People worry a lot about “regulatory capture” and how watchdogs can be turned by the very firms they’re supposed to be regulating. But a less observed phenomenon is no less pernicious. It’s when through some subtle medium — perhaps government influence or intellectual fashion — they somehow capture themselves and can’t easily change course.
Two current cases illustrate the phenomenon. One is the crisis involving Metro Bank, one of the UK’s so called “challenger” lenders, which was recently discovered to have miscalculated its risk weighted assets, and thus overstated its capital. The other involves a debate about capital adequacy in the market for equity release mortgages (ERMs), which allow older people to extract some value from their homes without selling up.
In both cases, regulators were lulled into encouraging outcomes that are now causing headaches. Not, it should be said, purely because of industry lobbying. Public policy reasons also played a part.
Metro was set up in 2010, claiming to be the first new UK high-street bank for more than 150 years. It fulfilled a government need for more competition in the banking sector at a time when EU state aid rules threatened costly break-ups for the high-street banks in which the UK had just taken huge stakes.
Equity release enjoyed similar official blessing as a way to address the looming pension shortfall without the state having to step in and pick up the tab.
Now there’s little fundamentally wrong with injecting some competition and innovation into finance. But history suggests a few caveats. Take the US drive of two decades ago to spread home ownership to the less well-off, which led to sub-prime lending. It’s a reminder that the road to financial perdition can be paved with the best-intentioned of thoughts.
As is common in such cases, the regulators looked on the projects with rose-tinted spectacles. Metro was founded by Vernon Hill, an entrepreneur whose previous venture Commerce Bancorp, while financially successful, ran into flak over its flaky governance. He resigned in 2007 after US regulators took umbrage at his tendency to rent the bank properties owned by his family interests, and get his wife’s branding business to design the branches.
This didn’t stop Mr Hill becoming chairman of Metro, or indeed using his wife’s business to design its new branches in Britain. He has used his dominant influence to expand the bank quickly, an approach that requires flawless execution. This is underpinned by a fan club of investors who supported Commerce Bancorp, and who have allowed Mr Hill to cement himself in place.
There was a similarly relaxed view to the rapid growth of ERMs. Firms were allowed to flog these complex products while hugely undervaluing the embedded guarantees contained within them, despite the baleful example of Equitable Life, the world’s oldest insurer, which hit the rocks in 2000 having made the same mistake. Unsurprisingly, ERMs proved highly popular with consumers and the market grew very quickly, ultimately forcing the UK’s Prudential Regulation Authority to re-examine the rules.
The problem with closing the stable door belatedly is that the horse has long bolted. Volumes of ERMs containing mispriced guarantees had already been sold. Capitalising those retrospectively is extremely difficult for the lender, and runs the risk of exposing less strongly-funded providers. Consequently the PRA chose to pull its punches.
Even watered-down changes have shaken the ERM market. Last week, one provider, Just Group, cancelled its dividend and announced a substantial capital raising. Its shares have since fallen more than 15 per cent. As for Metro, the PRA and the Financial Conduct Authority have announced parallel investigations into the risk weight miscalculation. Yet given the dependence on Mr Hill and his fans for the necessary capital raising, it remains to be seen what sanctions, if any, they could pronounce.
Regulators are human; they find it hard to admit that their previous policies were misguided. Look at the reluctance to punish the misdeeds of the period up to 2008. It is why the best hope remains a system that emphasises high capital ratios and heavy personal penalties for managers found to be shirking their regulatory duties.
Unfortunately, despite post-crisis reforms, that remains more of an aspiration than a reality. The FCA flunked the first test of its “Senior Managers Regime”, rules where the burden of proof is supposedly on the boss to show they did the right thing. It let Barclays boss Jes Staley off last year with a slap on the wrist and a fine despite clear evidence that he breached rules about the treatment of whistleblowers. And for all the new higher capital standards, most UK banks trade on price to book ratios of less than one.