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

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

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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.

Alternatives To Traditional Business Funding

Huge thanks to MarketInvoice for the kind invitation to their event at the Cass Business School yesterday. The event really highlighted the gravity of the SME funding situation and the giant leap in understanding that is required of politicians and policy-makers in this area.

Chuka Umunna MP, Shadow Secretary for BIS, gave the keynote, and the panel included Andrew Cave, the Head of Policy at the Federation of Small Businesses, Emmanouil Schizas of ACCA Global, as well as Anil Stocker of MarketInvoice and Andy Ralph, director of a company that has raised significant amounts of invoice finance in the past quarter. 

Chuka gave some useful context:

• All the recent banking industry figures point to a significant contraction in lending to SMEs in the past quarter. Worse, SME Finance Monitor says over half of SMEs applying for overdrafts this year for the first time have been refused, and more than 400,000 SMEs who wanted to apply for an overdraft in the third quarter  didn’t do so – a third because they were discouraged by their bank.
• A recent BACS report also suggests that "half of all the UK’s small and medium sized enterprises are awaiting late payments. On average, each firm is owed £39,000 in late payments, with the total amount owed to SMEs having reached a staggering record figure of £33.6bn."

Less helpful, however, were Labour's proposed solutions to this mess. In summary, notwithstanding his glowing endorsement of MarketInvoice's as a useful private sector alternative to bank finance and the acknowledged need for more non-bank competition, Chuka said that Labour wants:

• Banks to improve local relationship management;
• The government to be more active and directly involved in improving payment and supply chain management;
• To create a new agency along the lines of the US Small Business Administration and Small Business Investment Company programme, whereby SBICs use their own capital plus funds borrowed with an SBA guarantee to make investments in qualifying small businesses - a phenomenal soure of moral hazhard and downright fraud that's been well documented by David Einhorn in his US Senate Committee testimony and the book "Fooling Some of the People All of the Time"; and
• To use government procurement to help SMEs (notwithstanding Labour's notorious reputation for waste in that area).

Perhaps it's beyond his shadow brief, but it was notable that Chuka made no mention of the discussion of alternative regulatory solutions here and in the US, nor the Cabinet Office focus on red tape that inhibits disruptive business models that specifically identifies alternative finance platforms. There was no reaction to the suggestion that alternative payment providers should enjoy the same tax subsidies that banks and other regulated institutions enjoy through ISA/pension allowances and individuals' ability to off-set losses against income. And no thought appeared to have been given to the idea of a clearly defined 'safe harbour' for the likes of MarketInvoice and peer-to-peer platforms from the rules on collective investment schemes and/or arranging deals in investments, to enable them to start up more confidently, quickly and efficiently.

In fact, Chuka's pitch rather underscored his party's role in helping to create our desperate need for alternatives to traditional business funding. Let's hope we see some decent ideas from the opposition in future.

In the meantime, it's down to the participants on MarketInvoice, Funding Circle and CrowdCube and the many angel networks to carry the alternative funding hopes of SMEs.