Regulatory Fines – the most lucrative investment a bank (or any financial services company) can make

London, New York, and Chicago are the World’s main financial centres. There was a time, only a decade or two ago, when this was principally because of the need to communicate.  The Lloyds Insurance Market’s lifeblood was the stream of insurance brokers walking along Lime Street to sit, in offices and restaurants, with the underwriters negotiating and administering insurance policies. Exchanges from stocks and shares to futures and options involved traders massed together in large open halls shouting deals at one another. The reason for these cities’ pre-eminence was the advantages that came from being at the centre of trading – which once could only be done by being physically there in person. Now your physical presence is no longer required to trade in person. Placing insurance and trading shares, futures, and options is done electronically. Where you are in the world doesn’t matter.

However, the falling importance of physical location has not undermined London, New York or Chicago. New York and Chicago remain locations of choice because they are at the centre of the World’s largest economy. London joins them at the top table because of the promise of pussy-ish regulation. From banking and trading all the way to personal taxation, regulation in London and to a lesser extent in the USA has been bent into a pretzel to be accommodating.

Financial services firms have long since learned that the most lucrative of all their investments is the money they pay in fines, without admitting wrong-doing, which allow them to carry on with their dodgy doings. They regard paying fines as a cost of doing business, just like paying their rent and their electricity bill.

In evidence taken by the US Senate in 2003, investigating dodgy tax evasion tactics, it was stated that a senior KPMG tax professional calculated just how excellent an investment paying fines is.

“Based upon our analysis of the applicable penalty sections, we conclude that the penalties would be no greater than $14,000 per $100,000 in KPMG fees”… “For example, our average [OPIS] deal would result in KPMG fees of $360,000 with a maximum penalty exposure of only $31,000.”

Even where it comes to aiding the financial transactions of despots and terrorists, the banks are let off lightly. Barclays and LloydsTSB were fined hundreds of millions of dollars by the US authorities for clandestinely processing transactions with banks in Libya, Sudan and Burma. But in each case, the banks were not required to admit to any wrongdoing. Admitting wrongdoing would have triggered further legal sanctions and curtailment of their businesses, which the regulators were keen not to do. US judges rejected and criticised the deals being done with the banks by the US financial regulator, the SEC. Commenting on a deal done by the SEC with Barclays involving a US$298 million fine with no admission of wrongdoing, US District Judge Emmet Sullivan said:

“The public has very little confidence in white-collar crime prosecutions. It’s proceedings like these [that raise questions about] fairness and justice. Why are the financial institutions being treated like this? People plead guilty to criminal conduct. This bank isn’t being asked to do that,” …..“If other banks saw that the government was being rough and tough and that bank executives had to stand before a judge and plead guilty, it might be a powerful deterrent,” 
US District Judge Emmet Sullivan, August 2010.

It’s not only the top firms that are let off lightly. Even the pipsqueaks are allowed to turn their trade profitably in the face of regulator action. In January 2008, the FSA  demonstrated where its sympathies lay, when it imposed a fine on Square Mile Securities for mis-selling.  The FSA’s report, included the following comments –

“Square Mile recklessly established a high pressure sales business to recommend higher risk securities and adopted unacceptable sales practices and methods that undermined the requirements of the regulatory system”.  It’s customers were “subjected to inappropriate sales practices which actively encouraged and pressured them to make immediate investment decisions about higher risk securities based on information that was inaccurate, incomplete and misleading.”. “Square Mile's customers were exposed to the risk of loss as Square Mile failed to assess the competence of its advisers or provide appropriate training for them, knowing that customers would rely on their apparent skills, knowledge and expertise”. Squaremile’s “failings were widespread and impacted at all stages of Square Mile's sales process of recommending securities in smaller capitalised companies.”

The FSA report continued to say –

“This dishonest conduct, by these advisers, posed a significant risk to Square Miles' customers as they could have been charged for the purchase of securities they did not consent to. By way of example:

(1) One 89 year old customer had at least £75,000 charged to his account from five transactions entered without his consent. At the time of these transactions he had an agreed risk capital limit of only £25,000, yet, by the end of May 2006, Square Mile ended up selling the customer securities at a cost of £398,000.

(2) One 79 year old customer had at least £129,000 charged to his account from 13 transactions entered without his consent. At the time, the customer had an agreed risk capital limit of only £10,000, yet, by the end of May 2006, Square Mile ended up selling to the customer securities at a cost of £284,000.”

According to the FSA report, Square Mile earned gross commissions of £947,307 from “recommending the Securities during the Relevant Period”. And the total fine imposed by the FSA was £250,000.  To be paid in 4 instalments over a year – to avoid unduly stressing Square Mile’s cashflow.

 “Annual income twenty pounds, annual expenditure nineteen six, result happiness.”

Said by Mr.Micawber in Charles Dickens’ novel David Copperfield.

Mr.Micawber’s wisdom was that so long as your income is greater than your expenditure, you will be happy. With an income earned by “failings [that] were widespread and impacted at all stages of Square Mile's sales process” almost four time greater than the FSA imposed fine, the Square Mile’s residents would have been beaming.

In January 2008 the FSA also fined HFC Bank, for mis-selling payment protection insurance.  The FSA report states –

“In a sample of sales reviewed by the FSA, the average cost (including interest) of a usual, single premium policy (i.e. with life cover) was approximately £2,100 (£1,200 excluding interest), adding some 40% on average (23% excluding interest) to the loan to be repaid”. The degree to which PPI was being pushed is made clear by the HFC advisers and branch managers having “a target of selling PPI with 80% of the loans”.

HFC, which sells to poorer customers, is a wholly owned subsidiary of HSBC. HSBC group’s profit in 2006 was over £10 billion. HFC’s fine was just over £1 million. That is equivalent to one hundredth of a penny in the pound. Once again, readers of Mr. Micawber would have been beaming!

As a general statement, the FSA’s punishments have been derisory. Having been shown up as surplus to requirement by the regulatory failure that became the 2008 Credit Crisis, the FSA started throwing its fly-weight around with a steep rise in the fines it was imposing from 2009.

However, a good measure of how much of a deterrent fines are to the Financial Services can be seen by comparing the level of fines with the level of bonuses paid in the City of London.

If you squint very hard, you can just about see a small blip for the FSA fines. Try and use the zoom on your internet browser – that might help, at least for 2010 and 2009.