Chris Gilchrist: Regulatory rules and unintended consequences

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Regulators make rules with the best of intentions but almost always without enough knowledge to anticipate the unintended consequences.

At some point, regulators thought it was a good idea to require adviser firms to hold capital that could be used to provide service to clients if a firm got into trouble. Of course, the kind of firm that gets into trouble will not usually have any cash left to help anyone by the time Mr Sleepy from the regulator reaches them.

Now, though, the unintended consequence shows up. Take two adviser firms with turnovers of £1m and try to put them together. Any conventional acquisition (I mean conventional in method and accounting) is likely to fall foul of the FCA capital adequacy rules.

If Firm A wants to buy Firm B – or just its clients and income stream – it must have more net equity than any firm is likely to want to have or its owners must subscribe more equity. Or they have to create multiple company structures that scrape through the rules while making a nonsense of their supposed intentions.

In my view, it is this handicap of FCA rules, not superior business models or client propositions, that has accounted for the success of IFA consolidator businesses, which have used typical private equity gearing methods to buy up adviser firms.

Quite how flimsy their foundations are I do not know but forensic accounting might tell some interesting stories. For example, I would expect consolidators’ balance sheet liabilities in respect of future payments for their acquisitions to be significantly lower than the promises they have made to the owners of the firms they have bought.

The consolidators have little interest in advice other than as a process from which to extract cash. Executives look forward to the AIM flotation when they can cash in their share options. For them, advice is nothing more than a business and profit maximisation is the goal.

Sending a boy to do a man’s job is the simplest way of extracting more profit from an advice business. A 1 per cent advice fee may be reasonable if clients actually get advice on a regular basis from an experienced and qualified adviser. But what if the service is sporadic or reactive and the adviser is newly qualified and inexperienced?

If the regulator bothered to check, they could probably find plenty of cases in which service levels have fallen short of what clients had signed up to. But this is not what the FCA does. It simply requires evidence that there is a process that has been followed. Of course there is: a bible-sized process manual, whitewashed client files and a readiness to ensure complaints never reach the Financial Ombudsman Service. Boxes ticked.

Next best as a profit maximiser is increasing the fee for the same level of service. A fancy new multi-page service agreement can usefully disguise the fact the client is getting nothing that they were not getting before.

Regulators are happier dealing with large firms because large firms are just like regulators: bureaucracies in which career advancement and enrichment do not necessarily result from delivering any benefit to the consumer. The client knows that small is beautiful. The regulator prefers large even if it is ugly. In the advice sector, large has almost always been somewhere between ugly and loathsome.

Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits the IRS report