MIFID: EU meddling or necessary safeguard?
One of the reasons I support Brexit is that it will enable the UK to jettison many dysfunctional and bureaucratic pieces of legislation imposed by the EU. Though there are some myths surrounding this subject (think straight bananas), the EU’s Market in Financial Instruments Directive, or MIFID, is a genuine example of EU over-regulation, the scrapping of which would benefit the UK (full text of the legislation can be accessed here).
Understandably, the (sadly few) who remember the last financial crisis are wary of any kind of financial deregulation:
Warren Buffet remarked that the excesses of the last financial crisis, which were abetted by a loose regulatory framework, left a lot of the firms involved swimming naked. Would the abolition of MIFID do the same to the UK financial sector?
I think the MIFID regulations are completely different from those whose absence (or reduction) caused the crisis in 2008. But I can understand that people will be skeptical. The point of this piece is to analyse the causes of the 2008 crisis, and see whether repealing MIFID might contribute to such a crisis in the future.
What is MIFID?
The UK’s Financial Conduct Authority (FCA) neatly summarises MIFID as “the EU legislation that regulates firms who provide services to clients linked to ‘financial instruments’ (shares, bonds, units in collective investment schemes and derivatives), and the venues where those instruments are traded” (by “venues” the FCA means stock and other exchanges). So any company in the EU which offers mutual funds, such as unit trusts or UCITS, or offers a share dealing service, has to comply with MIFID.
MIFID regulates a number of things including:
- The staff investment services firms have to employ for a variety of functions;
- How such firms can hold assets on behalf of clients;
- How much commission they can pay to intermediaries;
- What sort of reporting they have to provide.
While some of these might be OK in themselves as aims, the details of the directive are overly complex. MIFID, for example, forces firms to record a reason for every one of their trades in excruciating detail. This is a very burdensome requirement, with not much benefit to the client. If the firm managing your fund invests in a sub-prime mortgage collateralised debt obligation (“CDO”), and all the mortgages in the CDO turn out to be worthless, the fact that they made a record of their reason for investing in that dud CDO (e.g. “the security offered an attractive yield for risk rated AAA by S&P”) doesn’t help you get your money back.
Deregulate the financial sector? Have you forgotten 2008, stupid?
I will be writing in more detail about MIFID, but at this stage suffice to say that it represents the sort of legislation the UK could happily ditch post-Brexit.
I can however fully understand that people lump MIFID in together with financial regulations in general, and that the 2008 crisis makes them leery of any deregulation, including scrapping MIFID. Financial regulation is complex and riddled with jargon, so it’s understandable that trying to draw distinctions between individual segments of financial regulation should be an unappetising prospect.
However, although all financial services are loosely connected – encouraging people to see their regulation as a kind of broad brush effect – each area has its own specific ecosystem and regulation (e.g. banking versus fund management), and within each area there are further divisions (leasing versus business lending or equity versus credit investment) and sub-divisions (auto versus computer equipment leasing or mezzanine versus investment grade credit) and endless further sub-divisions of sub-divisions … but you get the idea by now. Different pieces of legislation regulate different pieces of the financial services jigsaw, and although each might have an impact on the other, the bottom line is that you can increase regulation in one area while loosening it in another.
So while the 2008 financial crisis and its many predecessors teach us to look at any move to loosen financial regulation with a beady eye, each item of regulation (and deregulation) must be analysed on its own merits. That’s what I’m going to do with MIFID – so you don’t have to.
Regulation: Banking (and Insurance) versus Investment Services
Luckily, we don’t need to drill into any micro-subsegments to understand the distinction between MIFID and the area of regulation which was so sorely lacking in the run up to 2008. Instead, we can consider two broad, distinctive zones of activity which require financial regulation – banking (and some kinds of insurance) and investment services – in order to understand the difference between MIFID and the lack of regulations which contributed to the 2008 crash.
My point will be that MIFID regulates the integrity of the investment services sector, not the banking (and insurance) sector. I will then argue that it was an issue of solvency in the banking (and, to a lesser extent, insurance) sector, which is now governed – at a European level – by the EU’s Capital Adequacy Directive (“CAD”), not MIFID, which contributed to the 2008 crash. So it is solvency guidelines like CAD, not regulations like MIFID, which will keep us from “swimming naked.”
- If you’re happy with the distinction between banking (and insurance) and investment services regulations you can skip the next bit.
- If you’re also happy that it was banking and (to a lesser extent) insurance solvency that caused the 2008 crash you can skip the whole blog.
Banking (and insurance)
The banking sector requires regulation, above all, because it is highly leveraged and because it depends on trust. It is highly leveraged because, essentially, it borrows in order to lend. The core of the bank’s activity is to take in other people’s money in the form of deposits (from both individuals and companies looking to save), and put that money back out in the form of loans (to individuals and companies looking to invest). The bank will also borrow by issuing bonds to investors, or from other banks etc., and buy bonds issued by companies or lend to other banks etc., but the core of its activity is borrowing from Saver A and lending to Borrower B.
The banking sector only works on trust because it can only give a long term loan to Borrower B if Saver A trusts it enough with her deposit. If the savers ever get nervous and ask for their money back, the bank has to pay it over to them (as with Mary Poppins or Northern Rock). But the companies or individual borrowers with mortgages need that money long term. They can’t just repay it on demand, at the drop of a hat. So if savers ever lose trust in the banking system you get a run on the banks and the whole thing falls down.
Similarly, insurance companies take in other people’s money in the form of premiums, promising to make payments to those customers if they have a legitimate claim. The industry only works if customers can trust their insurers to make good on the claims, which can be gigantic in the case of things like earthquakes or asbestos.
On top of that, the banks and insurers developed an additional layer of leveraged activities in the run up to the sub-prime crisis, when, as we shall analyse below, they began to make significant use of derivatives to hedge their credit, interest rate and other exposures. Banks and insurance companies also made (and lost) a lot of money writing such derivatives. Although different from a bank deposit, these derivative contracts are, like deposits, promises to make payments. The derivatives market, like the banks’ core activities of deposit taking and lending, only works if participants can be are financially robust enough to make good on their promises.
This is where regulation comes in:
- It forces banks to hold a certain amount of equity relative to the loans they make. Equity is permanent capital, i.e. money investors have injected into the bank which it can lock up and keep. Equity increases as profits are retained in the bank or fresh capital is injected by investors. If loans on the asset side of the bank’s balance sheet are impaired, equity acts as a buffer to enable the bank to make good on the deposits on the liability side.
- It also forces banks (or insurers) to hold a certain amount of equity relative to their other risks, such as the risk of losses in their trading books or, crucially, derivatives portfolios.
- It forces banks to maintain other prudential ratios such as ratios of loans to deposits or of readily realisable assets relative to short term obligations (LCR).
- It forces banks to make provisions for future bad debts according to specified parameters. This reduces the profits and therefore the retained profits and therefore the equity and therefore the total size of the bank’s balance sheet and the loans it is able to make.
- It restricts the types of loans banks can make, for example prohibiting them from making mortgage loans for more than a certain percentage of the value of the property securing a mortgage.
- This regulation aims to prevent banks (or insurers) from taking risks which might undermine trust and lead to a run on the banks (or defaults by insurers).
The investment services sector includes brokerage, asset management, wealth management, spread betting and others. It requires regulation because it invests most people’s life savings in products most people don’t fully understand. The sector enables savers to invest directly in a great variety of instruments, whether in stock exchange traded equities or mutual funds or structured products. The investments are held in custody by the investment services company on behalf of the investor, but whether the investor gets any money back or not depends purely on whether the market price of the investment goes up or down. It’s not a question of the strength of the investment services firm’s balance sheet, as it would be with a bank deposit. By investing in these products, savers can ultimately channel their money into long term assets generating economic returns, which can provide them with a source of wealth in their old age. This is a potential benefit to society because long term capital stimulates the economy and private savings reduce demands on the State from an ageing population. Or at least that’s the idea.
To do this effectively, the sector requires disclosure and integrity (stop laughing at the back). It requires disclosure because most of its customers – most people – are not financially sophisticated. They therefore need to have all relevant information regarding an investment explained to them in clear and simple terms in order to take an informed decision. Investment firms make more money the more products they sell. The industry therefore requires integrity in order to ensure that this economic motive does not induce its participants to sell unsuitable products to investors in order to make more profit.
This is where regulation comes in:
- It forces investment firms (and individuals involved in the industry such as IFAs) to be approved in order to operate, and this approval is contingent on demonstration of business practices which involve acting in the client’s best interests. It also audits those firms and individuals on a regular basis to ensure continuing compliance.
- It regulates the way financial products can be presented to investors, to prevent misleading information from being given.
- It regulates payments made to intermediaries in order to prevent conflicts of interest.
- It creates eligible investment products, such as mutual funds, which need to follow certain rules such as using an independent custodian and administrator, or having an independent board of directors, or observing limited levels of leverage.
- It creates rules for exchanges on which financial instruments such as equities can be traded by individuals, such as price transparency, disclosure of commissions and spreads for brokers acting on the exchange, or disclosure of significant events for companies listed on the exchange.
- This regulation aims to prevent investment services firms from mis-selling products or otherwise shafting their customers, and thereby discouraging people from making adequate provision for their retirement.
Who regulates banking (and insurance) and who regulates investment services?
The banking industry in any country or region is, with a few strange exceptions (see below), regulated by the central bank of that country or region. And it is the central bank which guarantees the deposits and steps in to lend to the sector at times of financial crisis. The insurance sector is regulated by the insurance regulator. In the EU, the ECB has used the CAD and other directives to establish minimal capitalisation and other standards to which national central banks (NCBs) have added a prudential buffer on top.
The investment services sector is typically overseen by a regulatory authority dedicated to that sector. These authorities generally emerged later than the central banks, as the investment industry became more complex (the Federal Reserve was founded in 1913, the SEC in 1934). The activities of investment sector regulators were often performed by a department of central government before being spun out into a separate agency. Such regulation is provided both at national level, and at supra-national level with directives like MIFID. Most of the bullet points concerning investment services regulation above are covered by MIFID in the EU, however some, such as those pertaining to eligible investment products, are covered by UCITS legislation.
Central banks do a lot apart from regulating the banking sector. They are also active as banks, meaning they take deposits and make loans (just like the banks they regulate), and they control the money supply. By contrast, the investment services sector is, typically, regulated by a body whose only function is that regulatory activity. In fact, the investment services regulator fundamentally resembles the regulators of other sectors, such as food or medicines or building.
A notable and bizarre exception to this rule was created by one of the UK Chancellor Gordon Brown’s many gaffes, now somewhat obscured by his more high profile debacles (such as his managing to increase the UK’s budget deficit in a period of high octane growth – fuelled by mushrooming consumer and mortgage debt – during which deficits are supposed to reduce). When Brown made the Bank of England independent in 1997, he for some reason handed regulatory supervision, including of banks, to the FSA (a predecessor of the current FCA). The FSA spectacularly failed to regulate the UK’s banks during the financial crisis and their regulation was, thankfully, subsequently handed back to the Bank of England (and, within the Bank of England, has been handled by the Prudential Regulatory Authority since 2012).
In Europe, the banking sector is overseen by both NCBs and the ECB, which is jointly governed by the NCB governors, overseen by its chairman. The European Commission created the European Banking Authority (EBA) to harmonise legislation between the different NCBs. It therefore has a role in banking regulation, but it would be excessive at this stage to say that the EBA represents the sort of confusion of responsibilities introduced by the power handed by Brown to the FSA in 1997.
The Big Short versus the The Wolf of Wall Street
The distinction between these two areas of financial services and the regulations governing them is vividly illustrated by two very successful recent movies. The Big Short (2015; based on Michael Lewis’s brilliant book published in 2010) focused on the over-leverage of the banking and insurance sectors, while The Wolf of Wall Street (2013; based on Jordan Belfort’s autobiography of the same name, published in 2007) focused on Belfort’s outrageous scams in the investment industry.
The Big Short is of course the story of the sub-prime bubble which led to the 2008 financial crisis, whereas Jordan Belfort’s boiler room scams made him rich in the late 80s and early 90s. MIFID is a set of regulations aimed squarely at the investment sector, in other words they are there to catch future Jordan Belforts, not future Lehman Brothers.
However, it would be unwise to assume that investment services regulation didn’t play any role in the 2008 financial crisis. One therefore needs to investigate whether the sort of scams depicted in the Wolf of Wall Street were operating in the background during the sub-prime bubble. To decide whether this is the case or not, two things are required:
- An analysis of the sub-crime crisis and the regulatory failings which helped cause it;
- An analysis of whether any of the provisions in MIFID constitute the sort of regulations which might prevent a future financial crisis.
Background to the 2008 crisis 1: recycled Asian exports
It may seem odd to start with Asian exports, but the sub-prime crisis’ inception came at a time when Asian countries’ (mainly China’s) trade surpluses with the US were recycled into US treasuries to prevent their currencies from appreciating against the dollar. This can be seen in two charts:
Foreign reserves are constituted by stocks of foreign currency held at central banks, mainly, in the period covered by this chart, Asian central bank reserves of US dollars held in the form of US treasuries. This sum increased roughly 3.5x from 2003 to 2008, to around $7 trillion. Incredibly, it took just over five years to accumulate a full three and a half times the total amount of reserves it took the global system almost a century (ninety years) to accumulate from the foundation of the Federal Reserve in 1913 to 2003.
This growth was the result of the growth in global trade, which generated the export dollars in Asia that were handed over to Asian central banks whose policy was to recycle them into US treasuries (in order to keep their currencies from appreciating). From 2003 to the peak in 2008, the period we focused on in connection with foreign reserve accumulation, the annual amount of global exports increased just under 2.5x to around $17.5 trillion dollars. This is eye watering growth. In five years, exports increased to two and a half times the annual amount it had previously taken centuries to reach. The key date, marked with a red arrow, is the end of 2001, when China joined the WTO. It was this which preceded and led to the breathtaking growth in both exports and foreign currency reserves.
At the heart of the growth in exports and foreign currency reserves was a self-reinforcing, circular financial flow. The US would buy imports from Asia for which it paid in dollars. The Asian central banks would use those dollars to buy US treasuries – effectively lending their trade surplus to the US government. This depressed US government borrowing costs relative to what they should have been given the strong economic activity underpinning such voracious importing of Asian goods. That depressed interest rate then allowed people to borrow more cheaply, boosting both consumption and house prices. This boost in turn increased the demand for Asian exports, and so on … US consumption of Asian exports was booming, funded by loans from Asian central banks. As one wise economist I know put it at the time, “every Korean car arrived in the US with an auto loan cheque under the windscreen wiper.”
The relevance of this circular Asian export boom is that it created strong economic growth and a wall of money looking for a home. It was how the US financial system and its regulators coped with that wall of money which determined the inception of the financial crisis.
Background to the 2008 crisis 2: US banking leverage ratios
This environment was rocket fuel for the US banking sector. A strong economy with low unemployment and booming house prices kept credit defaults very, very low. And assets, especially the mortgage loan book, were expanding rapidly. In such an environment, banking suddenly seemed like a low risk business. However, on the face of it, it might look as though US banks had entered the crisis having accumulated a prudent level of equity capital relative to their assets. In other words that they weren’t fooled by this benign environment.
Equity to assets is on a continually rising trajectory in this chart from the St Louis Fed, with an apparent one percentage point increase in the ratio in 2004/2005, a few years before the crash. Assuming this isn’t because of an accounting change, the chart might suggest that the banks were increasing equity reserves in the good times ahead of any possible set-back.
However, the picture is more complicated.
- As is well known, US banks were increasingly off-loading or securitising their mortgage loans to investors such as insurance companies and pension funds during this period. So they were able to grow their activity faster than their balance sheet because of appetite from investors to take some of the loans they were writing off their balance sheet. In many cases, although the assets sold to those investors went off balance sheet in accounting terms, the banks had sold them with guarantees that they would support the products in which those assets were wrapped. In other words they would come back on balance sheet if things were to go sour;
- The US banking sector had gone through a massive merger and acquisition (M&A) binge and a lot of the equity on its balance sheet was goodwill, or an accounting entry for the premium over net asset value (i.e. book value) that had been paid for acquisitions, and not any reflection of any capital injected by investors or retained profit. Unfortunately, you can’t use goodwill to pay the people queuing up outside Northern Rock;
- The quality of the assets was rapidly deteriorating as more and more highly leveraged mortgages were written on more and more unaffordable homes. So the value of the assets left on balance sheets was overstated. Had this been correctly provisioned for, the equity ratio would have looked much worse.
This can be seen, albeit obliquely, in the c. 0.5% fall in the equity ratio in 2008. The optically small fall happened despite a massive injection of fresh equity, mainly by the US government and the Federal Reserve, into the US banking system. This equity injection hides what the dramatic decline of that ratio would have been had it reflected an adjustment to a realistic valuation of the banks’ equity and assets.
The impact of low government bond yields was therefore amplified by equity capital ratios which, in reality, were not keeping up with the growth in balance sheet risk. This created a powerful banking multiplier effect which poured fuel on the flames of the recycled Asian surplus.
Background to the 2008 crisis 3: derivatives
Unfortunately, this over-leverage was not restricted to bank loans. The Big Short focuses on credit default Swap (“CDS”), a kind of financial insurance product, as a central cause of the financial crisis. At the epicenter of the last crisis were sub-prime loans, effectively mortgage loans to borrowers who were too poor to afford the houses they lived in, and which would turn sour if property prices ever stopped going up. Naturally, there was great demand for insurance against defaults on the various classes of sub-prime debt from a number of entities: the banks writing the mortgages, financial institutions to whom (as we saw above) those mortgages were repackaged and sold in the form of CDOs, CLOs etc. and, crucially, the heroes of The Big Short who thought the whole thing was a fraud. These entities went into the CDS market either to hedge their credit risk or (in the case of the heroes of the Big Short) to make money when the house of cards collapsed.
On the other side of that trade were the villains of The Big Short, insurers like AIG and Wall Street brokers like Goldman and Morgan Stanley who thought it was easy money to take juicy premiums against the risk of sub-prime default – a risk they underestimated. When property prices eventually stopped rising and mortgages on variable rates (“ARM”) with two year teaser rates re-set to higher market rates, mortgage defaults exploded and a lot of the CDS “credit insurance policies” were triggered. The problem was that by the time this crash happened the derivatives market was gigantic. And the contracts in it were so complex that the extent of the risk they represented was not understood. Warren Buffett, devastatingly, and, as so often, ahead of the game, called them “weapons of mass destruction” in Berkshire Hathaway’s 2003 annual report.
The companies writing the insurance turned out not to have nearly enough capital and were therefore unable to pay out; they were caught with their trousers down. Not only was there a lack of equity capital backing the loans that banks were making, there was also insufficient equity capital backing the commitments they (and insurers like AIG) had for the CDSs and other derivatives they had written. The banks and insurers’ insouciance about their CDS exposure was a result of the the wall of money and ultra-benign conditions created by the recycled Asian export effect and the insufficiently high banking equity ratios; it seemed impossible that defaults might occur in such boom times.
Despite being incredibly risky, the CDS market was not supported by any Clearing Houses or CCPs, which, in effect, “reinsure” the credit default insurance. The investment banks were trading directly with each other, relying solely on their counterparty’s financial strength. When that financial strength turned out to be only a fraction of what was required to pay out on the credit default insurance, there was a domino effect: Wall Street bank A had bought insurance from Wall Street bank B, but Wall Street bank B couldn’t pay out so Wall Street bank A couldn’t make good on the insurance it had sold to Wall Street bank C, and so on. Two early casualties of this hot mess were Bear Stearns and Lehman Brothers. As Buffet succinctly put it with his usual barbed wit, “when the tide goes out you discover who’s been swimming naked.”
Background to the 2008 crisis 4: credit ratings
As is also well known, the ratings agencies such as S&P and Fitch gave AAA ratings to CDOs which consisted entirely of loans that would never be repaid. This was the result of the long term bull market in property in which house prices in one part of the country were uncorrelated with those in another. Not only was it hard to imagine the property market falling anywhere, but it also seemed that the market was diversified, and that any potential losses in one part of the property market would be offset by gains in another, making it less risky. This of course turned out to be a deadly illusion. Behind this confidence in the property market was, again, the atmosphere created by the recycled Asian export boom and easy money from the banks – which made it easy for the ratings agencies to think that default risk had disappeared. In addition, the ratings agencies made more money if they rated more products, so they had an incentive to hand good ratings out like confetti.
It was those apparently bullet proof credit ratings which encouraged the insurers and other investors to buy re-packaged assets from the banks, thereby enabling the banks to make more loans without growing their balance sheet. And it was also these credit ratings which encouraged the investment banks and insurers like AIG to write so many dangerous CDS contracts. Those CDS contracts also encouraged insurers and other investors to buy more re-packaged assets from the banks, thinking that their credit risk had been hedged. The ability to hedge credit risk then encouraged banks to write more loans, which in turn encouraged the ratings agencies to rate more bonds …
In other words, the financial sector’s own circular, self-reinforcing system of securities and guarantees was a ghoulish mirror of and super-imposed itself upon the circular, self-reinforcing system of recycled Asian trade surpluses. It was a Ponzi scheme fed by another Ponzi scheme.
Background to the 2008 crisis 5: the Greenspan put
It would be remiss to write about this sorry saga without giving due credit to the former chairman of the Federal Reserve, Alan Greenspan, for his role as éminence grise or Svengali of the system that made it possible. Greenspan, notoriously, thought that invisible hand market forces would correct any imbalances in the market, such as the sub-prime bubble eventually proved itself to constitute. What he ignored was the extent to which the sub-prime boom was the result of very political, mercantilist, Asian central bank policies. His dogmatic belief in the market’s ability to auto-correct itself led him to underestimate the system’s vulnerability, as a result of which he allowed banks and others to operate with insufficient capital. Despite this, Greenspan was happy to intervene by cutting interest rates whenever stock markets fell (thus seeming to provide a support level for the markets which was dubbed the “Greenspan put”), notably in 1998 following the collapse of the Nobel economist studded LTCM hedge fund, and in 2001 following the collapse of the dotcom bubble. While he zealously endeavored to prop asset prices up, Greenspan took no measures to prevent the dangerous over-leverage of the financial system he was there to oversee. His approach was all carrot and no stick.
Greenspan’s legacy was perpetuated by his successor, Ben Bernanke, who bailed Wall Street out when they weren’t able to pay up for their stupid CDS bets. The Fed effectively waded out into the sea and handed Wall Street a towel. It makes you weep.
Lessons of the financial crisis
It is clear that the causes of the financial crisis can be summarised as follows:
- Unsuitable loans were made to people who couldn’t repay them;
- Insufficient equity was held by banks and other companies making loans and writing derivatives;
- This lack of equity encouraged banks and others to take on too many risky loans and derivatives contracts.
The subsequent regulatory response took several forms. Central bankers, among other measures:
- Introduced affordability tests for loans and in particular mortgages;
- Increased the amount of equity and above all tangible equity required by banks;
- Introduced limits for the loan to deposit ratio banks can run with;
- Increased the amount of equity banks had to hold for the value at risk (“VAR”) of the derivatives contracts to which they were exposed.
In parallel, insurance regulators increased the equity insurers like AIG needed to hold against the derivatives they wrote and other products they sold to insure customers against financial risks of various kinds, mainly credit risk.
The driving principle behind these reforms is “Capital Adequacy,” which is a synonym for solvency. The reforms are there to ensure that there is enough capital backing the financial system and its customers. All of the lessons of the sub-prime crisis, and the subsequent regulations enacted to avoid the mistakes that led to it being repeated, fall squarely into the purview of the central banks (and to a lesser extent the insurance regulator). The part of the sub-prime debacle which you might class as mis-selling, and so might seem to fall into the investment services category, involved individuals taking out mortgages they could never repay. The rules charged with preventing this are not investment services rules imposed on, say, mortgage brokers, but solvency rules directly restricting the kinds of mortgages banks can write.
The attempt to avoid future crises was embodied in the EU’s CAD, which provided minimum capitalisation levels of various kinds to which all national governments added some kind of buffer (as mentioned above). The UK’s application of the CAD is dictated in the UK by the Bank of England, not the FCA. These are all issues for the banking (and, to a lesser extent, insurance) sector, not the investment services sector. None of them have any relevance to the investment services rules governed by MIFID. It is the CAD, not MIFID, that matters.
MIFID does mandate the use of a CCP for certain derivatives, which would of itself increase the capital committed to derivatives trading. It would mean there was an extra layer of capital, namely the CCPs equity, and probably tighter collateral requirements backing up the payments promised by the derivative instruments. But, as we analysed elsewhere, the use of a CCP is something which the ECB will quite reasonably demand as a condition for standing behind the derivatives market as a backstop. Without any need for MIFID, this demand from the ECB will lead to the same prudential outcome. Whichever way you cut it, it is the central bank which is in charge of solvency.
From our review of the financial crisis we can see that it was driven by too much leverage and use of other people’s money by financial companies, and by mortgage borrowers who didn’t have enough of their own money invested in their house to stay solvent. The solution to that problem was, quite simply, regulations dictating less leverage and more own money invested. In fact, the Bank of England’s insistence on a 3% leverage ratio goes much further than the CAD. It forces banks to have even more skin in the game. That is a good thing. To me, that seems a perfectly adequate solution to the problem. As long as the Bank of England keeps to this stricture, the UK’s financial system will be robust. MIFID, by contrast, does not have any specifications with respect to the key issues of leverage or equity solvency.
Potential MIFID relevance
Hang on, you might say. Didn’t a lot of investors lose a lot of money because of the sub-prime collapse? They certainly did. As described above, a lot of the worst toxic crap was hived off to German insurance companies and other naive investors. However, MIFID mainly affects the way a German insurer has to treat the client buying the insurance product. Whether anything in MIFID can stop the insurance fund from using the client’s money to buy the AAA rated insolvent mortgage CLO is what needs to be investigated.
To do this, I read the 148 pages of MIFID regulations. In doing so I found that much of what MIFID has to say about treatment of clients is already contained in UK domestic legislation. For example, MIFID prohibits fund managers from paying a percentage of the fee paid to them by the investor back to the IFA who sold the fund to the investor. This share of the fee, or “trail commission,” might encourage the IFA to sell the investor the fund even if it isn’t in the investor’s interest. Section 2, article 24 of MIFID accordingly stipulates (p 58):
This is a perfectly sensible provision which may prevent people being sold dodgy products in the future. The thing is, such trail commission was abolished in the UK by the FCA’s predecessor, the FSA, in 2012 – two years before the publication of MIFID. A significant portion of what is contained in MIFID merely seeks to ensure certain minimum standards already in force in the UK. It is effectively forcing Europe’s financial services industry to catch up with the UK. That shouldn’t be surprising. The UK has a more advanced equity and investment culture than the rest of Europe, so has longer experience of what regulations are needed.
If MIFID only contained such simple regulations then scrapping it wouldn’t make much difference, positive or negative. But there are some provisions in MIFID which go beyond what is mandated in the UK. Some of these, as described above, are overly burdensome regulations concerning reporting, whose abolition could not reasonably be thought to increase the chance of future financial crashes.
MIFID also contains articles which it believes will improve the corporate governance of investment firms in a way that reduces the risk of future crashes. By improving how German insurance firms are managed, the authors of MIFID believe it might avoid future German insurance funds buying future baskets of toxic crap. This is from the recitals to MIFID (p 2):
But, when examined, these provisions hardly fill you with confidence that their implementation will make the financial system more robust in the face of the next financial calamity. The recitals state that (p 8):
You may think that diversity is a good thing and even that it should be made mandatory by government. Be that as it may, it is clear that more women or ethnic minorities on boards, or other management directives in MIFID (such as the restrictions, in Recital 54 p 9, on the number of directorships directors of a financial services company may hold), are not going to prevent a repeat of the financial crisis.
Indeed, once the client has been duly informed and advised, there is little in MIFID which makes it illegal for the German insurer to make a duff investment. And nor could there be. All investment comes with some risk. The investor has to choose an investment, to the best of their ability, which gives them the right risk return profile. But there is never any way of knowing what returns that investment will actually deliver. The investment companies who bought the toxic products were guilty of terrible professional misjudgement. But there is no way of preventing such misjudgement with legislation. If you passed legislation making it illegal to make stupid investments, no one would dare invest.
You might also claim that the ratings agencies’ conflict of interest should have been the object of increased regulation. That may be true, although the very point of ratings agencies is that they are independent. They have to be able to independently rate the credit of US government or Federal Reserve debt. So you don’t want them to then be regulated by a US government agency or the US Federal Reserve in a way which compromises their integrity (stop laughing at the back). In any case, the regulation of bodies such as ratings agencies is not something which MIFID remotely addressess.
In summary, you could easily drop MIFID and ease the burden on investment firms without abetting the kind of excess leverage which contributed to the 2008 financial crisis.
People will always make mistakes. More complex legislation won’t abolish that basic reality. Indeed, part of the madness which preceded the sub-prime crash was the idea that sophisticated mathematical models informing intricate strategies, often implemented with equally complex derivatives, could manage risk away. It was partly the false sense of security created by these complex managerial strategies which encouraged banks and insurance companies to leverage up. The solution to that problem is not more complex regulation. That might even give financial firms a false sense of security. Rather, central banks should, as they are doing, force banks and other financial services companies to have enough capital – so they can pay for and survive the mistakes they will inevitably make.