UK8217;s City watchdog set to bite

But the FSA is not waiting for its replacement,or even for tougher European rules that are due by 2014.

Some of the new British moves 8212; including issuing health warnings on products or even banning them entirely 8212; will break new ground for regulators in Europe,and acting early will help the FSA,as regulator of Europe8217;s biggest financial centre,shape the EU8217;s planned new rules. Financial services in London contribute 62.5 billion euros 90.5 billion to the national economy,according to lobby group CityUK,compared with 45 billion euros for Paris and 22 billion for Milan.

Margaret Cole is one of the main public faces of the new watchdog. Currently the FSA8217;s interim managing director of business conduct,the experienced litigator joined the FSA in 2005 with a mission to crack down on financial crime. It8217;s a mission that may now be yielding results,as last week a father and his two sons were jailed for a total 19 years for a share-selling scam. She is widely expected to become number two at the FCA to its acting CEO,Martin Wheatley,who starts on Thursday.

Cole is particularly concerned about complex structured products that neither consumer nor regulator may fully understand.

I expect us to start being more clear,being more direct both to firms planning products and to consumers about the dangers of products,such as structured products we have concerns about,Cole told Reuters.

A tougher regulatory line is politically overdue. The FSA was accused of turning a blind eye to the bad debts racked up by many of Britain8217;s top banks,which left taxpayers with a 1.3 trillion pound 2.1 trillion bill and firms including Northern Rock and Royal Bank of Scotland owned by the state. Even before the financial crisis,the regulator had failed to stop insurer Equitable Life selling policies with guaranteed minimum returns,leading to its near collapse in 2000 and a taxpayer-funded compensation bill.

Even since the financial crisis,the current regulator missed the industry8217;s wrongful sales of insurance policies to cover people8217;s potential inability to repay debts 8211; known as payment protection insurance PPI. Many customers were never able to make a claim,and banks now face a bill of over 6 billion pounds in compensation.

It8217;s no surprise the new mood is uncompromising.

Product regulation is going to be big in the next five to 10 years,says Etay Katz,a financial services lawyer at Allen amp; Overy. Simpler,low margin products will emerge.

CRACK THE PRODUCT

In Britain,Cole is using the FSA8217;s existing powers to toughen up its approach in three main ways. For a start,rather than just look at firms and the claims they make about their products,it will examine the products themselves.

We8217;ve been asking for minutes of product approval meetings and there are examples where we have told a firm to go back and add features to a product to bring about greater comfort on our part,Cole said.

To date,the UK has typically supervised firms,and what they tell consumers,rather than their products. Investment firms were already required to have a formal product approval process such as a committee,but lawyers say the watchdog paid little attention to them.

What8217;s changed is now they are starting to get heavily into the weeds of what are the issues considered when approving a product,says Simon Gleeson of law firm Clifford Chance.

This will squeeze out complexity in favour of simple offerings,as banks err on the side of caution.

ISSUE A HEALTH WARNING

The regulator intends to issue health warnings on those products where it sees dangers,and it will delay licences if a company8217;s business model relies on a novel product with a suspect design.

Lawyers say this step is inevitable,so the FSA can make an example of a company to deter others from pushing the boundaries.

I expect us to start issuing warnings soon,Cole said. These will be publicised in the press and on the watchdog8217;s website,and cover any product offered to consumers that is raising concerns.

BAN IT

Building on this,the British government plans to give the FCA new powers to ban products entirely for a temporary period.

Structured products for consumers,which are among the most complex,are in the line of fire. They include guarantee and bonus certificates based on derivatives 8212; heavily traded in Germany 8212; warrants,notes and asset-linked insurance,which are traded in Italy,and all largely linked to shares.

Website Structuredretailproducts.com,which tracks the sector,said that in 2010,total sales of structured products in Britain were 12 billion pounds: in Europe overall,the total was 165 billion euros.

Britain is not alone in moving towards banning products. The financial services industry looked on in dismay earlier this year when the Belgian financial authority,FSMA,announced a moratorium on selling particularly complex structured products to retail investors from Aug 1.

There were 85 billion euros8217; worth of structured products in circulation in Belgium last year. The aim of our initiative is to ensure a more transparent and simpler range of products offered to retail investors,FSMA chairman Jean-Paul Servais said at the time.

Lawyers say a decision in 2006 by Britain to ban commission on product sales from 2013 will accelerate the trend towards cheaper,simpler products,which can be sold without expert advice.

DON8217;T BE DUMB

This search for simplicity irks banks deeply.

Sometimes complex financial engineering is there to generate risk protection,says Tim Hailes,chairman of the Joint Association Committee which represents the banking,derivatives and capital markets industry on retail structured products.

To say 8216;all complexity is wrong and let8217;s ban it8217; is completely counterintuitive to the overall policy objective of consumer protection,he said.

The argument in the industry is that some degree of complexity is needed to generate higher returns,because simpler products rely solely on the performance of stock and bond markets or interest rates. Two recent complex products in Britain that have outperformed stock markets include Morgan Stanley8217;s FTSE Bonus Growth Plan,and two options from Gilliat Financial Solutions,industry officials say.

Cole denies the FSA wants to snuff out complexity for its own sake: she says the watchdog has to make a series of balancing decisions.

But to a degree the financial services industry depends on consumer confusion. For ordinary people in the UK to comprehend compound interest,figure out how to compare rates of interest labeled AER Annual Equivalent Rate and APR Annual Percentage Rate,or measure if any rate beats inflation is hard enough.

Add to this such concoctions as synthetic exchange-traded funds 8212; already being eyeballed for action by regulators 8212; or with-profits life insurance policies,and the regulators8217; urge to keep a tab on what8217;s being rolled out is understandable.

MIND THE GAP

Most worrying of all for banks,the FSA is also beginning to look at the profit margins on their planned products. These can be substantial.

A UK Competition Commission report on PPI in 2008 showed customers paid 4.4 billion pounds in premiums in 2006,with typical commission rates of 50 to 80 percent for policies to insure personal loans and credit cards,and 40 to 65 percent on insuring home loans.

Regulators seem to be moving to the position that profitability is a proxy for product quality 8212; the more profitable the product for the bank,the worse a deal the consumer must be getting,says Clifford Chance8217;s Gleeson.

The current regime has never had anything to say about profitability and this is the new thing. This is likely to be the battleground. Regulators will require oversimplified products that will have the effect of depressing returns on retail investments generally,he warned.

Cole argues that if a product is unusually profitable 8212; like PPI 8212; then it8217;s worth looking at what is driving this. It8217;s a good flag,profitability. PPI produced enormous amounts of profits,she said.

The watchdog has no informal rule of thumb yet on what is a fair margin,but has not ruled out such a step. We are not at that point yet. There is more to be developed here. We have an open mind on whether we should have price caps,Cole said.

NO WAITING

As part of their defence,UK banks argue the FSA is jumping the gun ahead of planned European Union laws. Cole is pressing ahead regardless.

The European Union,whose financial rules Britain must observe,is due to beef up its consumer protection arsenal with two draft laws in coming months: both will bring more products under retail rules,which are typically tougher than those for wholesale markets,and give the EU8217;s European Securities and Markets Authority ESMA powers to intervene.

There is a migration from wholesale categories to retail and banks dread this because it means more costs,says Allen amp; Overy8217;s Katz.

Some of the more complex mutual funds are likely to be covered by the new EU-wide rules,but Cole said the FSA8217;s existing powers already allow it to push ahead on product intervention,so it can usher in a cultural change.

We don8217;t need to wait for new legislation or regulation to be moving in that direction,Cole said.

ESMA is also studying returns on complex retail products,and its chairman Steven Maijoor said in July it may issue investor warnings or product bans unless a national supervisor acted promptly.

A lot of our European regulator colleagues have been in contact with us and are very interested in the direction of travel we are taking and very supportive of our approach with earlier product intervention,the FSA8217;s manager of investments policy,Milton Cartwright,told Reuters.

AVOID LIABILITY

But one step the UK regulator won8217;t take is to require that financial services firms receive its formal seal of approval on new products. Cartwright says that could stifle innovation and restrict customer choice too much.

Lawyers warn it would also open up other traps.

I don8217;t think the UK regulator will want to be in the situation of actually approving products as this could confer liability on it,says Michael McKee of DLA Piper,a lawfirm.