Regulation, entrepreneurship and the law of unintended consequences 

Ben Mason, CEO, My Compliance Centre

30 March 2022

In a series of articles, Ben Mason considers the impact of a hardening regulatory environment and if the benefits really outweigh the costs. 
In the first of the series, Ben examines how a regulatory structure intended to prevent financial crime has allowed wealthy criminals to prosper, while badly impacting the prospects of smaller, entrepreneurial firms and in contradiction to the FCA’s competition objective.

About ten years ago (as an experienced financial services licencing consultant) I was contacted by a well established and highly profitable money transfer brand.  They wanted to start a bank. 

“Why?” I asked.  

“We have been ‘de-risked’ by Barclays and being a bank is the only way which we can gain our independence and stay in business”, came the answer.  By which they meant Barclays was withdrawing their banking and clearing services, putting them out of business, but, if they were a bank they would have access to clearing services, allowing them to continue to function.  (As we all discovered in time, that simply was not true: to have real independence you needed to become a member of the payment systems themselves; most banks are not payment systems members and still have this risk ongoing, to a lesser or greater degree, depending on their business model.)   

This market issue – access to banking services and payment systems for financial services firms – has become increasingly well publicised.  For too many years, many new firms simply cannot get bank accounts, halting their development and the innovation that comes with it in its tracks.  Larger firms rarely have this problem, as “money talks”, and the primary (and challenger) clearers can justify the overhead of managing high risk accounts if business volumes are high enough.  It is an old problem. 

What are the causes of this problem?   

It is the structure of regulation, whereby each regulated entity in a transaction is responsible for the conduct of those beneath it in the chain.  Clearing banks must carry out ongoing due diligence of agency banks; agency banks similarly must carry out ongoing DD of their clients (such as regulated firms or payment institutions) and so on.   
Everyone is vulnerable to regulatory enforcement, based on the weakest link in the chain.  Criminals, of course, are clever and look to penetrate the system at weakest point. 
Why have I come back to this old chestnut now?    

Barclays recent fine (28th February 2022) for its oversight (or, allegedly, lack thereof) of Premier FX has brought this point sharply back into focus.  Barclays’ failing on this occasion was not making enquiries to ensure that Premier FX’s actual business activity aligned with the bank’s expectations.  Additionally, Barclays did not identify that Premier FX’s internal controls were deficient. This constituted a failure by Barclays to conduct its business with due skill, care and diligence. 
The fine itself is relatively small by Barclays’ standards (£784k), although there is the small matter of £10m reimbursement to Premier FX’s clients also to consider.   

However, what is concerning me deeply is what Barclays might now do.  Hundreds of small firms live on a knife edge, knowing that they may be put out of business at any time because they may lose access to banking facilities.  I know, from first hand experience, that while Barclays may have got this one wrong, generally they have been diligent and professional in their oversight of their regulated financial services clients.  Their ongoing forbearance has kept many firms in business. 
If Barclays further tightens its risk appetite, many small firms may simply be put out of business.  Many others will not be able to get started.  Other clearing banks may further tighten their risk appetite simply on the basis of Barclays’ fine. 

Innovative FinTech sectors such as payment services or online trading may become unviable for medium and small firms, reducing the financial innovation many of us are so proud of. 
In fact, the UK’s propensity to innovate and be entrepreneurial, and to attract innovators and entrepreneurs to our shores, is something we should all be proud of.  However, if new firms simply cannot open a bank account, it does not matter how clever and innovative they are – they simply cannot run a business.   
Are these regulations “a good thing”? 

Undoubtedly, legislators and regulators have deliberately built a structure where different members of the regulated community are on risk for the conduct of others.  And everyone accepts that there is a cost to the ‘good guys’ of imposing sanctions on the ‘bad guys’ (e.g. there is universal acceptance that we will all suffer an economic cost as a result of sanctioning Russia, but we willingly accept it.) 
The challenge for me is that it is very difficult to know, from here, the full costs and benefits of our regulatory structure.  Only regulators have any chance of seeing the full picture, and their view can get heavily tainted by the media and investigative pressure put on them.  While it is easy to be critical, because of the clear damage done to so many entrepreneurial businesses, we should reflect that many of these rules have been dictated by international standards.  Additionally, regulators and legislators have a wider dataset on which to base their decisions than the businesses that they are imposed on.   

There are upsides to this structure: banks will not do business with some firms that do not hit certain conduct standards, in essence doing regulators’ dirty work for them by keeping those companies out of the market and raising standards for all.  But, by also refusing to do business with firms that may have high standards, but are just too small to deal with, plenty of ‘good guys’ are also prevented from trading. 
I honestly have no idea how you possibly go about weighing up the pros and the cons.  While my admiration for regulators is unstinting (and that is a genuine comment) I have never observed them effectively assess the true costs of their actions on the firms they regulate. 

A very simple analysis would be to say, particularly at the current time (spring 2022), that any rules fighting financial crime are positive.  However, while we are all navel gazing right now about how the UK has turned a blind eye to the source of so much of our wealth and thrived on the profits of kleptocracy, it has always felt, to this author at least, that those who cannot access banking facilities are those who need them most: small firms and the underclass – not the rich, who launder money in its billions.  Criminals with enough assets generally can do with what they want with them.   

Is regulation, and the huge costs of financial crime prevention to regulated firms, really delivering the outcomes expected? 
An intended or unintended consequence? 

The penalty of the current regulatory structure is very high for many firms it is not intended to penalise.  The regulations and their consequences have become a barrier to entry to small, innovative firms, and thereby favour established firms, protecting their market position.  
Is this an intended or unintended consequence of regulation? 

Are regulations accidentally making the world a worse place?  

The FCA has a competition objective, which is intended to support innovation and new firms bringing new products and services to the market.  This objective contradicts what is happening for small firms that cannot access banking services.  (And the FCA itself, amongst all the other challenges of getting authorised, is generally very supportive of applicants for a new licence as they finalise their banking facilities at the point of authorisation.)   
Similarly, the efforts of the Payment Systems Regulator to open up payment systems access to all should not be underestimated; phenomenal progress has been made.   

I would love to know whether the people that came up with these rules understood the damage that they would do to so many small firms and their entrepreneurial aspirations.  I suspect they did know and consider the cost acceptable because, as so often is the case, while the current structure may be far, far from ideal, quite simply, no one knows how to do it better. 

For now, at least, the banking market access problem we have all come to know and love over the last ten years will sustain.  Every fine for a clearer for an oversight failure, such as Barclays and Premier FX, will put more firms out of business and prevent others from getting into business. The impact of this overall is to reduce competition and increase the power of incumbents, in contradiction to the FCA’s competition objective, while regulators and legislators try to find a better way. 

With my thanks to David Rodriguez of Compliancy Services for his insight and input into this article.

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