The waterbed effect

The Waterbed effect is a phenomenon that should increasingly cause concern to those who regulate the industry and those it regulates in regard to pricing and the detriment the post RDR world has wrought upon the intended beneficiary- the consumer.

The Waterbed effect is the natural but not necessarily intended potential to squeeze one part of a complicated and complex regulated business model (and the attendant regulatory processes) to cause a serious bulge elsewhere in the process.

As an owner in the 70’s of a waterbed (with the attendant fond memories) the metaphor of the water-filled mattress seems to be a common sense albeit simplistic description supported by a little known mathematical formula called Bode’s Sensitivity Integral.

The Waterbed effect is already well illustrated in the mobile phone and utilities industries where regulation and political interference fixes or manipulates the prices of basic products and services only for consumers to see complicated pricing structures ensue by way of significant increases in the price of peripherals and additional services as a direct consequence.

So, the Waterbed effect theory in RDR dictates that in achieving:

  • the elimination of bias in the market
  • ensuring the adviser is the true agent of the consumer
  • clarity over the costs of advice
  • and various other factors,

We will no doubt see the bulge appear somewhere else.

And this will be seen in costs in every conceivable way and particularly for consumers. Cost is something that the FCA incurs for firms, often with little thought of logic or affordability and with little benefit analysis being done on the consumer impact and detriment it created. And none is being considered politically at least until 2015.

So how else will the Water Bed effect manifest itself?

In ensuring the adviser is the true agent of the consumer, the result is that the mass-market consumer will not, does not want to pay for advice that has previously been seen as free. Why do you think the banks bailed out of the crashing plane, much to the annoyance of Martin Wheatley, who felt they had 5 years to prepare?

For clarity over the costs of advice, sadly that clarity will be that for the mass market, cost equals no advice sought if they have to be seen to pay for it, even indirectly by way of fund deduction.

Consider an investment in an ISA. The fee costs of advising could be a couple of hours work. The average hourly rate is around £150 based on our recent research. This could equate to say £300. I suspect that in the current market this cost, together with other management costs would mean no client return of any significance in year one. Similar to the days of commission in both amount and effect, you really could not make this up if you tried?

So clarity is achieved, but as for savings to the client or the cost impact to the client by way of fee rather than commission, what is the outcome?  Also consider this example of the Waterbed effect.

When a consumer is able to obtain lower prices from an adviser, is it possible that other consumers will have to pay more for the same input from another adviser firm as a result? Is this bad for consumers?

The asymmetric exercise of consumer power can lead to consumer detriment through raising other consumers’ advice charges- the Waterbed effect.

While a large and powerful firm or distribution channel improves its own terms of advice supply by exercising its market power in getting cost reductions, the terms of its lesser resourced competitors can deteriorate sufficiently so as ultimately to increase the average price of advice – the Waterbed effect.

Even the recent FCA paper on inducements will have little effect now for smaller firms, but it will later on networks- in extreme cases the reduction of cash flow resulting in network failure- the Waterbed effect.

Such consumer detriment is more likely very soon if adversely affected firms are already sufficiently squeezed, due to relatively higher regulatory and other operating costs and a lower market share. They will close leaving orphan clients – the Waterbed effect..

So while we lay in our Waterbed, what should we wear to prevent a bulge getting the better of us?

Chanel No. 5, of course was Marilyn Monroe’s choice, what is yours?

Wheatley is pleading the ‘Fifth’

In the constitution of the United States when a suspect invokes his or her Fifth Amendment right to remain silent, this is referred to in the vernacular as “pleading the Fifth.” It should not by any means be taken as a sign of guilt, but it is generally portrayed as such in the movies when some criminal act is trying to be covered up in the hope it goes away.

The FCA consultation paper CP13/14 states that “We are funded entirely by the fees and levies recovered from the firms we regulate – we receive no subsidies from other sources”.

Perfectly clear then. But there should be an expectancy that firms are charged correctly, reasonably and above all fairly.

Buried in CP13/14 section 3.6, on page 21 of a very tediously worded document we find this:

“At the same time, it creates an opportunity to remove an anomaly in the outcome of our fees

calculations for fee-blocks A12 and A13.

Fee-block A12: We are recovering £44.5m of costs from only 1,899 firms. Their total

income is £19.1bn, giving a fee-rate of £2.39 per £1,000 and an average fee per firm of


Fee-block A13: We are recovering £39.2m from 6,768 firms. Because the firms are on

average smaller, their total income is only £6.1bn and the average fee per firm just £6,210 but the fee-rate is higher than in A12, at £6.89 per £1,000. 

The A13 fee rate is nearly three times higher for firms that carry a lower risk.

I was reminded of this great quote from Al Capone “When I sell liquor, it’s called bootlegging; when my patrons serve it on Lake Shore Drive, it’s called hospitality”.

Now we know why APFA quite rightly asked that firms should be compensated for what in effect is an overpayment for many years and not as the FCA would suggest an “anomaly”.

So in the world of financial services regulation, Martin Wheatley appears to have just “plead the fifth” in saying that “We work out our fee blocks every year, and the fact there may have been a mistake in one of the fees is quite different to saying there was an overpayment and a need for an adjustment the following year”.

As I understand it, Mr. Wheatley places great store in regulated firms and individuals asking themselves if their actions are morally correct.

This is a question to now ask of himself and the staff who created this £118m “anomaly” I would suggest.

Wheatley says “We have to collect our fees and we end up with zero at the end of the year, it is not as if we have a lot of reserve funds.”

Try telling that to the regulator when you cannot pay the fees and I suspect we know the answer.

Why are there not lots of reserve funds?

Simples: because they take money from regulated firms then find a way to spend it as quickly as possible, not conserve it or ensure value, then ask you for more.

I am deeply disturbed that such a very large amount can be dismissed as an “anomaly”. I think APFA may have to consider some drastic actions to counter this if these assumptions are correct.

If this was a bank or insurance company overcharging it’s customers and they tried the “anomaly defence” I am sure the fines would be raining down thick and fast.

Should advisers withhold fees if they can demonstrate an overcharge?

Should APFA support such action?

And should the TSC be asking why no refunds are forthcoming, especially when the victims are mostly small businesses who do not have lots of reserve funds as they have paid more than they should to an inept regulator over a number of years?

Al Capone reckoned that Capitalism is the legitimate racket of the ruling class”. I wonder what his view on financial services regulation would be?