In Your Face

The Rotten Core at The Heart of Britain’s Financial System

It is often assumed by both the public and the politicians that, aside from the occasional scandal such as the Maxwell fraud, Britain’s financial system is well run and relatively honest.

After all, the UK has a plethora of rules, regulations and watchdogs (such as the FSA) governing; the stock market, financial advisers, pensions, auditors and all the other components that go to make up the UK’s financial system.

However, I am firmly of the opinion that this “confidence” is based on nothing more than hubris; and that, in fact, we live in country that has a fundamentally rotten financial system.

I would like to cite a number of examples that support my view:

The Endowment Mis-selling Scandal

The endowment mis-selling scandal, of the late eighties and nineties, readily springs to mind as one of the major failings of our financial system. As has been well documented, the life assurance companies used the bull market to create a totally unsuitable, and useless product, that they aggressively sold in the manner of TV sets and washing machines to over 8 million unsuspecting home owners.

The theory being that the bull market would create high yield returns on this product; that would not just pay off the mortgages of the hapless holders, but would also give rise to a modest surplus. Needless to say, what the life assurance companies did not bother to clearly tell people was that their commission charges would rob the product of much of its initial value, and that their projections for growth were totally unrealistic.

It now turns out that the 8 million holders, of these white elephants, are facing shortfalls of over £40BN. Although, in theory the policyholders can try to claim compensation, the life assurance companies are using every excuse in the book to slow the process down in order to avoid paying compensation. To date a paltry £1BN has been paid to those seeking redress.

The FSA, although they offer some fall back position for those refused compensation by the life assurance companies, do not have any intention of “rocking the boat” too hard. The FSA refuse to acknowledge the fact that the life assurance companies perpetrated the greatest financial scandal in the UK in living memory.

Pensions

Needless to say the results of the endowment policy mis-selling scandal have, coupled with the ill thought out tax raid by Gordon Brown on the pension’s industry, destroyed peoples’ confidence and willingness to invest in life assurance/pensions policies. The British people are facing a pension black hole that will leave the majority of pensioners, over the next few decades, living in penury. The politicians have failed the electorate, by allowing the electorate the self-delusion that they will forever have increasing standards of living without having to work harder. Instead of telling it straight, that people are going to have to work beyond what is considered to be the normal retirement age of 60-65, the government fiddles while “Rome burns”.

Corporate Governance

Corporate governance, so long thought of as being well established and effective in Britain, is failing lamentably. The boards of many companies are made up of directors and non-executive directors from a small clique of friends, and contacts in the City, who sit on each other’s boards. These people, instead of seeking to ensure effective and robust management in the interest of the shareholders, in fact more often than not sit passively; nodding through a host of half baked business plans, and the most greedy of executive remuneration packages.

I can certify that, more often than not, the primary qualification for being selected to serve as a non executive director (a position that in theory is meant to oversee the actions of the main board, so as to safeguard the interests of the shareholders) is that they have probably served in the same company before, or have certainly got “the right” connections. The concept of robust, proactive, independence doesn’t apply.

Directors of companies are routinely lambasted for awarding themselves, like pigs with their heads in the trough, inflation busting pay and pension packages. Politicians wring their hands, and shed crocodile tears, lamenting at this practice. However, once they have left ministerial office, each one of these “champions of the people” soon finds their way on to the boards of the companies that they were criticising.

Post Enron and Sarbanes Oxley the UK has, in its normal slow unhurried way, put together via the Higgs/Smith reports and the Combined Code a set of guidelines for companies and executives to follow with regard to corporate governance. However, it is not compulsory; all the company has to do, if it wishes to ignore these guidelines, is to write a few notes in the accounts.

Companies that are increasing their internal control and review procedures, not I may say because they want to, but because Sarb-Ox has forced them to; are complaining loudly about the increase in audit fees. It seems to me that it is not unreasonable that, because a greater amount of work is required to be done by the audit firms, they will have to charge more.

Audit Firms

Audit firms are not entirely immune from the rotten stench that emanates from the UK financial system. I well remember as a trainee auditor witnessing the booking of extra hours, that were not in fact worked, to the timesheet of a well known FTSE company; so that the audit fee could be justified to the FD of the client who, not unreasonably, had asked to see a breakdown of the hours worked.

A few years ago, audit firms, having felt the pressure of the market were forced to find ways to cut costs. Their brilliant and inspired solution was to create the concept of “risk management”, and audit only those areas that were deemed to be high risk; system compliance tests, which took up a lot of time, were thrown out of the window. The audit became a cheap and cheerful “risk management” exercise; whereby the real money was made by selling on added value services, such as consultancy.

In 2000 I attended, as an observer, an Arthur Andersen training course in Chicago; the mantra “forget about the audit, hard sell the high margin add ons” was pumped into the participants at every opportunity.

The consultancy advice usually given to the hapless client was to outsource mainstream functions such as; internal audit, tax and treasury to yes, you’ve guessed it the audit firms. I would say this, if Arthur Andersen had not been the first to “cop a fall” over lack of segregation of practices and excessive greed with its Enron and WorldCom debacle, then one of the other big firms probably would have done so.

Now they are forced to segregate services, and as such are reverting to the old “tick bash” routine in order to keep fee incomes high.

There is one other fly in their ointment. With the Enrons of this world came mega sized law suits, something that the accountancy firms and their insurance firms do not wish to pay for. This has caused something of a stand off with the government; Gordon Brown wishes for uncapped liability of audit firms, the audit firms are arguing for a cap. Their secret weapon is that if they don’t get a cap, they will dump certain “high risk” clients; this would leave the government with the responsibility for reviewing these companies’ books of account. In other words, the audit firms are holding the government to ransom; and trying to pass the risk of errors and omission in their working practices on to the shareholder and tax payer. Nice trick isn’t it?

The Stock Market

Those of you who are still not convinced that the financial system in the UK is rotten, should take a look at the stock market; and ask yourselves whether the ordinary investor, with a modest portfolio, can make money to the same degree as the big market players.

Monitor the swings and movements in the share price of any share, that you care to pick, over a few months; and watch the buys and sells preceding the announcement of any news that affects the share price, such as a take-over bid. In the majority of cases you will see that there are significant buys/sells (depending on the nature of the announcement), prior to the news being made public. That is not coincidence, but the result of the news being leaked to a few well connected “players” in the market.

When there is little news coming out about a company, more often than not the market makers will adjust the prices to shake out sellers or buyers; there is no reason for these price movements, other than to panic smaller holders into adjusting their portfolio which in turn generates commission for the market makers.

Consumer Debt

I will take as my final example the house price bubble that has grown over the last few years. As I write this, the effect of the recent interest rate rises by the Bank of England seem to be slowing the price rises down or indeed may even have pricked the bubble. The fact that this unsustainable rise could be allowed to continue for so long is damming in itself. However, the real issue is what has been sold on to the unsuspecting, and financially illiterate, consumers on the back of the bubble.

In the eighties, as already noted, we had endowment polices; now we have equity release schemes designed to consolidate credit card debt to encourage borrowers to borrow more, and spend on short term consumption. Borrowing long to spend short is recipe for disaster, as Weimar Germany and the world discovered to its cost in the 1920’s.

Loan companies have been allowed to aggressively target their advertisements at the most vulnerable, financially illiterate, people in society; without any regulatory interference. The interest rates on many of these debts bear no correlation to the risk profile of the loan. Instead they reflect the lending company’s “greed pricing grid”; which is the in house pricing model utilised by the lender to identify the maximum rate of interest that it can charge without losing customers to other lenders.

The result is that consumer debt in the UK now stands at over £1 trillion, which in my view is unsustainable. As house prices start to deflate many people will find themselves in a situation with negative equity; unable to move house, or restructure their finances. They will be saddled with an unsupportable level of debt for the rest of their lives.

Now, taking all of the above into consideration, do you feel that the financial system in the UK is well regulated and honest?