator? If the recent history of regulation is anything to go by, there are – to borrow a no-nonsense Northern phrase – more kicks than ha’pence.

The core problem regulators face is that they’re in danger of satisfying no one. If they come on heavy, they’re accused by financial services providers of damaging their competitiveness. But when a fresh scandal emerges, consumers and MPs accuse the regulators of being asleep at the wheel.

It would be easier if providers and consumers could agree on the rules of the game. If the two groups accepted a common set of principles against which regulation would be judged, the regulators themselves might get less stick when another financial scandal hits the headlines.

But what outcome is a regulator seeking to achieve? If that’s clearly defined, everyone should know how it should be judged. As ICAEW says in its Principles for Good Financial Regulators: “Regulatory activity is not an end in itself; only outcomes matter.”

Yet the problem with principles is that they’re expressed in general terms which are open to interpretation in different ways. Principles are great as a standard to aim for. But if they become too specific, they turn into a prescription for action – and that could reduce the flexible approach regulators need when they are dealing with a wide range of different situations.

ICAEW argues that “regulators should recognise the paramount importance of developing and embedding in financial services a culture of strong ethics, focus on the interests of clients and, more generally, determination to do the right thing”. But there’s more than a touch of motherhood and apple pie about that aim and financial services firms are unlikely admit to doing the opposite.

That doesn’t mean principles can’t act as a helpful guide. ICAEW’s approach focuses on four areas that all need more attention. The first is that regulators should make their stakeholders understand the approach they adopt. That means communicating their objectives clearly so that stakeholders know how their performance will be measured.

It helps also if the regulations are simple to understand, so that stakeholders know how they are supposed to behave in given situations and the standards of competence they’re expected to display. Stakeholders also need to predict with some certainty how a regulator would judge the outcome of a course of action. So no more running to the lawyers to ask whether it’s possible to do something or not.

The second principle is that regulations should be proportionate and fair. The proportionate principle means defining regulations at a level that matches the complexity and risk profile of a market. Regulations can’t achieve everything – for example, they can’t always spot deliberately criminal behaviour. But they can provide a framework for policing a market which the main players understand and buy into.

One way to win support for regulation among stakeholders is to make sure that the regulations and the way they are made are transparent. And when regulations are stable – rather than a moving target of constant changes – stakeholders find it easier to apply them consistently.

The third principle is that the regulators need to understand the markets they regulate in depth. During the past 50 years, financial markets have steadily become more complex and there is no sign that the drive towards more complexity will abate in the future.

Innovation in financial services has often been based on developing a fresh layer of complexity. So regulators need to understand the significance of new complexities, but also the unforeseen consequences of failure in an unfamiliar or innovative market.

There is some truth, too, in the red tape jibe about regulation. It does impose costs on businesses that are often fighting for a commercial rate of return in a competitive market. So regulators need to be aware of the costs of the regulations they impose.

The final principle is that regulators need to be robust both in the way they monitor regulations and the way they supervise regulated entities. It ought to be the case that a firm approach to enforcement will, over time, reduce the need for enforcement actions – because more companies will up their internal regulation game. But that’s a game which is yet to be won.