Unintended consequences of regulatory intervention

In 2002, a conservation-minded couple – a photographer and helicopter pilot – had a big idea. They decided to take 12 000 overlapping photographs, documenting the entire coastline of California to provide a baseline against which the impact of future development and coastal erosion could be measured. The entire photographic record was made publicly available on a website that still exists today. But one of the shots included the Malibu cliff-side mansion belonging to Ms Barbra Streisand.

When Ms Streisand became aware of this ‘invasion of privacy’, she took steps to have the offending image removed from the web and proceeded to sue the couple for $50 million. The irony is that prior to her instituting legal proceedings the photograph had only been downloaded six times, including two downloads by her lawyers. One month later, more than 420 000 people had visited the site. She also eventually lost the court case with costs.

And so the ‘Streisand Effect’ was coined – the internet era’s defining example of the law of unintended consequences. Since this episode, most wise people understand that any attempt to censor information in a free society is likely to lead to the perverse outcome of much wider publication.

As Ms Streisand has learnt the hard way, the outcome of your actions can sometimes be contrary to your intentions. This is especially relevant when you decide to intervene in complex systems. The likelihood of unintended consequences becomes even higher when many related systemic interventions follow in quick succession. This is the current situation facing the investment and savings industry.

Policymakers and regulators around the globe – scarred by the devastating impact of the global financial crisis in 2008 – have embarked on an ambitious programme of making the regulation of capital markets and financial services businesses tougher, more interventionist and more intrusive. At the same time, the public mood has created an environment in which banks especially, but also fund managers and insurers, are being asked more searchingly to prove that their particular area of financial intermediation adds more value to society than it collects in fees.

This process is also playing out in South Africa, despite the high regard in which our financial markets and financial services industry are held globally. The recently released World Economic Forum Global Competitiveness Report affords South Africa an overall ranking of 53 out of 148 countries. Within that, we rank 3rd in the world for financial market development and 1st for auditing standards, regulation of securities exchanges and minority shareholder protection. In terms of affordability of financial services we are placed 13th.

In spite of achieving a highly competitive global rating, the local financial services industry faces a daunting reform agenda. Some of the initiatives aimed at further strengthening the credibility of our savings and investment market currently on the agenda include:

• Implementation of the ‘Treating Customers Fairly’ framework. This will hold financial product providers to account for meeting a set of principles defining how clients should be treated (this is in addition to, rather than replacing, the existing detailed rules-based regulations).
  
  
• A comprehensive review of the retirement system, aimed at removing structural deficiencies in the way the market operates and ensuring that it delivers more value to its beneficiaries.
  
  
• Tightening governance standards in the retirement system and extending the responsibilities of fund trustees.
  
  
• Tougher market conduct rules for a wider group of product providers and financial advisors.
  
  
• A review of the relationships between investment managers and other intermediaries, such as indepen-dent financial advisors, with the aim of eliminating the potential for conflicts between the interests of investors and their advisors (primarily focused on eliminating conflicted remuneration models).
  
  
• Additional disclosure requirements aimed at making it easier for prospective investors to compare different options, understand the fees that they will pay, the contractual terms that they agree to, and the risks they will be exposed to.
  
  
• Removing constraints limiting the allocation of client assets to infrastructure-backed investments.
  
  
• Strengthening of the capital adequacy rules under-pinning certain categories of business.

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While the intentions informing the various proposed government interventions in how the market operates are mostly good, the risk is that the complexity of attempting to make so many changes at once could lead to perverse outcomes.

Examples of the possible unintended consequences include:

• Increases in compliance costs for the industry that may in some instances be passed through to clients. To limit this risk, or at least make the price worth paying, all interventions must be subjected to careful cost/benefit analysis.
  
  
• Reduction in supply of certain products or services. When the operating environment becomes too onerous it acts as a disincentive to conduct business. Regulatory intervention that reduces competition is not in the best interests of clients.
  
  
• We are especially concerned that the current reforms may lead to a reduction in the availability of independent financial advice. It would be ironic if the very reforms aimed at removing potential conflicts and market abuse (by advisors at the expense of their clients) result in a situation where it becomes significantly more difficult to obtain access to independent advice, simply because many providers have been forced out of the market.
  
  
• Undermining the credibility of the system and, in the process, the credibility of South Africa’s capital markets.
  
  

This list of potential problems is in no way exhaustive as sub-optimal outcomes are often only identifiable with the benefit of hindsight. It does, however, serve to highlight how important it is for all stakeholders to carefully apply their minds to the resolution of the current reform agenda. Collectively, we need to achieve government’s desired and laudable outcome of a stronger financial sector to serve all South Africans better.

At Coronation, we know that the regulation of investment and savings activity is a necessity. Regulators need to ensure that those permitted to take responsibility for other people’s money are up to the task by setting ‘fit and proper’ entry requirements. Regulation can also play a vital role in reducing the information asymmetries 
between industry insiders and their clients. This can be achieved by ensuring transparency, comparability, appropriateness and integrity of information. However, it is also important to ensure that the right balance is struck between adding credibility-enhancing rules and avoiding cumbersome red tape that reduces the value 
available to all. In the current environment, our challenge is to prevent the pendulum from swinging too far in the direction of overregulation. 

If you require any further information, please contact:

Louise Pelser 

T: +27 21 680 2216
M: +27 76 282 3995
E: lpelser@coronation.co.za

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Notes to the editor:

Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 25% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the September 2013 quarter-end, assets under management total R492 billion.