Author: IIMI Admin

As the financial services industry seeks to rebuild itself in the wake of the global financial crisis, the need to find new ways to manage risk becomes a greater part of the debate. With national governments, the European Union, and various global associations and supranational bodies all looking at additional ways to regulate the industry, this paper examines whether there is an alternative, and perhaps more effective, route to reforming the industry through the encouragement and incentivisation of behavioural change.

Better alignment of managers with their clients can reduce risk, improve performance, and rebuild trust in the financial services industry. We do not believe that this should be accomplished by additional regulation on remuneration or ownership, but rather through a process of cultural change and increased transparency. The aim of this paper is to offer practical suggestions about how investment managers can become better aligned with their clients, drawing on our experience as financial SMEs for whom this is a fundamental tenet of our businesses. We then explore how these suggestions can be applied to participants in the financial system more broadly. Finally, we offer suggestions to policymakers on how they can encourage better alignment within the financial system.

Policy Responses:

Response 1

Support and accreditation by regulators and industry stakeholders for the establishment of a ‘Code of Good Practice’ for the fund management industry.

Response 2

Deferral of income tax on remuneration fund managers are compelled to invest into their own funds, and limited deferral on voluntary co-investment in order to encourage alignment.

Response 3

Simplification of the regulations around making employees partners in financial LLPs, and encouraging employee ownership further in both companies and LLPs in line with policymakers’ efforts to increase employee ownership more broadly.

The explosive growth of Exchange Traded Funds (ETF) over the last decade is the latest in a long line of financial innovations to come out of the investment banks who, over the last five years, have seen many of their traditional revenue streams evaporate. Behind these apparently simple, easy and cheap financial vehicles there are armies of traders employed in their ‘construction’. It would not be too far from the truth to say that swaps, futures and stock lending departments now rely for their very existence on the increasing appetite for the ETF.

The purpose of this short note is to point out the downside of this latest of financial innovations. The marketing and lobbying muscle of the investment banking fraternity has been extremely effective at highlighting the advantage to investors of the ETF. The potential downsides of these instruments are less often heard.

Since Jack Bogle launched the First Index Investment Trust in 1976, assets in tracking products have grown from just $11 million to over $1.5 trillion today. Whilst these funds initially focused on equity indices such as the S&P 500, there has recently been an explosion of products in more esoteric and illiquid markets, with ETFs accounting for a large proportion of this growth (ETF AUM has increased by 40% p.a. over the last decade). Investors can now buy ETFs in anything ranging from agricultural commodities to one providing leveraged exposure to volatility.

The growth of ETFs has been embraced with relish by the financial services industry and such products now constitute a highly profitable earnings stream. For investment banks, profit margins on ETFs are significantly higher than on traditional actively managed products. Beyond management fees, issuers make extra profits through securities lending, swap origination and futures sales. The high profitability of ETFs creates a powerful incentive for issuers to continue aggressively expanding the number of markets and assets that ETFs purport to track, regardless of whether this is to the benefit of investors and securities’ markets in general.

Good ideas taken too far would be an apt summary of the history of financial innovation. While the ability of investors to gain exposure to a broad array of asset classes at a low cost should be seen as a positive development, the enormous increase in both the scale and scope of ETFs brings with it a number of dangers, which need to be considered by both investors and regulators. Such dangers affect both broader market participants in the form of higher volatility and higher stock correlations, as well as higher valuations of indexed stocks. Investors in ETFs are also exposed to counterparty risk and in certain asset classes, returns far below those of the underlying assets.

The impetus for this paper arose in a most unlikely manner. At a meeting with the NCI, the Business Secretary Dr. Vince Cable asked about the scale of small and medium sized financial services businesses, and how many jobs this sector provided, in the capital. Nobody had the answer. The Board of the New City Initiative promised to find out and to report back to the Secretary of State. With the significant assistance of IMAS Corporate Advisors and the Lord Mayor’s office, we delved into the data, and found that this interesting question revealed some surprising statistics. We therefore thank the Business Secretary for inadvertently initiating our latest policy paper, which we hope will fill some gaps in knowledge about this robust and thriving section of the financial services sector in the UK (and indeed by inference in Europe more widely). As this paper will demonstrate, the so-called “City” is far from being about the financial giants alone.

Taxpayers were called upon to bail out ‘big banks’ after the financial crisis, leading many voters to resent the financial services industry bitterly. But there is another City. It is made up of entrepreneurs who manage significant sums on behalf of investors and employ many tens of thousands of people. Some of us have come together to form the NCI, whose members alone have some £200 billion under management and employ several thousand individuals.

However we represent but a small part of the diverse body of financial SMEs that contribute to the City. According to our research sources, the financial SME sector (typically defined as firms employing less than 250 employees) as a whole employs up to an astonishing 57 per cent of the UK’s total financial services staff. Accurate figures for assets under management are harder to come by, but the UK’s Financial Services Authority (FSA) suggests that UK-based hedge funds alone manage some $550 billion.1 In Europe as a whole, it is estimated that the hedge fund industry – just one category of the SME sector – employs 50,000 people across the EU, and that their partners, employees, consultants and service providers pay taxes of more than $8 billion every year.2 Clearly this is just the beginning as far as the wider financial SME sector is concerned across Europe.

We believe that financial entrepreneurs are a valuable asset for the UK and wider EU at a time when economic growth, particularly outside the European core, cannot be taken for granted. Given the rise of emerging economies and the pressing need for developed nations to compete, SMEs are vital because they stimulate excellence and hence competitiveness within the financial services sector.

In the light of financial SMEs’ significant roles as employers and innovators, as discussed further below, we believe that there is a vital need for regulators to ensure that the new regulatory framework distinguishes between different kinds of financial businesses with a particular focus on the levels of risks they may (or may not) create for the financial system. This will help the City and financial centres throughout Europe to thrive as valuable economic assets for their own countries and for the EU more widely. The alternative is to expose Europe’s financial centres to avoidable competition from offshore regimes such as those in Switzerland and many emerging markets, where the authorities aim to attract institutions through lighter regulatory and tax burdens.

This paper covers lots of ground, but it focuses on one key point. We must avoid imposing regulations designed for banks and shadow banks on SMEs.

The first step towards this is to correct the misconception – common in policymaking and regulatory circles in both the UK and Europe more widely – that the financial sector consists solely of big banks. When regulators and other officials deal with financial services companies, they must distinguish between two categories. The first includes those businesses which use their balance sheets for trading purposes. The second is comprised of companies that do not – which are, effectively, third-party advisers – and which also demonstrate a strong focus on alignment with their clients. The UK government set out its commitment to small businesses of all industries in its budget of March 2011, although many would argue that its proposals did not go far enough. With this principle established, we would like to see measures taken to encourage SMEs in the financial services sector specifically, based on the key distinction identified above.