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 what part of the financial services industry is regulated by MIFID, and see whether repealing MIFID might, in the future, contribute to a crisis like the 2008 financial crisis. A detailed analysis of that crisis can be found here.
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 argued in our post on the causes of the financial crisis, 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 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 or some life insurance policies. 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), control the money supply and set an official interest rate at which they lend to the banks they supervise. 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.
Lessons of the financial crisis
I have written a separate piece about the elements which contributed to the 2008 financial crisis “A Ponzi Scheme feeding on a Ponzi scheme”. The elements I identified in that piece are: (i) the recycling of Asian dollar trade surpluses into US treasuries, which lowered developed world borrowing costs relative to the level they should have been given the strong demand fuelling those imports; (ii) inadequate levels of banking equity and borrower leverage amplifying the effect of that recycled Asian export surplus via the banking multiplier effect; (iii) inadequate levels of equity held by banks writing gigantic volumes of credit default insurance products such as Credit Default Swaps (CDS); (iv) liberal granting of investment grade credit ratings by the credit rating agencies; and (v) Alan Greenspan’s “Greenspan put,” which attempted to prop markets up at any sign of weakness but refused to take the necessary action to prevent bubbles forming.
It is clear that the causes of the financial crisis can be summarised as follows:
- Debt fuelled growth was extrapolated into the future;
- Artificially low rates and strong growth led investors and lenders to misprice risk;
- Unsuitable loans were made to people who couldn’t repay them;
- Banks and other companies were allowed to hold insufficient equity when making loans and writing derivatives;
- This lack of equity encouraged banks and others to take on too many risky loans and derivatives contracts;
- The banks could take these risks with limited downside because the Federal Reserve would bail them out.
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 CCP’s 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 so doing 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. The only way to make it illegal to make stupid investments is to ban all investment.
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.