WEDNESDAY 30 SEPTEMBER 1998
BUILDING THE FSA – PROGRESS TO DATE AND PRIORITIES AHEAD
SPEECH BY HOWARD DAVIES
CHAIRMAN, FINANCIAL SERVICES AUTHORITY

Three aims this morning:

  • First, to give you an update on the construction of the Financial Services Authority.
  • Second, to give you a snapshot of the draft Bill, and what I think it means, overall, for financial regulation in the future and
  • Third, to try to sum up in a very few words what I think all this will mean, and will not mean, specifically for the London banking community.

(Slide 2)

But first, what are we trying to achieve. Gordon Brown set a high objective for us at the outset, saying that we were trying to build ‘a regulatory regime to meet the challenges of the 21st century’.

I have to enter a caveat, here. I cannot offer any guarantee that I will run the FSA for the next 102 years. But I am not yet subject to impeachment proceedings, nor did I have to undertake, before taking on my appointment, that I would only serve half the term. So I aim to stay around long enough to create a legislative framework which provides a good degree of flexibility for future regulation to adapt to changing market circumstances.

I want to insist on that point at the outset. The aim is to create a flexible and adaptable system. That inevitably means that the legislation is a framework, rather than a lengthy set of detailed provisions. Quite a lot of the comments on the draft Bill which we have seen so far, mainly emanating from law firms, has argued that there is too little detail in the Bill. To some extent, this is a fair point. There are some detailed schedules to come. But I would urge you to think about whether you really want a piece of detailed legislation, which could be a straightjacket in the future, or whether you are prepared for a flexible regime, in which regulation involves a continuing dialogue between the regulator, the regulated, and consumers, within an overall framework of objectives. I will return to that point later, but I wanted to get it off my chest at the start, since there is a lot of research to suggest that most people only listen to the first three minutes of what you say, before sitting back to worry about their other problems.

(Slide 3)

The timetable so far:

announcement, launch, transfer of banking supervision, managerial merger of the two tier investment business system.

(Slide 4)

A Reform Bill published on announced timetable. Relocation to Canary Wharf also on announced timetable. Cannot be said for Jubilee Line extension. Legislative timetable remains somewhat unclear. But we are expecting the whole system to have been changed by some time in the first half of the year 2000.

(Slide 5)

The structure of the FSA was described in outline in our Report to the Chancellor last July. It has not changed much since. The engine room of the organisation is the supervision of firms and markets under Michael Foot.

(Slide 6)

The Supervision Directorate is divided into six areas. The top two are the ones which most concern you, under Oliver Page and Carol Sergeant. Oliver Page will talk much more later about the structure of complex groups, and his plans within that. 55 institutions in there.

(Slide 7)

All of this largely a managerial operation. But what are the main legislative changes.

The draft Bill was published at the end of July, with consultation running to the end of October. That is a short consultation period, I recognise, and at another conference at the end of last week Stephen Byers made it clear that it was not an absolutely rigorous cut off point for comments, particularly not for detailed comments.

In spite of what I have said about flexibility, the Bill is a pretty substantial document already, even though quite a lot of detail remains to be filled in. It is 233 clauses. Do not worry. I propose only to spend two or three minutes on each clause this morning.

The overall intention is clear, to create a one stop shop arrangement for regulation and to provide better flexibility and accountability. This latter point has already attracted some attention. Is the new FSA sufficiently accountable to its paymasters, or indeed to consumers, or to Parliament? [As president Clinton would no doubt say, it depends what you mean by is.]

My aim this morning is to explain, first, how we plan to interpret our statutory objectives as set out in the legislation, and, second, how we see the accountability framework operating.

But even before considering the interpretation we place on the statutory objectives, there is one prior question it is worth trying to answer

Why regulate at all?

(Slide 8)

It may surprise some of you to learn that we regulators do spend a considerable amount of time asking ourselves why we do what we do. Indeed, almost every day en route to the office I ask myself whether my journey is really necessary. And since I commute from Shepherds Bush to Canary Wharf, there is plenty of time for me to think up long elaborate answers.

I hope that, throughout its life, and certainly while I am involved, the FSA will adopt a questioning and self-critical approach to what it does. Indeed we plan to issue a series of occasional papers on the theme of "why regulate?". But for now we believe there are two principal strands to the rationale for regulating financial markets, business and transactions.

First, there is the problem of systemic risk. There is persuasive evidence that a stable financial system provides a favourable environment for efficient resource allocation, and therefore promotes economic growth. Further, experience shows that, left to themselves, financial systems are prone to bouts of instability and contagion. We are seeing some interesting examples of that at the moment. There is therefore a public policy case for the prudential supervision of institutions, especially banks with their important maturity transformation role, to ensure that they are soundly capitalised and correspondingly less vulnerable to "runs" and other market shocks.

The current crises in a number of Asian economies, now perhaps spreading further afield, are a vivid illustration of the dangers of financial systems which are not properly regulated. While the underlying cause of market instability in Asia may have been a combination of over-heating economies, unrealistic exchange rates and excessive foreign borrowing, it is now common ground among analysts of the Asian crisis that weak financial regulation, poor accounting in banks and inadequate disclosure created conditions in which what might have been market correction turned into a full scale systemic collapse.

The second prime justification for financial regulation is rooted more in an analysis of the nature of the market for retail financial services. It is a market characterised by asymmetries of information which make it difficult for buyers to assess the risks and returns of the transactions they undertake. That is what distinguishes the financial services market from the market for second hand cars, or second hand footballers, where performance can be very quickly assessed.

This problem of asymmetric information is especially acute for investors long-term contracts, where the expected returns may not appear for many years. Without regulation to give consumers some independent assurance about the terms on which contracts are offered, the safety of the assets which underpin them, and the quality of advice received, saving and investment is discouraged, again with damaging economic consequences. Furthermore, healthy competition in the financial services industry will be enhanced by empowering consumers through education and disclosure of information on charges and other key features of financial products.

This definition of the consumer oriented case for regulation applies particularly to long-term investment and savings products. It is hard to erect a similar case in relation to deposits, where the returns are clear, and where savers can, relatively easily, shift around from one institutions to another, without incurring high costs. In my view, therefore, there is not a strong public interest argument for extending this kind of regulation to straightforward deposit products. It will be interesting to see how that argument plays in Parliament, where I expect we will hear arguments for further extension and scope. The particular case of mortgages is rather a different one. There Ministers have said clearly that they plan to watch the development of the mortgage code, put together by the Council of Mortgage Lenders, before deciding whether or not to extend the scope of the new legislation to mortgage products.

This rationale underpins the case for both prudential and conduct of business regulation, and for the supervision of markets and exchanges. For the FSA, it finds expression in the statutory objectives incorporated in the draft Bill.

(Slide 9)

These objectives are:

  • maintaining confidence in the UK financial system;
  • promoting public understanding of the financial system;
  • securing the appropriate degree of protection for consumers, and
  • reducing the extent to which it is possible for businesses to be used for financial crime.

These objectives can be pursued simultaneously, but from time to time there may well be tensions between them and a regulator might be pulled in different directions. So we will need to make judgments about how to strike the balance. The objectives will be a crucial discipline on us in the future. They will act as a kind of triangulation mechanism. What we have to hope is that the space within that triangle is available, and that it does not turn out to be one of the Bermudan variety.

But let me say a little more about how we see the delivery of those statutory objectives in practice.

(Slide 10)

The first objective, maintaining confidence in the UK financial system, is one which can be delivered effectively only in close collaboration with the Bank. The framework for that collaboration has already been set out in a Memorandum of Understanding between the Treasury, the Bank and the FSA, which established a Standing Committee to ensure that they three organisations work together effectively.

That Standing Committee has now been in operation for some months and has already proved itself to be an effective forum in which emerging problems can be addressed, whether they arise in domestic or overseas markets, if they could threaten the stability of the UK financial system. I have to say that there has, in recent months, been no shortage of topics to discuss. It has been a convenient test of our arrangements – though I can assure you that we did nothing to engineer it. The Committee has provided a disciplined process within which the risks to the UK from, for example, the Russian financial collapse or market closure in Malaysia, can be assessed and potential corrective action can be determined.

I know that I can speak for the Governor also when I say that this aspect of the new system, which caused some concern at the outset, has so far run very smoothly indeed.

The second statutory objective, promoting public understanding of the financial system, takes us into very different territory, well away from the traditional concerns of a central bank.

For the first time in the UK, a financial regulator has been given a specific objective in the area of consumer education. We believe this makes sense. Consumers need appropriate information on which to base their decisions, and the ability to understand that information. Transparency is essential for financial markets to work effectively, and can bring real, measurable improvements to consumer welfare.

We plan to undertake significantly more work on promoting public awareness of the costs, benefits and risks of financial products than the FSA’s constituent regulators have been able to do in the recent past.

(Slide 11)

The third objective, the protection of consumers, links closely with all the others and therefore lies at the heart of the work of the Authority.

But it is important to highlight the ways in which this objective is couched in the legislation.

The legislation envisages that the prime responsibility for dealing fairly with consumers rests with the management of regulated firms. So our regulatory approach will be designed to focus and reinforce that responsibility.

Also, wherever possible, our approach will focus on outputs. In other words, we shall seek to address directly the consequences for consumers of firms behaviour. But those consequences are not always easy to measure, so it will often be necessary to focus on internal processes and on the selling or advisory activity itself. We will therefore also give attention to the robustness of firms systems for identifying, measuring and controlling risks both to the firm itself and to its customers.

Our aim will also be to put in place mechanisms for complaints handling and redress which will offer greater simplicity and ease of access to consumers. As required by the new legislation, we will introduce a single financial services ombudsperson scheme and a unified compensation scheme, within which there will be appropriate differentiation between different markets and types of customers.

However, as the terms of the statutory objectives recognise, it is neither possible nor appropriate to offer complete protection to customers of financial institutions. That principle applies, very clearly, to sophisticated commercial customers. In professional markets, characterised by consenting adults exploiting each other in private, our regulatory touch should be very light. But the principle does apply in retail markets too. No system of regulation can fully insulate even retail consumers from the responsibility of taking their own decisions on their savings and investments. This principle will on current plans be recognised both in the overall approach we take to regulation and in the arrangements adopted for the depositor policy holder and investor compensation schemes, where it is our current intention to maintain an element of co-insurance.

The last objective, fighting financial crime, will integrate the relevant efforts of financial regulators with those of other criminal law intelligence, investigation and prosecution agencies. Together with certain new powers set out in the draft Bill, it will enable us to build on the work which existing regulators have undertaken in this area in the past. Our prime focus will be to ensure that financial institutions have systems and practices in place to protect themselves against being used as vehicles by financial criminals, especially by way of money laundering.

These objectives, as I have said, provide a reasonable framework within which to situate the Authority’s work. But without further qualification, they could be pursued in a number of ways.

That is where the other general duties come in.

(Slide 12)

Firstly, we are told that we must pursue our objectives in an efficient and economic way.

I am acutely conscious that, faced with a sceptical industry audience, there is very little I can say which will sound persuasive in this area. Assurances about the future development of regulatory costs are bound to be treated with a "he would say that, wouldn’t he" kind of response. I can point to the fact that, in this first year of the new system, our budget was slightly lower, in real terms, than the previous year’s budgets of the component institutions put together. And that, in spite of rather rapidly rising salaries in the key City labour markets in which we operate. So far we have managed to contain those increases within an overall budget slightly reducing in real terms, because we have been able to achieve some early wins in terms of economies of scale in back office functions.

But of course the total cost to the industry of a regulatory system is influenced more by the compliance costs we inflict on regulated firms themselves. In the longer run, we believe that a risk based approach – both at the level of supervising individual firms and in setting policies and priorities – will be the key to efficient deployment of our resources and yours. The requirement in the draft Bill for the Authority to publish cost benefit analyses will impose an important discipline on regulatory activity.

We are also required to facilitate innovation. That duty will best be pursued through the maintenance of close relationships between the regulators and regulated institutions. Institutions will be encouraged to discuss new product ideas and new market developments with us at an early stage to ensure that the risks, for them and their customers, are properly understood and managed from the outset.

We will also try to ensure that our rules and guidance, and the way in which they are interpreted and implemented, do not impede or distort competition, which must be the best guarantor of fair treatment for consumers.

Lastly, we are required to take account of the international character of financial services and markets, and the UK’s competitive position within those markets.

London is a uniquely international centre of financial services. There are more banks, from more different countries, in London than in any other financial centre. Much of the business undertaken in the UK is internationally mobile and almost all aspects of our responsibilities have an international dimension.

We are therefore committed, first, to playing a full part in discussions with international regulatory bodies, to ensure that the UK’s influence on the development of international regulatory standards is commensurate with the weight of our markets in global terms. In many areas this work will proceed in partnership with the Bank of England. A good example of that partnership in action was a conference we ran last week with the Bank of England on credit risk modelling. That attracted a wide international audience, and has undoubtedly pushed forward international regulatory thinking in a crucial area for the banking system.

At home, we must ensure that the UK system of regulation remains attractive to mobile international firms and markets. There are, of course, some international flows – laundered money, for example – which we would not wish to see attracted to the UK. But, subject to that qualification, the FSA will regard the developments of UK financial markets as an important indicator of the success of its regulatory approach.

The regulatory environment is frequently revealed to be an important factor in influencing financial institutions location decisions. So if anyone has any evidence that we are alienating business from London, we want to know about it.

This framework is, I would argue, a reasonable and appropriate one for a regulator. But you may reasonably argue that it leaves many cards in our hands. The regulator has many hoops to jump through, perhaps, but she holds all the hoops herself.

That is not, however, the way we see it. And we think the Bill, and the undertakings the Board has publicly given so far, does incorporate a framework of accountability which provides a reasonable set of checks and balances, and allows the various stakeholders in the regulatory process considerable purchase on our decision making.

(Slide 13)

In the first place, we have a Board appointed by the Treasury through Nolan procedures, with a large majority of non-executive members. And the legislation gives a new non-executive committee some defined responsibilities, particularly in the area of ensuring the economic and efficient use of the Authority’s resources. This parallels the arrangements already introduced in the Bank of England by the Bank of England Act.

The Authority is also, of course, accountable through Treasury Ministers to Parliament. The Treasury Select Committee has already undertaken one inquiry into part of our work, and plans another in the coming weeks.

We must submit an Annual Report on our performance against the statutory objectives in the legislation to the Chancellor, and through him to Parliament. It is also worth noting that the Treasury would have the power under the new Act to commission inquiries into the failure of financial institutions and our role, or non-role in any such failures that may occur.

These are, if you like, the outward and visible manifestations of our accountability. But we also plan to build checks and balances into our internal procedures. We do so not for public relations purposes, but because we genuinely believe that involving both consumer representatives and practitioners in the regulatory process is likely to produce a better quality of outcome. That is something which has been learnt in the self regulatory system which has been operated for the last decade.

(Slide 14)

So we are in the process of establishing a Consumer Panel, building on the model already in operation within the PIA, which will look across the whole of the FSA’s area of responsibility. That Panel will be able to report publicly on our performance against the key consumer related objectives of promoting consumer understanding and consumer protection.

To mirror the Consumer Panel we plan a Practitioner Forum. We are close to completing a slate of members of that Forum, drawn largely from nominations put to us by the key trade associations representing different branches of the financial services industry. We want that Forum to focus particular attention on whether our regulation is appropriate to the type of market we are dealing with (the wholesale/retail division which I referred to earlier), whether our regulation is cost effective, and whether we are meeting the requirement to take account of international mobility of financial services, and the competitiveness of the UK as a place to do business.

We aim also to maintain the successful experience of the SROs in incorporating practitioner and public interest representatives in committees overseeing the authorisation and enforcement process of the Authority. Of course I recognise that we will depend heavily on the willingness of firms to provide good people to participate. I hope that institutions will see doing so as being in their enlightened self interest.

The legislation also provides for appeals against decisions by the FSA to go to an independent financial services tribunal, run as part of the court system by the Lord Chancellor. So it will have entirely independent judges, and expensive flock wallpaper. We will also have an independent complaints commissioner to look into complaints against the way in which we have managed our own procedures.

(Slide 15)

Lastly, under the general rubric of accountability, we also have a series of statutory requirements to consult on rules, on cost benefit analysis, and on our budget.

And the terms in which the legislation is drafted make it clear that our interpretation of the general duties placed upon us could be subject to judicial review.

I said that, lastly, I would say something about the implications for banks. Much more on that subject will be said by Oliver Page, a little later on, and Dan Waters will deal specifically with the enforcement issues. But let me try very briefly to give you some pointers as to what you can expect to change in the new regime, and what not.

(Slide 16)

In the first place, there have of course been important changes in institutional responsibilities. Since we still find some lack of understanding of the point, I have to emphasise that it is now the FSA, rather than the Bank of England, which is responsible for all authorisation decisions in relation to Banks in London, and all the key supervisory decisions relating to them, too. The Bank of England’s continuing responsibilities are well set out in the Memorandum of Institution and relate to the payment system and the stability of the financial system, as a whole. I recognise that the fact that most of my banking supervision people are still tenants of the old lady is potentially confusing. But they are just there as tenants, paying an extortionate rent as a matter of fact, and the legal separation has occurred.

There are changes, too, on the charging side. We hope that, in the long run, we will be able to produce a much more coherent system of charging for all supervision and regulation across the Financial Services Authority. In the meantime, we have adapted the Bank’s mechanism related to cash ratio deposits, made a few changes which we think make the system a little fairer, when it is specifically related to charging for supervision, and pressed on. Since the Government arranged for the size of cash ratio deposits to fall more than was necessary to create the headroom for our charging, overall the banking system is paying less for the combination of services provided by the Bank of England and the FSA than it was in the future. I trust you are all suitably grateful and appreciative of the effective lobbying activities on your behalf carried out by the BBA (Tim Sweeney specifically asked me to mention that point).

Looking forward, banks will in future be subject to the FSA principles, a revised version of which we have already published. Of course many of you have been subject to the old SIB principles in the past in respect of your investment business, so you are familiar with the implications. I should emphasise that some of them will be dis-applied in relation to elements of your activities which are not covered by conduct of business rules.

Lastly, we would expect to be able to produce increasingly effective group-wide views of your strategies, risks and controls. We plan to remove overlap as far as possible, and to take a single view of capital adequacy, management competence and risk management systems, in the future. All of this will, I hope, bring some benefits to the banks, but also make us better informed interlocutors, which institutions ought to welcome though some, in my view mis-guidedly, seem not always to see that it is good for them to have regulators who are well informed and able to challenge them.

But there are important things which should not change.

(Slide 17)

We shall be carrying forward the RATE and SCALE approach to banking supervision which was introduced as a result of the Arthur Andersen review of supervision which I led when Deputy Governor at the Bank. We believe that that approach is already paying dividends. We have carried out a full RATE analysis for quite a large number of banks, now, and what we call desktop RATE analysis for all the institutions in our care. Many of you have been kind enough to say that you have found this a useful exercise. We hope that the benefits are both short-term and long-term.

In the short-term, it ought to leave us with a much clearer understanding of the shape of the institution and the risks it runs. It ought also to leave you with a much clearer understanding of our comprehension of the riskiness of your business and the aspects of it which we wish to pay attention to in our supervisory programme. In the long run, it should allow us to target our resources more effectively, paying relatively little attention to those areas of the business which we believe are low-risk, and focussing our efforts more effectively on high-risk areas. All of that is carried forward seamlessly from the Bank of England into the FSA.

It is also my expectation that the general scope of our regulation in relation to banks will not materially change. The case for conduct of business regulation of deposit-taking does not seem to me to be made out at this point, though of course there have been recent public and Parliamentary concerns in relation to some practices adopted by some banks, in relation to depositors. It will be interesting to see how this argument develops as the legislation proceeds, and it would obviously be right for me to say that we will regulate whatever Parliament tells us to. But I have explained my own view of the position clearly this morning.

Lastly, I do not propose to change the character of open relationships which has existed between the Bank of England supervisors and banks in the past. In my view effective supervision is built on good relationships, except where the relationships of trust break down. One of the FSA principles which we have published for consultation is that institutions must be open with their regulators. Where they are open with us we will be open with them. But of course that does not mean that we cannot and should not take effective enforcement action where principles or rules have been clearly breached, and particularly where institutions have sought to conceal things from their regulators.

With that caveat, I want to see an open and responsive relationship between you and us. That is not just because it is nice to be liked and loved, but because I am persuaded that effective supervision proceeds on the basis of a good understanding by supervisors of what banks are trying themselves to achieve. That is at the heart of the RATE process, which begins with strategy. You cannot operate that kind of regulatory system from your desk, or in a confrontational relationship between institutions. So it follows that we shall want to keep in close contact with you.

That is almost all I wanted to say this morning, you may feel it has been far too much, but I ought not to conclude without giving you a glimpse of what will happen from now on.

(Slide 18)

In our August paper, Meeting our Responsibilities, we set out a schedule of consultation papers which we are committed to producing over the next eighteen months. There are in fact 28 of them. I can make no apology for that number. It is just an indication of the scale of the task ahead.

We aim to consolidate all this new material into a new regulatory handbook. I say handbook, but with the best will in the world I doubt if it will all fit comfortably into the palm of one hand, except in the CD-Rom version.

On the practical front, we are about to move into our new building in Canary Wharf. The first purpose-built regulator in the world, complete with all the essential accoutrements of regulatory life: tribunal rooms, torture chambers, video cameras and cans of diet coke. Ministers have also recently announced that we can integrate the staff of the regulators who have still been outside our single management structure hitherto, from the Registry of Friendly Societies and the Insurance Directorate of the Treasury. In the next few weeks we shall set up our Consumer Panel and our Practitioner Forum, and they will, I hope, quickly become the focal points for consumer and practitioner input to our work.

And we are very close to being able to establish shadow Boards for our new Ombudsman and Compensation Schemes. Those are mini-FSA’s, in practice, with all the challenges which setting up a new single management structure brings. Fortunately, we have now done it once and are certainly aware of the mistakes it is all too easy to make.

Lastly, one plea. The FSA is a creature of the markets it regulates. We are paid by financial institutions or, perhaps, by their consumers. We will only build a better regulatory mousetrap if we do so collaboratively. I recognise that there are many more interesting things to think about than changing the regulatory framework. But we really do depend on the contribution of financial institutions and their trade associations to the work, if we are to produce a durable and market sensitive regulatory system. So it is encouraging to see so many people here today, and I hope that you will not be backward in coming forward with your constructive comments, criticisms and questions.

More Speeches: