Monday, 24 September 2018

The Dynamics of Financial Penalties

In response to the news that KPMG has ‘rejected’ the size of the fine given to it by the Financial Reporting Council (FRC), today’s post will discuss some of the dynamics of financial penalties. We have analysed the FRC a number of times in Financial Regulation Matters, and it will be important to assess whether the recent pressure being heaped upon the regulator has had the effect of changing the dynamic within that particular regulatory sector. However, it will be worth looking into the issue of financial penalties moreover, to ascertain whether they are considered effective enough, and if so then why that may be.

The news story that initiated today’s post can be found in The Times, and runs under the headline ‘KPMG rejects size of misconduct fine’. The fine is based upon the auditor’s performance when auditing BNY Mellon, and specifically in relation to its recent £126 million fine from the FCA regarding the mixing of institutional and client assets. KPMG has admitted that it had fallen short of ‘the standards set for auditors’, but that it was rejecting the fine because it felt the fine was too high. At first glance, and especially when one views the headline, it seems to be remarkable that the auditor would have the gall to ‘reject’ the fine, and further still even be in the position to do so. After the performance of auditors in other high-profile cases like the collapse of Carillion, it is easy to see why such a headline would cause widespread consternation and further distrust in the capacity of auditors to perform at an adequate level. However, there may be other issues at play rather than the obvious one.

The reality of the situation is that KPMG has the right to reject the fine within the current regulatory framework, and has plenty of reasons for doing so. The first is that the issue will be now be escalated to an independent tribunal, and other auditors have seen their fines reduced by similar tribunals only very recently. The second issue is that, relatively speaking, the fine really may have been ‘too high’. The word relative is important here, however. Regular readers of Financial Regulation Matters will know that very rarely, if ever, will a fine be considered ‘too high’ by this blog, but for the auditors and their relationship to the FRC, this may very well be the case. Very rarely will the FRC’s fines exceed £10 million, and whilst we do not know the size of the fine in this instance with KPMG, it is likely that it is near that £10 million figure. That is, of course, speculation, but there is a reason for that speculation, and it is likely the reason that KPMG would have decided to challenge this fine and, in all likelihood, win a reduction via the tribunal. The FRC has come under increasing pressure from MPs to toughen up, which has been received by the FRC as an indicator that its fines need to be increased (rather than look at alternative forms of punishment, for example). As a result, there is a potential that the FRC is exceeding the limits of its regulatory dynamic with the firms that it is exceptionally close with, although this is all relative still. If that is the case, and more auditors reject the fines given to them by the FRC, then there is a real potential for the FRC to be facing a critical juncture in its future. In reality, can the regulator maintain any sense of authority, authority which it struggles to maintain anyway, if the regulated entities, en masse, reject its decisions? If the tribunals put forward lesser fines, then that may essentially destroy any credibility the regulator has with its regulated entities, as it has very little outside of that sector. Yet, should the regulated entities even be allowed to accept or reject a punishment given to it?

Professor Cartwright discusses this very issue of ‘credible deterrence’, in relation to financial penalties in particular, and put forwards some very thought-provoking points. Within Cartwright’s chapter he discusses how traditional corporate crime theories focus on the usage of financial sanction to deter negative behaviour and encourage positive behaviour, but the question for us is the effect of financial sanctioning on the regulator themselves. Whenever a regulator imposes a fine upon one of its regulatory subjects, it is essentially extending its authority to impose such fines. For some regulators this action is enshrined, and can rarely be questioned, but for others it is part of a process, or a ‘game’ within which both sides battle for what, for them, constitutes a victory. For the regulated it may involve ‘settling’ or negotiating down a fine so that the fine is palatable for it and its members (RBS and its recent fine from the U.S. DoJ comes to mind), or for the regulator it may be that it needs to signal to stakeholders, which may constitute politicians and/or the public, that it is taking the appropriate action against a wrongdoer. All of this is fairly well understood and is admittedly basic, but what happens when that regulator does not have the authority? It is likely that we are seeing the answer to that question play out in front of us with the FRC and its current politics-inspired approach to regulating. Perhaps the major issue with the FRC is that it is becoming a very reactionary body, which is a result of its incredibly lax approach in the past. Perhaps it is simply too late for the regulator to ‘toughen up’ on the orders of politicians, as it either has no authority to do so, or the dynamics of the regulatory arenas within which it operates simply do not allow for such heavy-handed tactics to be employed.

Yet, there are a number of issues with those last few statements. The ‘toughening up’ that has been called for, and the ‘toughening up’ that has seen KPMG reject the recent fine, is only a very slight increase on the levels of fines in the past – the difference between £1 or £2 million and £10 million, to a firm with revenues of £2 billion, is negligible. It is arguable that KPMG and their oligopolistic are themselves disciplining the regulator, but that is a very dangerous approach. It is dangerous because whilst it is very difficult to make a case for the FRC continuing, its demise would bring about uncertainty within the regulatory framework – what happens if a new, fundamentally tougher and more removed regulator is put in its place? The effect of this would indeed be felt by the auditors, particularly as in the UK the opposition parties are calling for the break-up of their industry – the development of a tougher regulator could move the needle fundamentally in that direction. Nevertheless, for the FRC, KPMG’s rejection of its fine may well prove to be a turning point for its ultimate future, and if another oligopolistic members rejects a future fine then it is not outside of the realms of possibility that the FRC as we know it will not be able to survive such insolence.

Monday, 3 September 2018

Wonga’s Collapse: The ‘Platform for the Future of Financial Services’ Ceases to Exist

The issue of short-term lending and its connection to the post-Crisis era has been discussed on a number of occasions here in Financial Regulation Matters, most notably here and here. We discussed how the growth in this particular market was borne out of a desperation experienced by citizens who were, for the most part, struggling to make ends meet. One of the largest players in that field was Wonga, set up in 2006 just before the Crisis hit the Western world. In this post, we will look at Wonga’s recent collapse and discuss what its collapse may mean, both for consumers and the marketplace moreover.

In a previous post we discussed how, in June 2017 the Financial Ombudsman revealed that consumer complaints against Wonga and other similar lenders had exploded by 227%. That increased rate of complaints has subsequently been cited as being one of the core reasons behind Wonga’s recent collapse. The Guardian notes how the company ‘collapsed into administration after it was brought down by a welter of compensation claims’, with the newspaper also reporting that, as we stand after the company failed to save itself, there are still an estimated 200,000 customers who still owe upwards of £400 million in short-term loans. A worrying development is that as Wonga became renowned for targeting vulnerable people with their lending practices, those still in debt with Wonga have been instructed to continue making their payments whilst a buyer if found for Wonga’s loan book. One wonders whether the news of Wonga’s collapse will lead to an increased rate of delinquencies and/or non-payments, which will simply further place these already vulnerable borrowers into financially unhealthy predicaments.

Nevertheless, Wonga’s collapse is significant for a number of reasons. The company had survived a stinging PR campaign against it, from the Church of England amongst many others, but what is perhaps at the heart of its collapse is the positive potential of financial regulation. Between 2014 and 2015, the Financial Conduct Authority (FCA) had flexed its regulatory muscles and had enforced new rules that mandated that payday lenders needed to increase their checks on the affordability of its products (and also whether borrowers could afford repayments). Most tellingly, the FCA brought in new rules in 2015 that capped the rate of interest that payday lenders could charge, and this cap was a significant reduction in comparison to the rates that they were charging borrowers before the new rules were established. The article in The Guardian cited earlier states that ‘once lined up for a stock market floatation with a price tag approaching £1bn, Wonga was laid low by a cap on interest rates that ruined its business model’. It is worth pausing here to deconstruct that sentiment, as in the news media it is often passed over. Consumers were subjected to extraordinarily high interest rates before the cap was imposed, with rates as high as 5,833% being cited in some sources. Though the cap has been installed at 0.8% of the amount borrowed per day, the fact that charging incredibly high rates of interest and targeting vulnerable people who the company knew were unable to repay is nothing short of despicable. One would possibly imagine that people who had devised such a business strategy would be facing criminal charges, not administration and insolvency, but in reality what they were doing was not, in effect, illegal. Of course targeting vulnerable people with high-interest loans can and should result in sanctions, but criminal prosecution is, regrettably, not even a consideration in the world we inhabit. What is does do, however, is allow us to single out the people who were responsible.

In 2012, the company’s founder Errol Damelin stated that (in relation to the company’s creation) ‘we have dared to ask some hard questions, like how can we make loans instant, how can we get money to people 24 hours a day, seven days a week, how can we be totally transparent?’. It has been discussed in the media recently that Demalin’s proposed foundation for the future of financial services was to create an almost fully automated process that removed the stigma from borrowing and appealed to a number of different demographics. However, as discussed in econsultancy, the altering of lending variables from traditional indicators of creditworthiness to more fluid variables has not, and will not change fundamental components of the lending/borrowing cycle – the money given by the lender must be repaid. This was, in essence, Wonga’s business model: charge extortionately high rates of interest to ensure that the initial payment if repaid, whilst leaving anything else paid as pure profit. Their argument would be that such high rates of interest are required in order to lend to people who did not meet traditional standards of creditworthiness, but this is a poor argument. Whilst there are isolated cases of people benefitting from using companies like Wonga, the reality is that Wonga were exceptionally vicious in its marketing to vulnerable consumers and hiked their interest rates up to reflect the fact that they were lending to people that they should not have been lending to; this is further demonstrated by fines of £2.6 million (to be paid in compensation) and a write-off of £220 million’s worth of debt after admitting that the company had targeted people who it knew could not afford to repay.

Ultimately, Wonga should not be missed. Whilst one author presenting an opinion in The Guardian paints a picture of Wonga providing a useful service to society, this to miss the point entirely. The author describes how he would utilise Wonga to supplement his £20,000 annual salary, but the reality is that the majority of those affected by Wonga had no such foundation upon which to fall back on. Furthermore, the company actively targeted those in much lower brackets in the knowledge that the economic cycle in the post-Crisis era was ripe for exploitation. Such companies cannot prosper in boom periods, so it is not a stretch to label Wonga, and the many companies like it, as parasitic. There is a lot that can be said of Wonga, with the vast majority of it negative, but its existence is a direct indicator of a much broader and deep-rooted problem. That so many consumers required the services of Wonga is a testament to the financial quagmire that the Crisis plunged the West into. What is also telling is that it took regulators 4, 5, or even 6 years to even begin to consider putting a stop to such clearly exploitative practices. The sentiment that presents is that this exploitative post-Crisis process is almost expected, and potentially worse is fundamental to the development of economic cycles in the modern era of capitalism. It would be satisfying to see the executives of Wonga publically castigated and held accountable, but that will not happen. The reality of the situation is that many were happy to look the other way, as at the same time Wonga were raising its interest rates and targeting the vulnerable, the Government was pumping money into financial institutions at an unprecedented rate, whilst also slashing public budgets and obliterating the welfare system that defines the U.K. and acts as the ultimate safeguard against citizens being pushed into the waiting arms of the venal. With that in mind, perhaps Wonga was a necessary evil, but the truth is that we really should never have need for such a company to exist.

Keywords – Wonga, payday lenders, loans, administration, politics, capitalism, @finregmatters