Outlook: Three challenges for McCarthy as he picks up FSA mantle

Callum McCarthy is not the most obvious choice as the next chairman of the Financial Services Authority, if only because he wasn't widely seen as available. He's long made clear he'd be hanging up his boots as soon as his present term of office as head of the energy industry regulator, Ofgem, came to a close.

But even if he was second or third choice – it's got all the hallmarks of a rushed job – he also seems to be a good one, combining as he does a long career in the City with direct experience as a regulator. He's been both poacher and gamekeeper, a double act which might seem ideally to suit him to the FSA, where he must be mindful of the dangers of too much regulation as well as too little.

Mr McCarthy's main work while at Ofgem, the introduction of the New Electricity Trading Arrangements, has proved controversial, driving down wholesale prices to the benefit of consumers and industry, but arguably undermining the commercial viability of Britain's nuclear power industry and perhaps storing up a shortage of capacity for the future. None the less, it was what the Government wanted, and it has certainly resulted in some dramatically lower electricity prices.

There are three big challenges he faces when he gets to the FSA. One is to roll back on the ever increasing weight and cost of compliance with financial regulation. Most financial services companies still think on balance that the creation of the FSA was "a good thing", but there is growing concern, particularly among smaller firms, about its cost, and its effect on international competitiveness.

A second challenge is the life assurance sector, where the effect of the three-year long bear market in equities is most keenly felt by ordinary people through their pension and endowment policies. The life sector is a classic example of what Sir Howard Davies, the present chairman of the Financial Services Authority, called in a speech to the Securities Institute yesterday "the sledgehammer" approach to regulation.

In the last great bear market of the mid-1970s, many insurance companies became insolvent, in the sense that their liabilities began far to outweigh their assets. There were no rules to prevent this from happening, so in the aftermath new solvency requirements were introduced which have remained in place ever since.

During the present bear market, these rules have acted in a perverse way, forcing life assurers to sell equities to preserve capital and thereby ensure that liabilities are matched with "safe" assets such as bonds and cash. In so doing, the rules have poleaxed the main purpose of life assurance as a low risk, "smoothed" investment product with exposure to the upside of equities. They have also helped exaggerate the bear market.

Having been forced largely to sell out of equities to preserve capital, the rules make it hard to impossible to know when and how life assurers can buy back in again. Many life companies have closed to new business altogether, while others have had their investment flexibility almost wholly removed. The rules have condemned policyholders to years of poor returns. In his speech yesterday, Sir Howard referred to there being "no market situation so bad that it could not be made a bit worse by an ill-targeted regulatory intervention".

The context was different, but he might just as well have been talking about life assurance. Policyholders were better off during the bear market of the mid-1970s, when regulators turned a blind eye to insolvency of the life sector, than they are now with the solvency rules in place. The FSA is working on a root and branch reform of these rules, but it may be too late.

It's rather the problem with regulation, isn't it? Invariably it seems to trail events. Stable doors are slammed long after the horse has bolted, in a manner that often does as much harm as good. In his speech yesterday, Sir Howard referred to "The Bubble Act of 1727", a legislative overreaction to the South Sea Bubble which held back the development of joint stock companies for 100 years or more.

Pre-emptive action might seem equally bad. It takes enormous arrogance to think you know better than markets how events are unfolding and should be moulded, and Sir Howard was surely right in his speech yesterday to suggest that any attempt to institutionalise investor caution towards equity markets "could well be a cure worse than the disease".

None the less, I think there are some areas where the FSA should be more on the front foot than it is, particularly with regard to mis-selling. Regulators have managed to miss until after the event virtually every mis-selling scandal of the last twenty years, including most recently split capital investment trusts. With the boom in house prices and the growing plethora of equity drawdown products now emerging, there's probably another in the making right now. So here's Mr McCarthy's third challenge; a little more foresight.

Apocalyptic Sony

Of the music majors, Sony has consistently been the most apocalyptic in its view of what the internet and other forms of piracy might do to its long term future. Nobuyuki Idei, Sony's chairman, has said on a number of occasions that unless the industry can find ways of persuading people to pay for music downloads, then it is dead within 10 years.

As it is, the company seems to be planning for the worst. Andrew Lack, head of Sony Music, has admitted that layoffs of 1,000 staff announced at the weekend are on the premise that global music sales will fall a further 13-15 per cent this year. That's much worse than others think likely, and even Sony says it is worst case. None the less, after a fall of nearly 10 per cent last year, this would be an industry in meltdown if the continued fall came even close.

Sony has long found itself in a faintly invidious position in arguing the case against piracy, as alone among the music majors it also produces the hardware that makes it possible. From the Walkman to the video recorder and the CD, and now the CD burner, Sony has always been at the forefront of piracy technology. With each wave of new technology, the industry throws its hands in the air and says it's lethal unless stopped.

In fact it has usually proved a boon, the most startling example being the CD, which far from resulting in the death of the music industry persuaded millions to replace their old vinyl collections with expensively priced CDs.

For Sony, then, the conflict between hardware and software is nothing new. If the internet is good for the consumer, then it ought to be good for the music industry too. The internet is already working to Sony's benefit in the games market, witness the success of EverQuest, a never ending online adventure game for which Sony manages to charge. Only it isn't working out that way for music, which is seeing legal sales of CDs steadily eroded through physical and online piracy.

I suspect that Sony is right to be preparing for the worst. CDs worked for the industry because they allowed the music majors to remain largely in control of distribution. With the internet, which with the growth of broadband is eventually likely to become the preferred form of distribution for consumers, that's not true. Regardless of the illegality of piracy, the industry finds itself being rapidly disintermediated. In such circumstances, the sort of prices and cost base the music majors have historically sustained get progressively undermined.

There's plenty the music majors can do to improve their lot. Embracing the internet, rather than constantly complaining about it, would make a good start. That way music companies might eventually figure out a way of making it pay. But there's no getting away from the bottom line. The industry must just get used to the idea of being a lot less profitable and profligate than it was. That's obviously bad news for shareholders and the globally marketed superstars. I'm not convinced its bad news for the great bulk of artists, for whom the internet is a liberating force, and it is certainly not bad news for the consumer.

jeremy.warner@independent.co.uk