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John Kay: FSA’s legalistic approach is not working

John Kay: FSA’s legalistic approach is not working

Leading economist professor John Kay has hit out at the FSA’s legalistic approach to regulation and fears it will take another financial crisis before the industry sees real reform.

The author of the recent report, Review of UK Equity Markets and Long-Term Decision-Making, advocates ‘simple structural rules’ as an alternative to the FSA’s increasingly interventionist and rules-based approach, and warned on the dangers of the burgeoning industry developing around regulation.

He said the expansion of the chain of intermediation over the past two decades has in some cases created a misalignment of incentives, which at its root has not been addressed by the regulator. 

Speaking to members of the New City Initiative, a think tank made up of independent asset management and wealth boutiques such as Stanhope and Odey, Kay explained: ‘There are two consequences – all of them [intermediaries] take something out of the cake, which gets smaller by the time it gets to the saver from when it came out of the company.

‘The other is that the more intermediaries there are, the more scope there is for misalignment of incentives between intermediaries,’ he explained.

Linked to this, Kay says there are flaws in the regulator’s approach, allowing perverse incentives to exist and then seeking to correct them with ‘detailed rules about how to behave’.

‘This has not worked well. It has led to financial services regulation, which is on the one hand extensive and intrusive and on the other rather ineffective at achieving its underlying goals, and which because of its complexity and detail is subject to regulatory capture.

‘That is the people who regulate the industry… compliance people at firms, and lawyers and consultants who intermediate between the two, [have] an interest in its expansion, which it is doing successfully.

‘I think to get outcomes the public wants from the industry, we need a different approach to regulation,’ he said.

He says the regulator should start by addressing the inherent conflicts of interests that exist within the different activities undertaken by large organisations, and argues that regulators have placed too much faith in organisations to address these conflicts. ‘Almost all institutions we deal with are conflicted in this way and people go on naively believing that conflicts of interest are managed in their interest.’

Although the professor has identified the problems, he is concerned that due to the ingrained nature of dominant interests and philosophies, without political backing to tackle them, it will take another financial crisis to genuinely spur change within financial services.

‘I am a bit less pessimistic about that than I was even a year ago. I thought then that it will take the next very serious financial crisis before political attitudes start to change. Public attitudes at the moment are very negative about the financial services sector, but they are negative in an incoherent and unspecific way.

‘Frankly, I found that a scary process because I am worried the way it will happen is it will be taken up by populous politicians of an unpleasant kind who will play with fire.

‘The reason I am more hopeful than before is because over the course of the calendar year, among the public and politicians, there has been a realisation that what has gone wrong in financial services is in large part a product of culture in the industry and not simply unpredictable events that hit the industry unexpectedly in 2007-08,’ he said.

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