Sunday 26th June 2016
NEWS and COMMENT ROUNDUP - June 24th – The UK has voted to leave the European Union – Prime Minister David Cameron has resigned, saying he will leave office in October, following an orderly management of the run up to the declaration of Article 50, which will precipitate the UK’s exit from the Union. The question is whether the incoming leader of the Conservatives will be the next prime minister and can take up the post without an electoral mandate – will the country have to vote again before the end of the year? – EU President Donald Tusk says that the remaining 27 members of the EU have recommitted to the European project and that if the UK wants to leave, it should do so quickly; a view reiterated by Martin Schultz, the president of the European Parliament – Nicola Sturgeon says she will begin talks with the EU on possible Scottish membership and that a second referendum on the Union is now likely – Sinn Fein’s Martin McGuinness has called for a border poll on union with a United Ireland, resurrecting potential secession from the Union by part of Northern Ireland as well - Jeremy Leach, Chief Executive Officer at Managing Partners Group, believes Brexit will have little long term impact on the UK financial services industry. He says: “Financial services will continue to be the UK’s biggest export for the same reasons it has been for the last 100 years, which is its pragmatism, innovation and desire to trade. Nor will the UK necessarily be excluded from the European Union’s pass-porting regime for financial products. Most of the EU’s regulatory processes were adapted from those of the UK’s Financial Conduct Authority anyway so negotiating a workable agreement will be more straightforward than for other EEC members that are still evolving on their regulatory framework.” With regards to Sterling, Jeremy Leach believes it will settle down and strengthen in the longer term: “As much as sterling has fallen today, the market will gravitate back to pre-referendum levels within a few days. In the longer term, sterling will strengthen against the Euro because the UK’s economy is in much better shape than many of its European peers.” - Steve Davies, fund manager, Jupiter UK Growth Fund says, “The UK domestic economy held up surprisingly well in the run up to the referendum, aided by the fact that disposable incomes are still rising by some 7% year-on-year (according to ASDA’s income tracker). The uncertainty of ‘Brexit’ clearly poses some threat to this: business investment is likely to be put on hold during the negotiation process and there is also likely to be a hit to consumer confidence, while a weaker pound may lead to higher imported inflation. Some offset may occur if the Bank of England chooses to reduce interest rates from here or introduce a further round of quantitative easing. Commodity prices may well weaken too in response to a stronger dollar – the fund remains zero weighted in the oil and mining sectors … One final thought: a falling pound combined with a hit to the share prices of UK domestic assets is likely to reignite M&A interest in the UK market from overseas players and I would expect Chinese investors to be right at the front of that queue” -- Mark Burgess, CIO EMEA and Global Head of Equities at Columbia Threadneedle says, “Not surprisingly, equity markets are going to be quite weak today, with sterling assets more broadly quite weak. The thing that markets hate most is uncertainty and with the prime minister resigning we’ve got political uncertainty thrown in on top of economic uncertainty and we don’t know what shape the UK economic arrangement with Europe is going to take. That is going to take quite some time to negotiate and we are going to have to negotiate any bilateral trade agreements with the rest of the world as well. The real issue is about what it means for Europe. We’re likely to see calls for referendums in some of the other European countries and members of the Eurozone and the single currency, and I think the market is going to worry about the implications of that. We’re a single trading nation and clearly what the nature of our trading arrangements with rest of the world looks like is going to be uncertain and I think that will naturally slow activity. The uncertainty as well as what this means for Europe will also slow European equities unequivocally so this is a negative event for global GDP.” Richard Colwell, head of UK Equities at Columbia Threadneedle adds: “Certainly in the short term the Leave vote will be a negative for both Sterling and the UK economy. In the longer term the consequences are much less clear. However, given the FTSE 100 is comprised of around 70% overseas earnings, the implications for the UK equity market may not be as great as some people fear. There may be further opportunities in UK domestic stocks that have been sold off aggressively, in particular those stocks that were in the various ‘Brexit Baskets’ created by investment banks as they tried to exploit concerns about leaving the EU. Clearly, any exposure to overseas earnings is positive for investments as they are considered less exposed to the domestic economy and can benefit from a weaker sterling.UK stocks (excluding financials) are also, to a degree, cushioned by the current market yield (at time of writing) of 3.95%, which is three times that of gilts and attractive in a global context. Indeed, gilt yields are already at their lowest level since records began in 1729.” Meanwhile, Jim Cielinski, global head of fixed income at the firm says, “ This outcome was very different to what the markets expected and certainly to that which was priced into the market as recently as yesterday. Consequently, the market reaction has been as immediate as it has been extreme. Core bond markets have rallied sharply – as market yields have plunged to record lows in many developed markets. The benchmark 10-year US Treasury bond, for example, is lower in yield by around 20 basis points. This takes that yield to around 1.5%, the lowest in recent decades. German 10 year bonds have fallen by a similar amount to -0.10%. Peripheral European bond markets are being hit hard (Italian government bonds are wider in spread by around 30 basis points) and this should continue. Within currencies, sterling is around 9% weaker to the US Dollar (1.35), the weakest level since 1985 and the euro is also weaker by around 3% (1.09). Meanwhile, the yen has surged, strengthening to 101.5. Credit markets are weaker. The widely watched Main index opened 26 basis points wider (around 25% wider of actual spread) and is at the widest level this year. Meanwhile, the Crossover index opened wider by 100 basis points (in percentage terms a similar amount). Financials, higher beta and cyclical credit have been harder hit with spreads around 30% wider over the last day. Commodity prices have been marked down with the exception of gold which has rallied. We believe that a number of central banks (Bank of England, European Central Bank and Bank of Japan) will need to ease policy. A weaker UK currency will produce higher inflation in the year ahead but this will ultimately prove to be transitory. Hence, although the decision to ease may be a close call - growth and stability concerns will dominate policy maker’s thinking. Core government bond yields have plunged to record lows and will be supported as long as risk aversion prevails but further declines in yield should be limited. The price of so-called safe havens is now extreme. Corporate issuers have become well-accustomed to operating in a low growth, weak revenue environment and for such companies it will be the extent of economic weakness that matters most. Our central case is for slow growth, no credit improvement but no sharp rise in defaults. Demand for income remains and this will continue to support spread markets as will a policy response (for example, corporate bond purchases) that provides a ‘back stop’ and cushions losses in corporate bonds. As such, we remain modestly constructive of corporate credit” - Howard Cunningham, fixed income portfolio manager, Newton Investment Management says, “The leave result is likely to be supportive of shorter dated gilts as activity slows and the prospect of interest rate increases recedes even further into the future. The gilt curve may steepen as investors demand more compensation for the longer term uncertainties, but overall yields should not necessarily be higher. It is worth bearing in mind that, to the extent investors initially view the leave vote negatively and want to dump sterling assets, we doubt gilts will be top of their sell lists. Sterling corporate bonds face conflicting forces and greater uncertainty may ultimately lead to risk premia, i.e. higher credit spreads (particularly for UK domiciled issuers). It is important to point out that with yields on euro denominated bonds already low, sterling corporate bond yields might look more attractive. Particularly if, as we expect, ECB intervention has unintended negative effects on liquidity in the euro corporate bond market.” -- Paul Hatfield, Chief Investment Officer, Alcentra says, “We think the short-term impact will definitely be negative for the UK economy, with the uncertainty delaying investment decisions and stalling spending all round. Longer term, it is possible the UK can renegotiate a good outcome with the EU but it hasn’t said how, or on what basis. You could see the other EU countries making life difficult for the UK after Brexit, partly out of pique and partly to deter other countries from doing the same.” -- Mark Bogar, European Smaller Companies Manager, The Boston Company Asset Management “Follow-on risk is now a major factor and we have to think about potential knock-on effects; for example, other countries voting on their membership of the EU. If this leads to an unravelling of the EU the hit to economic activity over the immediate term will be significant. I like to think over the longer term countries will figure it out – and will continue to trade with one another – but it could take up to three years to iron out the ‘new order’ and in the meantime economic activity and GDP growth in European countries will feel the impact. In my opinion the Eurozone will go into recession again during that time.”

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Twin peaks: the fire walk of UK market regulation?

Monday, 05 March 2012
Twin peaks: the fire walk of UK market regulation? Those who were keen followers of the 1990s cult television series Twin Peaks and its prequel film, Twin Peaks: Fire Walk With Me may have experienced some concern at hearing recently in a speech by the Financial Services Authority's (FSA’s) chief executive officer, Hector Sants, that the regulator would very shortly start adopting a ‘Twin Peaks’ model of regulation.  However, rather than a drama concerning the murder of a teenage girl, which explored the gulf between the veneer of small-town respectability and the seedier layers of life lurking beneath it, this is the continuing drama of the progress of the UK’s regulatory reform programme, though it is also laced with some underlying seediness, mystery and double-think, all thrown in for good measure. Charlotte Hill, partner and head of the financial services and regulation practice at law firm Stephenson Harwood, gives a sprightly, sometimes humorous run through the implications of change, positing that it might all be too complicated for it’s own good.

Those who were keen followers of the 1990s cult television series Twin Peaks and its prequel film, Twin Peaks: Fire Walk With Me may have experienced some concern at hearing recently in a speech by the Financial Services Authority's (FSA’s) chief executive officer, Hector Sants, that the regulator would very shortly start adopting a ‘Twin Peaks’ model of regulation.  However, rather than a drama concerning the murder of a teenage girl, which explored the gulf between the veneer of small-town respectability and the seedier layers of life lurking beneath it, this is the continuing drama of the progress of the UK’s regulatory reform programme, though it is also laced with some underlying seediness, mystery and double-think, all thrown in for good measure. Charlotte Hill, partner and head of the financial services and regulation practice at law firm Stephenson Harwood, gives a sprightly, sometimes humorous run through the implications of change, positing that it might all be too complicated for it’s own good.

The financial crisis and recession caused the FSA, the United King-dom’s financial markets reg-ulator, to be criticised for being too costly and ineffective in its approach to regulation, resulting in a complete reform of the UK's regulatory structure.

Right now the UK financial markets are governed by a tripartite system of regulation, with regulatory responsibility being shared between the Bank of England (BoE), the FSA and HM Treasury. However it looks as if this system has now had its day and change is afoot. There is much optimism that this time around, all will be well and the shortcomings of the previous system will be addressed and a new dawn is breaking.

The old structures will be replaced with an all-new, all-improved, shiny new system, where responsibility for regulation will be shared between, em ... three new regulatory bodies! These are the Financial Policy Committee (FPC), which will sit in the BoE and take responsibility for the macro-prudential regulation of the UK financial system; the Prudential Regulation Authority (PRA), which will sit as an independent subsidiary of the BoE and take responsibility for the micro-prudential regulation of financial institutions of systemic importance, such as banks and building societies; and the Financial Conduct Authority (FCA), which will inherit the majority of the FSA’s current regulatory functions and be responsible for the conduct of business regulation of all firms currently regulated by the FSA. This will include those firms that will be dual-regulated, authorised and subject to prudential regulation by the PRA.  

In two speeches on February 6th and 7th this year, Hector Sants announced what he termed a "major milestone" in the progress of the regulatory reform programme, namely, the introduction of a "Twin Peaks" model of regulation, which would be operating within the FSA from April 2nd 2012. From this date, two regulatory models (the Twin Peaks) will operate within the FSA in preparation for those models becoming separate regulatory entities early in 2013. One peak is earmarked for prudential regulation and the other for conduct regulation. So, banks, building societies, insurers and major investment firms will have two separate groups of supervisors: one focussing on prudential issues and the other on conduct.

Whilst the FSA could not completely replicate the new approach envisaged by the Financial Services Bill at this stage, the Twin Peaks model will ensure that the transition to the new regulatory structure early in 2013 (termed, in true superb FSA-speak, the "cutover") would be "seamless".  

Not only are there the two independent groups of supervisors for banks, insurers and major investment firm but also, all other firms (that is, those which are not dual-regulated) will be supervised entirely by the conduct supervisors. These separate groups of supervisors will make their own separate judgements, and against different objectives. This is an important distinction, as we are told that they will be "pursing different goals". Up to now, there has been little clarity on what all this means, but the approach is summarised in another piece of fluent FSA-speak: "independent but coordinated decision making"––an approach that will be "stressed to staff". The thrust of this appears to be a policy of sometimes working together, but sometimes not, whilst somehow managing to share all data collected from companies.  Although no detail is given, "greater clarity" apparently has been given to the objectives of the two supervisory groups. No information is given on what this "clarity" entails.

Those still reeling from the spectre of two separate sets of supervisors will exit screaming at the intelligence that the existing ARROW risk mitigation programme will be split between the Twin Peaks. The Financial Services Authority (FSA) is a risk-based regulator and ARROW is the framework it uses to make risk-based regulation operational. ARROW stands for the Advanced, Risk-Responsive Operating Framework and covers firm specific (vertical supervision), thematic (those involving several firms or relating to the market as a whole; the FSA terms this ‘horizontal’ work) and internal risks (these are operational risks that might impact the FSA).

ARROW will be split between those actions which are relevant to the conduct supervisory group's objectives and those that relate to the objectives of the prudential group. What is worse is that this is only just around the corner. From April 2nd 2012 onwards, the two separate supervisory units will run their own risk mitigation programmes and firms will have "two separate sets of mitigating actions to address".  

The two supervisory teams will assess risk separately, against their own separate objectives (and of course, firms do not as yet know what these are). Any firm currently preparing for an ARROW visit, or anticipating one later in the year will not be delighted by the knowledge that each group may well ask apparently similar questions, but that the purpose will be different.  

Conclusions drawn from the ARROW process will be coordinated with "a single pack of documentation" being presented to the firm's board––but this will have "two separate sections". However, there will not be a consolidated list of required actions arising from the ARROW visit.

Doubling up on visits
The meaning seems to be that you will still have an ARROW visit (at least, for the lifetime of the current FSA), but this will in fact be two visits. When the visit is over, the FSA will provide one, consolidated pack of documentation summarising the conclusions of the assessment. However this will be divided into two, with two separate sets of actions, to each of which firms are required to give "equal focus". So, you are indeed seeing double––your one ARROW visit has suddenly become two. Anyone who has been through the current ARROW process well knows the enormous amount of preparatory work that is necessary and the stress of the increasingly demanding interviews, so it is hardly welcome news that the amount of work involved is about to be doubled.

Firms will be required to make "behavioural changes", so that the new approach works "to the benefit of society" as a whole. In line with this, firms must comply with supervisory judgements "willingly" and "proactively"; in other words, not challenge FSA judgements, but take it like lambs. Firms must align their goals with those of their supervisors and (again) "with society as a whole". So, now companies have "the best interests of society" to contend with, along with everything else.

Unsurprisingly, no steer is given as to what these might be, or which society the regulator may have in mind. Rather puzzlingly, a further feature of this new world is that firms must "recognise that there are times when both firms and the regulator will make judgements which in hindsight are found to be wrong".  Sounds sinister!  What does this mean exactly?  

Perhaps the killer punch comes in an apparently throwaway line that is not elaborated further that firms must "recognise that this new approach will require greater resources and expertise and thus costs more than the old reactive model". Double the trouble, it seems, means double the cost. More fees and a greater cost of regulation at a time when companies are feeling the pinch of uncertain markets and falling revenues and buckling under the weight of around thirty-five (at last count) separate new legislative measures from Europe.

There is much still to be done and in his speeches, Sants provided a shopping list of the issues still to be addressed within the next twelve months, any one of which would be enough to keep an army of regulators busy for a good deal longer than this. They include amendments to the threshold conditions; the designing of a new "operating platform" for the FCA and the PRA; designing a new supervisory framework to replace ARROW; finalising the new Memorandum of Understanding detailing how the FCA and the PRA will coordinate their activities; splitting the Rulebook between the PRA and the FCA; and training (and presumably, recruiting) staff.

The next twelve months are likely to be extremely lively, as the FSA wrestles with operating within the Twin Peaks framework and labours with the complexity and volume of the issues still to be addressed.  Firms once again will be obliged to wrestle with major operational changes due to regulatory upheaval. Twin Peaks looks like being only the beginning of the fire walk.

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