Draft Financial Regulators' Powers (Technical Standards Etc.) (Amendment Etc.) (EU Exit) Regulations 2018

John Baron Excerpts

Wednesday 10th October 2018 General Committees

[Mr John Baron (Basildon and Billericay) (Con)]

I thank the Minister for his opening comments, and it is a pleasure to be speaking in this debate under your chairmanship, Sir David. As the Committee is discussing how we can ensure that those financial standards presently governed by EU law are transferred to our own regulatory bodies in good order and that any deficiencies are made good—it could become a very real issue if we do indeed leave without a deal in five months’ time—I would like to highlight for the Minister and the Committee a real concern in the financial services industry about some present EU regulations that, if transferred wholesale, would continue to cause major concerns, particularly to investment trust investors.

Let me start by highlighting for Members my interests in this issue, which include my business interests. I have also written a Financial Times book relating to investment trusts, and I direct Members to my entry in the Register of Members’ Financial Interests. I believe there may even be people on my side of the Committee, if nowhere else, who have bought the book—in which case, my apologies.

The EU’s core retail financial services regulations—known as packaged retail investment products, or PRIPs—have at their heart a key information document, which is supposed to be produced for every single investment trust and unit trust, and from 2020, in order to help investors better understand what they are buying. The intention is good, but the problem is the execution. Many in the industry believe that these key information documents—or KIDs—are grossly misleading on the assessment and comparison of risk, grossly misleading on the projection of future returns and certainly misleading on the comparison with similarly mandated sister funds within the unit trust sector. I suggest to the Minister that all this makes for a perfect storm from which investors might seek redress in numbers if no corrective action is taken soon. No wonder that all three of our major trade organisations—the Investment Association, the Association of Investment Companies and the Personal Investment Management & Financial Advice Association—believe that the regulations should be scrapped or reworked. Even the FCA has instigated a call for evidence, believing that something is wrong here.

Let me give some examples, and perhaps to help Members, I should describe very briefly what an investment trust is. They are unique to this country. They are quite old—the oldest form of collective investment—and quite difficult to ignore as an industry. The Scottish Mortgage Investment Trust for example is a FTSE 100 company. An investment trust is a closed-ended company with a limited number of shares, like Marks & Spencer, GlaxoSmithKline or BP, but instead of managing clothes, pharmaceuticals or oil, it manages investments of different types and with different briefs.

The unit trust, which is the investment trust’s better-known cousin, is another form of collective investment and is open-ended. Investors put money in, which adds to the pot; it is not closed-ended. It is generally recognised that while investment trusts have a better long-term track record—as closed-ended companies, they can gear and they have discounts because their share price will sometimes be at variance with their net asset value—they can be more volatile in the short term because of the very same factors that make for good investment: their gearing and movement in discounts, when compared to unit trusts. I ask hon. Members to bear that in mind as we go through the regulations.

When it comes to the issue of assessment and comparison of risk between investment trusts and unit trusts, the documents required and produced under EU regulations are grossly misleading. The documents have similar titles, and I do not want to get too technical here, but the investment trust sector is governed by key information documents, or KIDs, whereas the unit trust sector, from 2020, will be governed by documents called key investor information documents, or KIIDS, which are being produced now in preparation for 2020. They have similar titles, but very different methodologies for assessing risk. When measuring risk on equities between investment trusts and unit trusts, the risk-reward indicator average puts unit trusts at 5.1 and investment trusts at 4—there are seven bands; the higher the band, the riskier the investment. In other words, it assesses investment trusts as less risky than unit trusts, which is simply not the case. It is generally accepted across the industry that investment trusts are actually riskier because they are more volatile, although they produce superior returns over the longer term. Yet here we have an example in which an EU-inspired KID is actually saying completely the reverse. Investors could be misled into believing that investment trusts are less risky than unit trusts and there could be repercussions because that is simply not the case.

The documents also overstate expected returns. The problem is that the documents extrapolate recent returns. In a bull market, KIDs will suggest higher returns, while in a bear market, they will suggest lower returns. We all know that past returns should be no guide when investing. The 42 KIDs forecast 20%-plus returns per annum in a moderate performance bracket for investment trusts. In any normal existence, 20% cannot be achieved without taking on a significant degree of risk. Anyone who knows the financial services industry, as I do, having worked in the City for 15 years as a director at both Henderson and Rothschild & Co, where I invested money on behalf of individuals and charities—apologies, Sir David; I should perhaps have mentioned that—knows that it is necessary to take on extra risk to earn 20%. If we are not careful and do not address that point, we will encourage the kind of investment behaviour that we should really be doing our best to avoid—buying high and selling low. That is the complete opposite of what people should do in the investment world. Extrapolating recent returns misleads the investor, so KIDs again are of no help.

Finally—I am conscious that time is short for everyone—those documents are misleading for another reason. KIDs are produced for investment trusts, and their equivalent is produced for unit trusts. There is such a thing as sister funds, where an investment trust manager also runs money in a unit trust—the same manager, with a similar brief and remit, and a similar portfolio. There is often a large overlap between the portfolios held by a unit trust and an investment trust. I mentioned that investment trusts, because of their gearing and discounts, are higher risk, but Association of Investment Companies research compared 56 investment trust KIDs with those of their unit trust sister funds, and none of the 56 had a higher risk indicator. That is misleading. In fact, the vast majority—53—had a lower risk indicator. Again, that is completely misleading.

I take issue with the shadow Minister’s swipe at a no-deal Brexit. The industry and many businesses actually say that no deal would not be the Armageddon she suggests. We trade with the majority of the rest of the world on no-deal terms. We have no trade deals with China, India, Brazil or America, because the EU has been very poor at negotiating trade deals. In essence, we trade on World Trade Organisation terms with those countries.

The shadow Minister asked for a specific example of who would be smiling if we left the EU and were able to take control in the event of no deal. I suggest to her, and more importantly—in the nicest possible way—to the Minister, that this is a concrete example of what our financial regulators need to grip when power returns to this country. At the moment, we have a completely misleading EU directive, in part because other EU countries do not understand investment trusts, because they do not exist there. They are almost uniquely UK investments, which have done very well over the years.

I ask the Government, well before March 2019, which is not far away at all, as part of the preparations for no deal, to prepare the ground to either scrap or rework that EU legislation. It is still possible that, at the end of March, that legislation, about which the whole industry is up in arms, will suddenly be incorporated into UK law and given to bodies such as the FCA to oversee. Meanwhile, thinking about the audience outside this place, I suggest that the FCA needs to raise its game. True, it has asked for evidence, but the writing has been on the wall for a long time. It should warn investors not to rely on the information in KIDs, because it is misleading. The time to act is now, before too many investors get hurt. I leave that thought for the Minister to consider.

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[Mr Jones]

He did try, to be fair to him; he is not a bad Minister. This puts a spotlight on a cost of Brexit that is not being factored in. Those 800 SIs will all have a cost to them. It would be interesting if the Minister supplied information about not just the number of SIs relating to this regulation, but the estimated cost of each of them, including the cost of preparations by the Department. That will be a huge cost across Government.

My hon. Friend the Member for Oxford East and the hon. Member for Glasgow Central made a good point about the capacity of the Bank of England, PRA and FCA to implement this and take over this responsibility. I have sat on many Committees since I have been in Parliament, and I do read the explanatory notes, even when the subject is boring or dry, as this may be. Uniquely for an explanatory note on a piece of legislation, no costs are included in this one. It will be interesting to see if all the SIs we get have explanatory notes in which no costs are included, as though this were a zero-cost game.

There is not just the question of what the SI will cost; there are other costs. Clearly, the tasks being taken on by the Bank of England, the PRA and the FCA will involve cost. If we are to do justice to the transparency of the Brexit process and those claiming great wins for the taxpayer out of it, the full extent of those costs needs to be known. It is unfair on those organisations to be given extra responsibilities but no cash to go with them, unlike other parts of Whitehall, where hundreds of millions are being spent employing new civil servants. This is a hidden cost of Brexit. This is one piece of legislation; how many times will it be duplicated across Government? I suggest many, many times, adding up to millions and millions of taxpayers’ pounds.

The explanatory notes state that no consultation was done, although the statutory instrument was published in draft in April. The notes say:

“The financial services regulators plan to undertake public consultation on any changes they propose to make to Binding Technical Standards or rules made under the powers conferred upon them by the Financial Services and Markets Act 2000 using the powers delegated to them”.

The important point there is about who will decide. Will there be ministerial or parliamentary oversight of what is in the consultation? Who draws it up? Is that left to the regulators to do? There will obviously be controversy on the issue that the hon. Member for Basildon and Billericay raised, and people will complain about it. Again, how will that be dealt with? Will Parliament or a Minister have any say over the regulators and how they conduct the consultation? It is said that the devil is always in the detail, and that was clearly demonstrated by the hon. Gentleman.

There may well be unintended consequences to taking on some of these regulations. There may well be better ways of doing things—I do not disagree with that—but where will the political pressure to get the authorities to change the regulations come from, if there is simply a general consultation? For example, someone has already decided that the regulation the hon. Gentleman referred to does not need looking at, but Parliament does need to look at it. Ministerial oversight is needed—not just of the draft regulations, but in a whole load of areas. Basically, we are delegating our responsibility to determine what should and should not be looked at to statutory bodies. In many cases, we might have a very different view from regulators.

We are all told that the draft regulations are being put in place for the nightmare scenario in which we do not get any deal in the negotiations that are taking place. I am interested in what happens to the SI if we do get a deal. Can the Minister explain—he may not be party to this—where this small piece of possible legislation is in the great negotiations? What happens if we get a deal? Does the SI fall?

As for regulators taking over these responsibilities, what will happen in future? Let us suppose we get no deal, the draft regulations go through and we try to transpose everything into UK legislation—this point was made eloquently by the hon. Member for Glasgow Central. What happens if our regulations get out of kilter with the EU regulations? Clearly, the sector is not based on a single company; We are talking about global business—money moving around the world—that does not recognise boundaries. What is the mechanism to ensure that if there are changes in EU regulations, we reflect them, or take them on board directly? Again, will that be left to the regulators? Will they decide which option we take, or will the decision come back to Parliament?

If such decisions are to come back to Parliament, we will be very busy in a whole host of areas for years to come. Basically, when EU regulations in this or any other area change, how do we ensure that we are not at a competitive disadvantage, or that the regulations for institutions based both in the EU and here do not somehow clash? This is not easy. It demonstrates one of the problems with what someone—I cannot remember who—on the leave side said: they said that that the deal would be the easiest ever done. No, it will not. This demonstrates in one small area the technical detail that will hit us.

I worry, because if our regulations are rather weaker—the hon. Member for Basildon and Billericay seems to think that our savers or investors are disadvantaged by the current regulations—and savers and investors are somehow less protected, that leads us to the point made by the hon. Member for Glasgow Central about what came out of the 2008 crash. What we needed was not more regulation for regulation’s sake, but international regulation to ensure that people in this country investing in a pension fund that might be investing overseas were protected, and vice versa. When people ask, “Will these dry regulations affect ordinary people?” the answer is: yes, they will if we get them wrong. That is why this is important.

[Mr Baron]

The right hon. Gentleman makes some good points. For absolute clarity, I was suggesting that current EU regulation was not serving investors well, and if it is to be encapsulated in our regulatory governance in March next year, we need to act quickly to put it right, because the consequences could almost make for a mis-selling scandal, if not a perfect storm. I just want to make him aware of that.

[Mr Jones]

I do not have expertise in this field, as the hon. Gentleman does, and I defer to him, but that is one area; what else is there? A proper consultation might have thrown these things up. The sector in which he is involved may well have made representations, particularly around the points he made.

Even if these measures are incorporated into UK legislation post March next year, how do they get unpicked? Who decides that? I sit on the important Regulatory Reform Committee, and we may well be very busy if we get flooded with things that have to be incorporated and then must be unpicked later on.

This statutory instrument seems quite mundane, boring and dry on the face of it, but it demonstrates the bigger picture that will hit Parliament. Not only will it have to spend an amount of time on this, but there will be unintended consequences that may not be relevant straightaway, but certainly will be. All those people said that leaving the EU would be simple, but these are the unintended consequences.

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[Mr Baron]

If I may just move away from the hypotheticals, I have tried to outline a serious deficiency in EU regulation here. Can I have an assurance from the Minister that our regulatory bodies will have the power to put that right, if we leave without a deal?

[John Glen]

The purpose of this process and this statutory instrument is to provide the framework to onshore the binding technical standards that are needed. Turning to my hon. Friend’s point, I will ensure that the FCA is aware of the issues that have been raised—I am sure it already is. I am told that this summer, it launched a call for input to seek feedback for consumers and firms, which closed on 20 September. Next time I see Andrew Bailey—I see him regularly; I saw him just last week—I will ask him to consider that.

I will come on to the other points and the broader principles. Some of the considerations about where we will be in the future are subject to the deal that we end up with. Again, I do not want to be drawn into hypotheticals at this point. I will come back to my hon. Friend’s point in a minute.

The hon. Member for Oxford East raised a number of other issues about resourcing. The right hon. Member for North Durham also raised this, in terms of the regulators having enough resource. In my travels to Indonesia, Malaysia and Japan over the summer, I have seen that UK regulators are highly regarded and among the most important and most respected in the world. They have the resource and expertise, and the Government are confident that they are ready and able to do what has been asked of them. The hon. Member for Glasgow Central was also concerned about this point. I have had no indications from my conversations with the PSR, the PRA or the FCA that there is a resourcing issue. If that changes, I am sure they will be very keen to come and talk to me about it.

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[John Glen]

I note the right hon. Gentleman’s point and I will now move on to the issue of supervisory co-operation and the continuance of that, as raised by the hon. Member for Oxford East. While it is true that we will be outside the EU’s framework, we want supervisory competition to continue. I am sure that the hon. Lady knows that there exists a high level of co-operation across many countries outside the EU framework, and our regulators stand ready to do this. A point was made about optimism for the future. The Chancellor set out some great opportunities in the Mansion House speech that we will have with global financial partnerships. The regulators will be deeply involved in that.

I turn now to the points made by my hon. Friend the Member for Basildon and Billericay and acknowledge the quality of his articles in the Investors Chronicle. I look forward to reading his book. The powers in the European Union (Withdrawal) Act 2018 deal only with fixing deficiencies at the point of exit, as he will know. Wider changes need to be considered at a later date, but I think he has put on the record some meaningful analysis of the implications of the regulations for the characterisation of risk around unit trusts versus investment trusts. I have heard that, as have my officials, and we will come back on that.

[Mr Baron]

I thank the Minister. All I have asked him to do is look at this and be conscious of it; I do not expect immediate answers now. Most of us, whether Brexiteer or remainer, would prefer a good trade deal that favoured both sides; trade deals tend to be good. Is the Minister able to confirm now—although I would be happy for somebody to do so afterwards—whether this bit of regulation, which is causing so much angst over here, will remain in force within the Chequers agreement? In which case, we have further battles to wage.

[John Glen]

Candidly, at the level we are at at the moment, in seeking a strong bilateral arrangement to determine the future dynamics of dialogue between the EU and the UK supervisory bodies, I cannot answer with that degree of specificity. I take the point and will seek to come back to him as soon as I can.