Do you think the Cost of Compliance in the financial services industry is in danger of outweighing the benefits?

The Big Debate

We asked leading finance professionals: Do you think the cost of compliance in the financial services industry is in danger of outweighing the benefits?

Michael Ruck, Senior Associate, Pinsent Masons LLP, London

The Financial Services industry has recently seen an extraordinary surge in fines and settlements being paid by regulated firms in response to regulatory breaches. What this demonstrates is twofold: firstly, how eagerly the regulators are to crack the whip and secondly, how financial institutions will respond by paying large financial penalties rather than disputing the allegations and facing further cost and delay.

Following on from the ever increasing financial penalties imposed and the desire of senior management to avoid being judged in the court of public opinion for longer than is necessary, the cost of compliance may have been seen to go through the roof.

Whilst the cost of regulation has often been identified as a significant concern for financial services firms there have been a number of high profile enforcement actions, which have been used to illustrate what the regulators interpret as a compliance culture in need of improvement. Investigations and financial penalties in relation to issues including PPI, card protection mis - selling, Libor and FX scandal have served to highlight how costly sanctions can be for those whose compliance regimes do not identify the relevant issues. Undoubtedly, public trust and confidence in the financial services industry has been severely damaged causing the industry’s reputation to be in need of repair, from not only a public perspective but also a political and regulatory one too.

Whilst (understandably) there must be a limit to the cost firms invest in compliance measures, carrying out ‘defensible compliance’ simply will not cut it anymore. Carrying out a
half measured compliance programme or tick box exercise, which may at face value give the ‘impression of compliance’, is simply not good enough in today’s regulatory environment (if
it ever was); compliance programmes need to be robust enough to protect against not only current regulatory breaches but also the recurrence of any relevant failures in the future. Genuine investment in proper compliance is the bedrock of any drive to improve reputation and regain the confidence that was lost.

It cannot be overstated that spending in compliance is something each firm should take seriously, that a regulator will hopefully consider as an investment. We are all too familiar with general phrases such as “Spend now, Save later”, or “an ounce of prevention is worth a
pound of cure”. Never have they borne as much significance as they do now in relation to compliance. Whilst there can never be a 100 per cent guarantee against a regulatory breach or failure occurring, firms would be well advised to exhaust all reasonably possible efforts now to protect against such breaches and the ever increasing financial penalties which will no doubt follow. Such steps can only help persuade any regulator whose attention is on a firm that proper compliance measures were taken, implemented and embedded in the firm to mitigate against regulatory breaches that do occur.

Leo E C Never, NEVE Tax Consultants, Rotterdam

The report From Enhanced
Relationship to Cooperative
Compliance published by the OECD in 2013 takes stock of developments in taxpayer relationships.

The items in that report relate to: (i) commercial awareness; (ii) impartial approach; (iii) proportionality in response; (iv) disclosure and transparency; (v) responsiveness; (vi) supervision based on Tax Control Framework. The focus of the report is on the cost-benefits for the tax authorities when engaging in compliance initiatives. Less attention has been given to the cost-benefits for the taxpayers. However recently Esther Huiskers-Stoop has published her empirical research cooperative compliance from a taxpayer into this question of effectiveness of perspective1.

In her study she researched four basic questions: (i) Does it lead to a better relationship, in the sense that cooperative compliance is more effective than traditional supervision? (ii) Does it lead to better compliance, which are the relevant factors to take into consideration ? (iii) Does it lead to more tax certainty, which factors are important in that respect? and (iv) is there a cost benefit for the taxpayer when engaging in cooperative compliance? In order to find answers on these questions, she interviewed relevant persons and prepared questionnaires.

The results differ between large companies and small and medium sized companies and between entities subject to cooperative compliance and those subject to more traditional forms of supervision. In general one can say that the large companies see benefits for themselves on these four issues. They value a better relationship with tax authorities, have a good functioning tax control framework, believe to have more certainty on their tax position and have in general a well-developed social and corporate responsibility towards society as a whole, including obligations under tax laws.

Small and medium sized companies report a higher compliance burden, feel secure about their tax position, have to bear more compliance costs for reason of complicated legislation, and cooperate less with tax authorities on joint issues.

In general the research shows that large and medium sized companies see the benefits mainly in more tax certainty, whereas smaller companies see a rising cost for that certainty and for that reason prefer the more traditional forms of supervision. The cost factor is an important factor for the smaller companies. A Tax Control Framework is an essential tool for gaining benefits of an improved relationship, but the cost associated with ‘being in control’ is relatively high for small enterprises.

1 Esther AM Huiskers-Stoop, De effectiviteit van horizontaal belastingtoezicht, Een fiscaal-juridische en empirische analyse, 2015 [On the effectivity of horizontal tax supervision, a
taxlaw and empirical analysis].

Glenna Smith, Managing Director, Smith Compliance Consulting

Let’s remember that bad things can happen with too little regulation. To protect our financial systems, we want the right amount of legislation and regulatory guidance. The key is to install a useful number of traffic lights to let traffic flow smoothly, but not too many to grind traffic to a halt and not too few which may cause chaos.

The cost of compliance is seemingly ever- increasing. While each obligation may appear worthwhile when inspected individually, that is not the point, it is the method of integration into existing programmes that is just as essential if they are to be effective. Otherwise you may drive reporting entities to solely meet the technical compliance requirements, and not achieve the principles and objectives.

Regulators are conducting rigorous inspections and issuing mind-numbing penalties for cases of non-compliance world -wide. Institutions now have to work their way through a complex web of legislation and regulatory guidelines – for which you need a specialized engineering degree to navigate and build on. Isn’t it high time legislative and regulatory bodies looked at the objectives, existing rules and current practices and adopted a holistic approach?

What commonly happens is when a new regulatory agency comes on board, or a major financial services company fails, or an eager politician tries to leave their mark or we experience economic turmoil – the response is new regulations.

This creates a pile on effect. While some may be an altruistic attempt to bolster existing regulatory platforms if the new rules are not done in unison with existing obligations, they have the potential to become a hindrance to doing good business.

Imagine a world where we all lived together in regulatory harmony! Picture this: a standard list of client identity documents required for all new applicants seeking a financial services product. To be clear, I mean world-wide; that is just one standard list. Would this not reduce instances of inconsistent service and alleviate customer frustration?

If you are a financial services company operating in multiple jurisdictions, you currently need a mammoth chart and a good pair of reading glasses to track the growing inventory of regulatory requirements in each location and map your processes for each one. Does that sound like an effective use of resources? No. I would rather have my compliance managers monitoring imminent risks and participating in brainstorming meetings to develop new products and services in a compliant fashion.

If we continue down this current regulatory path, yes, we are at risk of making the costs of compliance even more difficult to manage.

Mark Konyn, Group Chief Investment Officer, AIA Group Limited

A recent McKinsey report shows that investment management industry
costs are growing significantly faster than
operating profits. Worldwide operating profits expanded by 10 per cent in 2014, whilst costs grew by some 44 per cent. Costs associated with compliance were cited amongst the significant contributors. This echoes warnings from the industry’s senior leaders in the wake of the global financial crisis.

The fear has been that regulators would become ever more intrusive in the fund management industry in response to public pressure as the industry sought to re-establish credibility and trust post the global financial crisis (GFC). That fund managers are complaining about increasing compliance costs is not a winning public relations strategy; and to view compliance in fund management separate from issues that have surfaced since the GFC in other parts of financial services is in danger of missing the point and ignoring the public concern. Financial services continue to suffer from a trust deficit since the GFC. Rather than complain about compliance costs the industry needs to re-establish trust and demonstrate how it is aligning business objectives, pay incentives and resources with client outcomes.

Compliance enhancements in fund management are typically made incrementally – and this is at the core of the cost issue. Rather than view compliance as a function or a department, it should be considered intrinsic to the successful management of the entire business. It begins at the very top of the enterprise where culture and practice are set and led. For as long as fund managers respond to new regulatory requirements incrementally, they will not be able to take the initiative and hence will not be able to improve the productivity of how compliance is managed across the entire enterprise. Such productivity gains require a vision and a commitment to systems and long term investment.

Of course some fund managers are already practicing these principles and these forward thinkers will reap an advantage as the industry confronts falling margins and lower fees globally.

Do the costs outweigh the benefits? It is the industry’s responsibility to improve productivity and ensure they do not.

Andrew P Morriss, Dean & Anthony G Buzbee Dean's Endowed Chair, Texas A&M School of Law

Financial regulation helps when it builds a system of clear rules that enable private parties to engage in transactions that create wealth. It hurts when it imposes costs on economies that exceed the benefits it yields. Figuring out which is which takes good data and rigorous analysis. Unfortunately, financial regulation today largely resembles the US Transportation Security Administration (TSA) airplane security measures: it is costly, it is annoying, and it doesn’t seem to be directed at stopping much actual bad behaviour.

Regulation costs regulated entities time and money to gather information, maintain records, and respond to regulators. Those are resources that could be used to provide services that create wealth. Regulators usually ignore these costs because they are unseen (as noted by French economist Frederic Bastiat in his 1850 essay at Which Is Seen, and at Which is Not Seen).

There are useful things that financial regulators can do to enhance the financial system. Indeed, regulators in jurisdictions like Jersey and the Cayman Islands seem to have figured out how to focus their efforts on what’s important while keeping costs down. No regulation should be adopted without a rigorous analysis to ensure that the costs, both seen and unseen, have been minimized and the benefits are real and are greater than the costs.

Regulation is also costly because it diverts regulators’ efforts from their next best activity. If there were less regulation, some regulators would be employed instead doing productive things. In developing economies this is a particularly high cost because the number
of financially sophisticated accountants, lawyers, and other professionals capable of being a regulator is relatively small.

Financial regulation can have real benefits in some cases. Sadly, we have too little evidence that we’re doing it any better than we’re doing airport security. Parties pursuing ideological goals over vast estimates built on some implausible assumptions. (See Richard Gordon
& Andrew Morriss, Moving Money: International Financial Flows, Taxes, & Money Laundering, 37 Hastings Int’l & Comp L Rev (2014) for a critique.) We need much better data to evaluate which types of financial regulation are worth doing. Until we get that data, and subject
it to some rigorous analysis, we need to be cautious about imposing new burdens on financial services firms.