Stopping the party going too far

Anthony Hilton
12 Jun 2009

If Britain's financial services industry is indeed under threat from the European Union's “badly designed new controls which would needlessly undermine London's competitive advantage”, as shadow chancellor George Osborne alleged in a speech this week, then really Britain has only itself to blame.

Any student of the workings of the European Union knows that each of the big countries has its national interest and there is no point in seeking to change policy in that area unless that country agrees.

Thus there can be no change to the Common Agricultural Policy unless the French support it. There can be no change in heavy industry, in, for example, policy towards utilities or chemicals, unless the Germans are onside.

Yet when it comes to financial services, which is the UK's core interest, there is no such natural deference towards the wishes and special interests of the UK. This is the ultimate failure not only of British diplomacy over the past 30 years but also of British refusal properly to engage constructively with Europe. It is the price paid for being a permanent member of the awkward squad.

But having said that it obviously makes sense not just to try to get the regulation right but to question whether it is needed at all. Every banking crisis brings forth regulation to stop such a disaster happening again. But it always does.

They do of course say that it is a sign of insanity to do the same thing over and over again and expect a different outcome but this never seems to turn politicians away from seeing legislation as the cure for all ills.

Outside Westminster and Brussels, however, almost everyone agrees that it is rarely the absence of rules which is the problem, it is the absence of intelligent, knowledgeable enforcement of those rules.

This point about culture is essential because the most effective regulation comes from within organisations, not as a result of external threats.

That at least is the thrust of a new paper produced this week by Clare Spottiswoode — one-time gas regulator and most recently policyholders advocate for Norwich Union — and Stephen Kingsley one of the most knowledgeable and perceptive consultants in the financial services industry, once with Arthur Andersen and now a managing director at FTI.

The space here cannot do justice to the various proposals made to improve the culture within banks but their key insight is to give external accountability to internal risk management.

Every bank, indeed every major financial institution has a highly developed internal system of risk analysis and control. The problem is that the department does not have sufficient status to make its voice heard when everyone is chasing growth, and it certainly does not have the power of veto over the actions and policies of a gung-ho chief executive.

The banks brought disaster down upon themselves, not because no one in the organisation realised how dangerous it was all getting but because those who did realise were ignored and had no mechanism to make their voices heard by a management hierarchy which did not want to listen.

The Kingsley/Spottiswoode proposal is designed, in William McChesney Martin's great phrase, to make sure someone takes away the punchbowl before the party goes too far. It would give the internal function far more backbone by connecting it with the external regulatory apparatus in a way which would mean it could not be ignored.

The internal risk analysis would be subject as a matter of routine to external regulatory examination and the risk officers would have an obligation to make sure the external authority was fully in the picture on all the matters which worried the internal risk function. If bank policies were causing alarm to the risk officer, as they were for example at HBOS, the external regulator would be made aware of this, and obliged to intervene, so that the board would have to take notice. The corollary is that if a bank got into trouble, the risk officer would be called to account.

If it turned out that he did not know what was happening he would be seen to be a lousy risk officer; if he did know what was happening but had failed to make his concerns public then he would be culpable.

Either way he would be in the dock for failing in his duties. So of course he will make sure his back is covered by keeping the external regulator fully in the picture.

The net effect of this would be to force the chief executive to slow down if the risk officers reported that the engine was overheating, or visibility was too poor to stop in time. Such a policy would have made all the difference on the Titanic. It would similarly give us safer, better-run banks.