11 December 2006

In the third of a fortnightly series, Amin Rajan argues that far-reaching new rules on good practice are disparate and achieve too little.

By Amin Rajan

"Are we in danger of achieving the worst of both worlds: rules that go too far while achieving too little?" asked the chief executive of a global fund manager. He was reflecting on the new laws and the reinterpretation of the old ones coming in the wake of the market timing and late trading scandals in the US in 2002-03.

Although focused on mutual funds, the scandals gave rise to the perception that the losses generated by the last bear market were, at least in part, due to poor management and lax risk controls.

At a time when fund managers were themselves seeking to improve the governance practices of the companies in which they had invested, the irony was not lost. More than 80 per cent of fund managers worldwide have since tried to improve the day-to-day conduct of their own businesses, according to the latest study from Create and KPMG*.

"We are getting better results with less time and energy than two years ago. Business processes conform to high standards. Leaders have also set the tone at the top," says Tom Madden, chief risk officer at Pittsburgh-based Federated Investors Inc.

The study shows that special oversight committees have been created to ensure that clients are sold products that meet their perceived needs. Explanations are given when performance deviates from the benchmark and other options are offered. Mutual funds have independent boards. Artificial inflating of prices or trading volumes is banned.

These and other improvements are hard to ignore. But it has not been plain sailing. To investors, Eliot Spitzer, the former attorney general of the state of New York, may be a new Robin Hood. But to fund managers around the world, his investigations have indirectly produced regimes in which it is hard to be fully compliant.

"We go beyond compliance to observe the spirit of the laws. Our reputation means everything. But what do you do when laws in different regions are conflicting?" asks Tim McCarthy, chairman and chief executive of Nikko Asset Management.

New rules emerging from Washington, London, Brussels and Tokyo are far from harmonised. And benefits have been overshadowed by unintended consequences.

The study found that client service and investment performance have improved; but costs have gone up faster than revenues. Decision-making across the business has improved, as has the ability to do cross-border sales; but this has come at the expense of increased senior management time and bureaucracy. The product development process is more robust; but use of lawyers and disclaimers are up; while speed-to-market is slower.

These mixed outcomes stem from the one-size-fits-all approach inherent in the new regimes riddled with vagueness. For example, the concept of "treating the customer fairly" rolled out lately by the Financial Services Authority is a catch-all label for everything that is not in the old rules. The term "fair" is so subjective that it does not help a fund manager to strike a reasonable balance between client interests and shareholder interests. Under any definition, there are uncomfortable trade-offs.

The problem does not end there. Fund managers are selling ever more via third-party distributors: contacts with end-clients are getting more remote. On their part, distributors across Europe and Asia often direct customers to fund managers who pay maximum sales commissions, regardless of client needs.

"This arrangement follows Gresham's law under which the bad drives out the good. Client behaviour is also a big part of the problem. Many clients are neither rational in their choices nor consistent in approach to risk," says Paul Burik, managing director at Commerzbank Asset Management.

Better client education would help, but would not resolve the central concern that current rules go too far and achieve too little.

In an effort to be self executing, many rules are displacing human judgment. Indeed, there are fears that the European Union's flagship legislation - Mifid (the markets in financial instruments directive) - will be perfect in failure. Its noble aims could be met more effectively if two parties upped their game.

For fund managers, that means promoting cultural changes under which staff behaviours are self regulating on one hand and entrepreneurial on the other, so as to eschew a "tick box" mentality to regulation.

For their part, regulators need to harmonise rules around best practices.

Amin Rajan is chief executive of Create, a research consultancy. Email: amin.rajan@create-research.co.uk

*Towards Enhanced Business Governance, available free from www.kpmg.co.uk