This paper is being written in response to an assignment that has been given by the International Compliance Training for the International Diploma in Governance, Risk and Compliance. It looks at the factors surrounding financial services compliance along the industries lines of legislative, economic, industry driven, political, environmental and possible scandals relating to all of these areas.

The information has been gathered from the British Virgin Islands jurisdiction from sources such as Financial Services Commission, British Virgin Islands Government and internationally, from the International Monetary Fund, the Organization for Economic Co-operation and Development and the text, International Compliance Training Ltd. The research is basically theoretically driven to ascertain if the industry would be better off with regulation or left for participants to operate freely.

Introduction:

Scandals (such as Enron, WorldCom), the September 11 attack and financial crisis of 2007 and 2008 brought attention to loopholes of legislation that market participants have been taking advantage of for years. It was never the intention of regulation to cause market abuse, insider dealings or loss of investments or tangible properties. This paper details the shortcoming of legislation but also highlights how an effective regulatory environment can be achieved. What is Regulation? Regulation is defined according to the International Compliance Training Ltd as a set of binding rules by a public or private body with the necessary authority to supervise compliance and apply sanctions, penalties etc. for non-compliance (International Compliance Training, 2015). All financial services industry operates within a regulatory environment at many different levels. Different countries maintain their own financial services industries, for example in the British Virgin Islands, the Financial Services Commission is an autonomous single regulatory authority that is responsible for the regulation, supervision and inspection of all financial services in and from within the British Virgin Islands. The Financial Services sector especial the company and trust business are the main resources in the British Virgin Island and as it burgeoned to become the largest and most critical component of government revenue and the linchpin of the British Virgin Islands overall economy. However, the landscape began to change in 2007 to 2008 following the global economic recession and as a result political leaders of G20 countries demanded that there be a renewed focus on offshore jurisdiction around the world. This increased international pressure, required more compliance and transparency by licensed service providers hence the British Virgin Islands regulation have to be amended to remain in the core business of company incorporations. In view of (Hon. Dr. D. Orlando Smith, 2014) Premier’s report, which provides a brief synopsis on Building on a Thriving and Sustainable Financial Services sector in the British Virgin Islands. He stated, “The British Virgin Islands over the past 30 years, has established a leading position in the company incorporations. A robust, easy-to-use and adaptable legal and regulatory framework made the British Virgin Islands jurisdiction’s products superior to that of many peers. Company incorporation grew more than five times compared with our peers from 1993 to 2013.” The United Kingdom was similar to the British Virgin Islands with a single regulatory body. In 2013 a new macro-prudential regulator was created as a Division of the Bank of England’s Financial Policy Committee. This new regulator has oversight over the new prudential regulator called the Prudential Regulation Authority. Since the introduction of Prudential Regulation Authority, The Financial Services Authority was renamed the Financial Conduct Authority introducing a ‘Twin peaks’ approach to the United Kingdom. The Conduct Authority is responsible for conduct of business regulations (International Compliance Training, 2015).
It is noted that the financial crisis in 2007 to 2008 demonstrated that the single regulatory body had too broad a remit and insufficient focus to identity and tackle the issues sufficiently early to mitigate the lost occurred due to the financial crisis hence the failure of Financial Services Authority. Ironically, the Financial Services Commission still has a single regulator body that is responsible for the banking, insurance, securities and mutual funds sectors in the British Virgin Islands. So what makes the British Virgin Islands different from the United Kingdom? Lets look at the objectives of legislation that the factors that help shaped the regulatory environment. The objectives of legislation (International Compliance Training, 2015) states the objectives of legislation are as follows:

1. Investor/Consumer Protection - The aim of this objective is to protect the consumer. Many consumers are not adequately equipped to fully understand the complexities of the products and services they purchase and therefore they may be vulnerable to abuse. Hence the purpose of this objective is to help redress the information imbalance that exists between the consumers and the financial services market. In the British Virgin Islands, the Mutual Funds Act 1996 was amended and replaced by the Securities and Investment Business Act, 2010 to include provision such as corporate governance, offence of insider dealings, market abuse regulation to ensure that investors are fairly treated. This amendment stem from the sandals such as LIBOR fixing and flawed mortgage securities (sub-prime mortgages) that highlighted the need for tighter rules on capital adequacy and liquidity.

2. Facilitating Fair, Efficient and Transparent Markets - This objective links investor’s protection with the prevention of activities that can be considered to be improper. The aim of this objective is to ensure the market is not distorted by market participants exploiting privilege information or by those carrying artificial transactions. For example, the false accounting conducted by Arthur Anderson that lead to Enron Corporation (‘Enron”), an energy corporation based in Texas to file bankruptcy. Enron was an American energy, commodities and service company based in US. Prior to its bankruptcy, Enron was one of the world’s major electricity, natural gas, communication and pulp and paper companies. Enron was listed on the New York Stock Exchange so anyone could become potential investors and invest in stocks. Enron is now a well-known example of willful corporate fraud and corruption. The scandals brought into question the accounting practices and activities of many corporations in the United States and was a significant factor in the creation of the Dodd-Frank Act, 2010. The Act addresses issues such as corporate governance, new registration requirements for hedge fund and private equity fund advisers and asset-back securities with new rules for credit rating agencies etc. In the BVI, the Regulatory Code was introduced to act as guidance for corporate governance and ad hoc legislation where existing legislation fell short.

3. Reducing systematic risk - Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system that can be contained therein without harming the entire system. This was seen when the Lehman Brothers, a firm that was in existence since 1850 filed for bankruptcy. This cause financial panic and numerous household names collapse which some say lead to global financial crisis. International bodies took measures to establish a mandate for overseeing the risk in financial system. Such measures included the introduction of the prudential regulation. In the British Virgin Islands, prudential returns are require to be filed bi-annually with the Financial Services Commission to monitor capital adequacy. Although taking risks is essential for an active financial marketplace, the objective of reducing systematic risk is intended to strike a balance between protecting the marketplace from itself, by requiring robust risk-management practices and allowing legitimate risk to be taken. The aim of this objective is not to prevent business risk or failure but to ensure that: a) There is sufficient liquidity for firms to meet their financial obligations;
b) There are appropriate levels of internal controls and monitoring;
c) Professionals have appropriate knowledge, skills and experience to manage the risk 4. Reducing Financial Crimes - The aim of this objective is to reduce the extent to which a firm can be used for financial crime. Regulators have intensified their focus by amending legislation to curtail any loopholes in legislation. For example since September 2001, focus has intensified on non-profit organization as it was the belief that charities were a major contributor to the September, 2001 attack on the World Trade Centre and the US Pentagon. Due to international pressures from organization such as the Financial Action Task Force, International Monetary Fund, the British Virgin Islands introduced a Non-Profit Organization Act, 2012. This Act came into effect January 2013. The Act governs all non-profit organization such as charities, churches, non-profit organization like Red Cross etc. In addition, existing Anti-Money Laundering legislation had to be amended to be in line with the global standard setters such as the International Organization of Securities Commission and the Financial Action Task Force. Therefore in 2008 the Anti-Money Laundering and Terrorist Financing Code of Practice, 2008 and the Anti-Money Laundering Regulation, 2008 were enacted to supplement existing legislation, such as Proceeds of Criminal Conduct Act, 1997 to continue to counter terrorist financing and money laundering. 5. Enhancing Consumer confidence - Consumer confidence is the core objective of regulation within a financial system. For a financial system to operate it must have enough consumers willing and able to participate in it. In other words, they will not be willing to invest if they lack confidence in the System. This lack of confidence was demonstrated with the stock market crash in 1929 and subsequent bank failures which lead to enactment of Glass-Steagall Act, 1933. This Act was enacted to insure customer accounts and prohibits any one bank from accepting deposits and underwriting securities, and ensures that deposits would not be lost. The enactment of this legislation is a part of effective regulation of the conduct of business by participants within the marketplace. However, the Clinton administration repealed the Glass Steagall Act in the late 1990s. It is believed that the repealed contributed to financial crisis in 2007 and 2008 and it threatened the collapse of large financial institutions and affected stock markets globally. The liquidity crisis is believed to start when an international bank, BNP Paribas terminated withdrawal from three hedge funds citing ‘a complete evaporation of liquidity’. This had a triggered effect globally and a number of countries experienced recession including Greece which has not yet recovered.

The aftermath of the financial crisis and scandals such as LIBOR fixing, false accounting etc., empowered international organizations such as the International Monetary Fund, the Financial Action Task Force, the International Organization of Securities Commission, the Basel Committee on Banking Supervision etc. to increase their supervision on monitoring of its members and associates to raise public perception of regulation. Hence, in 2004 and then again in 2010, the International Monetary Fund assessed the British Virgin financial sector regulation and supervision against the Basel Core Principles for effective banking supervision, the International Organization of Securities Commission, the International Association of Insurance Supervisor and Financial Action Task Force to determine if the objectives of regulation were met. The assessment reveals that the BVI legislation was lacking in certain areas such as prudential legislation, need to increase on-site inspection that are more detailed and specific, need to increase administrative penalties as part of the regulator’s enforcement action, the requirement for all Company and Trust Services Providers to have professional indemnity insurance, immobilization of bearer shares etc. (International Monetary Fund, 2010). As a result of the assessment, various amendments were made to legislation including the consolidation of the two companies Act, the International Business Companies Act and the Cap. 285 Companies Act now known as the BVI Business Companies Act which included such amendments as the immobilization of bearer shares etc.; the amendment to the Anti-Money Laundering and Terrorist Financing Code of Practice which included significant increases in Government imposed penalties for non-compliant with BVI legislation. The consequences of not meeting regulation objectives are usually reputational damage (for example being listed on an international organization’s list for ‘non-compliance) and administrative penalties etc. There are significant amount of resources spent on establishing rules to govern regulation. These rules established have to be supervised, monitored and enforced. The supervision of regulatory rules ensure, for example that financial firms have provision in place that are adequate to: a) corporate governance and internal control systems, b) prudential rules and c) conduct of business rules which are essential to mitigate another financial crisis. However, having a highly regulatory environment that meets the entire regulatory objective is great but there should be adequate communication between regulators and firms that are regulated. For example if there are proposed changes to legislation, there should be consultation with the industry to attain their feedback prior to implementation of proposed changes. In attaining the industry feedback, human resources and some financial resources will be spent in having meetings to discuss the proposed changes but the regulated firms will be more receptive to the changes as they were instrumental the changes. Education is vital to any system. If resources are spent in educating the market and building consumer confidence then the market will be more receptive to changes, more aware of what is expected of them such as filing requirements, penalties etc. and therefore, the regulator will be assisted in meeting statutory or operational objectives. For example, when the Non-Profit Organization Act, 2012 was introduced within the British Virgin Islands, it affected churches, charities, associations and other non-profit organization. The individuals who have the day-to-day role of managing these entities did not have the same skill set as a person working in the financial services sector. Hence, the need to educate on the purpose of the legislation, key features of the legislation and the filing requirements etc., had arisen. The Financial Investigation Agency and various other government departments held workshops and question and answer segments so that consumers will be more comfortable with the legislation and its requirements. The regulation on non-profit organization globally is being amended to ensure that non-profit organization are not used to launder money or terrorist activities. We have seen the impact of non-regulation or little regulation with the September 11 tragedy. It is believed that charities paid the tuition of the individuals that flew the planes to attend aviation school. Paying tuition would be considered a normal activity as various other organization either grant partial scholarship or full scholarship to ‘qualified persons’ to pursue higher education so these actions were not suspicious. Terrorism activities cannot be detected unless regulation is in place to supervise source of funds both incoming and outgoing, the nature of business activities, the persons who managed the charities etc. In response to the September 11 attack, the Financial Action Task Force expanded its mandate to include measures to combat terrorist financing by issuing eight special recommendations. If there was no regulation, then there will be a free market. A free market as defined by (Investopedia.com, 2015) as an idealized form of a market economy where buyers and sellers are allowed to transact freely (i.e. buy/sell/trade) based on a mutual agreement on price without state intervention in the form of taxes, subsidies or regulation.
A free market contrasts with a regulated market, in which government intervenes in supply and demand through non-market methods such as laws creating barrier to market entry or price fixing. In a free market, individuals and firms have the liberty to enter, leave and participate in the market as they so choose. Prices and quantities are allowed to adjust according to economic conditions in order to reach equilibrium and properly allocate resources. In many countries around the world, government seeks to intervene in the free market in order to achieve certain social and political agendas. However, Government intervention in the free market can hamper economic growth, entrepreneurship and a healthy economy by disrupting the natural allocation of resources according to supply and demand. For example, during the revolution in Cuba, most of the privately-held properties were confiscated and the country became a state-controlled system. After a period of time, the black-market assume a prominent role in the economy. Workers within state-run factories stole goods to use in their homes or sell on the street. As a result, the Cuba government was forced to make some drastic changes in policy to encourage small business and joint ventures with foreign investors (Anon., 2011). The country is now experiencing economic growth in areas like tourism since the lifting of the US embargo. It can be assumed that if a free market should exists within the financial services sector, there may be an increase in financial crimes such as money laundering, fraud, bribery and corruption which can lead to market abuse and potential investors’ would not have any confidence in the market.

The financial crisis of 2007 to 2008 occurred in a regulated market that caused a global melt down worldwide and every country experienced some form of recession. For example, the housing market in the US suffered resulting in evictions, foreclosures and prolonged unemployment. The financial crisis was triggered by a complex interplay of policies that encourage home ownership, providing easier access to loans, overvaluation of bundled subprime mortgages based on the theory that housing prices would continue to escalate. Questions regarding bank solvency, declines in credit availability and damaged investor confidence had an impact globally (Max, 2004). The British Virgin Islands felt the impact of the global financial crisis as potential investors had reservations in establishing new BVI Companies. This affected the economy significantly as, income from ‘Financial Services’ decline significantly causing the economy to incur additional debts. According to the (International Compliance Training, 2015), it is the belief that financial crisis was the result of high risk, complex financial products, undisclosed conflict of interest, the failure in financial regulation and supervision, failures of corporate governance and risk management, risky investments and lack of transparency by financial institutions, a systemic breakdown in accountability and ethics etc.

However, a regulated market that is transparent can curtail market abuse and mitigate a repeat of 2007 to 2008 financial crisis. This can be achieved if regulators adopt a risk base approach to regulation. In so doing, regulators will ensure that they maintain a close relationship with firms, including their directors and senior management, who have the primary responsibilities for meeting prudential and compliance responsibilities, monitor and engage in periodic risk assessments of firms and to initiates thematic reviews via onsite inspections to ascertain the risk rating of the firms.

Regulation of financial services is constantly evolving to deal with emerging risks that threaten to undermine the core objectives of regulation. It is therefore up to the regulator to decide on the intensity of their supervision of firms. For example ‘desk-based supervision’ or ‘onsite inspections’.

Conclusion

Regulation of financial services is constantly evolving to deal with emerging risks that threaten to undermine the core objective. It is the intention of regulation to protect investors’ interest and to provide an environment where investors can operate in a fair, efficient and transparent market that mitigate risk that ultimately to ensure consumer confidence.

The five objectives of regulation are closely related and in some respects, they overlap. Thus effectively achieving one objective is likely to support the achievement of the others. Regulators on the other hand received many benefits when firms have clear sight of regulatory assurance such as assisting the regulator in meeting statutory or operational objectives such as consumer protection, market integrity, confidence in the market or building relationship of trust between firms and the regulator.

However, regulators cannot operate in a vacuum, it needs the assistance of firms to mitigate risk of financial crimes, liquidity issues, transparency to encourage a viable economy. In so doing, a firm will have better management of regulatory and compliance risk to lessen the likelihood of regulatory breaches and government imposed fines. Firms can also gained competitive advantage by increased levels of trust from consumers that can lead to more efficient exploitation of business opportunities such as new products and services.

References
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Hon. Dr. D. Orlando Smith, O., 2014. s.l.: s.n.
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International Monetary Fund, 2010. s.l.: s.n.
Investopedia.com, 2015. www.investopedia.com. [Online]
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Max, S., 2004. cnn.com. [Online]
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