UK Continues To Clear The Path For Growth Of Alternative Finance

Draft legislation has now been published to allow bad debt relief for investors in peer to peer loans, in addition to the new Personal Savings Allowance announced in the Summer Budget.

These measures are among those that address the key regulatory problems and perverse incentives that have been preventing the flow of finance to people and businesses who need it and improved returns to savers and investors. The first regulatory initiative was to regulate P2P lending, announced in 2013; while the first step in addressing incentives was to include P2P loans in ISAs - first announced in 2014.

In introducing the latest incentive measures the government says it remains "determined to increase competition in the financial sector, where new firms such as P2P platforms can thrive alongside the established players and compete to offer new and improved services to customers. This new relief will create a level playing field for the taxation of income from P2P lending when compared to the taxation of traditional forms of retail investment available from those established players."

The government's commitment is critical, given that the financial system is now less diverse than before the financial crisis blew up in 2008. Few bank reforms have actually taken effect - and some are being watered down. Recent fines and scandals also reveal little change in mainstream financial services culture from that described in the report of the Parliamentary Commission on Banking Standards and most recently in the damning report into the failure of HBOS.

From 6 April 2016, individuals investing in certain P2P loans will be able to set-off the losses they incur from loans in default against income they receive from other P2P loans, when calculating their savings income for tax purposes. 

In addition, under the Personal Savings Allowance announced in the Summer Budget 2015, the first £1,000 of savings income will be exempt from tax for basic rate taxpayers and the first £500 for higher rate taxpayers. An individual’s PSA will apply to interest they receive from P2P lending after any relief for bad debts. 

FCA Announces #ProjectInnovate

Hard on the heels of the Transforming Finance workshop, the FCA announced in a speech by CEO Martin Wheatley last week that it will support innovators by: 

• providing 'advice on compliance' to firms who are developing new models or products advice so they can navigate the regulatory system;

• looking for areas where the system itself needs to adapt to new technology or broader change – rather than the other way round; and

• launching an incubator to help innovative, small financial businesses ready themselves for regulatory authorisation.

The umbrella term for these initiatives is "Project Innovate". I look forward to hearing more about it, including contact details etc.

How The FCA Could Support Innovation And Diversity In Financial Services

Hats off to the Financial Conduct Authority for hosting and participating in The Finance Innovation Lab's recent workshop on Transforming Finance. It was an excellent, productive discussion and seems likely to help drive helpful change. For the sake of transparency, here are my notes/thoughts (unattributed, on the basis of Chatham House Rules).

The FCA board is interested in how the financial services market can be 'disrupted' in ways that are positive for consumers and small businesses. There is a new awareness of how regulatory uncertainty can be a barrier to entry/growth; and the need to get better at recognising the harm that comes from stifling good initiatives.

Key aspects of beneficial disruption include, innovation, diversity, and competition. There is evidence that competition within markets alone is insufficient, and can actually drive mis-selling (e.g. banks competed to sell PPI). Increasing diversity is also necessary, to enable competition amongst different business models and services in the same market. This requires the FCA to consider how firms outside the regulated markets are delivering better consumer outcomes, as well as firms within the regulated markets.

Greater transparency around fees, incentives and conflicts of interest allows excessive fees to attract competition and/or disintermediation; and the removal/re-alignment of perverse incentives and conflicts of interest.  

FCA could foster innovation with: 

• a 'sandbox' for entrepreneurs/innovators to consider how new models might be impacted by rules - this could include an online method for extracting all the rules in the Handbook that relate to a certain product or activity; 
• pre-authorisation workshops to coach firms through the evolution to authorsiation and obtain feedback on problems and potential improvements; 
• a shortened, small firms registration process that would allow new entrants to operate under certain thresholds before going through the lengthy full authorisation process (as for small payment/e-money institutions);
• a small firms unit made up of staff from each of the FCA's main 'silos' to ensure joined-up focus on innovation and diversity, consistency, fairness and positive discrimination in favour of sensible initiatives.

The regulatory/policy environment needs to be more open and accessible. We need to know which staff are responsible for what. The FCA tends to draft its rules and communicate in its own unique language, rather than in the language of the markets it regulates or even the same terms used in directives/regulations it is supposed to implement. It also needs to 'get out more', and participate in more forums involving firms, trade bodies, policy officials from relevant departments (e.g. Treasury and BIS) and the European Commission. There should be more public roadshows, roundtables etc - perhaps the FCA could host an annual, wider version of the P2P Finance Policy Summit that was run in December 2012? The consultation process should more positively discriminate in favour of those outside the incumbent firms, it should be more socially networked with a more widely telegraphed timetable. In this context it would also be helpful for the FCA to keep a register of who is lobbying it (e.g. as Ministers must disclose). There should be a body to scrutinise what the FCA (and HMT) is consulting on and how the consultation process operates.

The FCA views the market through the lens of products, and types of firms and their activities, rather than from the standpoint of the customer and how the customer can be empowered to achieve their own financial outcome. The customer is seen as victim, whereas the tide of technology and innovation is delivering greater control to the customer (e.g. over personal data - and financial transactions are just another type of data).

The FCA needs to participate in the debate over the best means of credit creation - should we separate banks' role in money creation from their role in actually allocating credit? Should we strip banks of their role in creating money altogether, as covered by Martin Wolf recently. 

How do we distinguish genuine innovation or invention from merely incremental changes to existing models/products? New rules should be tested for their potential impact on diversity, innovation and competition.

The Financial Services Consumer Panel and Smaller Business Practitioner Panel should have specific obligations to consider the above issues, as well as the interests of alternative finance providers and civil society more generally.

Interested in your thoughts!

Why Doesn't The ECB Try P2P?

horizontal vs vertical credit intermediation

In April, European officials finally realised that Europe's banks will be unable to lend enough to small businesses to finance economic recovery. The failure of the UK's Funding for Lending scheme has not gone unnoticed. So rather than establish an EU version of that scheme, the European Central Bank has been considering whether to kick-start a small business securitisation market. Last week, however, the ECB played down that idea. After all, the banks don't have the capability to make enough loans in the first place, and the 'shadow banking' sector has demonstrated that it can't reliably price endless tiers of bonds, CDOs, CDOs of CDOs.

So now what?

Peer-to-peer lending has grown rapidly in the UK, despite an awkward (though permissive) regulatory framework and perverse tax incentives. That headwind is changing, as even the UK government has begun lending on some platforms, and officials are getting on with the job of bringing P2P lending firmly within the regulatory sphere.

Oddly, perhaps, those regulatory changes are being made in the context of moving the supervision of consumer credit from the Office of Fair Trading to the Financial Conduct Authority in April 2014. However, that merely reflects the fact that P2P lending originated in the personal loan market, whereas there are now platforms that facilitate business loans, asset finance and commercial real estate funding. In other words, P2P lending has expanded into institutional investor territory, which should be of real interest to the ECB as it looks beyond the banking sphere.

As I've pointed out many times since 2010, a key feature of P2P lending platforms is that each borrower's loan amount is provided via many tiny, direct loans from many different lenders at inception. This permits lenders to diversify at the outset, so that loan maturities and rates of return do not need to be 'transformed' via securitisation later on.  Enforcement and due diligence are made easy on P2P platforms because the one-to-one legal relationship between borrower and lender is maintained for the life of the loan, and the performance data also remains readily available via the lender's account. This enables P2P lenders to avoid the concentration of credit risk that securitisation tends to obscure through endless re-packaging and re-grading, and the ensuing disconnect between bonds and the underlying loans. 

It will also be of special interest to the ECB that the scope for moral hazard is contained in the P2P context - the platform operator itself has no balance sheet risk, yet is able to implement all the compliance and operational risk controls one would ordinarily expect of lenders. This brings regulatory efficiencies, too. The authorities need only supervise the P2P platform operator rather than the lenders and borrowers on either side, who are effectively just payers and payees, as in the case of a payment institution. Funnily enough, that's the reason the UK's Peer-to-Peer Finance Association borrowed the substance of its "Operating Principles" from the Payment Services Directive - a piece of legislation with which the ECB is also very familiar...

That paves the way for anyone to lend to consumers and small businesses via P2P platforms without any concern about the need for lender-licensing. Indeed, the UK's Financial Conduct Authority has said that it intends providing investor-type protection for P2P lenders. That would mean exemptions for marketing P2P lending to high net worth and sophisticated investors and professional investment firms. So it would be strange to also require such investors to be separately authorised to lend, especially when the platform operator is taking care of all the compliance obligations. It would be like requiring a firm to be authorised to deposit money in the bank or to make payments via a payment institution - just red tape.

Given access to loan capital on that industrial scale, the ECB could justifiably view P2P lending to small businesses as a significant potential driver of economic growth. 

Payday Loans: Can Borrowers Have Speed, Convenience And Affordability?

Source: OFT

Problems with payday lending are not new. As with payment protection insurance, campaigners in the US were attempting to address poor practices in this area long before they rose to prominence in the UK - and still are. Regulatory solutions don't seem to make much difference. However, recent research shows that 46% of the UK's online borrowers shop around, versus 28% of those on the high street. This suggests technology may also help ensure compliance with affordability requirements, if only creditors would provide transaction and fees data in machine-readable format.

In its consultation on Payday Lending in the UK, the OFT estimates that the volume of payday loans has grown from £900m to £2.2bn since 2008. It says the top 3 providers account for 57% of all payday loans, but concedes the number of lenders has grown from 96 in 2009 to 190 in 2012. This growth, and the efforts of UK campaigners, sparked the OFT's payday lending compliance review in February 2012. As a result of that review, the OFT is now considering a referral of the industry to the Competition Commission, though it believes the transfer of its own regulatory role to the Financial Conduct Authority in 2014 "is likely to increase regulatory costs and make entry to the payday lending market more difficult."

True, the FCA will have more powers, e.g. to limit the number of roll-overs, cap interest rates and control advertising (see the Treasury and FCA consultation papers on the transfer of consumer credit). But the past decade here and in the US has shown that regulation itself is no panacea. Technology appears to have had a bigger impact, both in terms of access and the ability to shop around, and this suggests that technology represents the best avenue for addressing affordability issues.

It's important to start with the borrower. You can't ignore the fact that 90% of online customers who responded to the OFT survey find it "quick and convenient" to get a short term loan and 81% say it makes it easier to manage when money is tight. Customers expressed their satisfaction in terms of decision speed (36%), convenience (35%) and customer service (27%). While affordability therefore appears to be a secondary consideration for all concerned, that's a bit misleading. Research shows that customers ignore the annualised interest rate and look at the absolute charges. These may make loan cost comparison harder, but makes more sense to someone who believes he's only borrowing for a month - which is the case for 72% of payday loans (see graphic). Assessing affordability is also hard - especially for the borrower, on whom the lender is largely relying to provide the relevant figures.

It is therefore no suprise that the industry advertising generally emphasises 'time to cash'.  But the OFT also found that some lenders seem to skimp on credit and affordability checks in order to deliver that speed. You would think that's a dangerous game for lenders to play when their own money is at risk. But the OFT found that about half lenders' revenue come from the 28% of loans that 'roll-over' at least once before being repaid (see graphic). Instinctively, that looks bad. But if those loans are so valuable to lenders, it seems odd that the OFT found little evidence of competition for them loans that are about to roll-over. Perhaps borrowers think they have no alternative at that point, or perhaps they don't care about the cost. But it's also consistent with the fact that these borrowers - and lenders - find it really hard to assess affordability.

While the OFT will decide in June whether to refer the payday lending 'market' to the Competition Commission, you can see from Annex A to its report that it's struggling to define that market. There's a long list of potentially competing finance products. But there are at least 4 unmentioned 'gorillas in the room'. The 'silverback' is the overall debt scenario facing any borrower considering a payday loan. Another gorilla in this troop is the charge for unapproved overdrafts, about which the OFT is understandably gun-shy after its long-running court battle with the banks. Yet another is the fact that when you use a credit card you have no ready means of knowing what the outstanding balance is, as some transactions may not yet be recorded, and interest and charges may only be added to the bill at the end of the month. That's a common reason that the so-called 'financial excluded' give for not trusting financial services, including cheque books and debit cards. The final gorilla in the troop is the borrower's overall financial situation, including the non-financial implications of failing to pay existing or potential creditors, like kids having no school shoes...

However, like a credit reference search itself, these gorillas are all really data problems that are capable of a technological solution, as I've explained previously. Rather than skimp on affordability checks, lenders should figure out how to enable them to be carried out quickly and conveniently. Small lenders might share the cost of a common underwriting platform, for example. But, more importantly, borrowers need to be armed with an application that very simply presents an option that is affordable, based on the analysis of their own transaction data (including fees) from their existing creditors, and the competing costs of different financing options (including charges for missing a payment). 

This may sound futuristic, but it only requires a commitment on the part of all the typical creditors and financial services providers to make this data available to their customers (or their nominated service provider) in machine-readable format. The analysis can be done by either the customer's or a supplier's computer, with the results accessible either online or physically, via a print-out. 

There are plenty of examples of individual customers' transaction data being made available to them or their nominees in this way already, and the immediate focus of the government's voluntary 'Midata' programme is to persuade the banks, telcos and energy companies to do this for all their customers (rather than only those with internet banking accounts, for example). 

Problems like the affordability issues in the £2.2bn payday lending sector represent a good argument for getting on with it.

Why Our ISAs Don't 'Work'... Yet.

The Treasury consultation on expanding the ISA scheme provides a fresh opportunity to put our savings to work and boost economic growth at the same time.

What's wrong with ISAs?

The “Individual Savings Account” (ISA) rules encourage us to put £11,280 a year into bank cash deposits and a limited list of regulated bonds and shares by making the returns tax-free.

Last year the Treasury estimated that about 45% of UK adults have an ISA, with a total of £400bn split about equally between cash and stocks/shares.

But in 2010 Consumer Focus found that cash-ISAs were only earning an average of 0.41% interest (after initial ‘teaser’ rates expire). They also found that 60 per cent of savers never withdraw money from their account; and 30 per cent see their ISAs as an alternative to a pension. 

Yet the banks don't use this cheap £200bn very wisely. In fact, only £1 in every £10 of the credit they create is allocated to firms who contribute to economic growth (GDP) and 60% of new jobs. In other words, lending to businesses is just not our banks' core activity, even though we also guarantee their liabilities. They earn more by financing consumption and speculation in financial assets. They've even taken £9.5bn under the so-called "Funding for Lending" scheme, and lent even less than before...

So we need the ISA scheme to encourage people to put their ISA money - and the country - back to work.

That means adding alternative asset classes that provide a decent return by financing the real economy, such as those generated on peer-to-peer lending and crowd-investment platforms.

Why hasn't this been done already?

The Treasury has previously resisted calls to do this on two occasions over the past few years. Their defence has been that ISAs are popular, simple to understand, relatively low risk and peer-to-peer platforms are not regulated (see here at para 14 and here at page 13).

But on neither occasion did the Treasury acknowledge the risks posed by the huge concentration of ISA cash in low yield deposits. Or the potential benefits of enabling savers to make some of those funds available to consumers and small businesses at lower cost and far higher returns - especially given that peer-to-peer default rates have proved to be very low.

The regulatory concern also appears to have been misplaced. Banks have clearly demonstrated that regulation affords no guarantee that consumers will be treated fairly. And peer-to-peer platforms, which are already partly regulated by the Office of Fair Trading, have been requesting broader regulation for several years. As a result, the Treasury has begun consulting on plans for more comprehensive regulation by the new Financial Conduct Authority from 2014.

All of that means the latest consultation on adding new assets to the ISA scheme is a golden opportunity to convince the Treasury to let us put our savings to work. 

Let's not miss it.

Submission To Parliamentary Commission on Banking Standards

In the interests of transparency, I've embedded below my submission to the Parliamentary Commission on Banking Standards.

Submission to commission on banking standards sdj 08 02 13 final from Simon Deane-Johns

Dead Simple Financial Products

The Treasury has just summarised the responses to the Sergeant proposals for simple financial products. 

You know, the idea that 'simple financial services' means an "Easy Access Savings Account" a "30 day Notice Account" and a life cover product...  

This from a group led by someone who recently made a rather startling admission before the Parliamentary Banking Standards Commission over her role in Lloyds Banking Group's PPI fiasco.

Apparently, the team is now to conduct 'consumer research'. In other words, they're following the same well-worn path to futility that the banks have followed in failing to offer simple financial products to date. Dream up something that should be profitable for the provider, then figure out how to persuade consumers to 'demand' it.

This is not how to simplify financial services, as I've explained elsewhere. The Treasury is flogging a dead horse.

If the Treasury really wants simple financial services (which seems doubtful on the evidence to date), then it should fix the regulatory framework and perverse incentives that are constraining innovation and competition.

EC Sunlight On Shadow Banking

The European Commission has published a summary of responses to its consultation on shadow banking (basically credit intermediation by non-banks - largely securitisation). The Commission concludes that:

"The analysis of comments received suggests that there is support for regulatory measures in the EU subject to key principles, i.e. they have to improve financial stability, they are proportionate, they reduce regulatory arbitrage, they reflect the global characteristics of shadow banking, they improve transparency and they facilitate long-term growth."

The point about regulatory arbitrage is key. Not only should differences between member state frameworks be eliminated, but the regulated sphere of activity also needs to take account of activities and developing financial services that are not regulated.

While it's encouraging to see the EC finally working out how to close the stable door, albeit long after the occupant decamped, it's disappointing that the review did not look at peer-to-peer lending, a horizontal form of credit intermediation that avoids the need for securitisation altogether.

But I would say that, wouldn't I?

Horizontal vs vertical credit intermediation from Simon Deane-Johns

Government to Challenge Financial Red Tape

The UK government has announced proposals to clear the path for the growth of peer-to-peer finance platforms (also known as 'crowdfunding'). 

The latest government response to the Red Tape Challenge shows a determination to make it easier to innovate in ways that deliver lower cost, transparent financial services to consumers and small businesses. 

The government is sensitive to concerns that any regulation in this area should be proportionate and not raise barriers to entry or further innovation. As a result, the government wishes to encourage continued self-regulatory efforts by the Peer-to-Peer Finance Association to address common operational risks, and to engage with policy-makers and regulators. 

Critically, the government will also create a cross-departmental working group comprising representatives of all the relevant bodies it considers ought to be engaged in the development of peer-to-peer finance. Specifically, that working group will "monitor the appropriateness of the current regulatory regime for peer-to-peer platforms" and take the lead in engaging with the peer-to-peer finance industry. 

The composition of this working group is testimony to the broad policy implications and opportunities posed by this new form of financial model. The list of members includes the Office of Fair Trading, the Department of Business Innovation and Skills, HM Treasury, the Financial Services Authority and the Cabinet Office. However, it is known that the Department for Culture Media and Sport is also very interested in the potential for peer-to-peer finance to fund the development of the arts and entertainment industry. 

Peer-to-peer industry concerns were also backed by Mark Littlewood, Director-General of the Institute of Economic Affairs, in his response as Sector Champion for this aspect of the Red Tape Challenge. His report offers various additional solutions as an alternative to regulation. However, he does recommend certain exemptions be introduced to the financial regulatory framework to enable 'crowd-investing' for shares in start-up companies. 

Interestingly, Mark Littlewood has also suggested a means of 'future-proofing' regulation. He suggests regulators should be open to engage with new entrants at an early stage of their development to provide them with enough certainty to get started quickly. Officials should support appropriate self-regulation in the early phases, for example, through accreditation with the UK Accreditation Service (who presumably would also need to be similarly approachable and flexible).

Abandon Hope All Ye Who Enter The Financial Services Bill

The new financial regime is unsinkable

As a desperate alternative to the Eurovision Song Contest, last night I combed the latest version of the Financial Services Bill for a glimmer of evidence that the Government understands the extreme difficulty of innovating responsibly in a retail financial world dominated by a byzantine regulatory regime. 

Alas there's nothing much in the Bill except two new supervisory deckchairs from which the authorities can watch our major financial institutions power us inexorably into the icy depths. 

To be fair, the word "innovation" does appear once in this homage to complexity. But it is used in a way that could only be intended to evoke the maximum possible relief amongst those terrified of it. The financial authorities need only promote effective competition and innovation within the markets for regulated financial services. God forbid there should be a process for developing proportionate regulation of emerging business models, or that the authorities should provide guidance to those intent on delivering better outcomes for consumers than established firms or existing services. Here is the leading, bleeding, cutting edge of our giant financial regulatory regime:

"1E The competition objective

(1) The competition objective is: promoting effective competition in the interests of consumers in the markets for—
(a) regulated financial services, or
(b) services provided by a recognised investment exchange in carrying on regulated activities in respect of which it is by virtue of section 285(2) exempt from the general prohibition.

(2) The matters to which the FCA may have regard in considering the effectiveness of competition in the market for any services mentioned in subsection (1) include—
(a) the needs of different consumers who use or may use those services, including their need for information that enables them to make informed choices,
(b) the ease with which consumers who obtain those services can change the person from whom they obtain them,
(c) the ease with which new entrants can enter the market, and
(d) how far competition is encouraging innovation."

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.

Enabling The Growth of P2P Finance - Simon Deane-Johns

View more PowerPoint from Simon Deane-Johns

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. 

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.

Submission on New Model for Retail Finance

Set out below are both the initial summary and my full submission to the Red Tape Challenge and the BIS Taskforce on Non-bank Finance. I'm very grateful to the colleagues who contributed, as mentioned in the longer document.

In its invitation to submit evidence of ‘red tape’ that is inhibiting the development of ‘disruptive business models’, the Cabinet Office notes the example of Zopa, “a company that provides a platform for members of the public to lend to each other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…” 

This paper demonstrates that financial regulation similarly fails to deal with a range of non-bank, direct finance platforms (“Platforms”) that share some of the key characteristics of Zopa’s person-to-person lending platform (see Annex 1). Accordingly, financial regulation is failing to enable the cost efficient flow of surplus funds from ordinary people savers and investors to creditworthy people and businesses who need finance. In particular, as further explained in Annex 2, the current regulatory framework:

• generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance Platforms (even though some are licensed by the Office of Fair Trading);

• creates legal and regulatory issues that vary greatly depending on the structure of Platform and instrument adopted, particularly where investment is for return, rather than by way of donation (without return) to a good cause. This means that detailed legal advice is needed for any Platform and this is itself a barrier to entry for some schemes which may not pose any significant risk to the public. Platforms may also require a level of regulatory authorisation which may be inappropriate, again considering the low level of risk to the public.

• does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest (as explained in Annex 2), and the inability to deduct bad debt before tax and the tax on interest charged to cover bad debt exposes individual participants on Platforms to much higher ‘effective tax rates’ than their applicable statutory rates (see Annex 3);

• discourages ordinary savers and investors from adequately diversifying their investments;

• incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares;

• inhibits ordinary savers’ and investors’ from accessing fixed income returns that exceed long term savings rates;

• inhibits the development of peer-to-peer funding of other fixed term finance (e.g. mortgages and project/asset finance); and

• protects ‘traditional’ regulated financial services providers from competition.

These regulatory failings could be resolved by creating a new regulated activity of “operating a Platform”, for which the best-equipped regulatory authority would be the Financial Services Authority (as replaced by the Financial Conduct Authority). In tandem, or as alternatives, there could be exemptions based on size of investment or risk (e.g. some schemes or platforms may involve minimal investment in what is sometimes a socially useful venture); lesser regulation/authorisation within existing classes of regulated activity (as for small payment services providers or small e-money issuers) ; or the official endorsement of self-regulatory codes (as banks enjoy in relation to the Banking Code, for example). Direct and indirect incentives that selectively favour incumbent banks and investment funds should also be recognised and modified to balance the competitive landscape. Detailed regulatory changes are explained in Annex 4. 

Regulation of the platform would be independent of any regulation that may apply to the type of product offered to participants on the platform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for social projects, as noted in Annex 1). However, exemptions from regulations governing financial promotions and offers to the public could be granted for instruments that are offered on Platforms. 

Proportionate regulation that obliges Platform operators to address operational risks common to all products would also enable economies of scale and sharing of consistent ‘best practice’, and leave product providers and other competent regulators to focus solely on product-specific issues (e.g. consumer credit, charitable purposes). Similarly, participants on such Platforms do not need to be treated as if they are participating in the course of a ‘business’ if the Platform itself meets all the compliance requirements that a business of that kind would otherwise have to meet. 

Given the established nature of the financial regulatory framework and the dominance of incumbent banks in the provision of debt finance to individuals and small businesses in particular, it is unrealistic to assume that new business models will thrive without some alteration to the regulatory framework to enable rapid market entry and to facilitate strong, responsible growth.

Alternative finance briefing paper simon deane-johns 27 01 12

View more documents from Pragmatist.

Red Tape Challenge Submission - Summary

In its invitation to submit evidence of ‘red tape’ that is inhibiting the developmentof ‘disruptive business models’, the Cabinet Office notes the example of Zopa, “a company that provides a platform for members of the public to lend to each other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…” 

Financial regulation similarly fails to deal with a range of non-bank finance platforms that share some of the key characteristics of Zopa’s person-to-person lending platform. Accordingly, financial regulation is failing to enable the cost efficient flow of surplus funds from ordinary people savers and investors to creditworthy people and businesses who need finance. In particular, the current framework: 

1. generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance platforms (even though some are licensed by the Office of Fair Trading); 
2. does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest, exposing lenders to higher ‘effective tax rates’; 
3. discourages ordinary savers and investors from adequately diversifying their investments; 
4. incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares; 
5. inhibits ordinary savers’ and investors’ from accessing fixed income returns that exceed long term savings rates; 
6. inhibits the development of peer-to-peer funding of other fixed term finance (e.g.mortgages and project/asset finance, and even short term funding of invoices); and
7. protects ‘traditional’ regulated financial services providers from competition. 

These regulatory failings could be resolved by creating a new regulated activity of operating a direct finance platform, for which the best-equipped regulatory authority would be the Financial Services Authority (as replaced by the Financial Conduct Authority). Regulation of the platform would be independent of any regulation that may apply to the type of product offered to participants on the platform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for social projects). Proportionate regulation that obliges platform operators to address operational risks common to all products would also enable economies of scale and sharing of consistent best practice, and leave product providers and other competent regulators to focus solely on product-specific issues (e.g. consumer credit, charitable purposes). 

Similarly, there is no reason why products distributed via these platforms should not also be eligible for the usual mechanisms through which ordinary people save and invest, such as ISAs, pensions and enterprise investment schemes.

I'm off to Number 10 today to discuss these issues, and will be submitting a more detailed paper in the coming weeks, both to the Red Tape Challenge and the BIS Taskforce on alternative business finance. I'm interested in any comments you may have.

The Nature of Scepticism

Readers of Pragmatist will know that I've expressed my bemusement before that auditors have to be taught how to be sceptical. That was back in March. In November, the European Commission confirmed that the Financial Reporting Council wasn't joking:

"Article 15

Professional scepticism

When carrying out the statutory audit of a public-interest entity, the statutory auditor or audit firm shall maintain professional scepticism throughout the audit, recognizing the possibility that a material misstatement due to facts or behaviour indicating irregularities, including fraud or error could exist, notwithstanding the auditor's or firm's past experience of the honesty andintegrity of the audited entity's management and of the persons charged with its governance.

The statutory auditor or the audit firm shall maintain professional scepticism in particular when reviewing management estimates relating to fair values and the impairment of goodwill and other intangible and future cash flow relevant to the consideration of the going concern.

For the purposes of this Article, 'professional scepticism' means an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud and a critical assessment of audit evidence."

Proposal for a regulation on specific requirements regarding statutory audit of public-interest entities.

Next: a European Regulation governing the exercise of scepticism in the course of police interviews...  


Hat-tip to Mark from last night's London New Finance Meet-up. Image from The Philosopher's Magazine.

A New Regulatory Model For Retail Finance

"It's time for reflection..." FT.com

Non-bank retail finance models have been gaining momentum worldwide over the past six years, in spite of our creaking financial regulatory framework. Finally, it seems that framework is about to become more directly supportive. 

The mid-noughties saw the launch of various innovative person-to-person finance platforms in the UK, US, Germany and elsewhere, which have been tracked here. These were launched by teams that spent considerable time and expense trying to accommodate existing regulation that favoured incumbents, with little or no regulatory assistance. Meanwhile, the regulatory authorities discovered that their framework, ironically designed to protect consumers, actually guaranteed the worst banking excesses and failed to contain the downside to complex "shadow banking" system in which the incumbent institutions were also involved. And although taxpayers have had to step in and effectively democratise the financial markets, we are still unable to extract badly needed funding from retail banks.

Against that background, it is perverse that the regulatory framework does not already directly facilitate simple, low cost, alternative financial services. And let's not forget that banks and other retail investment institutions continue to enjoy indirect tax subsidies through individuals' ability to off-set losses, as well as ISA and pension allowances for which unregulated alternative investments do not qualify.

While substantial innovation in consumer and small business lending has been possible, UK rules against marketing investments like bonds, shares and unregulated collective investment schemes, have made it much harder to offer alternative funding for SME start-ups, trade finance and even social projects. Given a more proportionate investment regime, the likes of Crowdcube, MarketInvoice, Buzzbnk, Social Impact Bonds and the Green Investment Bank, for example, might operate rather differently. They would no doubt also be joined by existing and new P2P platforms as a substantial alternative to banks and other fee-hungry investment institutions.

Oddly, given its reputation for fast-paced innovation, the US is even less supportive of alternative retail financial models. Zopa, for example, which led the growth of P2P platforms with its launch in the UK, was unable to launch its P2P model in the US despite lengthy consultation with securities regulators. And life has been unnecessarily complicated for the likes of Prosper and Lending Club ever since.

To help remedy the regulatory imbalance, as mentioned in August, three of the leading UK commercial P2P platforms launched the Peer-to-Peer Finance Association and an accompanying set of self-regulatory measures. Their focus is platforms on which the majority of lenders and borrowers are consumers or small businesses, rather than, say, ‘investment clubs’ or networks of sophisticated investors. 

And in September the New York Times reported that there are three proposals in the US to allow peer-to-peer financing without securities registration and disclosure requirements:

"One petition, prepared in 2010 by the Sustainable Economies Law Center and, fittingly, paid for by a grass-roots crowdfunding effort, asks the S.E.C. to permit entrepreneurs to raise up to $100 per individual and an aggregate of up to $100,000 without requiring expensive registration and disclosure.

President Obama, as part of his jobs act, advocates an exemption for sums totaling up to $1 million. Representative Patrick McHenry, a Republican from North Carolina, has drafted legislation that would allow companies to obtain up to $5 million from individuals through crowdfunded ventures, with a cap of $10,000 per investor, or 10 percent of their annual incomes, whichever is smaller."

How would this work in practice?

The challenge (and benefit) associated with such 'safe harbours' is that there is very little room for fee income. This in turn favours 'thin intermediaries', like the new electronic finance platforms, as a means of broad, open distribution. Proportionately regulated, these platforms can deliver greater efficiency, transparency and cost savings that benefit providers and consumers alike. 

Specifically, these platforms can be the focus of regulation designed to control operational risk; deliver transparency (through adequate product disclosure and ‘my account’ functionality); and centralise customer service and complaints handling, with ultimate referral to financial ombudsmen. Focusing those regulatory burdens on the platforms would shift significant compliance costs away from the product providers who rely on the platforms as a means of distribution. This would also mean specialist product regulators could focus their resources on 'vertical' issues related to specific products and their providers rather than 'horizontal' issues that are common to all. Such is the primary intent behind the P2PFA's Operating Principles, for example, which cover lending to both consumers and small businesses.

In addition, since social investments and P2P finance offerings both involve some credit risk and therefore the potential for losses, tax rules should allow off-setting against gains and income derived via these platforms. And there is no reason why instruments so distributed should not also qualify for ISA and pension allowances.

Consumers and small businesses should expect further developments in this space throughout 2012.