Has Integrated Regulation Failed?

Is there a case for separating prudential regulation and conduct of business regulation after the wake of the biggest financial crisis the world has ever seen? How is Australia different in their regulatory approach to the US and UK/Europe?

In the current times, with the public scams and the credit crunch, we can ask questions on what happened to the regulators, why were they caught napping whilst the credit crunch bit us hard, and we experienced some of the largest scams ever seen - $50bn Maddox, followed by a string of others.

The Turner report has talked about the possibilities of separating out Prudential (PRU) and Conduct of Business (COB) compliance. These two activities need very different skill sets and specialist knowledge. Although the report favours the integrated approach, I would argue the opposite is what is required after the experiences of current times.

In PRU compliance, the regulator is looking at rules such as accounting, profit, capital and similar, whereas COB is looking at how the firm goes about its business and selling its services to the man on the street, who the regulators were set up to protect in the first place.

How did this happen? A quick history lesson is needed to understand how we got where we are today.

Some 20 years ago in 1988, when Self Regulatory Organisations (SRO) were first given statutory backing and became the regulators of their industry members – the Securities and Investments Board (SIB), Securities and Futures Authority/The Securities Association, Investment Management Regulatory Association (SFA/TSA, IMRO) and so on.

Each organisation and industry group was distinct and separate. In 1997, the super regulator, the Financial Services Authority (FSA) was created by throwing all the other regulators together. More importantly, banking supervision for the first time was moved away from the Bank of England to the FSA. In 2005 the FSA grew to include life, pensions and mortgages industries.

Two years later, in 2007 came the Northern Rock collapse, followed by a string of others, before the autumn of 2008 when the sub prime mortgages really hit the fan and with it went down the world economy.

Could the reason for this be that regulators have been too busy trying to play catch up for the past 10 years, that the warnings signs went unheeded? If we look abroad, at the US, where there is a stringent rule based approach – you are either in compliance or you are not – they have suffered even larger scandals – the $50 Billion Maddox scam – the largest the world has ever seen, then the failure of Lehmans, and Citi nearly going under, mergers of some huge banks – Wells Fargo and Wachovia – how could this occur in such a tightly regulated market?

Perhaps they just missed the point of regulation altogether with their tick box approach. In the UK/Europe – we keep assuring ourselves that we have a better risk/principles based approach – how does this explain the likes of Northern Rock, RBS & Lloyds?

In France, a single Soc Gen's trader managed to lose billions. Surely this must point that integrated compliance has not worked, and another more practical alternative is needed. Australia is the only country I know of that has separated PRU and COBs compliance, and as a result have had far fewer and less serious documented issues. Does this point the way forward?

Well let's look at this - why separate and break up a super regulator like the FSA?

There are several, I will instead list a couple of strong reasons.

1. Very different skill sets and knowledge bases are needed – PRU compliance requires an understanding of accounting rules and financial implications of changes – an analytical and conceptual approach is needed, whilst COBs requires a mindset change to understand how a business operates, the commercial practicalities of sales, trading, marketing etc. – this is more an experience based activity.

2. Focus – concentrating on one type of regulation means your skills and knowledge is better tuned, your training is more relevant as you can leave out masses of material. You will also attract and recruit individuals whose skill sets are a better fit to this type of work.

Overall your quality of compliance regulation will go up.

The idea of having all regulation under one roof is sound, providing you are not regulating everything under the sun, then your brief is just too broad to be really effective. Government has to find a more effective way forward, and perhaps going back to the good old days might be just what we need in the complex financial world we live in.