Tony Drury: Has George Osborne shot himself in the foot?

In the last week there have come together three apparently unrelated issues which have produced a remarkable consequence: they are
a) Moral Hazard
b) The Financial Services Bill
c) The SEED EIS implementation
The first of these concerns what the economist Paul Krugman said was “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” The term ‘moral hazard’ dates back to the 17th century and originated from the insurance industry. Put simply it suggests that if you protect people too much it may encourage reckless behaviour.

In recent times it was thrown into confusion by the decision by the American Federal Reserve on 14 September 2008 to allow Lehman Brothers, the investment bank, to collapse. There was a sense that this was partly to act as a warning that ‘moral hazard’ had gone too far: in crude terms to teach the market a lesson. It seriously backfired because at that point nobody had really understood counterparty risk. A domino effect of financial consequences was created and the global recession was underway.

When George Osborne became Chancellor of the Exchequer following the formation of the Coalition Government in 2010 he instigated a wholesale review of financial regulation. He and the Prime Minister blamed Gordon Brown, the Labour Party as a whole, the Banks, greedy investment bankers, Fred Goodwin and many others for the recession. They were both seriously influenced by the Governor of the Bank of England who told them that the UK financial system was near to collapse.

As a consequence a wholesale restructuring of the system of financial regulation, which is costing billions of pounds, is taking place. Central to this is the setting up of a Financial Policy Committee (FPC) within the Bank of England as a macro-prudential authority. It directs the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). There are huge tensions between the Governor and Andrew Tyrie, Chairman of the Treasury Select Committee over the issue of accountability.

The Financial Services Authority (FSA) is being absorbed into this new structure. It is also carrying out a draconian reform of investor protection. Stockbrokers aged 60 with decades of responsible service are being forced to attend week long training courses. Compliance Officers are Gods. The small-cap community has been torn apart.

Last Autumn in the 2011 Autumn Statement the Chancellor announced an exciting and innovative scheme to help smaller companies raise equity finance. The SEED Enterprise Investment Scheme (SEED/EIS) allows companies less than two years old and with gross assets of less than £200,000 to raise up to £150,000 once only in equity capital. Investors (no more than £100,000 per individual) receive mouth watering fiscal benefits: 50% income tax relief, up to 28% capital gains tax allowance (in the first year only), free dividends and tax – free share gains (if these happen).

The process has been tortuous: it has taken months for the extensive regulations to finally be enacted in the Finance Bill 2012. The scheme is now alive and across the United Kingdom thousands of small and medium enterprising business, rejected by the banks, and needing early stage capital, are looking forward to the implementation of this innovative scheme. Well done the Chancellor.

There is just one problem. It is not going to happen. Why – Moral Hazard? –this time “no”. The irony is that on this occasion it needs some moral hazard.

The outcome that no-one anticipated is that Compliance Officers are saying to their brokers that they can’t offer these deals to their clients because they are too risky.

An Independent Financial Adviser said to me “I can’t offer these transactions to my customers because by definition they fail the FSA definition of acceptable risk.”

There are some of us working in the City who believe that regulation is widely out of control and affecting the recovery of the country from recession. If you shut the M25 there will be no more road accidents.

The debacle now affecting the SEED/EIS scheme demonstrates that the balance between realistic and responsible regulation and economic reality has been lost.

I wonder who the Chancellor will blame for this situation?