Report to the Officers of the All Party Parliamentary Group against Financial Exploitation

Parliamentary Session January – July 2009.

The APPG organized a number of Meetings to discuss issues related to financial exploitations and its link with the current financial crisis. Academicians, practitioners, entrepreneurs and politicians made presentations. The basic concept was to grasp the key issues related to financial exploitations and analyze them in different perspectives to understand core issues. Some concrete recommendations and the rationales for them have emerged.

The APPG undertook sessions to examine whether consumers were adequately protected from the financial firms, particularly Banks, re-possessing homes by sometime unethical means.

In this report, we briefly summarize these presentations and point out how systemic failure has strengthened the case for the ‘’Twin peak’’ approach to financial regulation. Consumers’ safety and protection when buying financial products need to be ensured by instituting a dedicated agency.

This protection lies within the four statutory objectives of the FSA as recorded in the Financial Services and Markets Act.

1. market confidence: maintaining confidence in the financial system;
2. public awareness: promoting public understanding of the financial system;
3. consumer protection: securing the appropriate degree of protection for consumers; and
   
4. the reduction of financial crime: reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime.
   
   

1. Description and Summary of APPG Meetings:

APPG Meeting on the January 20th 2009

Summary of Presentation by Sanjay Banerji (Essex Business School, University of Essex).

The sub-prime crisis in the US housing market spread like an infection and ultimately reached epidemic proportions. It caused meltdown of US and global financial markets. It had its root in the changing nature of financial transactions in mortgage markets in US and Europe. An old fashioned system was replaced by a new sophisticated system without proper safeguards.

In this new system of financial architecture, the buzzword is securitization. It refers to a process where banks sell pools of loans to other intermediaries, normally an Investment bank or non-depository Financial Institution. The latter sells a modified package of the same loans to potential investors. This procedure replaces the single layer system to multiple layers of transactions between multiple parties in a multi-market setting. Since mostly unsupervised, each layer has transferred risk. The price in these transactions did not reflect proper risk. The structure of remuneration encouraged further risk taking. Ultimately the system got punctured with falling house prices and rising rates of interest. In order to avert severe crisis in the future, regulators must make note of at least two important lessons from this crisis.

First, remunerations of agents structuring a risky deal need to be carefully designed, especially in an environment of asymmetric information. For example, when an arranger is introducing a sub-prime loan into the pool, a typical compensation scheme could be to index his payments to the volume of loan generated and price of the MBS securities. If the volume of loans arranged by him is large but the price of the underlying securities backed up by pool of loans is low, it seems likely that a major part of the loans in the pool are toxic. Accordingly the arranger should be paid a low price. In that event, an arranger looses incentives to introduce bad loans into the package sold to the issuer. This general principle could be applied to all successive stages of securitization.

The second lesson lies in controlling leverage in Investment banks’ activities in the securities market. These banks have much less capital than traditional banks to support losses. They also hold far riskier assets on their balance sheet. While inter-bank borrowing and lending are reasonably collateralized via real assets, such as tangible and physical properties, investment banks borrow and lend funds by using securities, often pledged by their clients, as collateral. The value of claims in these securities is a lot more volatile than the value of assets themselves. They can grow out of hand very quickly. Hence, a proper collateralization which requires a healthy mix of paper and real assets is needed to avoid under capitalization of assets and help the system to survive through crisis.

A final observation from this crisis would be a timely intervention by the regulatory bodies. The value of sub-prime mortgages was around $20 billion at the start of this crisis. That is a small sum compared to the many $ billions of shareholder value lost in the last year. A disaster of this magnitude could have been avoided if financial authorities would heed warning signals transmitted by all financial markets.

APPG Meeting 21st April 2009

The Meeting was addressed by Lord Lipsey, who had recently resigned as Chair of the FSA Consumer Panel.

Lord Lipsey pointed out that in his view the financial crisis had dealt a serious blow to consumer confidence in financial services. Prior to his resignation he felt unable to make any meaningful contribution, as Chair of the FSA Consumer Panel. Lord Lipsey highlighted the FSA Consumer Panel’s budget was £380,000:00 out of a total FSA budget of £323,000,000:00. Such a derisory amount allocated to addressing consumers’ issues made the FSA Consumer Panel almost non functional.

Lord Lipsey introduced the Group to the concept of “twin-peak” regulation where safety of consumers purchasing financial products needs to be under the purview of a body separate from the FSA. He outlined why consumer protection issues need to be removed from the FSA. He also had argued that the FSA is financed by member firms. Arguably they cannot be expected to use those funds protecting the public from those members.

APPG Meeting 19th May 2009

The Meeting was addressed by Jeff Lampert, former Chairman of Heritage plc. (in Liquidation).

Mr. Lampert provided documents which demonstrated that in July 2007 the FSA had initiated an investigation into whether banks operated within Insolvency Legislation.

This investigation was into alleged perjury by a firm regulated by the FSA. The perjury related to the value of recoveries against the debt of Heritage plc to this firm, made by Receivers appointed by this firm. Allegedly the Receivers had “over-recovered” the debt. This had been concealed by the alleged perjury. Lampert’s guarantee of that debt had been called on, the alleged perjury creating a false shortfall. Initially Lampert’s MP, Dr R Vis MP was promised a full response by the FSA in September 2007.

At this time the “Northern Rock” crisis broke. The FSA apparently halted their investigation into the alleged perjury.

To date the FSA have refused to release documents relating to this investigation to Dr R Vis MP. Their reason for this repeated refusal is that Dr R Vis MP as a MP is not a “prescribed person” under the FSMA 2000.

Adair Turner personally has repeatedly refused Dr R Vis MP the documents.

Currently Lampert is attempting to obtain the documents through the ICO and the Courts.

In March 2009 Lampert delivered the matter to the Metropolitan Police. Within two weeks the police had identified alleged “perjured evidence” exhibited by a bank employee.

This Guarantee litigation has established a flawed precedent in Insolvency litigation. This flawed precedent may allow FSA member firms to make recoveries from consumers to which they are not entitled. This is potentially a further onerous burden on SME owners.

If there was a “twin peak” or separate regulator, such illegal activity by banks would receive the censure it demands. It would seem the FSA may allow their members to repair their Balance Sheets at the expense of the unprotected SME owners, without fear of regulation.

2. Failure of FSA:

A significant part of the current financial and economic crisis can be attributed to the FSA’s failure to rise to the occasion when their intervention in the financial markets was needed badly. To dissect the role of the Financial Regulatory Body in the modern financial markets, it is very important to understand the interconnected roles of Depository Banks, Investment Banks and Underwriters and Insurance companies. While the banks tap savings of ordinary and small customers in the form of deposit, investment bankers channel grand sums of these savings into the needs of investors by performing a variety of risky activities and actions. Products like Mortgage backed securitizations. Insurers play their role of mitigating risks involved in the process. It is apparent that it is the middle tier, Investment Bankers and underwriters, of the financial strata performed the riskiest activities. They have added multiple layers of complex transactions to complex financial products. The market for flawed financial products flourished abundantly on both sides of Atlantic. Remunerations and bonuses soared high. The following fundamentals factors were missed by the FSA, which initiated an era that has not been experienced since last Great Depression of the 1930’s.

• Erroneous Models of Risk and Inability to learn from Recent International Experiences:

The valuations for risky products were based on the assumption that risk was evenly spread across different scenarios and that these financial products are not subject to major macroeconomic risks. The end of the chains, namely the insurance companies, based their premiums on similar calculations, and were therefore over exposed..

• Moral Hazard and Endogenous Risk:

The perceived risk in any valuation model was based on macro indicators such as house price index, oil price shock and interest rates etc. The literature on Finance and Banking are replete with a wide range of studies that link the transfer of risk to over-leveraging and remuneration. These were again completely ignored by all regulatory bodies. Such ignorance and oversight had major consequences on the economic well being of consumers, small and uninformed borrowers. The assumption that the house price index will not fall led to a huge expansion of the mortgage lending even to borrowers who should not have qualified for loans. For lenders it was a win-win situation. If the homeowners pay their instalments, cash flow comes in and they receive their part of the share. If homeowners fail to repay, repossession of the property and sale at an expected higher price to a new borrower increase the lenders profit from the sale at the increased price, and the increase in borrowing required for that purchase at the new higher price.

Since remunerations are based on volume of business, it has led to huge over-leveraging and predatory lending. This predatory lending was unchecked by Financial regulators. Hence, financial markets falsely prospered while risk was passed to other parties and huge bonuses paid to people connected to Financial Markets They were made richer at the expense of uninformed borrowers. Both paid a high price once the over inflated balloon (house price index) got punctured.

Conclusion: The Case for a “Twin Peak’’ Approach.

One can make the observation that the UK Government has shown speed and resilience in combating disastrous effects spreading into other areas of the economy. The Government have floated various schemes such as the Bank Recapitalization programme to help banks clean up their balance sheets. Furthermore, Credit Guarantee Scheme and related measures will certainly help restoring stability of the financial system. While these efforts are timely and welcome, our recommendations emphasize two other aspects. These have been ignored so far. They are based on the principles of efficiency, stability and fairness to consumers of financial products.

Currently, the UK system is a tri-partite system composed of Bank of England, Treasury and Financial Services Authority. Though each institution functions separately, at times the nature of financial markets makes them overlap. This has a tendency to create both duplication of some of its tasks and at times lack of co-ordination between agencies, which prevent them taking timely actions. Our proposal is to break the FSA into two distinct and autonomous parts. While the main body of the FSA may continue with its mandated function of ensuring prudential regulation of relevant financial institutions, the second Authority may be entrusted with the safety of the financial products to consumers, imparting knowledge of basic finance to consumers and fairness issues in conducting business. Such an approach, known as the “Twin Peak” method will help promote efficiency, transparency and fairness and will enrich the system of financial regulatory Framework.

Firstly, given our studies and Lord Lipsey’s presentation, it is crystal clear that given the complexity, size and breadth of the financial markets, it is almost impossible for a single agency to deal with all the intricate issues related to regulations of financial markets. Formation of an independent body looking after consumers together with another body that deals with complementary aspect will enhance efficiency due to specialization.

Secondly, dealing with consumers’ safety of financial products will generate information regarding the compliance of laws by financial firms. This will serve as a source of additional information and will provide solid checks and balances of the system. Financial products are sophisticated information goods and consumers may not comprehend its full consequences before they start using them.

Finally, while sellers are few in numbers in financial products, buyers are always numerous, un-coordinated and disperse. Frequently they are both uneducated and uninformed in the use of these products. Hence, injustice inflicted on each may go unnoticed as they lack power to influence the regulatory body to force a hearing of their cases on an individual basis. Giving them an option to present their case to a body properly and legally equipped to make a decision will make the system fair in addition to promoting stability and efficiency.

Co-authors:

Dr Sanjay Banerji Ph.d.

International Academic, Fulbright Scholar; Reader of Finance, Essex Business School.

Dr Banerji (0044 (0) 7518118658) is currently lecturing in Japan.

Jeff Lampert

Former Chairman of Heritage plc (in Liquidation)

Mr Lampert (0044 (0) 7939138376) is currently in the UK.

Some Comments on this Report:

Alan Keen MP. (vice-Chair of the APPG) “This report makes some very valid and interesting points: it is a good report”.

Vince Cable MP (Treasurer to the APPG) “I receive numerous complaints by constituents about the way in which they have been “ripped off” by banks and other financial services providers, failed by the regulator and let down by the Financial Ombudsman. This report helpfully brings together a wide range of experiences.”

Dr R Vis MP (Lampert’s MP) “As a former Economics Lecturer I consider this report captures the causes of the current financial crisis: demonstrates the effect it has on consumers, and with the suggestion of “twin peak” regulation suggests a way to make financial suffering a little more equitable and less unfair.”