Howard Davies speech at Lord Mayors City Banquet

"My Lord Mayor, my Lords, Aldermen, Sheriffs, ladies and gentlemen. Could I first, on behalf of all the guests, thank the Lord Mayor for inviting us to this splendid dinner in his humble abode. We are all, I am sure, enormously grateful to you for your hospitality this evening.

Could I also add on my own part, but I am sure this is a sentiment shared by many others, that yours has been an outstanding mayoralty. I am in awe of the efforts you have put in, both in quantity and in quality, to support the City at home and, crucially, overseas. And I know from meeting people you have met abroad that they have been enormously impressed by your depth of knowledge of all aspects of the Citys business.

The Lord Mayor made the point that financial regulation must be appropriate and proportionate, and sensitive to the needs of the markets, as well as focusing on its core role of protecting investors. I share that view. Whether the FSA always meets that high objective is for others to say. We try our best.

But of course a regulator does not exist in isolation. It is affected by the popular and political climate, expressed in the legislation through which it works. And it is only fair to tell you that internationally, in Europe and domestically there are powerful re-regulatory, rather than de-regulatory pressures abroad at present. Indeed I would say that we were at a delicate moment as far as the regulatory system is concerned, and that there is a serious risk of ratcheting up regulation in a way that, in my view, could have damaging consequences in the longer-term.

What do I mean by that?

Well, at a time of falling equity markets and general economic uncertainty, we hear many calls for regulation and compensation. There are those who believe that regulation exists to compensate people for losses, even when those losses are simply attributable to market developments. Let me give you a couple of examples. When I go through my post bag each week, often on a Sunday afternoon, (weekends are thrilling in the Davies household) I am often tempted to award a prize for this weeks worst cause. And last weeks winner was a trader in second-hand endowment policies who was outraged to find that a market value adjuster had been applied to the bonus attaching to one of the policies in his portfolio. What was I going to do to put him back into the position he had hoped to be, was his question?

I have nothing against second-hand endowment salesmen. Well, nothing much anyway. But they are hardly to be counted among the aunt Agathas of the investment world. They are traders like any others, and should be aware that if markets fall there is a reasonable chance that returns on endowments may fall too. And of course life insurance companies have had to cut the payouts on policies in the light of weak equity markets. That is not welcome to anyone, but it is inevitable to ensure the long-term survival of the funds. If we try to compensate for that, we will destroy the business. That way madness lies.

Let me give you a second example. I am quite sure that there are many finance directors and chief executives who believe that their share price has fallen too far, and no longer reflects fair value for their business. That is certainly an arguable proposition in some cases. But some have gone on to look for culprits, and to try to identify conspirators who are manipulating their share price. In the past, these conspirators were often described as the gnomes of Zurich. Today, hedge funds managers have achieved gnome-like status, and are blamed for all manner of ills in the market.

Now I hold no special brief for hedge funds. The inaptly named Long-Term Capital Management caused me and my regulator colleagues around the world no end of grief in 1998. But that was largely because the fund had been helped by its bankers to achieve an inordinate degree of leverage. I continue to worry about leverage in the hedge funds sector, though it has fallen considerably, and indeed about opacity. But short-selling, practiced by them, and indeed other institutions, is a normal activity, which, indeed, has some pluses associated with it in terms of speeding the necessary process of price adjustment.

There are those, notably in Japan and Germany, who want to control short-selling directly. Good luck to them. But a financial centre like London which prides itself on its openness and flexibility should think long and hard before imposing such restrictions. At the FSA we agree that there is scope for more transparency. And indeed there are some interesting issues about the way in which shares which have been lent for short-selling purposes are voted. We are addressing those issues now. Indeed we held a roundtable last week at the FSA to canvass views from a wide range of market participants.

In both of these areas, and I could quote several more, I hope that at the FSA we can hold the line and not be pushed into more restrictive measures. We have some sensible legislation which requires us to balance our objectives and to produce cost-benefit analysis of any regulations we impose. That is a very helpful discipline.

But as you yourself said, Lord Mayor we have to acknowledge that recent events have revealed some problems in the market, and where one has to think hard about the appropriate response. Indeed, looking at Enron, WorlCom, the whole dotcom boom and bust on Wall Street, the revelations emerging from the Elliot Spitzer enquiries, Mr Kozlowskys art purchases etc, etc, it looks as though Wall Street has collectively been putting in a strong bid for more regulation.

It certainly appears that a number of the self-regulatory mechanisms in place in the US have performed very badly indeed, and indeed that normal business ethics were forgotten in the heady days of 1999 and early 2000.

As a result, we have new legislation in the US - the Sarbanes - Oxley Act, which has some consequences over here as well as over there. With their usual generosity of spirit, the Americans have ensured that a number of its provisions apply to overseas companies as well as to their own.

But are there domestic changes which also need to be made, in the light of what we have learned in New York? Could it happen here?

In the first place, I think we have to note that there are some differences in the way our markets work. Our principle-based approach to accounting, with the primacy given to the true and fair view, is clearly preferable to a detailed rule-based approach. Following our own accounting scandals in the early 1990s we put in place a system of auditor regulation which had more independence in it than the old US system. We have never, here, succumbed to the cult of the star analyst in quite the same way as in Wall Street.

On the other hand, there are some features of our markets which do it, seems to me, seem worthy of attention. There is evidence of systematic bias in analysts recommendations. Where an analyst works for an investment bank with a corporate relationship with the company she is analysing, she is - oddly enough - twice as likely to recommend it as a buy as she is if there is no such relationship. There are places where analysts are remunerated in relation to investment banking profits on the other side of the Chinese wall. There are analysts who take part in pitches for new business. All of this seems to detract from the important independent role which analysis can and should play in financial markets.

On the auditing front, too, we still have a largely self-regulatory system of auditor oversight, and no proactive review of company accounts. Not all independent non-executive directors are as sharp-pencilled as they might be. Not all are chosen for their independence of mind and the ability to challenge management on behalf of shareholders.

So there is a good case for review, here, of these features of our markets. We are leading the review of analysts. And we are working with the Government on their reviews of auditor oversight and the role of non-executive directors.

These reviews are bound to bring about some changes, which I hope we can manage through sensibly. But it is fair to say that there other changes in prospect in our markets which are not necessarily so well planned, or so welcome.

The Lord Mayor mentioned the growing impact of European regulation on us, so before I finish let me say a brief word about that dimension of our business.

The Lisbon commitment to open markets and dismantling barriers to cross-border financial business were widely welcomed as a sign of Europes growing commitment to openness and flexibility.

But a general commitment to openness and flexibility has turned into a Financial Services Action Plan made up of 42 lengthy and detailed directives.

Now of course it is easy to make fun of European directives. Indeed its almost impossible not to make fun of European directives. But in the Commissions defence it is often necessary to legislate to open up markets to competition. We can all applaud the Commissions work, for example, to outlaw state aids to the banking systems in some Continental European countries or to provide passports for investment firms to transact business across the European Union. London has benefited significantly from some of that legislation. It is one reason why so much Euro denominated business is transacted here.

But the Commission has now moved beyond the easy win territory into some areas where European legislation is much more problematical. You are all aware of the controversy generated by the prospectus directive, which in its early version seemed likely to dismantle parts of the wholesale market already operating effectively at European level. There is nervousness about the market abuse directive. We have just developed a new approach to market abuse in London, following extensive consultation, and few people can see a good reason to amend that now, before it has been allowed to work.

I detect growing anxiety in the City about this programme. People argue, not unreasonably, that there has been too little prior consultation about some of these proposals. That has involved Trade Associations and individual firms in an enormous amount of educative effort to try to produce a market-friendly solution, based on an unsatisfactory original draft.

In particular I detect increasing anxiety about what we know, in the jargon, as the maximum harmonisation approach. There is a world of difference between directives which set minimum standards which must be met to ensure mutual recognition across European borders, and directives which say that you can do things anyway you like as long as it is precisely as set out in the directive, no more and no less. This imposes a one-size fits all approach on European markets, which simply does not reflect the reality of the differences from one member state to another.

In this area we can do our bit within the covens of European regulators. But these are primarily legislative issues, which are for governments, and governments are influenced by market participants, rather than by us. Fortunately, over the last few months, I have noticed a new level of interest in European regulatory proposals in the City. The Lord Mayor and Judith Mayhew at the Corporation have both played critical roles in mobilising sleeping battalions. They have not yet proposed a liberty and livelihood march through the Grande Place in Brussels, but I am sure that day is not far distant.

In all these debates London has one great strength, of course. It is the nearest to a working model of the global marketplace that we have in Europe, and indeed in the world. So when we describe what works, and what doesnt work, we have considerable force behind our arguments.

Lord Mayor, tonights revived City Banquet has, I believe, been a great success. I know it is your ambition that it should become another fixed point in the Citys calendar. But it will certainly not achieve that status if guests believe they will be harangued into the night about European directives. So with renewed thanks to you for your hospitality this evening I will retire from the battlefield. But not before inviting all your guests to join me in a toast to the Lord Mayor and Lady Mayoress."

Notes for editors

1. The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection of consumers; and fighting financial crime.

2. The FSA aims to maintain efficient, orderly and clean financial markets and help retail consumers achieve a fair deal.