Incentivising Compliance with Financial Regulation
52 Pages Posted: 31 Mar 2017
Date Written: December 30, 2016
The regulated U.K. financial services sector is a large and dynamic industry. In 2015, it consisted of approximately 56,000 firms and 125,000 approved persons. Moreover, around one thousand new firms were authorised by the Financial Conduct Authority (FCA) in 2015. By some estimates, the industry contributes 12 percent of U.K. gross domestic product. The insurance industry alone held £1.9 trillion of invested assets.
The FCA is responsible for regulating the financial services firms that supply to retail and wholesale consumers in the U.K. The FCA, along with the Prudential Regulation Authority, was established in 2012 to replace the Financial Services Authority. From 1 April, 2014, the role of regulating the consumer credit industry was transferred to the FCA from the Office of Fair Trading. The FCA’s main roles are to maintain and ensure the market’s integrity, to regulate financial services firms so they provide consumers with a fair deal, and to ensure that the financial services market is competitive. The FCA is not a government body; it is accountable to HM Treasury but its funding derives from the fees paid by the firms it regulates.
The financial services industry is clearly in need of regulation. The failure of firms to comply with regulations is exemplified by many well-known episodes of mis-selling of financial products. There have also been many other instances of non-compliance. In 2013/14 the FCA imposed 46 penalties totalling £425m and secured criminal convictions against several individuals. The perceived magnitude of non-compliance has led to the view that financial services firms are characterised by a culture of non-compliance and that only a cultural shift will improve the regulatory outcome.
At the heart of any regulatory process is providing incentives that encourage regulated firms to comply. This paper reviews the basic economic theory of incentives and how they can be used to enhance compliance. It considers incentives theory as applied to tax compliance since it has many similarities to compliance with financial regulations and a much longer history of effort by authorities to improve it. This starts from the standard perspective of individual economic rationality and progresses into the additional insights offered by behavioural economics. The approach of HMRC to reducing non-compliance is then reviewed with a focus on recent initiatives aimed at culture change in large businesses. Introducing relationship managers and developing cooperative compliance are both explained as methods of shifting corporate culture and incentivising compliance.
The analysis of HMRC activities is then used as a basis to explore developments in enforcement and supervision at the FCA. The FCA faces similar issues to HMRC and it has implemented many similar programmes. Securing culture change in financial services firms is important to the FCA. The Senior Managers Regime is a central component in the culture change strategy but there are also programmes aimed at ensuring the operational structures of firms deliver good conduct. These programmes indirectly address compliance failures, such as mis-selling, by encouraging compliance. What they do not do is provide direct control of mis-selling. Many past episodes of mis-selling have continued for long periods before problems have been recognised. This has led to many customers being affected and compensation processes that take years to complete. Real-time monitoring of financial services transactions could directly reduce the extent of mis-selling if technological challenges can be overcome. Mis-selling is typically individual specific (i.e., it depends on whether a particular product is suitable for an individual consumer, given the consumer’s circumstances), so it requires the analysis of a large body of information about each transaction. This creates greater complexity than in individual tax compliance and poses a continuing challenge to regulation.
An important innovation of HMRC was to introduce the “tax gap” as a measure of noncompliance. The tax gap indicates the HMRC’s success at achieving compliance and, since it is a consistent measure over time, can indicate compliance trends. It also provides insight into the sources of non-compliance. The tax gap can be apportioned to tax instruments and to taxpayer groups. Each of these indicates where compliance resources should be focused. There is no similar aggregate indicator of compliance with financial regulation. If the FCA developed a compliance index, it would provide much clearer information about the state of compliance than judging it from the number and level of fines.
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