UK: Financial Services And Markets Group Bulletin - Volatility Dampens Outlook

Last Updated: 5 March 2008
Article by Neil Fung-on

According to our annual Financial Services Survey, City firms are uncertain about the future for the first time in five years. They believe the tax system inhibits business, and they are struggling to keep up with regulatory change.

MARKET VOLATILITY, TAX AND REGULATION

Our 2007 annual survey reports on the views of the City's FSA-regulated businesses.

Our tenth annual survey of FSA-regulated businesses in the City of London took place in November and December 2007. We surveyed 71 senior individuals from a variety of backgrounds, including banking, investment management, corporate finance and brokering.

Unsurprisingly, given the wide-reaching effects of the credit crunch, some of the results contradict what we reported this time last year.

Concern for the future

Research among the City's investment management houses and other FSAregulated businesses reveals that confidence has fallen since last year. Although 27% 'strongly agree' that turnover for 2007 will be better than the previous year, this is sharply down on the figures for 2006 when over half (52%) of respondents 'strongly agreed' that turnover for the year would exceed that of 2005 (Figure 1).

"The autumn of 2007 marks a turning point in confidence among the City's financial services sector. Optimism has been growing in recent years, but the credit crunch has put an end to this upward trend and the outlook now seems fairly uncertain, with only 55% of respondents confident about the next 12 months," said Neil Fung-On, head of the Financial Services and Markets group at Smith & Williamson.

Fig 1: Our business will achieve higher turnover in the current financial year than the previous financial year

The research also shows that while a resounding 90% of respondents believe London has strengthened its position as a key financial centre over the last five years, there is concern for the future, primarily surrounding macroeconomic issues.

"Market volatility ranks as the area of greatest concern, both in terms of how it might affect respondents' own firms and the financial services sector as a whole. The strength of the global economy and that of the UK were considered the second and third most important issues respectively, while fears of an economic recession came fourth," continues Neil.

"London's position remains strong – at least for the time being – but if these issues deepen, the worldwide financial services industry could feel the chill of a downturn. And, of course, London is unlikely to be immune to such difficulties.

"Other issues of importance for individual firms are managing the strategic direction of the business and the retention of key individuals, while dealing with the volume of new regulation is a concern for the sector as a whole," said Neil.

Tax has a growing influence

Our survey reveals that tax is playing a significant and increasing role in firms' business decisions. Indeed, eight out of ten (82%) participants believe the current tax system acts as a disincentive to undertake certain business decisions. This is in contrast to last year, when less than six out of ten (56%) respondents felt this way.

Fig 2: Tax system acts as a disincentive

The research reveals that over 56% of the participating firms have restructured their business to take advantage of tax efficiencies, whereas in 2006, just 45% did this.

In addition, a third of those who took part in the survey agree that tax was a key factor in deciding whether to expand or maintain operations in the UK, whereas just a quarter felt it was a key factor in 2006.

The majority of firms continue to make use of potential tax savings when considering remuneration packages: 59% of firms claim to have done this in 2007; the equivalent figure for 2006 was 55%.

"The danger is that with changes to the tax position of non-domiciled people – many of whom work in the financial services industry and who are extremely mobile – they may now be less inclined to work in the UK.

"This could put a serious question mark against London's continued pre-eminence, as what may be seen as marginal changes to tax legislation can have far-reaching effects. We are already seeing signs of this occurring, with an increasing number of clients exploring the implications of changing the jurisdiction from which they operate.

"These tax changes, taken with worries of an economic downturn, suggest a more uncertain outlook for both the City of London and the broader financial services industry," comments Neil.

Participants slow to comply with new regulations

Although MiFID was introduced on 1 November 2007, at the time of our survey, one in five participating firms claim to be only partly prepared for the new rules. And while a third of respondents have documented or finalised their Internal Capital Adequacy Assessment Process (ICAAP), at the time of the survey almost half (46%) were still in the research stages. However, most firms (53%) do not anticipate having to increase their financial resources as a result of their ICAAP.

Fig 3: Stage in ICAAP process (survey undertaken November/December 2007)

"Many firms, particularly smaller businesses, have been struggling to keep up with the volume of regulatory change. Not only do they have to shoulder the cost of implementation, many appear to see little or no benefit in the short term from these changes. As a result, many businesses have been leaving preparations until the very last minute," observes Neil.

ENCOURAGING MARKET DISCIPLINE - PILLAR 3

Pillar 3, which requires firms to provide key data on risks, capital and related management procedures, came into effect on 1 January 2008.

In accordance with Pillar 3, financial institutions within the scope of Basel II are required to disclose information about their risk exposures and the risk assessment processes. This final pillar came into effect on 1 January 2008.

Pillar 3's purpose is to encourage market discipline by providing the market with key information on an entity's risks, capital and related management procedures. It complements the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2).

Certain disclosure requirements of Pillar 3 overlap with those required by FRS 29, 'Financial Instruments: Disclosures', which applies for accounting periods beginning on or after 1 January 2007.

Points to note

The full disclosure requirements are covered in BIPRU chapter 11, Disclosure (Pillar 3). We discuss the main areas here.

Risk

For each category of risk, a firm must disclose its risk management objectives and policies and explain the techniques used to 'identify, measure, monitor and control' these risks.

Capital

A firm must disclose the following regarding its capital resources and capital adequacy.

  • Qualitative information on the terms and conditions of the main features of all its capital instruments, such as share capital and subordinated debt.
  • Information on the various types of regulatory capital it holds, as categorised by those defined within GENPRU (tier 1, tier 2, tier 3). It also needs to quantify this, for example, disclosing the level of share capital plus retained profit and loss reserve.

Nature and extent of risks arising

Pillar 3 requires disclosure to demonstrate compliance with, principally, the following.

  • BIPRU 3 – Credit risk For example, the definition and quantity of a firm's past due and impaired debtors.
  • BIPRU 6 – Operational risk For example, the method applied to calculate the firm's operational risk requirement.
  • BIPRU 7 – Market risk For example, qualitative disclosures, including separate Pillar 1 capital resources requirements for interest rate position risk requirement (PRR), equity PRR and foreign exchange currency PRR.

Furthermore, entities must ensure disclosure covers any additional Pillar 2 risks identified and capital requirements arising as a result of their ICAAPs.

Ensuring compliance

In demonstrating compliance, a firm is required to submit a summary of how it assesses the adequacy of its internal capital and how this supports its current and future activities. However, disclosure does not need to be made in respect of items which management considers are immaterial to the firm or which would 'undermine its competitive position'.

The FSA regards Pillar 3 as a principles-based regime rather than strictly rules based. BIPRU 11.2.8R states disclosure should be made on an annual basis as a minimum, and as soon as information is made available. If appropriate to the business, certain disclosures should be made on a more frequent basis (BIPRU 11.4.4R). For firms with 31 December as their accounting reference date, the FSA expects at least the qualitative disclosures to be made by the end of the first quarter of 2008.

Examples of where Pillar 3 disclosure should be made include a firm's annual statutory accounts, its website or any other publicly available domain.

PRE-BUDGET REPORT ON CGT

The new CGT flat rate will affect investors in varying ways, but small businesses are likely to be the biggest losers this time round.

The Government has now published draft legislation which confirms that from 6 April 2008, a flat rate of 18% will be charged on capital gains tax (CGT). The new system abolishes taper and indexation relief accrued pre-April 1998, potentially leaving many individuals with a far larger CGT charge than under the current system. Other reliefs and the annual exemption will remain available.

The impact on individual investors

There will be some relief for entrepreneurs selling a business and for directors or employees who own more than 5% of a trading company. To qualify, the business or shares will have to be owned for a minimum of one year. Provided the various conditions are met, the first £1m of gains will be taxed at an effective rate of 10%. Any gains over this amount will be charged at 18%. Many investors in unquoted trading companies who currently qualify for maximum taper relief (producing an effective tax rate of 10%) will see their potential tax liabilities increase by 80%.

These individuals may wish to consider triggering their gains before 6 April 2008 to capture a tax liability at the 10% rate. This could be done through an outright sale or by creating a tax disposal without losing control of the assets.

The new system will be beneficial to individuals who hold non-business assets, such as share and fund portfolios or investment property. Depending on the level of taper relief available, currently higher-rate taxpayers pay CGT at an effective rate of between 24-40% on such assets. After 5 April 2008, they will be liable at a reduced tax rate of 18%. These investors should therefore consider holding assets until after 6 April 2008.

Small businesses might lose out

The CGT rules are likely to influence individuals' future investment decisions.

From a CGT perspective, there is now less of a tax benefit for entrepreneurs and investors to invest in a potentially successful business, although the existing inheritance tax reliefs may still be of interest. Entrepreneurs may therefore be deterred and growing businesses may find it harder to attract funding. Investors will also have less tax incentive to hold onto their investments for the long term, so small companies could have less investor stability going forward.

Clearly, investors should base their decisions on investment grounds, but these new CGT rules should be borne in mind as they could affect investment returns considerably.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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