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Is the regulatory framework able to adapt to fast-changing practices and products as well as to new risks in the financial services industry so that it can continue to be effective in respect of its intended regulatory objective and impose obligations that remain appropriate?1

      Conclusion

      This chapter provides the framework for the remainder of the book: a model to evaluate differing regulatory systems and a roadmap for the future.

      Before we explore stages 4 and 5 in detail, and even suggest a stage 6, we will just reflect on recent experience and the difficulty some leading jurisdictions have had in stepping up from stage 3 to 4/5. Obviously, this transition, which we recognize is the most difficult in conceptual and practical terms, has been made even more difficult by the 2008 GFC. The GFC placed strains on the early steps in this transition as change had not had the chance to become sufficiently embedded. So now these jurisdictions have a chance to make the transition for a second time and ensure that it sticks.

Chapter 3

      Is Compliance Worth the Money?

      Bolt pulls up the ladder, secures the hatch.

– Simon Armitage, “Last Day on Planet Earth,” in Seeing Stars (London: Faber and Faber, 2010)

      An Unfortunate Unconformity

      Compliance has not had a happy record since 2008. This is partly because the apparent development in compliance and regulation into stage 4 of the General Model may have been superficial and not properly embedded. Also other firms and regulators were either complacent or comfortable in stage 3 and had failed to improve. In general, where regulators had been trying to press forward into stage 4, such as the UK's Treating Customers Fairly (TCF) initiative, compliance may not have had the frame of reference to have really got it, and so were unable to keep in step with changing regulatory expectations. This created an unstable unconformity between pioneering regulators and compliance. This is a high-risk situation for a regulatory and compliance system.

      This unconformity may have left compliance looking somewhat bewildered and embarrassed. Remedial actions have also seemed hasty and superficial, rather than embedded. So, despite regulation beginning to enter stages 4 and 5, the compliance results in the same period have been uncertain and fragile – as 2008 unearthed. It is reasonable to assume that development in compliance needs to progress further and faster, as Part II suggests, as some firms start from a position well behind the curve. Compliance must play catchup. But before setting out in a determined fashion it is necessary to consider the shortcomings we saw first time around, and this may help focus on how best to change.

      The 2008 Global Financial Crisis

      In 2006, the author wrote an article in the financial press warning that “the emperor has no clothes,”2 and so it proved. There were many causes of the 2008 GFC. Compliance failings were central. But it is also fair to say that the roots of the crisis and the contributory factors were many and various. The undoubted compliance failings were by no means the only factors adding to international instability. Causes and accelerators were to be found in almost every component of the financial system, including:

      ● Encouragement of the subprime sector by government policies, starting in the 1990s or even before.

      ● Target-driven selling in banks.

      ● Bonus culture.

      ● Relaxed and competitive credit policies.

      ● Consumer greed – wants became needs.

      ● Regulators, governments, and banks were happy to sustain the myth of continuing runaway growth. UK Chancellor Gordon Brown announced that New Labour had “abolished the cycle of boom and bust” as far back as 19973– all seemed delighted to believe him.

      ● Voters and consumers were comfortable and complacent and therefore unchallenging.

      ● Inadequacy of capital models and business-as-usual stress-tests.

      ● Panic due to a lack of understanding of complex products, the real levels of toxicity and liquidity.

      ● Retail banks trying to behave as though they were investment banks or being led by their investment bank arms (and acquiring such arms if need be, e.g., RBS's takeover of ABN AMRO in the midst of the crisis).

      ● Lack of product due diligence by buyers of complex products such as collateralized debt obligations (CDOs)

      ● Sometimes knowing connivance amongst the producers of complex products as disclosed by the U.S. Congressional hearings.

      ● Interconnectedness of the global financial system and some banks discovered to be “too big to fail” (e.g., Lehman Brothers).

      ● Lack of international cooperation and information sharing until it is was almost too late.

      The FSA Turner report highlighted from this list:4

      ● Unsustainable credit boom and asset price inflation (with inadequate capital requirements)

      ● Increasing complexity and opacity of the securitised credit model

      ● Misplaced reliance on sophisticated mathematics

      ● Transmission of loss of confidence and bank funding liquidity into real economy effects

      ● Hardwired procyclicality creating self-reinforcing feedback loops

      ● Impaired ability to extend credit to the real economy exacerbating the economic downturn

      Economist Robert Shiller added:

      The central bankers didn't see it as their mission to think about mortgages that are being written or to worry about the shadow-banking sector, because they weren't banks so they weren't under supervision, so they let things go. Those are mistakes, but understandable given the bureaucratic structure.5

      Compliance failing included:

      ● Insufficient due diligence seems to have been carried out on complex products traded.

      ● Insufficient attention was paid by compliance on the capital or funding positions of banks.

      ● Insufficient warnings were given about lending practices such as high multiples of income, low deposit requirements, buy-to-let mortgages, self-certified mortgages, and mortgages over 100 percent of asset value.

      ● Modelling of stressed situations that could arise was insufficient.

      ● Aggressive advertising and rewards were obvious but unchecked.

      ● Some more conservative banks, such as Standard Chartered and HSBC, to an extent, stood aloof, but this did not encourage different patterns of behaviour amongst the compliance community.

      These are the basics of compliance supervision. There may be instances where individual compliance officers had insight and spoke up, but they were either not listened to or did not have the stature or import to make a meaningful difference. Some, it is understood, were relieved of their duties for their efforts as the race for new business was on.

      Regulators' relative inaction and lack of pressure made it difficult to find an intellectual justification for a more compliance intervention. Particularly inexplicable was the unwillingness of regulators and compliance to do anything very differently after the early warning collapse of Northern Rock in 2007. Unfortunately, the performance of regulators and of compliance are actually and metaphorically bound together.

      Legacy of Failure

      Given compliance's recent record, it would be reasonable for boards, governments, and consumers to ask whether compliance is actually worth the money. Why should companies, the industry collectively, or its many stakeholders have confidence in the compliance function?

      Yet,

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