The failure of Equitable Life, a sad story which resurfaced last week, seems barely significant in the context of the international banking crisis.  But it contains critical lessons for the future of all financial services regulation.

Equitable Life was a medium-sized mutual British life insurer with a relatively affluent and sophisticated clientele.  Its business strategy paid out to its customers amounts close to the full value of their share of the underlying assets, including the goodwill of the business.  This approach was fair to successive generations of customers, and gave the Society a strong competitive position in life insurance and pensions markets..

The strategy was vulnerable to adverse shocks.  The Society reasoned that since the contractual obligation to policy holders was much less than the planned payout, the business was protected.  But an unfavourable legal ruling in 1999 on obligations for guaranteed annuities was followed by a fall in the value of investments.  The assets of the company were sufficient to meet narrowly defined liabilities but inadequate to meet policy holders’ expectations, and the goodwill evaporated.  Attempts to sell the business failed and benefits were substantially cut back.

The fall of Equitable Life is documented in an outstanding report by Lord Penrose, a Scottish judge.  That report is the basis for a recent review by the Parliamentary Ombudsman. Under the title ‘a decade of regulatory failure’ she concludes that the supervisors of the business were guilty of maladministration.  Ms Abraham proposes that the government should establish a fund to compensate victims.

It depends what you mean by regulatory failure.   In many respects, the regulators emerge with credit. They did what the Board of the Society, and the rating agency, conspicuously failed to do:  they asked probing questions about the company’s business strategy.  Incredibly, one finding of maladministration is that regulators failed to dissuade Standard and Poors from offering a  favourable assessment of the business up to the moment of its collapse.  The Board was dominated by a powerful chief executive.  The pattern of supine board and craven rating agency taken unawares by business failure is one we are getting used to.

While Government Actuary’s Department and the regulators failed to do – and this is the main basis of the findings of maladministration – was to pursue their concerns when faced with a robust response from that powerful chief executive.  The Financial Services Authority finally became more assertive in 1998.  The Ombudsman reports that the agency was then threatened with judicial review and an appeal to Ministers.  Regulators know that this is now a routine response to any attempt to impose significant restraint in business activities.  We do not know what would have come of such action since the events that led to the closure of the business followed soon after.  

The regulatory agencies are judged to have failed in their duty of prudential supervision.  The ombudsman interprets this duty as requiring that the regulator must not only assess the company’s business strategy but insist that the strategy should be modified if it seems unsound or risky.  That interpretation is probably right.  But the implications are far reaching.

The ombudsman further suggests that if regulation fails in its duty of prudential supervision, the taxpayer has an obligation to compensate.   At Equitable Life, a mutual company, the shareholders and customers were the same people.  In the more typical case, both groups would presumably have a potential claim on the public purse.   If there was a failure of prudential supervision at Equitable Life, was there not also a failure of prudential supervision at RBS and HBOS?  How far do the liabilities of taxpayers extend?

We seek regulators who are not just more competent than their private sector counterparts – non executive directors and rating agencies – but are robust to abuse, resistant to political pressure, undaunted by threats of judicial review.  We are asking them to review not just procedure, but business strategy, in the companies over which they exercise prudential supervision.  All this in a context in which they are ultimately accountable to Ministers and Parliament for their continuing behaviour and their inevitable failures.  We are expecting the taxpayer to take financial responsibility for these failures.

There is a name for that policy. It is nationalisation.