Equitable Life’s lessons for the bank crisis

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We seek regulators more competent than their private sector counterparts, we ask them to review not just procedure but also strategy, we expect the taxpayer to take financial responsibility for their failures. There is a name for that policy. It is nationalisation.

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

Equitable Life was a medium-sized mutual British life assurer 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 assurance and pensions markets.

The strategy was vulnerable to adverse shocks. The society reasoned that since the contractual obligation to policyholders was much less than their planned pay-out, 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 policyholders’ expectations and goodwill evaporated. Attempts to sell the business failed and benefits were 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. Ann Abraham concludes that the supervisors of the business were guilty of maladministration and says 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 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 & Poor’s 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.

What the Government Actuary’s Department and the regulators failed to do 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 restraint in business activities. 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 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 claim on the public purse. If there was a failure of prudential supervision at Equitable Life, was there not also such a failure at Royal Bank of Scotland 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 in the face of abuse, resistant to political pressure, undaunted by threats of judicial review. We ask them to review not just procedure but also strategy in the companies over which they exercise prudential supervision. All this in a context in which they are accountable to ministers and parliament for their behaviour and their failures. We expect the taxpayer to take financial responsibility for these failures. There is a name for that policy. It is nationalisation.

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