Increased regulation is inevitable

But changes need to be clearly thought through and not rushed into law in order to appease the public

Global head of compliance, global financial services company headquartered in London

There is an obsession in the UK, Europe and the US that the recent financial crisis is global when it is not. In reality, in Asia and Australia, banks did not have to be bailed out, their economies did not suffer to the same extent as ours, and there were not as many job losses in comparison. A lot of economies came out unscathed and so we should always remember that this is not a uniform experience. However, because, in the media, it is portrayed as a universal problem, it means the proposed global solutions may be attempting to fix something that is not a global problem, hence smaller, non-global financial services providers having to deal with regulation that is not aimed at firms of their size. This was one of the key problems at the Group of Twenty Finance Ministers and Central Bank Governors (G-20) where many leaders were not in the same economic boat and so could not reach a workable conclusion as a result. The varying levels of impact meant that not all leaders were under the same national pressure. As this imbalance continues, it may affect how our economies are directed in the future.

In addition, some governments’ regulatory proposals are targeted at problems that have not yet manifested and may not do so, and so there is a question as to whether they are even sensible. There is a fixation now at national levels that we need a lot of change and so there are a lot of detailed and complex proposed changes, which may actually make things worse rather than better.

In the UK, there has been a visible change in active Financial Services Authority (FSA) supervision. Financial institutions are spending more time and resources in managing regulator visits and maintaining a good relationship, and so are in more contact with the body than ever before. Despite the new government’s intention to disband the FSA, this level of intensity is unlikely to change in the short term. The regulator itself may change, but the regulations and regulatory powers will not.

The compliance profession has advanced dramatically over the past few years, and compliance departments are growing in all companies. They have to spend more time identifying and familiarising themselves with laws, putting them into practice and making sure they are adhering to the appropriate regulations. It is part of the business strategy and it does come at a high cost.

Worrying times?
I am concerned about the accumulative effect of some of the change being brought in; particularly as many of the new regulations appear as if they are being rushed through in light of political considerations. Credibility has been lost among the public and the government wants to get it back. I understand that. We are in a fragile political, social and economic environment, so it is important to regain confidence and trust, but drastic changes such as these need more planning. It can’t just be a knee-jerk reaction. For example, the issue of bankers’ bonuses was being pushed through rapidly by the outgoing Labour government. It’s a contentious subject, but that doesn’t mean you can’t approach it in a mature and sensible fashion. Of course, remuneration should be controlled and limited to prevent any future risk-taking; however, it’s important that any action materialises in a uniform, consistent manner throughout the EU and US, as it can cause major issues for global companies if not.

One of the biggest challenges that global companies face is inconsistency in regulation. There is too much national tweaking on regulation and ‘gold-plating’, which adds to costs because it requires duplication of work. It can also be dangerous for trade itself; for example, returning to the issue of bankers’ bonuses, if there is a cap on what bankers can earn, it means companies cannot move people around as easily. Senior staff would not want to be relocated there and would rather work where there are no legal limits on their bonuses or salaries.

The scale, complexity, pace of regulation and the risk of contradictory measures is a challenge. It is difficult to say what the solution is, but stepping back to think things through would be a sensible start. The banking industry is now in a bad position in terms of how it is perceived by the public and other industries. Our other major challenge comes in finding a way to air honest, genuine industry concerns in this environment. How will financial institutions face public intolerance? Will they be able to get their points across on regulatory proposals that may be detrimental?

A lot of factors led to the financial crisis and we have spent too long blaming institutions and individuals. My concern is that this may be clouding the true picture of future regulation and proposals.

In-house lawyers are feeling the heat

The UK government has upped the intensity of its supervision and is much more intrusive

Professor Julia Black, Law Department, London School of Economics (LSE)

Without a doubt, government regulatory bodies are going to play an increasingly important role influencing banks and other financial institutions on issues of corporate governance and the structure of senior personnel. In the UK, when a bank appoints a member to its senior management team, the candidates have to go through the FSA’s approval process, during which it decides whether they are fit for the role. In the past, this used to be quite a pro-forma process, in which the FSA was not too heavily involved. It ‘gave the go-ahead’ to allow the person to be appointed so long as the bank could show the appropriate level of due diligence had been applied. There are now reports, however, that the FSA is becoming more involved in the short-listing of candidates, the interview and the method of appointment. Indeed, the FSA has rejected a number of candidates, meaning that it’s not as easy for banks to appoint senior management as it was before. The recent Walker Review of Corporate Governance of the UK Banking Industry also hints at further significant change in requirements for senior management.

But that’s not all. Banks and financial service providers are facing additional risks due to regulatory and compliance requirements, and the FSA is fining companies heavily that do not comply with its rules.

Two sides to every story
Legal and regulatory change is generally good for external providers of legal services, of course. New legislation emerging from Brussels targeting hedge funds will be interpreted as potential positive business for law firms, too.

Of course, in-house lawyers will always grumble that external counsel charge excessive rates and will search for ways to save money. Law firms, on the other hand, will argue that big companies are imposing massive competitive pressure on them. In reality, sizeable companies and financial institutions have the upper hand; as far as legal services are concerned, it’s a buyer’s market. Companies can shop around and retain a range of firms to provide a variety of services and barter their law firms down in return for the promise of ongoing work. And work there will be – particularly in areas where regulatory policy is becoming significantly tightened. In other words, this means pretty much everything apart from retail policy, which has not been fundamentally changed… yet. In every other area, financial regulation has become more intense, enforcement actions stronger, and the FSA is likely to impose heavier penalties.

One of the major outcomes of the collapse of Lehman Brothers is the policy of ‘living wills’ or ‘how banks die’. The FSA appears willing to ‘help banks die’ and has introduced regulatory requirements on liquidity to ensure that subsidiaries have access to adequate liquid funds in the event of insolvency of the parent company. It wishes to prevent banks mimicking Lehman Brothers’ ‘Friday sweep’ during which, allegedly, all the bank’s European revenue was transferred to the US in advance of the bank failing over the weekend, which left many European employees unpaid. Living wills should ensure that such a loss of control never occurs again.

How then should financial institutions cope with these and other impending changes? Most important will be the need to keep up with the changes and ensure that they are implemented on an operational basis. Most institutions have only just finished implementing Basel II (the second set of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision); now they have the new set in Basel III to implement. Operational challenges such as these can reveal true weaknesses in legal departments.

Second will be the need to develop a strategy to manage the uncertainty. It is difficult for any department, but especially risk-averse legal ones, to develop practical coping strategies in uncertain regulatory environments. Hedge-fund managers are also likely to struggle in this regard.

Last, but not least, will be the people. Companies are going to find it difficult to find the right people with the right skills to deal with this change. There may be plenty of professionals who understand the sector, but how many have experience of managing it through a recession? Lack of vision and experience within corporate legal departments could prove a barrier when it comes to handling compliance and risk. For legal departments, there will be the costs of set-up (generally high) and capital requirements to consider. In the current environment, it may prove difficult for some to justify the cost of compliance in terms of the benefits it will bring.

For many, there will be EU issues to consider, too; hedge funds, credit-rating agencies and accounting systems are all on Brussels’ radar. And from a global perspective, new accounting regulation, the increasing power of the Financial Stability Board (among
G-20 nations) and Basel III will all have a major impact.

What about the British bar?

Regulatory change will give us the opportunity to reorganise ourselves for the new century

Richard Lissack QC, Outer Temple Chambers

Drastic changes are afoot for barristers in England and Wales. The Legal Services Act 2007 is heralding in a complete overhaul of the way that we deliver legal services in this country, and the Bar is not exempt from its effects. Just as law firms will be able to reorganise and affiliate themselves with other professional bodies and take on managers without formal legal training, so too will barristers be able to form themselves into corporate conglomerates. In other words, we’ll be able to trade using a different model to that which has been used by the Bar for the past ı00 years. What a time of incredible change – and, so long as it doesn’t result in a decline in quality, a wonderful opportunity.

A change in approach
The new Act will permit barristers’ chambers to organise themselves in a more modern businesslike fashion. It will give us better access to our clients and permit us to operate using a (corporate) structure that is recognised around the world. That’s not the case at the moment as the UK bar operates in a different way to the systems in most other jurisdictions.

The relaxation of rules defining the division of work between barristers and solicitors (or between chambers and law firms) is having a major impact, too; particularly the ability for solicitors to acquire rights of audience. Some elements of the Bar are very worried that this will result in an erosion of the work that enters our profession, as solicitors take on greater responsibility for prosecuting or defending cases in court. Clearly, there are some cost-related benefits for clients to go down that route, and I would say to those clients that they should regard this change as an opportunity to cut their bills. As a profession, we should all be pushing for a more inventive use of legal resources, so that clients use the most appropriate professional for the relevant task. regulatory change will give us the opportunity to reorganise ourselves for the new century

Recovering public opinion

Banks and financial institutions face a big challenge in regaining the public’s trust

Professor Peter Cartwright, School of Law, University of Nottingham

Law firms, emerging blurry-eyed from the recession, will be cheered at the opportunity for greater regulatory work at all levels. In its election manifesto, the Conservative Party proposed a significant reorganisation of the current institutional structure of regulation, with supervisory powers likely to revert to the Bank of England and the possibility of the FSA being replaced by a bespoke consumer-protection regulator. I believe there will be plenty of work for financial lawyers as regulatory change is inevitable in a range of areas, although the detail of change remains unclear.

Another challenge facing banks and financial services firms lies in the need to try to recover public opinion. Bankers are not popular with the public at present (many would say for very good reason) and some highly prominent figures have been less than savvy in their dealings with the press. Despite what they may say, this is closely related to financial regulation because the more unpopular bankers are, the more incentive there is for governments to be seen to be tackling some of their conduct – financial regulation is an obvious way of doing this. We may also see regulators making greater use of negative publicity to secure their objectives. For example, the UK Financial Ombudsman Service is now publishing complaint data, making it easier for consumers to identify poor practice (as it includes data on the proportion of complaints upheld). This information is unlikely to be used systematically by many consumers, but it may be used both positively and negatively by other commentators – including journalists – and by consumer groups.

In the UK, the issue of redress for consumers of financial services is likely to be increasingly prominent. The Financial Services Bill originally included provisions to facilitate a form of class action for consumers. This was dropped in the run-up to the 2010 General Election, but the issue of how we ensure consumers receive redress will not go away. This concerns not only banks (which have received additional negative press as a result of the decision of the Supreme Court to allow them to continue implementing ‘unfair’ bank charges), but other providers, too. It is likely that consumers and claims handling firms, smarting from the Supreme Court’s decision, will look for ways to recover charges they regard as unfair.

Harmonisation is needed

Inconsistency between national systems is costing financial institutions dearly

Simon Dodds, global head of compliance, Deutsche Bank

In many banks, regulation is a joint effort between legal and compliance departments. Generally, the compliance department will manage the day-to-day relationship with the regulator, all regulatory analysis, the impact of regulations and, where appropriate, lobbying for change in the systems. It’s when it comes to enforcement actions or close supervision that the legal department will get involved.

Compliance departments are necessary because banks are subject to regulation in multiple jurisdictions; for example, in the UK and in their parent country. Normally, this means that the UK’s FSA is responsible for regulating conduct only from a business point of view; it will be the parent regulator that takes on the supervision mantle. Although this can mean that banks with parent companies elsewhere are spared some of the heavy requirements that other UK banks have to face, they certainly don’t have it easy in comparison. The inconsistency between FSA requirements and those of overseas regulator can be a considerable burden. It’s important, however, for a legal department to be pragmatic in its attitude to heavy regulation. It’s just something that general counsel need to face and react to. Even when the Conservatives abolish the FSA (as they have said that they intend to do), that won’t mean that regulation will be abolished, too; most likely, it will just come from a different body.

Business priorities
Complying with regulation is already costly, and it reduces a bank’s profitability as a business, as it does for all corporations. In addition, increasing liquidity requirements are proving problematic for most banks (one of the aftershocks from the collapse of Lehman Brothers), partly because of the way that they are being implemented around the world. If regulators demand that capital be kept in a bank’s operating country, as they are now doing, this limits its ability to move money around; for example, back to the bank’s parent country. Complying with regulation in one country is difficult enough; complying with regulation worldwide, especially for a global company, poses banks a major dilemma.

Justifying the amount we are spending on regulation to the business isn’t as difficult as it could be. Business heads understand the pressure we are under, which makes it relatively simple to explain our need for additional resources or increases in our legal spend. But, of course, my priority isn’t just cost. There are many causes for concern in the system as a whole – for instance, I would question whether the FSA is even competent enough to get involved in some of the process that it wishes to (such as senior management appointments). Similarly, there is increasing talk about a return to provisions such as those instituted by the Glass-Steagall Act 1933 (which introduced banking reforms to control speculation in the US during a time of incredible financial difficulty). If regulators do go overboard and decide, for example, that they want to separate investment and commercial banking, then this will have a serious impact on the market.

In addition, I believe that regulation should be more thoughtful and proportionate. Regulators should be thinking about the end benefits: do they justify the time and expense? The US Sarbanes-Oxley Act of 2002 is just one example of a regulatory policy that does not do that. It seems to me that the legislation was put in place as a result of political anger, rather than actual economic intelligence, hence the requirements it introduced being clearly disproportionate to any end benefit. My concern is that the same will happen with the new regulation being discussed currently in the UK and elsewhere.

Governments know the public is angry and they want to be seen to be doing something about it. If only they would take a step back to consider the impact more thoroughly – or work with their colleagues in other territories to implement a more global solution.

Regulatory change is important

But who’d have thought it would come upon us so quickly?

Joanne Hindle, consultant to the financial services industry

We all expected regulatory requirements to become more stringent after the financial crisis hit, but change has progressed far more quickly and advanced much more dramatically than I had initially thought. New, sophisticated, complex and detailed forms of regulation have appeared, it seems, almost overnight. In particular, there has been a substantial growth in the focus on systems – and that’s at global and European levels, as well as national ones. One of the problems that this has exacerbated is the lack of consistency in application between countries and regions. Even those regulations coming from the EU have not been applied throughout its member states in an equal manner.

There are positives in all of this, though, especially for larger companies, as the number of regulators that they have to work with in Europe has dropped considerably. The opposite is true, however, for smaller firms, many of which are struggling to find the resources they need to understand how it affects them, let alone to actually apply the rules. This is partly because these new rules are clearly aimed at larger global firms. I’m not sure how much thought has been put in as to how they will apply to companies that don’t fall within those parameters.

It is clear that new regulatory proposals are much harsher – and that’s certainly not a criticism. Yes, it puts greater pressure on in-house legal departments, but most firms have been regulated for more than 20 years; they should know what they are doing. And if they don’t, they should know to talk to people who do. Some of the changes will need greater review and thought than others, of course. For example, the UK has traditionally followed a principles-based approach to regulation, so some firms are going to struggle with detailed compliance requirements that call for a broader view.

The question mark hanging over the head of the FSA is also a worry – how will its replacement be organised and what will the difference be? The FSA was established in lieu of individual sector regulation to help streamline the system, but, when the financial crisis hit, people began to question whether it had been successful in this goal. Returning its powers to the Bank of England may not provide much improvement. It’s my view that we should be following the lead from Europe by looking to the European Union for the sort of high-level regulation that befits the realities of the marketplace. We may already be heading that way; many regulatory decisions are being made and applied on a wider European scale. Normally, that kind of approach would have taken a long time to develop but, due to the financial crisis, it has been sped up considerably. However, governments need to try to minimise their propensity for national tweaking of regulation (or what we like to call ‘gold-plating’), otherwise those rules won’t work in the systematic way that they are intended to.

No panacea
I’m not suggesting that this will provide the full answer to the problems we are facing. In fact, we’ve implemented many regulatory boundaries in the last few decades and they didn’t help us to avoid the financial crisis. More regulation may help the economy recover, but it could also make it worse – or even have no effect at all. Nonetheless, it is the reaction of choice for nervous governments that are wanting to be seen to be doing something. At some point, however, this influx of regulation will have to stop. We can’t go on regulating for ever.

Businesses will be keen for there to be an end in sight too. More regulation always requires more investment, and there is a tension within companies at the moment as they recognise the substantial legal cost involved with these changes, and yet still need to turn to external counsel for advice.

A shift in focus as well as practice

Law and legal infrastructure have an important role in supporting the financial sector’s development

Misha Patel, legal counsel at the International Centre for Financial Regulation (ICFR) and a secondee from Clifford Chance LLP

The rule of law at international level has become ever more necessary. The interconnected nature of global business and trade no longer allows for individual nations to control and regulate their own economy because, as the recent financial crisis demonstrates, failure to properly regulate a single market or commodity can lead to devastating effects across the globe.

Financial systems require certain legal and institutional elements to be in place in order to function. These include property rights, collateral frameworks and company law, which, in turn, must be set in a framework supporting effective governance providing for enforcement of contracts and commercial dispute resolution, insolvency regimes, corporate governance, and accounting and auditing systems. All of the above protect market integrity and thus confidence in the financial system; establish a system of international standards directed towards the overall goal of financial stability; and ensure that financial liberalisation, regulation and supervision can function properly.

Law and legal infrastructure have an important role in supporting the financial sector’s development, underpinning economic growth and financial stability, and promoting a controlled, coordinated financial system. In addition to hard law, a system of international financial soft law based on implementation and monitoring of non-binding standards exists and supports the global financial system. The crisis and fall of Lehman Brothers has illustrated how the current international financial architecture and legislation failed to explicitly link domestic restructuring (addressed by the current matrix of international financial standards and laws) with the globalisation of financial markets and the role of the international financial institutions in this process.

New systems of support
The global crisis has required that law firms give their new and existing clients support in three key areas: restructuring, global regulatory systems and risk management. As the regulatory landscape shifts, so does the focus (and, on occasion, size) of regulatory practices within law firms in order to respond to client demands, particularly in sectors such as banking, corporate and insurance.

Certain law firms are creating, maintaining and/or strengthening relationships with regulators in order to keep at the forefront of likely developments, while also ensuring that such firms are best placed to achieve the objectives of both the regulator and the client. It is a mammoth task for any individual to be on top of all the different regulatory agendas and proposals, let alone for a global international client company. Legal support will be needed to explain how the regulatory landscape is shifting, the impact for clients and action needed from them in order to transact business and not fall foul of any new regulations should they impact a client’s particular industry. External advisers may also be asked to give clients a heads-up on the changes before implementation, so that clients can adapt their businesses and educate internal staff easily and readily.

As the regulatory web increases, legal service providers will have to create and/or maintain a breadth of knowledge across difference practice areas and geographies in order to not only provide a depth of legal and regulatory expertise, but also a breadth of experience and sound judgement to different industry verticals. Going forward, it will be harder for those who operate in a single-country law firm. The changing regulatory landscape demands cross-border legal services and global knowledge of differing regulatory regimes.

Financial institutions may seek to make greater use of legal services outsourcing and the procurement of such services will play an important role going forward. Putting in place new regulation for the sake of simply creating regulation to deal with the crisis will be ill-fated and cause confusion, and may make it harder to advise quickly and effectively in a future crisis.

Companies, meanwhile, will need to be better informed about regulations impacting their industries as well as how best to comply and monitor risk within their organisations. Recent events have shown the impact of the financial sector’s inability to anticipate and address threats to the stability of our financial system, and the links between this failure and poor internal risk management systems and the regulator/supervisor’s failure to establish a coherent, coordinated approach to financial regulation. At a time of ever-more complex regulation, companies need to know their obligations – and avoid the ever-more costly pitfalls of non-compliance.

Jobs for lawyers

Growth in regulation will result in an increased need for lawyers, and that’s a good thing for the industry

Mark Stobbs, director of legal policy, the Law Society

Increased financial regulation is good news for lawyers in that it provides us with plenty to do. The role is changing, of course – these days, more lawyers are filling the role of ‘compliance’ officers and it’s gratifying to see that they have the right skills set to respond to the growing demands for compliance and regulatory work. This is a profession that will continue to grow in a significant way, providing a bigger legal role and opportunities for law firms in the process. After the job losses in the profession that came along with the downturn, this is clearly good news. Undergraduate and conversion law degrees are increasingly popular among new and returning students. Until now, it has been a worry that the number of training contracts has declined.

The financial crisis has also revealed other concerns; for example, in the UK, small (high-street) practice firms could find themselves squeezed out of business if they do not get enough customers or are unable to compete with each other. Smaller firms will find it difficult to support customers in areas of compliance, as the area is expanding at such a fast pace. There are other areas of growth, of course – for example, insolvency work is increasing, along with work in employment law due to the rise in corporate redundancies.

Alternative ways of operating
My other worry lies in the changes to the profession that are likely to come about as a result of the Legal Services Act. The new Alternative Business Structures (ABS) that it allows have attracted the label ‘Tesco law’ to reflect the dramatic manner in which ownership and investment will be liberalised by 20ı2. The Act allows for the formation of ABS firms to provide legal services, rather than the current partnership model, in which ownership is shared among senior lawyers and the firm run by them. At its most basic level, ABS could allow Tesco to start selling wills and personal-injury lawsuits alongside fruit and veg.

That is not to say that there won’t be benefits. For example, ABS will increase law firms’ access to finance as, at present, law firms can face constraints on the amount of equity that they can raise. It will also allow for increased flexibility in the profession by providing non-legal firms, such as insurance companies, banks and estate agents, with the freedom to realise synergies with legal firms by forming ABS firms and offering integrated legal and other professional services. Allowing new providers of legal services into the marketplace should lead to innovation, too.

Again, this may result in the decline of some smaller legal practices if they are unable to compete with ABS firms. Not only will these new firms have more capital, but they’ll also be able to provide a ‘one-stop shop’ in their areas of expertise – for example, the legal work for insurance claims alongside the insurance itself. In a few years’ time, if ABS is successful and creates more competition in the legal industry, then banks themselves may have the capital and power to go into this ABS field as well. Of course, ABS firms are not accepted in all countries, so these firms could not provide legal services globally; that market should be retained by well-established law firms.

This expanding, more efficient and cheaper legal market will be good news for the legal profession in general because it will provide more jobs for lawyers. It should also kick-start it into innovation; new entrants to the market won’t be using the same processes as established firms – they’ll be bringing with them techniques and practices that have been applied with great success in other industries. Just look at how quickly accounting firms matured when their industry was deregulated in the UK.

However, there is still concern over how ABS firms will be regulated – and how the profession will ensure that the standards of lawyers don’t become watered down or their ethical role diminished. There is also a question mark over timing. Does the economic downturn mean that existing law firms won’t have the time they need to recover before potential bigger players with higher capital enter the legal industry?

 Interviews by Murshidah Boksh

The interviews for this special focus took place between March and June 2010.