Change ahead!

Part 1 of an important policy and regulatory update by Pieter Koekemoer

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We are amidst a material overhaul of the policy and regulatory frameworks under which the financial services industry operates. Government, in line with global trends, launched a barrrage of new concepts and acronyms over the past decade: Twin Peaks (the PA and the FSCA), COFI, TCF, RDR, retirement reform, SSF, NHI, COBT/PST and RCPD. Enough to make even an anorak’s head spin. Herewith an attempt to make some sense of what is going on.

What is the purpose of acts, policy frameworks and regulation?

The fundamental rationale for regulatory intervention in any industry is to ensure that customers are protected. It would be rather difficult to get anywhere if all motorists were free to drive on whatever side of the road they felt like on the day. Sound policy creates certainty and aids in the building of a better society. Sound regulation assists in building trust between providers and their customers. This is especially relevant in the financial industry, as providers have access to more information than their customers and because customers may only know decades after an initial purchasing decision whether they received value for money.

Only die-hard ideologues believe that only the government or only the market knows best. Successful countries and industries are those where governments, citizens and providers cooperate in robust, transparent and fact-based processes to find the best balance between freedom and rules. Pragmatic compromises produce better outcomes than forceful apparatchiks ruling by fiat, or tame regulators that are captured by commercial interests. This never-ending process is best attempted in small incremental steps and depends on building knowledge through hard work underpinned by good data. Unfortunately, there are many constraints and biases that can undermine these lofty ideals.

Common biases that often undermine the efficiency of regulatory interventions in our industry include:

1. The Streisand effect

The entertainer Barbra Streisand sued an environmental activist for invasion of privacy in 2003. The activist took 12 000 aerial photographs of the Californian coastline to study the impact of erosion and published these on the web. One of these images showed Streisand’s cliffside mansion and she wanted it removed from the record. Before her lawsuit, the image was downloaded only four times by members of the public. However, more than 420 000 people eventually viewed it because of the publicity created by her lawsuit (that doesn’t count the Google searches that will result from this article). This is the law of unintended consequences in action. No intervention is just virtuous. Every rule change has the potential to create winners and losers. It is very hard to identify these effects before the fact.

2. Proportionality

Real problems do exist and often require a regulatory response. But when the intervention is too blunt or extreme, much harm can be done in the process. Little regard is in many cases paid to a rational and detailed cost-benefit analysis when new proposals are made. Formal analyses very rarely attempt to cost externalities and second or third order effects.

3. Caveat emptor vs caveat venditor

There is a reason why the common law principle states that the buyer should beware. No amount of regulation will prevent the presence of bad actors or incompetent providers. When new rules are made, they add costs to all providers, for the account of the customers. The regulatory approach currently globally in vogue is to attempt to shift to a "seller beware" model. Time will tell whether this will add customer value.

Unpacking the changes

Twin Peaks, the Prudential Authority (PA), the Financial Sector Conduct Authority (FSCA) and the Conduct of Financial Institutions Act

Traditionally, regulation of financial services providers happened in silos. The banks were under the supervision of the Reserve Bank, while everyone else were regulated by separate line departments in the Financial Services Board. As a result, each product (bank deposits, unit trusts, life policies, retirement funds), service (investment management, financial advice and intermediation) and market infrastructure (stock and bond exchanges, depositaries) ended up with their own set of rules. This creates the opportunity for regulatory arbitrage or rule shopping, as activities that would be forbidden by one set of rules may be allowed under another. The purpose of the Twin Peaks intervention is to regulate by activity rather than licence type, to ensure that the same rules are applied consistently to similar activities. The risks of this model include implied equivalence where none exists (eg where the legal form of activities is very different, but it ends up being regulated as if the different options use the same contractual principles) and lack of specialisation, leading to a hollowing out of regulatory capacity.

The implementation of the Twin Peaks model is well advanced, with both the PA and the FSCA now in existence, albeit still in transition from their prior roles. The PA regulates systemic integrity by setting capital adequacy requirements and performing stress tests for banks, insurance companies and in future, retirement funds offering defined benefits. What all these institutions have in common is that they promise certain outcomes for their customers, backed by their balance sheets. These promises are only as good as the quality of the balance sheet making them, hence the focus on capital strength.

The FSCA is responsible for overseeing the market conduct of all players, including banks, insurers, collective investment schemes and advisers, in their customer-focused activities. The next step in the process of fully empowering the FSCA to fulfil its new mandate is the publication of the Conduct of Financial Institutions Bill (COFI) for public comment. COFI will eventually repeal all the conduct standards under sectoral legislation (such as FAIS, the Banks Act, CISCA and the LTIA) and replace these with conduct standards applicable to all entities performing specific activities. The future conduct standards will also be the final phase of implementing the Treating Customers Fairly principles.

The intention is for the new regulators to be more proactive and forward-looking, outcomes-based rather than rules-based as well as more intensive, intrusive and judgmental. Much work remains before this vision will be fully realised.

The Retail Distribution Review (RDR)

The RDR started formally in 2014. Its objectives are simply to reduce conflicts between advisers and their providers and, where possible, to reduce complexity in the industry to make it easier for customers to know what is going on. The main recommendation, namely a ban on commission and rebate payments between investment product providers, platforms and advisers, is uncontroversial and has already been implemented by most of the industry without any formal regulation requiring this. It has become a very complex project, however, as its scope is much wider than similar initiatives undertaken in other countries, most notably the UK, Australia and the US.

The first phase of the RDR focused on the life insurance industry and resulted in new policyholder protection rules already implemented. The current phase deals with investment matters (currently in consultation) and adviser categorisation. The final phase can only commence once COFI is promulgated.

The consultation on investment matters is still at an early stage. A discussion paper was released during June with a comment deadline in August. Further detailed consultation will follow in the coming months. It is very clear that a necessary, but outstanding step is to agree on the definitions of the various activities in the industry informed by the data. The industry value chain has become complex, with a wide variety of business models. Single managers, multi-managers, funds of funds, model portfolios, white-labelling, sub-advised funds, traditional with-consent advice implementation, platforms and distribution strategies creating no or wide-ranging conflict between providers and advisers all co-exist. This complexity creates ample scope for unintended consequences if changes are not considered carefully. Key risks to avoid are regulatory interventions that end up reducing the availability of unconflicted advice, or inadvertently favour certain business models over others. Regulation should aid fair treatment of customers and fair competition, not tilt the playing field in favour of certain market participants. Blunt responses to isolated problems increase the risk of this occurring.

Adviser categorisation is the other controversial aspect of the RDR. The FSCA proposes two types of advisers, regulated financial advisers (RFAs) and product supplier agents (PSAs). The differentiation attempts to answer two questions:

  • Who is responsible for a bad advice outcome?
  • What are the scope restrictions on the advice that can be given?

The idea is that RFAs will have no scope restrictions and will be solely responsible for the advice they give (as long as no provider influenced the outcome of the advice given). While it is not a necessary condition for RFAs to be independent, the FSCA also seem to want RFAs to be able to prove that their advice is unbiased, despite accepting that RFAs may be influenced by providers with, for example, a shareholding in the RFA. The intention for PSAs is to have strict scope restrictions, potentially limiting them to only advise on products and services provided by their group, which will always be responsible for advice outcomes. The theory is that PSAs should refer clients with needs better met outside their scope to an RFA. However, it is also stated that PSAs will be allowed to advise on third-party funds hosted on a platform in their group. This model seems contradictory and requires clarification. It is the view of this author that regulatory scope restrictions are very problematic for investment activities, given the complexity and variety of industry models referred to above, with one advisory often using multiple models at the same time (an advisory may for example use model portfolios for clients with compulsory assets but prefer bespoke portfolios for discretionary assets).

Vigilance is required to avoid the risks created by an overzealous regulatory response to the increased complexity of the investment value chain. It would be ironic indeed if an intervention designed to simplify and reduce conflicts results in a more conflicted, less efficient and more complex industry. 

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