Cicero Policy Briefer

Issue 15, August 2007

Retail financial services: can the EU deliver integration?

By Mark Twigg

After almost a decade of major EU regulatory reform across all aspects of the financial services market, common consensus suggests it is now time to examine how the Single Market serves the interests of retail consumers. The EU’s consumers enjoy ever-increasing affluence, they are also part of a more highly educated and mobile workforce. Demand for financial services—banking, electronic payments, mortgages, savings and insurance—is all set to grow and as people become more mobile, they will demand more flexible and more portable financial products. Yet the way we regulate retail financial markets has failed to keep up. With July came the deadline for submissions into the European Commission's green paper on retail financial services. As that deadline passed, there now begins a period of contemplation, aided by the EU Commission’s forthcoming Open Hearing in September. Now is the time to decide what next steps are necessary. Inaction will not be an option.

While many firms doubt the consumer's interest in ever wanting to buy financial products cross-border, the evidence suggests otherwise. As fund providers seek to benefit from the freedoms of the Single Market, an increasing number of UCITS funds marketed in the UK are now registered in fund centres elsewhere in the EU such as Luxembourg or Dublin. The development of new distribution channels, such as fund supermarkets, should over time encourage more distance selling on a cross-border basis. But measuring the success of the single market is not all about selling products cross-border. Single market legislation in retail financial markets can contribute to integration in other ways. For example, the EU’s role in developing standardised product features on motor insurance, such as foreign use extensions, designed to aid the free movement of people, has helped EU citizens to become more mobile.

Crucially, the Green Paper asks what obstacles consumers face in accessing cross-border products. The nature of the obstacles will differ depending on the nature of different home markets, the needs of the consumer and the complexity of the product. For more complex long-term savings and investments, poor access to financial advice must be fairly high up the list of concerns. Even with improvements in the levels of financial capability, consumers will continue to require support, guidance and advice on long-term planning—especially given the inherent complexity of tax and social security systems (particularly in the UK, with its means-tested state benefits and tax credits). If consumers don’t have access to financial advice about products available across the EU, they simply won’t contemplate buying them. In the absence of financial advice, many consumers choose products on the basis of brand alone. Here again, the absence of trusted cross-border retail brands is perhaps another reason why consumers’ comfort zone remains orientated to local markets. And then there are the really intractable obstacles, not least in the area of pensions. While the Commission is to be commended for its attempts to promote the cross-border portability of pension products, the divergence in social security, fiscal and labour laws makes a mockery of such worthy intentions. The introduction of a 28th regime for a simple retirement product would probably receive a very cool response from pension providers—note the failed attempt to create a standardised, simple, low-cost ‘Stakeholder Pension’ in the UK.

Of course, we have to ask what kind of single market it is realistic to aspire to given where we are starting from. For example, the British tradition of saving into a pension is likely to be sustained, if for no other reason than the general lack of consumer confidence in the state pension to provide a decent income in retirement. Cicero research shows that only 17 per cent of Britons believe the State will provide over 75 per cent of their income in retirement, reflecting the fact that the UK has one of the least generous State pension systems in Europe, providing a replacement income in retirement of less than 40 per cent of National Average Earnings (NAE). This compares with replacement ratios of over two-thirds in many of the EU 15. Our research showed that in Spain the percentage of consumers who expect the State to provide over 75 per cent of their retirement income jumped to 64 per cent, while in France the figure stands at 41 per cent, still much higher than in the UK. Unsurprisingly, French savers choose to invest in more flexible savings vehicles, such as the highly popular Société d'Investissement à Capital Variable (SICAV). Clearly, such structural differences in pensions systems will continue to inform consumer attitudes and behaviour for the foreseeable future, which will in turn impact on the extent to which consumers choose retirement products at all, let alone whether they choose to access them on a cross-border basis.

The introduction of the euro—perhaps the greatest catalyst for the integration of financial markets—has been adopted by only 11 of the 27 Member States. Psychologically, consumers using (for example) British pounds or Swedish krona will feel less integrated than French, Spanish or German consumers, who are all sharing the same currency. It is difficult to see how or why those consumers in the UK or Sweden would find it worthwhile to purchase financial products in Germany or France, when as consumers living outside the Eurozone they will continue to deal with practical obstacles such as higher (often unjustifiable) transaction costs and less price transparency for the foreseeable future. Indeed, with the introduction of SEPA, bringing in harmonised electronic payment systems for euros only, the uneven development of the retail Single Market will be further extended. While you can't blame the Commission for this state of affairs, it is nonetheless an important consideration in shaping the future retail market.

One final point about the green paper: while it is fairly comprehensive, there are some important omissions. Regulation in the UK has, in recent years, paid increasing attention to the diversity of the consumer market, particularly in the area of faith-based products such as Alternatively Secured Pensions (introduced in 2006) or Shari’a compliant mortgages. Speaking at the recent FSA annual public meeting, Callum McCarthy highlighted that developing Shari’a products formed an important part of promoting the financial inclusion agenda. This is already an issue for the whole of Europe, with a population of over 15 million Muslims—a figure which will increase to over 80 million with the planned accession of Turkey. Yet, the issue of Islamic finance is not addressed at all within the green paper.

The Commission also needs to think about what the better regulation agenda will mean in practice. It is far easier to talk about the principles of ‘risk-based’ or ‘proportionate’ regulation than it is to put those principles into practice. In the case of investment funds there is the potential for over-regulation in which UCITS rules determine the product features, while MiFID rules determine the sales process. Any risk-based approach should not require regulation of both the product and the sale, yet the reviews of the ISD and UCITS directives have not addressed this issue.

Another area where more detail would be appreciated in the coming months is how further improvements in the institutional arrangements and policy making processes can play an important, indeed central, role in improving the impact of regulation on the market place. Hitherto, the EU Commission has served Europe’s financial markets poorly as a result of its failure to test the regulatory impact of its proposals.

Even now a lot of uncertainty surrounds major legislative undertakings such as the introduction of MiFID in November. The Lamfallusy process, which contains a lot of positives, does not work as it was intended to. A general observation would be that user groups—the consumers—are often poorly represented. Specific problems are demonstrated by the recent call to evidence by CESR on the effectiveness of the Level 3 implementation of the Prospectus Directive (PD), which revealed widespread concerns amongst market participants about unnecessary regulatory barriers arising from the failure by national regulators to properly harmonise their approach to national transposition. Too many divergent national rules effectively undermine firms’ attempts to benefit from passporting arrangements. Any firm looking to passport its operations across EU borders soon realise that the Internal Market still has some way to go. Similar longstanding concerns with the UCITS passport have been identified, and thankfully are being addressed; but the conclusion as the PD and many other aspects of the FSAP comes up for review in 2008 must be that there are still plenty of lessons for the policy makers to learn.

Mark Twigg can be contacted on +44 (0)20 7665 9537 or click here to email.

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