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In the hyper-competitive world of financial services, there is no shortage of information available to institutions and investors. But while compliance has helped greatly to expand the data available to those making financial decisions, it has often failed to improve the quality of those calls.
When Lloyds Banking Group was offered, with government knowledge, the opportunity to buy troubled rival HBOS two years ago, the banking group saw a once-in-a-lifetime chance to snap up one of the UK’s top five banks at a fair price, while anti-trust rules were held in abeyance.
It was the wrong decision. To give Lloyds credit, even the savviest commentators were unable to predict the deal would not only fail to save HBOS, but imperil Lloyds too.
In fact, the poor state of HBOS’s property lending portfolio almost drowned the combined bank, a situation that was only averted by state support. The information about HBOS’s lending was there, but the implications of how bad it had become were not.
Sadly, they were not alone. Credit rating agencies, paid to analyse the soundness of financial institutions and even countries, ascribed triple-A ratings to complex sub-prime lending derivatives that turned out to be next to worthless. While the agencies complained that the problems were not foreseeable, it begs the question whether products that fox the skills of even professional credit analysts should even exist.
“I have a simple solution,” says Joseph Lampel, professor of strategy at Cass Business School in London. “Every financial innovation should be audited and tested by an independent financial agency, and then monitored.”
This was the job credit rating agencies were supposed to do. But because they were effectively being paid by those who issued the product, rather than those who bought it, there was a possible conflict of interest.
According to Mr Lampel, what is required is a financial equivalent to the US Food and Drug Administration. “No one would dream of allowing a pharmaceutical company to bring on to the market a product with potentially life-threatening side effects without independent oversight,” he says. “The same should be true of equally dangerous financial products.”
James Jenkins knows all about the problems of poor information and poor professional judgment. Having received a £300,000 ($470,000) industrial injury settlement in the 1990s, he employed an independent financial adviser to help him invest £50,000 of it as safely as possible.
The IFA suggested not only that he buy traded endowments with all of the sum, but also that he leverage that risk by borrowing another £100,000 to invest in the same products. In the stock market falls of 2002 he lost everything he had invested. “The adviser had promised me it was safe. I don’t know anything about investments, and I trusted him,” says Mr Jenkins. It took three years of assistance from the Citizens Advice Bureau and the Financial Ombudsman Service to get the IFA to pay compensation.
While consumers are often criticised for failing to read the small print on credit cards or personal loan agreements, professional investors also balk at reading the hundreds of pages of disclosure that come in investment prospectuses and annual reports. Yet in both cases, vital and important information may lie hidden beneath reams of extraneous material.
Indeed, Mr Jenkins’ problems were triggered because the IFA had overlooked a loan covenant that could force the sale of his endowment portfolio when it fell beneath the value of the loan. Without that forced sale, the portfolio would eventually have recovered much of its value.
“Regulation is a relatively good tool for managing non-compliance by a few recalcitrant firms and ensuring a level playing field for compliant firms,” says Sharon Gilad, a consumer protection expert. “But it is not a good tool for managing industry-wide problems such as mis-selling of personal pensions, endowment mortgages and payment-protection insurance.”
Ms Gilad insists there is no easy way to represent in simple form the complex products that are now on sale. Instead, she says, there should be more focus on teaching the industry that simple products can still offer a competitive advantage.
“The key challenge that regulators face is to stop firms from selling products that are known to cause customer detriment,” she says.
What is really required to deal with the mountain of information that fails to help us is to simplify and regulate the products and services it tries to describe.
Put simply, this means that regulators need to assert the public good as a motivation for product simplicity. Although, seeing how the financial services industry has managed to fight off most of the new rules and restrictions suggested in the wake of the financial crisis, this could be a tough fight.