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Regulation - a double-edged sword

The financial crisis has changed the financial services industry as we know it. Markets are focusing more on risk management, stock markets are volatile and corporate bonds not as safe. The credit rating agencies, relied on by regulators under the Basel II capital adequacy regime for banks, are discredited, and global regulation faces restructuring. The Basel Committee is revising its capital adequacy standards, and there are moves in the US and Europe to set up bodies overseeing systemic risk. 

The focus on more stringent regulation is a double-edged sword for high net worth investors, who will benefit from the greater security but lose from any curtailment of profitable risk taking.

Hedge funds are one example of this trade off. Increased regulation within hedge funds will attempt to ensure money invested in a fund, or, indirectly, in a fund of funds, is not put at too much risk by hedge fund managers, who skim off the profits but lose nothing if the strategy fails. There will also be a greater focus on transparency, the downside of which means others will copy strategies, diluting their effect.

In the longer term, however, regulation is also about opening up markets.

Within the European Economic Area, stock exchanges are now facing competition from multilateral trading facilities, which are accumulating market share. This is due to the Markets in Financial Instruments Directive that helped create this competition. High net worth investors will benefit from faster equity trades at lower commissions, with easier access to stock markets abroad.

Passporting financial services across ECA jurisdictions, allowed under European regulations, offers opportunities to diversify your money. However, there are risks. If you deposit funds in an overseas jurisdiction and it fails, you will normally have recourse, at best, to the local compensation scheme. This may not be as comprehensive as the compensation scheme in your own jurisdiction and may also be slow to pay out.

The collapse in 2008 of certain high-interest paying Icelandic banks is an example of such risks. Depositors from 127 UK local authorities invested £953 million in total in the banks that subsequently failed. Had the UK government not intervened, the depositors could have lost everything in the collapse.

In better times, diversification of investments across jurisdictions or asset classes will serve investors well, however, in the current recession it has not given them much protection against declines.

Although the proliferation of share trading organisations increases access to foreign markets and jurisdictions, there are concerns that there will be less demand for cross-boarder listings of shares, which means less IPO opportunities. This is not necessarily bad for high net worth individuals, who generally come behind institutions in the queue when allocated shares in IPOs.

The need for increased regulation has been made more acute as past fraud has become apparent. Many wealthy individuals and professional advisors were seduced into giving money to Bernard Madoff, even though the red flags were there, including too consistently smoothed returns, custodian services under the same roof as fund management, and too small an auditor. The Securities & Exchange Commission had ignored the warnings of a Madoff whistleblower. Now, among regulators and law enforcement, there is a new onslaught on fraud, which surveys show has massively increased in the recession.

One problem with ever increasing regulation is that those employed to regulate the industry are still paid far less than those working within the industry. There is no reason to think regulators will sharpen up their act if there is little incentive to do so and, the more sophisticated the investors, the less emphasis there is on bringing them under their umbrella of consumer protection. Here again is the double-edged sword.

The big bonuses are already back in investment banking, as we have seen at Goldman Sachs, and success in one area of financial services will pass on eventually to other parts. Opportunities for trading off balance sheet such as shadow banking have faded but there are signs that structured products are taking on a new form.  

In the 2009 world wealth report, Capgemini and Merrill Lynch Global Wealth Management predict that global financial wealth of high net worth individuals will grow to $48.5 trillion by 2012 from $32.8 trillion last year, driven by the recovery in asset prices. Unlike in the present crisis, regulation will not have the upper hand.

Alexander Davidson is author of How the Global Financial Markets Really Work. Published by Kogan Page. £15.99


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