SECURITIES INSTITUTE ETHICS COMMITTEE : 3RD ANNUAL LECTURE
LONDON, MONDAY 2 NOVEMBER 1998
Howard Davies
Chairman, Financial Services Authority

Thanks to the Securities Institute for the opportunity of speaking on this important topic tonight. It is a credit to the Institute that it promotes high-quality debate on ethical issues. I believe it is vitally important for the City to be seen to be thinking hard about the quality of its business practices. And the two previous lectures – which I dutifully read while preparing for his evening – have been important contributions to the debate.

So holding this lecture series is an achievement. And persuading me to speak in another. I do not say that – I hope – out of any exaggerated view of the eminence of my position, or the value of my time. It is rather that I have a well-developed allergy to the idea that I should lecture others on standards of behaviour. Though I might have had an excuse to do so at the Audit Commission, and though I had many invitations to do so at the CBI, and subsequently at the Bank of England, I have always resisted the temptation. I hope that is not because my ethical standards are lower than the next man’s. It is simply that I do not think it right to use such positions as bully-pulpits from which to lecture the nation.

I was employed at the CBI largely to inflict industrialists’ views on unsuspecting ministers, and at the Bank largely to provide good quality monetary policy advice to Kenneth Clarke (which he cheerfully ignored, incidentally) – not to tell people they should be kind to animals and always confess when they are given too much change at their local Pret a Manger. [Not that you get much change at Pret a Manger]..

So I am a reluctant ethicist, I fear. And I do not propose as Chairman of the FSA to seek to act as the conscience of the Square Mile. There is in my view an important distinction between regulation and ethics. As Elaine Sternberg puts it in ‘Just Business: Business Ethics in Action’ – "Law does not and should not specify all that is ethical. Nor could it: acting ethically requires freedom of choice". But in my current job there is no escape from some involvement in ethics. Indeed we plan to approach the task of regulating the City – building on the practices of our predecessors – by establishing a set of general principles of good business practice, cascading down through guidance codes to some detailed rules. Those principles will, as the SIB principles were in the past, be developed in consultation with the industry.

But before coming to those principles, and the way we hope to ensure that our regulation reinforces them, it is worth reflecting on whether we can say, today, that the City is a den of vice and iniquity, or a paradise of selfless practitioners, interested only in the progress of Aunt Agatha’s modest portfolio [or the well-being of unemployed workers in the North-East].

I think we have to recognise, sadly, that the City’s image is not all it might be. There have been too many ‘accidents’ for that to be so. I do not plan to revel in the disasters of the past tonight. But let us recall a few which have made the headlines in recent years.

In the banking sector there was the closure of the fraudulent bank BCCI, which caused serious losses to many depositors – especially small businesses in the Asian Community. And of course the collapse of Barings bank as a result of the uncontrolled activities of a derivatives trader in Singapore, who contrived to cause the loss of the bank’s entire capital.

Also in the derivatives markets there was the Hammersmith and Fulham interest rate swaps case. Clearly the council officers involved, who took on swaps with a nominal value of some 25 times the capital base of the authority as a whole, exceeded their powers, and little understood the risks they were taking on. But what of the institutions who traded with them? Were they not aware that they were dealing with a non-professional investor, who was – not to put too fine a point on it – taken for a ride?

There have been a number of similar cases in the US, involving American local authorities, and sometimes inexperienced corporate treasurers, who have been induced to over-trade on a massive scale by institutions who must have been aware that they were exploiting ignorance and innocence for short-term profit, and associated bonuses. [FIASCO]

Back closer to home we recall the Guinness take-over of Argyll, the Blue Arrow affair, or the aborted raid on the Co-op, all of which brought into sharp focus some of the least attractive features of corporate life. Then of course the Maxwell affair. That was a many faceted story, of course, but the most offensive aspect was the misuse of pensioners’ funds to support Robert Maxwell’s ailing business empire. Eventually, compensation was forthcoming in many cases, but the anguish generated for those who saw their pension provision disappear into a corporate maelstrom was most upsetting.

We recall, too, the affairs of Mr Roger Levitt, who conned many unsuspecting investors out of their savings. And Barlow Clowes, who claimed to have invented a cast iron way of doubling your money through the gilt market. In reality, it was a pyramid selling scheme of the most dangerous kind as many small investors discovered to their cost.

Of a somewhat different character, but hugely disadvantageous to many small investors nonetheless, is the pensions mis-selling scandal, which we continue to live through. By our estimates many hundreds of thousands of people were persuaded by commission-based salesmen into personal pensions which were less advantageous to them than their previous, largely employer-funded arrangements. We do not yet know the full scale or cost of this but it seems likely that between £7 and £10 billion of redress will be payable to affected investors. It is right to point out that, certainly for the big firms, there is a full acceptance of the nature of the problem and of the obligation they have to recompense those whose pensions were materially damaged. But that does not remove the fact that many large firms, household names, were – not so long ago – running sales forces which operated with a cavalier disregard for the long-term financial interests of their customers.

Putting all these together might suggest that the City was constantly riven with scandal.

And of course those who watch these affairs closely will be aware that in this lengthy list of scandals, relatively few of the participants have been brought to book. There have been some prosecutions, certainly. Roger Levitt undertook a number of hours of community service, for example. But the record in heavily contested serious fraud trials has, frankly, not been good. And remarkably few prosecutions have been brought for insider trading. There is a common perception, which it is hard to dismiss, that City crime is simply not punished on the same basis as other forms of theft.

So is it true that the City is a lawless place where anything goes, as long as you can get away with it, as you usually can? Are business practices today in the financial services sector significantly worse than those in the second hand car trade, or indeed the second hand footballer trade? (This may not, of course, be a particularly rigorous test: a survey published last week reported that 60% of middle class employees admitted that they had taken something from their employers).

But, also, what is happening to City standards over time? Are ethical standards in the City on the decline? Are they really much worse than they were in the past? Was there an age when a gentleman’s word was his bond, a golden age, when scandals of the sort I have enumerated were quite unknown?

Having posed these questions to you in this stark form, you might reasonably have some expectation that I would now be about to answer them. And, surely, you might say, the City’s main plain clothes policeman ought to have some view of how prevalent wrong-doing is on his patch, before deciding how much resource he needs to police it, and how that resource should be deployed? You might very well say that, and you might have a point. But the sad fact is that it is frustratingly difficult to answer these questions with any degree of accuracy. There are remarkably few figures available to help one assess the extent of fraud or market abuse in the City. And those figures we do have are almost certainly unreliable.

There has been, overall, a gradual increase in the number of disciplinary cases brought by the different regulators coming together in the FSA. But much of that increase is attributable to the pension mis-selling review. And to use those figures is rather like using the number of arrests to measure the amount of crime. The fact is that the City’s regulators have in recent years become somewhat more willing to impose fines and other disciplinary action on recalcitrant firms than they were in the past.

There are some data about particular aspects of financial crime. It is estimated, for example, that somewhere between £2.5 and £5bn worth of criminal funds are laundered through London each year. That sounds a lot, but recall that around £150bn a day flows through the high value clearing system, and more through small payments. The number of suspicious payments notified to the National Criminal Intelligence Service has grown sharply in the last decade, but again partly because financial institutions have been encouraged to upgrade their reporting, and to take money laundering more seriously. It does not necessarily imply that the underlying activity has increased – though in this case I would guess that it probably has.

But what of the suggestion that things have got significantly worse in recent years? Was there a time when mis-selling, over-trading and insider dealing were unknown?

As a matter of fact, I rather doubt it. And indeed one reason why there is more publicity these days about wrong-doing in the City is that standards of behaviour have altered very significantly over the years. It is not so long ago, for example, that there were no closed season restrictions on trading by directors in the company’s shares, or when financial journalists regularly supplemented their salaries by tipping shares in which they had built up a position of their own. (I am quite sure – it goes without saying – that no such thing happens today).

Niall Ferguson’s just published history of the House of Rothschild shows that in the early 19th Century even Treasury officials, the least corruptible of men (regulators excepting), were commonly granted privileged banking facilities, and what were frankly described as bribes in the bank’s records. Another fascinating illustration of different standards at work can be found in Roy Jenkins’ biography of Gladstone. Jenkins writes:

"When [the 1870 Franco-Prussian] war became virtually certain on 14-15 July, British government stocks including Consols fell heavily. At a long Cabinet on Saturday the 16th reports were received and dispositions made which caused Gladstone, as he informed the Queen by letter, to be more confident that France would respect the neutrality of Belgium and that Britain, partly in consequence, would be able to keep out of the conflict. These of course were bull points for Consols, and on Monday Gladstone calmly bought for his own account £2,500 of them at the temporarily depressed price of 90. It was a shrewd speculation, and it is unlikely that it ever occurred to him, through his carapace of innocence and faith in his own motives, that he was doing anything remotely improper. He made no effort at concealment".

In his lecture in this series called "Crooks, Cheats and Charlatans" my own Deputy Chairman, Lord Runciman, reviewing the evidence, concluded that while there may never have been a golden age in which a gentleman’s word was truly his bond, "it is at least arguable that the pressure for regulation springs from a recognition, by those who regard the City’s reputation for fair dealing as one of its most valuable competitive assets, that there has been a simultaneous raising of standards and falling off in the willingness of the players to conform to them".

It is interesting to speculate on why that might be so. I can think of three explanations which might form part of the background.

First, the sheer scale of financial activity in the City has continued to grow and grow, so that the opportunities to make enormous sums of money through cutting corners has risen. At the same time much of the transactional activity in the City is remarkably impersonal. The days when brokers knew all of their clients names, and the ages of their dogs, are long past. (They may know the name of the option pricing model they use, but that is not quite the same thing). Much business is carried out either on screens, or on the telephone to people in Greenwich Connecticut you may never have met, and may now not want to. I cannot help thinking that this reduction in personal contact is part of the problem.

Secondly, the City has become a much more heterogeneous place, with far more foreign-based institutions operating in the UK, and institutions of very different kinds moving into each others markets. I do not want to be trapped here into casual, little Englander observations about foreigners cheating at examinations. The point is simply that much of the strength of the City’s self-policing activity in the past was based on a commonality of interest between members of different trade associations or clubs. Members felt a strong sense of identity with each other and rightly believed that their reputation stood or fell by the reputation of others in the same trade. There are still echoes of that in some parts of the City today, but those ties of mutual self-interest are nothing like as strong as they used to be, now that it is much harder to identify and categorise an industry sector. For example, life insurance these days may be sold by a traditional life office, by a clearing bank, by a supermarket, or by an operator of ancient cross-country train sets. Their interests are not identical; their overall reputations do not stand or fall together.

It is also probably true to say that in the City of today one can afford to rely less on the inheritance of ethical standards from one generation of professionals to another, as was perhaps the case when the City was dominated by small long-standing institutions, many of them with powerful traditions. So while there is no evidence that bankers and brokers are now inherently more wicked than they used to be, there may be more need to work at ingraining and developing ethical standards, which may no longer be passed on from generation to generation as a corporate inheritance. To quote Adrian Cadbury, "the unwritten rules – the way we do things here – no longer hold. They were passed on by those with longer service to new entrants. The steady state on which this approach depends is of the past".

Lastly, there is the nature of the customer base with which many financial services institutions now deal. Here I am talking mainly about the retail end of the business. The financial affairs of large numbers of people in this country have become much more complicated than they were in the past. Of course there are very many people, perhaps almost half the population, who have very small savings indeed, less than £300 in total. But that still leaves perhaps 15-20 million people who are engaged in some kind of saving or investment activity.

People increasingly recognise that they will not be able to survive happily on their wages, spending them each week, and then expecting a state pension to arrive at the appropriate time and provide a decent standard of living. We may have two views about the way this position has changed, but it is now clear that very many people are obliged to make provision for their own future, and to make a wide range of long-term decisions which they were not required to think about in the past. And many of those people are not well educated or informed about financial services products. They are therefore much more open to exploitation and abuse.

Furthermore, and this is the crucial difference between financial services transactions and other market transactions, such as buying a toaster, or a car, or an ageing mid-fielder – it is often not possible for a very long time to see the performance of the investment you make. A personal pension plan, for example, may typically have a 30-40 year life and you are not sure until close to the end of that period what return you will get. The same is true of a with-profits life policy. There is little opportunity for repeat purchases, which are normally the surest way to produce well-informed consumers.

This combination of ill-informed consumers, and uncertain outcomes, is potentially highly combustible, as the pensions mis-selling saga has shown. There can be heavy incentives, in the form of commissions, for salesmen to sell products which are quite inappropriate for the consumer. And the consumer does not know, and without assistance will not know for many years, that the product she has brought will not deliver the returns she hoped for. In the jargon, this is called a problem of asymmetry of information, and it is highly acute in the financial services sector.

As the Economist’s survey of social insurance last week concluded ‘the privatisation of social insurance may often require some sort of government regulation to make it work. It has already become clear that getting this regulation right is crucial … and that getting it wrong is all too easy".

To sum up this part of the argument, therefore, while there is no conclusive proof of low and declining ethical standards in the City, there is sufficient evidence of mischief to justify public concern. And, furthermore, there are opportunities for exploitation which do not obtain in many other markets. Consumers are not well placed to respond to poor delivery. When that poor delivery becomes apparent, it is often too late to change. Of course in some areas of financial services there are repeat purchases – people do not normally go twice to bureaux de change which charge them 10% commission – but in many areas that is not the case. And, lastly, there is evidence of a much more diverse industry, where the self-correcting or self-policing mechanisms are weaker than they were in the past.

All of this justifies, in my view, some effort being devoted to devising a regulatory framework which seeks to guard against the worst potential excesses in financial markets, to provide opportunities for compensation and redress when people are exploited. Yet at the same time this needs to be a system which does not impose such a straightjacket on financial markets that they are unable to operate flexibly and freely, thereby reducing the opportunities for individuals to make good returns from their savings, and to find products which match their changing financial needs through their lives. That points to the need to regulate financial markets in a way which attempts to raise standards within firms themselves, rather than simply imposing them through inflexible rules from the outside.

This is a tall order. And I don’t think we would pretend, at the Financial Services Authority, to have got anywhere near to devising a regime which meets all these objectives simultaneously. But let me give you a glimpse of how we are putting together our new regulatory structure in a way which, we hope, will help to safeguard the interests of consumers and, at the same time, to promote higher ethical standards.

I do not propose, this evening, to go into detail about the rules which the FSA will require firms in the financial sector to obey in all areas of their business. That is a subject for another day, indeed, for me, for all other days. But I do want to explain briefly how we plan to operate, at a high level, to try to raise business standards wherever possible.

In the first place, we shall operate within a system of statutory objectives set out for us in our new legislation, which has now been published in draft, though it has not yet begun to wend its way through Parliament. There are, in the draft Bill, four objectives. We are required, first, to work to maintain confidence in the UK’s financial markets. Second, to protect the consumers of financial services. Third, to promote consumer understanding of the risks and benefits of financial products and services. And, fourth, to reduce the extent to which financial firms are used fore the purposes of financial crime.

For the purposes of this evening’s discussion, the key aim is the protection of consumers. But that objective is not an absolute one. It is draft so as to protect the interests of the users of financial services, while recognising that individuals must take some responsibility for their own decisions. Linked to that objective is a proviso, to the effect that we should ensure that our regulation is appropriate, taking into account the characteristics of the particular market, and the consumers who operate within it. Taken together, these imply that we should tailor our regulation to the sophistication of consumers or, to put it another way, to take account of the asymmetry of power and information which exists in some markets. We ought therefore to focus our attention not so much on inter-professional markets, where one investment bank is dealing with another – consenting adults in private, if you like – but rather on those markets where there is the greatest potential for exploitation of the consumer, particularly vulnerable consumers.

There is, furthermore, another linked proviso, to the effect that we should take account of the primacy of the firm’s own responsibilities for managing its affairs prudently and properly. This means that, as far as possible, we should seek to regulate in a way which reinforces, rather than substitutes for, the responsibilities of the management. It is quite evident that the influence which senior management can exert over the business practices of an institution is very considerably greater than that which a small number of regulators can bring to bear.

We believe that it is a logical consequence of this kind of statutory framework that we should begin by setting out some principles of behaviour which firms, and the individuals in positions of influence within them, should seek to follow. Those principles need to be underpinned with guidance and detailed rules, where that is appropriate. But they are essentially the foundation stones of regulation, and set the tone for the sort of behaviour which regulators will in future regard as acceptable.

We have recently published for consultation a draft of the principles for business. They are couched, deliberately, at a very high level of generality. For example, we say that "a firm must conduct its business with integrity". That is principle one. Principles two, three and four are largely about skill, management and prudence, while principle five notes that "a firm must observe proper standards of market conduct".

Principles six and seven relate to the way in which a financial firm should deal with its customers. First, "a firm must pay due regard to the interests of its consumers and treat them fairly". We note that this should include paying due regard to their information needs – to get at the point about information asymmetry which I made earlier – communicating information in a way that is fair and not misleading; and managing conflicts of interest fairly.

We also have suggested a principle to the effect that "a firm must keep faith with any customer who is entitled to rely upon its judgement". This will include taking reasonable care to ensure the suitability of its advice and of any discretionary decisions which the firm takes on behalf of the customers. And, lastly, though by no means least as far as we are concerned, "a firm must deal with its regulators in an open and co-operative way". That means being prepared to acknowledge regulatory failures when they occur, and not seeking to ignore them or cover them up.

These principles are, you will note, couched at a pretty high level of generality. As I have said, that is deliberate. We do not want a regulatory system where the focus is solely on seeking to meet detailed prescriptive requirements, while ignoring the underlying need for businesses to act ethically. Of course there is a need to give guidance on how the principles will be interpreted in different areas of market activity. We have already begun consulting on ways in which that can be achieved. But it simply is not possible to capture every conceivable market circumstance in a code of practice and nor, in our view, would it be desirable to do so. That would lead to highly constipated, rule-bound markets which might fail to deliver the positive contribution which the financial sector can make to economic growth and the well-being of individual citizens.

In adopting this approach, we will be building on the practices which have increasingly been adopted by the regulators we replace, though there will be many significant changes in approach in the new regime. One important change will be the introduction of principles of behaviour for individuals, as well as firms. As I have pointed out, our legislation will require us to take account of the responsibilities of management of financial firms in setting a regulatory framework. So we plan to make it clear what regulators expect of the most senior management in regulated firms – how they will consider the distribution of responsibilities in the event of a failure of a firm to follow good business practices.

One of the least appealing features of a number of the scandals I referred to at the outset is that while junior, or operational managers have lost their jobs and been disciplined by regulators for clear rule breaches, senior management have not always been held to account. Regulators have tended to find it difficult to pin clear duties on chief executives. There have been cases where a highly legalistic approach on their behalf to the responsibilities they consider themselves to have has allowed them to escape, when a commonsensical view would argue that they must surely have had some responsibility for ensuring that the business was controlled in a way which prevented either its customers being unreasonably exploited, or indeed its shareholders money being put unreasonably at risk.

So, for two good reasons, we aim to implement a system where the responsibilities of senior management are clearly set out, both in practical terms and in relation to the principles of good business practice I have enumerated. The two reasons are, first, that by so doing one maximises the incentives on senior management to ensure that a firm follows good business practices, and senior management must be far more influential with their staff than any regulator can be. Second, it ensures that, where failures do occur, senior management takes its appropriate share of responsibility for the consequences of those failures.

We are currently working on our ideas for a set of principles for individuals, and we will be consulting on a draft before Christmas.

I said at the outset, and re-emphasise in closing, it is not for regulators to devise a full-scale ethical code for financial firms. Our focus is on the direct interface between those firms and their customers, flowing from our statutory responsibility to protect those customers. And to ensure that those customers are treated fairly we aim to promote a culture of compliance with regulatory standards. But a culture of compliance is not necessarily the same as a strong ethical stance.

As a recent Demos pamphlet by Sheena Carmichael of the European Institute of Business Ethics pointed out "some companies point to their compliance officer as evidence that they behave ethically, but all the existence of this person demonstrates is that they are obeying the written rules of their profession. This is, in other words, a necessary but far from sufficient condition for internalising ethical principles’.

Effective compliance is in fact just the first of seven steps identified by the Federal Sentencing Commission in the US, which has gone further than any other public agency to define a effective corporate ethics programme. The Commission’s aim was to establish a culpability score to provide guidance to judges and regulators involved in fining corporations. If a company can prove that it has an effective ethics programme in place, fines can be mitigated by as much as 95%.

Having offered you eight FSA principles earlier, and promised you at least half a dozen more for individuals, I hesitate to offer seven ethical guidelines. But, very quickly, they provide – after the compliance point, that companies should:

  • - ensure that specific individuals are responsible for ensuring compliance;
  • - screen personnel exercising compliance functions;
  • - communicate ethical standards and procedures to all employees, and institute effective training programmes;
  • - monitor and audit their achievement of standards, and safeguard whistleblowers;
  • - operate disciplinary procedures to penalise breaches; and
  • - respond promptly and effectively to failures.

This may seem like a recipe for compliance taking over the whole of the business. And perhaps it carries that risk. But a rigorous approach on US lines is probably preferable to the alternative suggested by Marx, who said ‘in business, a reputation for honesty and fair dealing is the key to success. If you can fake that, you’ve got it made’.

To go back in conclusion to my title this evening, let me quote from a speech in Parliament when the current regulatory legislation, the Financial Services Act 1986, was introduced. Sir Anthony Grant, a pillar of the Conservative establishment with a career in the City behind him, observed "it is immensely sad that the standards that prevailed when I started working in the City have, alas, deteriorated. Far too many flash Harry’s attracted to the City are long in aggression and cunning but short in morals. In the City the old saying used to be "my word is my bond". All too often now if a man says that his word is his bond, one would be well advised to insist on taking his bond".

My own personal perception is that this is a slightly harsh verdict. But then I do not have a long career in the City behind me, and perhaps not one in front of me, either. But in such time as I am allowed, I hope it will be possible to strengthen the focus on ethical issues in the square mile, and wherever savers, investors and depositors are induced to part with their money.

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