The European Commission has just finished its consultation period on potential conflicts of interest relating to financial analysts.
The Commission was seeking responses about the risks posed by financial analysts in investment banks advising clients on investing in companies for which their investment bank also provides paid services.
Since the consultation was launched in September, a series of financial scandals in the US concerning mutual funds and currency traders, have once again highlighted pitfalls that will face us in Europe in the immediate future along with some possible solutions.
This step-up in regulation and crackdown on misbehaviour comes at a time when the future of self-regulatory financial bodies in the US is being reconsidered, and the markets in the US are still in the doldrums.
The exuberant confidence that led to the repeal of the Glass-Steagall Act in 1999 is gone. This Act, passed in 1933, separated the business of banking and the business of selling stocks and shares after the Wall Street Crash of 1929. The Glass-Steagall Act laid down the psychological foundations for the belief that the public have to be protected from those who offer them financial services.
Over the last 25 years, the walls dividing different types of financial services have been eroded, but the US is now rebuilding them. The latest move by the EU is to see what type of division, if any, should exist here and, though it is of limited effect, it will be a marker in the industry.
The regulatory history of the US holds many lessons for Brussels.
While the deregulation that started under President Carter and had its heyday during the Reagan years led to a time of huge growth, the recent market downswing and the amount of corporate corruption that has been discovered show that self-regulating markets will not always achieve the desired result.
Laissez-faire attitudes in the US led to the Telecommunications Act in 1996, which facilitated the fraud at WorldCom, and also kept regulators out of the over-the-counter derivatives market, which was the favoured tool of deception at Enron.
The European Commission is expected to go with a more principled than prescriptive route when they ruminate over the submissions on this latest consultation. This was the approach of the UK Financial Services Authority when it set down some of its own principles in September, and the International Organisation of Securities Commissions (IOSCO) when it set out guiding principles in October.
It is unlikely that the EU will be liberal in their approach to this area. The Commission set up a Forum Group on Financial Analysts in November 2002, and it is on the Forum's recommendations that comments were being sought. The string of financial disasters in the US are a constant reminder of what happens when banks have too many fingers in too many pies, and to avoid such scandals the Forum Group set out a list of five core principles to be observed by those producing and passing on investment research. The principles are clarity; competence, conduct and personal integrity; suitability and market integrity; conflict avoidance, prevention and management; and disclosure.
On the basis of these five principles, the forum group have set out 31 recommendations, all of which are largely common sense. For the implementation of the principles, the Forum Group highlight the importance of senior management, and their role in ensuring a properly regulated marketplace.
However, there is also a realisation in the corridors of Brussels that there is cold comfort in taking a principled stance in financial regulation which may hurt European trade. This is evident in the stated aim of the Commission to balance consumer protection with an open and competitive market.
The EU has a historical tendency to err on the side of over-regulation. This was recently evidenced by the longstanding declaration that Brussels would adopt the new Basel Accord for banking supervision for the forthcoming Capital Adequacy Directive, which was a sound principled stance. The fact that the US declared earlier this year that it would be limiting the full application of the new Accord to a small number of large banks has left the Commission unsure whether European markets will suffer because of over-regulation.
Academic research that preceded the repeal of the Glass-Steagall Act in the US showed no underperformance of initial public offerings (IPOs) underwritten by related investment banks. However, financial markets, like other societal structures, are as much about confidence in the system, as performance. The tide of regulation ebbs and flows. There is no objectively correct level of governance of financial markets. The regulatory optimum is elusive, and can often only be seen over a substantial period of time. The European Commission has an unenviable task ahead of it in finding the correct balance between consumer protection and market openness, and should pay close attention to the regulatory history of the US before deciding what to do.
