Regulate the regulator

Last week, a report was released by the UK’s Parliamentary committee saying that the UK regulatory body for financial conduct - the FCA (Financial Conduct Authority) - is “incompetent at best, dishonest at worst” and that it has a “toxic culture”. This is based upon an investigation of the FCA which took almost three years and collected evidence from 174 fraud victims, whistleblowers and the regulator’s former staff. The report concludes “that the FCA is now ‘drinking in the last-chance saloon’. But the problem is worse than that: the bar is about to close, and the regulator is at risk of being thrown onto the street”.

It reminded me of 15 years ago when Alistair Darling accused the Financial Services Authority (FSA), the then leading regulator of UK finance, of being “asleep at the wheel”. This was after the run on Northern Rock that triggered the UK’s financial crisis of 2008 as part of the general crisis in the US and Europe. That led to a nice exchange in a Commons Treasury Committee where Sir John Gieve, the then Deputy Governor for Financial Stability at the Bank of England, who had to explicitly say that he was awake:

Chairman: Sir John, you sit on the FSA; were you having a sleep in the back shop while a mugging was taking place in the front?

Sir John Gieve: I am on the board of the FSA, that is true. I do not think the FSA or the Bank were asleep at the wheel.

Chairman: I am asking you, Sir John, about your responsibility. Do not talk to me about the FSA—

Sir John Gieve: I thought you were asking me as a member of the FSA board.

Chairman: Exactly, about your accountability.

Sir John Gieve: I do not think I was asleep at the wheel.

So, we are back there again. What is the issue this time? Fraud and the mistreatment of customers.

There have been a series of financial scandals in the UK where financial services firms are accused of mistreating consumers and small businesses, and the FCA has been blamed for “doing too little too late – or nothing” to prevent or punish alleged wrongdoing.

The cases studied include everything from victims of alleged pension and investment scams, bank misconducts towards SMEs, misconduct from payments institutions or other non-investment scams to “mortgage prisoners” and more.

What the report shows is that, under the scrutiny of the FCA, serious financial misconduct was happening across the UK financial markets. That does not seem to say they were doing a good job. In fact, the worst example of these schemes has to be LCF, London Capital & Finance.

London Capital & Finance (LCF) raised £237 million from more than 11,600 investors by issuing mini-bonds. Mini-bonds generally offer higher returns and many consumers were on-board with the wave of their offerings. The thing is that it was a Ponzi scheme, with the directors using the money invested to buy property, supercars, luxury travel and make donations to the Conservative Party.

In November 2024, the High Court of Justice in London concluded that LCF operated as a Ponzi scheme to pay old bondholders with new bondholder’s money between 2013 and May 2018. That’s a proven model that works for those who run them, like Bernie Madoff or the original innovator of such schemes, Charles Ponzi*, except it is illegal and immoral.

The basic idea is that you offer attractive rates of return for investors, to lure in money, but returns are paid from money coming in from other, new investors. This happens until the scheme ends up owing more than they hold in investments and eventually collapses.

LCF is only one of several fraudulent schemes that took place under the watchful eye of the FCA who, on reflection, were asleep at the wheel again. They would claim not. When all of this came to light they blamed PwC (Pricewaterhouse Coopers), the auditor of LCF, and fined them £15 million for a lack of audit oversight.

But LCF wasn’t the only issue that happened under the FCA’s watch and the Parliamentary investigation concludes that the FCA’s “actions are slow and inadequate, its leaders opaque and unaccountable” where current and former employees “depict its culture and leadership as profoundly defective” from the top down “where there is little accountability, and those who challenge a top-down ‘official line’ on any given issue are bullied and discriminated against, or even managed out”.

One former employee said that it was “the worst staff culture I have ever experienced in nearly 40 years. Top-down hierarchical management; do as you’re told; don’t argue. An astonishing arrogance that FCA ‘insiders’ know more than any newcomers.”

The thing for me is that this is nothing new. Most regulators are incredibly rigid in their ways, which is why most financial firms are afraid of them, and they often let fraud happen under their watch until they can see it.

This was brought home to me in China where the peer-to-peer lending markets were rife and then collapsed in 2018. Thousands lost their life savings, and it was all the result of the regulator. The regulator let the markets run rife with zero oversight and then woke up one day, and switched the market off so that thousands of firms collapsed.

China’s online P2P lending industry grew rapidly between 2011 to 2015, with the number of P2P lenders growing from 50 to nearly 3,500 respectively.

But then trouble started brewing in 2016 as the Chinese Banking Regulatory Commission found that about 40% of P2P lending platforms were in fact Ponzi schemes. Consequently, it forced authorities to tighten regulations with the introduction of over 100 new rules, resulting in the shutdown of many P2P lending platforms. Over 900 closed by the end of 2016 and, by 2018, only 1,021 providers remained in place with only 50 to 200 expected to survive longer term.

That all sounds fine, except for the millions of investors in the schemes that were unregulated previously who lost all of their money, and have no rights of revocation.

The bottom-line, as I’ve seen this quite often, is that innovation with no regulation is a horse that has bolted from the barn. You cannot close the barn gate after the horse has gone, but you can try to catch the horse. Regulators regularly do this, once they can see it is out of the barn, but the question is how fast can the regulator run and can they deal with the issue in a way that ensures the farmer is unaware they lost a horse.

Something like that anyway.

Then, as I always say, the regulator can never predict what happens next – they are not geared up for that – they purely play in a market rear view mirror, seeing what has happened in the past, and the challenge is how fast they can react to the traffic ahead when they are looking behind. After all, there are three kinds of people: those who make things happen, those who watch things happen, and those who ask what happened? Regulators are always in the final category.

 

Postscript:

The conclusion of the UK investigation into the FCA? Establish a Financial Regulators Supervisory Council to oversee the activities of the FCA or, in other words, create a regulator to regulate the regulator. Great …

 

For more read and listen to:

• APPG on Investment Fraud and Fairer Financial Services
• Money Box - FCA Seen as 'Incompetent' - BBC Sounds
• FCA is ‘incompetent at best, dishonest at worst’, claim MPs and peers | Financial Conduct Authority | The Guardian
• Collapsed London Capital and Finance operated 'Ponzi' scheme - BBC News
• PwC fined £15 million for failing to alert the FCA to suspected fraudulent activity at London Capital & Finance plc | FCA
• The rise and fall of P2P lending in China: By Chris Holmes

Oh, and:

• Andrew Bailey 'fell asleep' during meeting over pensions scandal | This is Money

* Ponzi may have been inspired by the scheme of William W. Miller, a Brooklyn bookkeeper who, in 1899, used a similar deception to take in $1 million (approximately $35 million in today’s money).