Paying the penalty

$250-300 billion is a big figure. It is roughly equivalent to the annual GDP of Hong Kong or Singapore. It also equates to the sum total of penalties and fines levied on the banking industry since 2008.

$250-300 billion is a big figure. It is roughly equivalent to the annual GDP of Hong Kong or Singapore. It also equates to the sum total of penalties and fines levied on the banking industry since 2008. And, in case the financial deterrents are not convincing enough, The UK’s Prudential Regulation Authority has declared: “senior managers will be held individually accountable if the areas they are responsible for fail to meet our requirements. Our new accountability regime will hold all senior managers, including non-executive directors, to a clear standard of behaviour and we will take action where they fail to meet this.”

Making senior managers liable for failings within their remit is understandable. To some extent the fining and penalty regimes, although painful, have become a cost of doing business. This is mainly due to the regulatory philosophy of abolishing any concept of caveat emptor (or buyer beware) and, often retroactively, finding fault in documentation and process irrespective of the true culpability of the provider. This has also led to a further culture shift, part for the better and part for the worse, in the horrific increase in regulatory, risk and legal overhead in financial institutions.

The danger is that a too strict, and possibly unfair, liability regime is making the banking sector, in some areas of its traditional coverage, too risk averse. It is leading to the exclusion of certain industry sectors and individual constituencies from mainstream banking. It is encouraging the migration of activity to shadow banking, which can cover robust and transparent quality financial entities but also a large number of operators in the grey area between the strictly legal, on the one hand, and the possibly permitted but morally dubious on the other. And then, beyond the shadow banking area, we have the criminal financial system.

As far as the securities services markets are concerned, they have not been immune to fines and penalties. The Madoff and Lehman scandals affected our industry. Foreign exchange gauging has not been unknown. Portfolio transformations have not always complied with best execution and best practice. Stock loan collateral management has often failed the prudence test. Administrator duties on portfolio limits and pricing have, at times, been deficient. Fraud has been rare but attempted crime and cyber-crime is not unknown. In an industry with assets under custody in the tens of trillions, the actual losses have been modest, perhaps closer to the $5 billion GDPs of those favoured offshore locations of Liechtenstein and Jersey.

But what could go wrong in our industry, increase financial penalties and risk placing senior managers in jail? Ignoring the theft of assets, which is an obvious and understood crime, for what would a senior manager be accountable that could end up with a criminal sentence. On a rational interpretation of the rules, an action that led to meaningful losses by investors, attributable to failure of control, could be such an event. Is a depositary guilty of reckless decision making if they allow investment in markets where infrastructure eschews responsibility for cybercrime impacting their own platforms or misconduct by their own employees? Is an administrator breaching their fiduciary responsibilities if they fail to follow through promptly and effectively any breaches of their client funds? Who could be liable for repeated errors in pricing that results in material mispricing of units sold over a period of time?

One thing is certain, the culpable risk the loss of their livelihood, or, in the worst cases, serious fines and possible imprisonment. That is the driver for the explosive growth of the risk management, legal and compliance population in the banks. Risk manuals have become longer than “War and Peace” and many appear a blend of core principles, detailed regulation and operational procedures. Paradoxically, they are so user unfriendly that few understand them in totality and yet they could be the decisive instrument of guilt in a Court of Law. The same issues impact client legal agreements, written by experts in obfuscation and dangerously allowing multiple interpretations by different parties. The same issue impacts regulation with detailed interpretation changing on the same issue dependent on the regulatory body originating the guideline and the function under scrutiny.

Almost every meeting is attended by lawyers, regulators or risk professionals. And, if they are not physically present, they are omnipresent in spirit and referred to on too many issues for guidance. Businesses often forget the difference between the commercial decision and the legal or regulatory impact. Executives take shelter under the mantle of stakeholder involvement, enabling meetings where the sole objective appears to be to ensure there is collective responsibility rather than individual accountability.
It is no wonder that buy side clients are considering how to disenfranchise the sell side. Dark pools and MTFs have marginalised Exchanges, at times to the detriment of market liquidity and transparency. Automated trading is decimating secondary market spreads and reducing broker dealer profitability. Debate is current on the feasibility of a utility to cover fund pricing and analytics. The notary function of the CSD and the custodian could be subsumed by Blockchain or one of the next generation technologies. Enhancements to information flows and possible income and event depositories could decimate the custodian role in those areas. Depositary-lite structures risk becoming more popular especially if major providers decide to align price and risk in the new regulatory environment. And robo-advisors are becoming the new must have of many investment houses.

The question is whether these trends are good for the market. It is in the interest of the investor, and especially the regulatory managers of the different compensation funds, for business to flow through well capitalised and well-regulated banks and brokerage houses. The reality is that, for the large investors who account for the bulk of activity and risk, hunger for business from the sell side continues and the only real change has been an increase in documentation and a reduction in price! One major loss due to the new environment could, though, threaten the entire traditional edifice. Unlimited risk assumption in uninsurable. Except that is, at least at the moment, for a securities services industry that believes, erroneously, that their client on boarding processes are so sound that their actuarial likelihood of loss is sufficiently low to ignore it.

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