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Sunday, 25 March 2012

A Financial Innovation Federation?

On Friday, the Finance Innovation Lab brought together various people who are active in the financial policy space to consider whether disruptive policies can help deliver a sustainable financial system. Chris Hewett explained where various policy ideas feature  in the evolution from a 'glint in the eye' to 'political battleground'. He then introduced short speeches on Reshaping the Banking Sector (from Tony Greenham of the NEF), Re-interpreting Fiduciary Duty (from Catherine Howarth of Fair Pensions) and Enabling the Growth of P2P finance (from yours truly, summarising recent submissions to government and the response - slides embedded below). Chris then invited us to discuss the best policy ideas based on the 3 approaches.

Our particular break out discussion focused on how a new regulatory 'channel' might "create an environment for responsible financial innovation to flourish". The context for this exercise was the government's reluctance to amend the financial regulatory framework and related tax incentives to promote alternative finance.

We thought that financial innovation could flourish within a forum comprising groups or networks that reflect the functions within any business - IT, marketing, finance, operations, legal and so on - with a group focused on facilitating the development of innovative business plans through a series of local, regional and national 'finance innovation labs'. Let's call this overall environment a "Financial Innovation Federation". The Federation could be governed via a council that would facilitate agreement on the criteria against which innovative ideas would be judged as being 'responsible' or not, as well as the governance of the body itself and that of its members.  Such agreement could be facilitated via an open, web-based system of governance in which all the members of the Federation could share their knowledge and vote on governance rules and so on. The council could comprise representatives of member businesses and their customers, independent non-executives, and representatives of the Financial Conduct Authority, HM Treasury and Business Innovation and Skills, so that the key regulators and policy makers would be directly engaged with the process of self-regulation and could not claim to be somehow separate from or 'above' the innovation process. The presence of government representatives would mean the approach would be better described as 'co-regulation', which has parallels in other industries. Proportionate formal regulation could evolve as necessary and appropriate.

The basic criteria against which innovative ideas could be judged as 'responsible' or not would be their simplicity, direct connection between participants, product neutrality, the promotion of diversification and whether a real customer problem is solved. The rules relating to the operation of the 'approved' services would focus on managing shared operational risks at the platform level, such as the Rules and Operating Principles of the Peer-to-Peer Finance Association (P2PFA). The overall result would be the creation of a 'safe harbour' in which many different innovative business models could flourish under the watchful gaze of a community of those with expertise in managing operational risk, as well as those charged with protecting consumers and the financial system itself.

In essence, this has already been happening over the past 6 months or so, in the context of submissions made to the Red Tape Challenge on Disruptive Business Models, the Breedon Taskforce and numerous approaches to the FSA by business teams seeking either regulatory guidance or authorisation. A 'Financial Innovation Federation' would draw all this knowledge together more tightly, enabling the more cost-efficient iteration of business plans and quicker time to market for responsible, workable, innovative business models.

We considered that the most useful next step towards establishing such a Financial Innovation Federation would be a meeting between the The Finance Innovation Lab, the P2PFA and other interested parties to explore the practicalities.

Wednesday, 21 March 2012

Government Responds To Breedon

The Government has penned a rapidfire response welcoming the Breedon Taskforce report. Broadly, there is support to explore most of the avenues recommended, except the extension to the ISA programme.

While there's no appetite to make formal changes to the tax and regulatory framework necessary to boost alternatives to banks, the good news is that the Government has acknowledged the industry's desire for proportionate regulation, and welcomed the self-regulatory initiative in setting up the Peer-to-Peer Finance Association to "help raise awareness among SMEs and investors and establish industry standards to protect investors and borrowers". The Government has also :
"...allocated £100m of the Business Finance Partnership to invest through non-traditional channels that can reach smaller businesses, which could include peer-to-peer lending as well as mezzanine loans and asset-based finance. The Government will request proposals for investment in May."
However, the Government "is not minded to amend the ISA scheme" by adding new asset classes. Ironically, the rationale for resisting the Breedon recommendation on this front provides the very basis on which it should be accepted. The ISA scheme is too popular and too narrow to be called "safe" and does not efficiently allocate spare cash to people and businesses who need it
"ISAs are a successful and popular product - around 45% of the adult population currently holds one – and their relative simplicity and the coherence of the brand are important to that success. ISAs already offer generous reliefs allowing people to invest up to £10,680 each year in a “stocks and shares” ISA without incurring tax on their returns. The range of qualifying investments includes securities issued by companies listed on a Recognised Stock Exchange: this may include companies of a range of sizes. There is also scope for UCITS, NURS and other investment funds that qualify for inclusion in an ISA to invest part of their funds in smaller, unlisted companies. The Government considers that this provides the right balance of risk given the nature of an ISA investment. The proposed changes would complicate the scheme and undermine its core purpose of providing a relatively simple, safe vehicle which encourages people to save."
Small investors' life savings should be placed in many more baskets than this. 

Tuesday, 20 March 2012

Breedon's 11 Ways To Finance Small Businesses

Following a rapid but inclusive review, the Breedon Taskforce has recommended 11 ways to improve the financing options for the UK's smaller businesses. As a result, the next few years promise a wealth of innovation and competition in the market for SME finance.

The report confirms that net bank lending to smaller businesses will continue to decline due to the banks' own credit problems and the capital adequacy headwind. In fact, the report estimates a funding gap of about £26bn to £59bn for SMEs over the next 5 years, and an overall finance gap of up to £190bn for UK business sector as a whole.

But the Taskforce has found plenty of scope for growth in alternatives, both in the form of new funding sources, as well as more traditional finance options that have developed in countries where banks have not been so dominant.

The most interesting aspects of the report are: 
  1. the acknowledgement (in section 4) that the plethora of government interventions to date (EIS, EIG, etc. etc.) have failed to gain traction; 

  2. the recommendation (in section 5) for either an extension to the ISA scheme (as also submitted here) or a new 'Enterprise Savings Account';

  3. the acknowledgement (in section 5) that the financial regulatory and promotional framework presents barriers for investors and businesses alike (as also submitted here), and that capital controls and limits on unregulated investments are creating a culture of "reckless prudence" amongst regulated financial institutions (section 8);

  4. acknowledgement (in section 7) that there is "some sense" in the request by peer-to-peer platform operators for "proportionate regulation, to protect investors and provide confidence" (as also submitted here) but that officials are concerned that "over-zealous regulation would add to costs, destroying the market before it has a chance to gain scale organically;"  

  5. the recommendation (in section 7) that the government should lend in conjunction with the private sector via direct finance platforms;

  6. encouragement (in section 6) for standardisation to promote the trade in invoices;

  7. the recommendation (in section 5) to create an Agency for Business Lending that would "aggregate a large number of SME loans and finance them via the corporate bond markets" - although, presumably, this would have to be designed to avoid the downside of previous shadow banking activity which is unduly complex compared to direct finance (as also submitted here):

Source: Lipstick On a Pig, p.109.

Wednesday, 14 March 2012

Taxing Bad Debt

In January, I submitted to the Red Tape Challenge on Disruptive Business Models and the Breedon Taskforce a paper explaining how the government could encourage the development of peer-to-peer finance platforms. Since then, there has been some discussion about potential regulatory changes, as well as the basis on which individual lenders might deduct any bad debt they incur on loans to people and businesses before tax (as banks are allowed to do).  

In other words, personal investors/taxpayers should be entitled to a similar tax framework to the one used by the banks they are competing with in the provision of loans. For example, loans via two peer-to-peer (or direct finance) platforms are listed among the rates available today on MoneySupermarket for a personal loan of £5,000 over 3 years to a borrower with an "excellent profile". There are also competitive rates listed from another direct finance platform in the business loans section.

Denying ordinary taxpayers this tax benefit not only discourages them diversifying their investments, but also limits the flow of competitively priced funding for creditworthy people and businesses. It also means, perversely, that your bank can use your cheap ISA cash to compete against you in the lending markets - and gain a tax deduction on any bad debt that you cannot. So the tax rules are both anti-competitive and confer a selective advantage on some players in the personal and business lending markets - a state aid issue.
To allow you to deduct any bad debt from your income before tax, HMRC will no doubt want to know that your loans were made responsibly at arms-length and that there were decent attempts at recovering missed payments. Here are the criteria on which direct finance platforms ensure this: 
1. The platform operator is not a party to the instruments on its platform and segregates investors’/lenders’ funds, so it has no credit/investment risk, no temptation to engage in regulatory/tax arbitrage and derives no benefit from the segregated funds nor any of the tax benefit available to participating lenders;

2. Finance is drawn from many lenders at the outset according to objective criteria, so lenders are competing against each other on price and not merely choosing friends/family members to lend to;

3. Lenders can achieve diversification across many borrowers at the start, removing the need for subsequent costly re-packaging or securitisation;

4. The one-to-one legal relationship between each borrower and lender is maintained for the life of each loan via the same technology platform (with a back-up available), so all the loan data is readily available to participants and for collections/enforcement activity as well as creating an audit trail for tax purposes;

5. The platform operators abide by applicable legislation such as anti-money laundering regulations: HMRC will want to know who the participants are too so they need to be properly identified;

6. The platform operators can provide information on lenders’ income to HMRC to allow them to collect taxes if desired.
 Of course, none of this would be an issue for the ordinary person, if you could simply lend your ISA money via a direct finance platform, instead of having to put in a savings account or in regulated stocks and shares.

Tuesday, 13 March 2012

Privacy Must Be A Core Business Competence

The European Commission's proposed General Data Protection Regulation is just that: general regulation. No longer can businesses afford to treat data protection compliance as a 'bolt-on' to their marketing department, or even the compliance department. CEO's need to understand how the demands of personal data privacy are going to re-shape their business.

Just ask yourself whether you think the following rights go to the heart of any business that deals with individuals: the "right to be forgotten", "data portability", "data protection by design and by default", the logging/reporting of personal data security breaches, personal data processing impact assessments, prior consultation and regulatory consent for potentially risky processing. Not to mention requirements for enhanced internal controls, numerous enforcement and compliance burdens, and the obligation to appoint a data protection officer.

The trouble is, none of these concepts is straightforward, nor are the rules easily digested.

But digest them you must. Even if they don't make it onto the statute books, the genie is out of the bottle. Many of these 'rights' reflect the current concerns of at least some consumers (albeit most of them probably also happen to work for the European Commission and various consumer groups). Existing services will be judged against them as 'best practice'. Some businesses and new entrants without legacy systems will factor them into new services. And if they do make it onto the UK's statute books, you can bet they'll be gold-plated.

The Society for Computers and Law has done a great job of stimulating debate on the EC's proposals, and helping identify the implications for businesses generally. But there's a long way to go before the practical implications for businesses and business models are understood and fed back to the authorities in time for a new directive to be finalised in 2014. In fact, bitter experience suggests this won't happen at all.

At a recent seminar, Mark Watts, Chair of SCL's Privacy and Data Protection Group, polled about 100 delegates on the questions asked in the 4 week Ministry of Justice consultation on the EC's plans. The results can be downloaded via the Society for Computers and Law web site. One response made a telling point:
'Writing wide-ranging, broadly applicable laws that affect almost everything a business does but which can only be interpreted and implemented with the assistance of specialist data protection lawyers is surely not the best way to go. Laws that potentially affect so much of what ordinary business does on a day to day basis should be capable of being understood by "ordinary businessmen". The Regulation is a long way from this and will keep data protection lawyers in business for years.'
Further, As Dr Kieron O'Hara explains in relation to the technological challenges presented by the 'right to be forgotten' in his excellent article in this month's Computers & Law magazine, the EC's ambitious plan for personal privacy requires "a socio-legal construct, not a technical fix."