1999 Travers Lecture
London Guildhall University Business School
Thursday 11 March 1999
Howard Davies
Chairman, Financial Services Authority

1. The broadest financial regulator in the world

First, the Financial Services Authority will be the broadest financial regulator in the world, in the sense of a regulator which covers a wide range of industry sectors ranging from independent financial advisers operating on the high street, to global investment banks.

In saying that, one immediately raises the question as to why other people have not adopted this model, and whether we are not, in fact, trying a heroic task which other countries have wisely eschewed. I do not believe that is so.

First, there are some models of a single regulator available for inspection, albeit in markets rather smaller than London’s. The Swedes and the Danes have successfully operated unified regulators for some time. We have been able to learn some useful lessons from their experience.

It is also true to say that regulatory consolidation is now happening in many other jurisdictions, in a number of cases clearly as a result of the announcement in the UK, though in others it began before we announced our change.

The Canadians, for example, merged banking and insurance regulation some time ago, outside the central bank. The Belgians and Swiss have banking and securities regulators, also outside the central bank. The Australians have chosen a different approach, with a single prudential regulator (again outside the central bank) covering all sectors. There is a separate conduct of business regulator, again cross-sectoral, and an overarching council sitting above the two of them. The Australian change followed a major investigation by a committee appointed by the Government.

Elsewhere, the Japanese have merged banking and securities regulation in the Japanese Financial Supervisory Agency, known as the JFSA. Their model owes quite a lot to their observation of the FSA here. Koreans have introduced a single regulator on our model in the last year. The Irish have decided to do the same, though it is not yet clear whether it will be inside or outside the central bank of Ireland. The Luxembourgers merged banking and securities regulation last year.

You may ask where the United States fits into this analysis. Clearly, there, there is no chance of a single regulator for the foreseeable future. First of all there is the Federal dimension to American regulation, but there are also fierce defenders of the different sectoral responsibilities of the Federal Reserve, the Office of the Comptroller of the Currency, the SEC and the CFTC. But it is fair to say that the US system is not now typical of international practice.

So the general trend internationally is towards regulatory consolidation, even though few countries have gone as far yet as we, in our hot-blooded, Latin way are doing with the FSA.

I believe that our model offers two key advantages, one which relates to the market sensitivity of regulation, if you like, and the other related to its effectiveness.

From a market point of view, there are considerable attractions in a one-stop regulatory shop. Large financial institutions constantly complain about regulatory overlap, and strongly disapprove of the plethora of different reporting requirements. Many international financial institutions have already told us that they see one-stop shop regulation as being a serious competitive advantage for the City as long, of course, as we get the intensity of regulation roughly right.

But also, from a market protection perspective, it makes increasing sense to look at institutions in the round, and to look at the risks they run in the way they do themselves. So where a major financial institution manages its risks on a global basis, it makes good sense for a regulator to do so that way too. That is the logic behind the Complex Groups Division which I referred to briefly earlier. In that area we will be trying to look more comprehensively than before at the total risk run by a global institution, and the potential impact of its failure on the financial system.

There is one more point worth making in relation to the international dimension of financial regulation. The G7 Finance Ministers have recently agreed to set up a committee, under Andrew Crockett of the BIS, to bring together regulators and central bankers around the world. The proposition is that each country should be represented by its finance ministry, central bank and by the "leading national regulator". In the UK, it is easy to see which organisation fills that rôle; in other countries, it is less easy. I would not be surprised to find that this initiative led to further regulatory consolidation in other countries, in order to match the emerging needs of the global financial marketplace.

2. Clear accountability

The second crucial advantage of the new regime is that it incorporates clear lines of accountability. There is clearly no doubt about who is responsible in the event of a regulatory failure. I may live to regret that clarity of responsibility, but at least as a theoretical proposition it is attractive. There is a clear separation of duties between the Treasury and the FSA, with Ministers responsible for the statutory framework while the Authority is responsible for acting effectively within that framework.

There has been some public debate about whether the accountability of the new Authority is adequately buttressed by appropriate procedures. In my view, with a Board dominated by Non-Executive Directors, a statutory Practitioner Panel, a statutory Consumer Panel, the requirement to hold an open Annual Meeting and submit an Annual Report to Parliament, the oversight of the Treasury Select Committee as well as Treasury Ministers themselves, are an adequate set of mechanisms. But that point will undoubtedly be debated in Parliament.

There is also a very clear articulation of the different responsibilities of the Treasury, the Bank of England and the FSA in the event of financial crises.

These different responsibilities were set out in a Memorandum of Understanding published in the autumn of 1997 which described the different responsibilities of the three of us. The FSA is clearly responsible for all regulatory relationships with financial institutions, and for ensuring that they meet supervisory requirements. In the event of a failure, or incipient failure, we are required to assess whether an institution is, in fact, on the verge of collapse and what the direct impact of such a collapse would be on other institutions. We are also required to assess whether there is the possibility of a rescue mounted by other private sector bodies. If that is not the case, and we consider that there would be a risk to the financial system then we bring in the Bank of England. The Bank is required to assess the nature of the systemic threat, and assess the justification for any kind of public sector support, whether the provision of short-term liquidity, or indeed the provision of capital. If the latter is required, then clearly the Treasury must be involved since, ultimately, we would be talking about public money. (All of this would, of course, happen in real time).

This framework is clear and has the advantage of pinning appropriate accountability on the different actors in the system. It is also published, so that market participants know where they are. The IMF have recently reviewed these arrangements as part of their assessment of the financial system here and have given them a clean bill of health. Indeed I think they will increasingly be seen to be a model for appropriate arrangements elsewhere in the world.

Financial regulation is not all about coping with failure. For the most part it is about trying to ensure that failures are few and far between. But it is often difficult to give a clear description of the aims of a supervisor. How far is one in the business of protecting depositors? How far should one have regard to the desirability of maintaining market stability?

3. Clear objectives

Another new feature of the Financial Services and Markets Bill, my third key point, is that it is based on a set of statutory objectives, which act as the capstone of the new legislation.

The draft legislation gives us four objectives.

First, to maintain confidence in the financial system. This is clearly not easy to measure actively, though it will be fairly obvious when such confidence is lacking. A lot of our prudential work, ensuring that institutions are adequately capitalised and that their risks are well managed, contributes to this objective. So, of course, does our continuing supervision of markets and exchanges.

The second objective is of a rather different order. We are tasked with promoting public understanding of the financial system, and of the risks and benefits of financial products and services. This is such an important initiative that it deserves separate treatment, which I shall give it later.

The third objective relates directly to consumer protection. Our aim must be to protect consumers, but bearing in mind their own responsibility to inform themselves, and to take responsibility for their decisions. There will be lively debate in Parliament, I am sure, about the extent to which this objective should be qualified by the principle of caveat emptor. Some consumer groups do not think such qualification is appropriate. Financial institutions, by contrast, are strongly in favour of including a reference to consumers’ own responsibilities. Without it, they argue, one could justify almost any degree of regulation, and indeed wholesale retrospective re-opening of contracts.

My own view is that it does make sense to incorporate the general principle of caveat emptor in the legislation, although it may be that the current drafting could be improved. In practice, too, we shall need to take account of this principle in different ways in relation to different consumers and markets. Consumers making long-term decisions in conditions of uncertainty, and vulnerable consumers, are clearly more in need of protection than high net worth private investors in hedge funds.

The last objective gives us the aim of doing what we can to reduce the extent to which regulated businesses are used for the purposes of financial crime. This is an important area of work, both domestically and internationally, but I do not propose to go into it in any detail this evening.

These objectives provide the framework within which the Authority must make its decisions on both the type of regulations to impose, and the intensity of effort which should be devoted to policing them. It is quite clear that they will require careful decisions on balance.

But my Board is not left to make those difficult decisions without further guidance. And the draft Bill includes a set of provisos which we need to bear in mind, and which must condition our work.

There are six such provisos, all of which must, as the police say, be taken into consideration.

We must take account of the need to be economic and efficient in our use of resources, and indeed in our use of other people’s resources. We will have to produce cost-benefit analyses of any major regulatory changes we seek to introduce, and those costs should include both our own in-house expense and the costs we impose on regulated firms, which generally outweigh the out-of-pocket regulatory charge by around 4:1. So far, I think we have made a good start on our own costs. Over the last two years our budgeted costs have fallen slightly in real terms each year and, indeed, this year we shall come in well under budget, producing a useful rebate for many firms. Next year our budget is expected to go up by 1.9%, below the rate of inflation, and considerably below the increase in financial sector salaries. This is because bringing together the nine different organisations already gives us the opportunity of achieving some economies of scale, particularly in the support areas.

The second main proviso is of a rather different order. It is that we should base our regulatory approach on the principle that senior managers are responsible for the management of their firms, and for ensuring that they comply with regulatory requirements.

This is an important aspect of the new régime, and one which has perhaps not attracted sufficient attention so far.

In fact, the different regulators coming together into the FSA have all been moving in this direction in recent years, seeking to clarify the regulatory responsibilities of those who control City firms. It is entirely clear that management within firms will have much more impact on the compliance culture, and the way in which the firms’ employees treat its customers, than any number of regulators. But an unhappy feature of some recent cases has been the willingness of those senior managers to distance themselves from the actions of their sales forces, brokers, traders or whoever. We need, I think, to reinforce these linkages, and the in-firm responsibilities for compliance. If we can do so, then the need for intrusive and detailed regulation may be reduced.

The third proviso is also crucial. Different types of markets, with different levels of expertise in the customers within them, justify different intensities of regulation. This can, if you like, be paraphrased as the wholesale/retail split. In fact we believe things are a little more complicated and, in a recent paper, we suggested a three-way classification of counterparties, even in wholesale markets, between market professionals, expert end-users and retail investors, who deserve more protection. Some have argued for a more rigorous retail wholesale/retail division within the legislation itself. In our view the language of the statutory objectives and the provisos should provide market participants with the assurance they need that we will not be more intrusive than is justified in the wholesale sector.

Objectives four and six can perhaps be dealt with more briefly. We must take account of the desirability of innovation. So it will not be open to the FSA simply to ban a new product type because we do not like the look of it, or because we think it is capable of being mis-sold. And we must also take account of the desirability of competition. That means, I think, not regulating in such a way as to bias the market in favour of a particular category of provider. It also points towards regulatory interventions which improve the quality of decision-making by consumers. In other words, it justifies greater disclosure of costs and charges, simpler disclosure of expected and actual returns, perhaps league tables based on the former, at least, and a strenuous effort to improve consumers’ awareness of competing homes for their savings.

Lastly, we are enjoined to take account of the international nature of markets, and the desirability of maintaining the competitiveness of the UK’s financial markets. This does not mean that we should be cheerleader for the City. That would not be an appropriate role for the regulator. Nor does it mean we should champion the cause of any individual institution, category of institution. But we need to be aware, as we reach our decisions, that international financial business is mobile and to recall that we do not necessarily contribute to the achievement of our other objectives if we simply push business off-shore into less well regulated jurisdictions. Some overseas regulators have raised an eyebrow at the existence of this proviso in our legislation, worrying that it could provide an incentive for a "race to the bottom" in regulatory terms. I think those concerns are exaggerated, and am quite content for the FSA to be required to reflect on the impact of its regulation on competitiveness, in the careful way in which the relevant clause has been formulated.

These provisions form the cornerstone of our effort, or will do in the future. They build on the approach taken in the past, and in some ways merely codify the approach the existing regulators have taken. But one objective is new, and justifies further consideration. That is the requirement to promote public understanding of the financial system.

4. Promoting public understanding

We are, as yet, at a relatively early stage in determining how to pursue this objective. Some of the existing regulators have undertaken work in that area, but none has yet been able to make it a core feature of their mission. We are therefore feeling our way, and began with a Consultation Paper near the end of last year, which set out various different options. Somewhat to our surprise, we have had more than 100 responses to that paper, almost all of which were enthusiastic about the potential role for us, and we are now working up a more comprehensive and coherent strategy.

Our overall aim must be to improve the quality of decision making. There has, sadly, been a good deal of mis-selling, particularly in the personal pensions area in recent years, and perhaps in endowment assurance, free-standing Additional Voluntary Contributions to pensions, and some other areas too. But there is also a lot of mis-buying. That is not the fault of the institutions, and they cannot reasonably be blamed if people in full possession of the facts make decisions about their finances which turn out to have been mistakes. There could be a significant welfare gain if we can help consumers to be better purchasers. And, in the long run, better educated, more demanding consumers will be better for the industry. Companies in other sectors are aware that the best stimulus to competitiveness is a critical and discerning domestic customer base. Firms may have second thoughts about that from day to day, but the general principle is sound in the long term.

We therefore see our two key rôles as being to work to enhance financial literacy, and in the provision of what we call generic advice. In other words, advice which stops short of recommending particular products, but helps people with the questions they need to ask themselves, and potential advisers and providers, before they reach final decisions.

Undoubtedly the best means of promoting financial literacy will be to try to promote the incorporation of financial literacy courses into the curriculum in schools and colleges. We know, of course, that the school curriculum is crowded, perhaps more crowded now since the introduction of the National Curriculum than it was in the past. But there are moves afoot to incorporate a citizenship component, into which financial literacy can comfortably sit. And we believe it is possible to link financial literacy to the mathematics curriculum in a variety of ways. There are also plenty of courses at further education colleges in which this kind of work can find a place.

On the advice front we are already quite active. We have produced a first set of publications helping people think through the implications of the choices they face, including a guide to Individual Savings Accounts and to the potential retail implications of the Euro. We have introduced a series of help-lines, both generally and specifically in relation to pensions mis-selling. We already get thousands of calls a week. And we have held three pilot town meetings around the country, getting us into direct face-to-face contact with investors. I have chaired two myself, and found them very valuable experiences in giving a first hand understanding of the kind of worries and uncertainties in people’s minds. Town meetings have been held around the US by the SEC for many years, associated with local publicity to ensure that the messages gets across to more than those who attend the meeting. Our initial experiment suggests that there is an appetite for face-to-face contact with the regulators in this country, too. Each of our three meetings so far has been over-subscribed and lively.

5. Tackling market abuse

I said earlier that the scope of the FSA’s regime would be broadly that of the component organisations. But there is one important exception. The Bill includes new powers for the Authority to tackle market abuse: the manipulation of market prices through artificial transactions or insider dealing, in particular.

It has been obvious for some time that public authorities in the UK lacked the powers needed effectively to tackle market abuse. The fragmentation of responsibility in the current regime is perplexing. The Serious Fraud Office, the DTI, the self-regulatory organisations and the recognised investment exchanges all potentially have an interest in dealing with market misconduct. The self-regulators and the exchanges are responsible for enforcing regulatory rules; the FSA may investigate the affairs of firms carrying on regulated business; the DTI is responsible for investigating and prosecuting insider dealing and the SFO may investigate and prosecute in cases which involve serious and complex fraud.

In addition to the problems created by agency fragmentation, difficulties arise from the absence of specific civil remedies for much conduct which is market abuse, but is not covered by the existing criminal regime. The criminal offences are narrowly defined. They apply only to individuals and not firms, and require the prosecution to prove criminal intent. It is possible to damage the integrity of markets and confidence in them without necessarily having any intent to do so.

The consequence of this fragmentation of responsibility, on the one hand, and imperfect specification of the offences, on the other, is that in spite of a good number of suspected cases and references, there were only five insider dealing convictions between 1993 and 1998, and eight acquittals. Cases under the Financial Services Act which outlaws misleading statements to induce people to deal in investments are similarly very rare, with very few having been successfully prosecuted. Perhaps London’s markets have been perfectly clean throughout this period. I beg leave to doubt it.

The new regime aims to bring about improvements in three areas. First, it aims to reduce the fragmentation of responsibility. The FSA will have powers to deal with regulatory breaches, to prosecute the new market abuse offences in the Bill as well as the existing criminal offences. The changes also aim to increase the scope for non-criminal means of dealing with market misconduct. The proposed civil fines regime would apply to non-regulated as well as to regulated firms, and to individuals who take advantage of the facilities of organised markets. Had we had these powers in 1995, we would have been better able to deal with the damage inflicted on our markets in the Sumitomo case. As it was, the different laws in the US enabled the American regulators to tackle this problem more effectively than we could, even though the market directly affected was in London.

Thirdly, the new provisions provide a mechanism to clarify the nature of the wrong-doing that should be prohibited. The FSA is required to issue a code of market conduct which will specify the description of behaviour that it considers is, or is not, market abuse, together with the factors it will take into account in making a determination. We are required to consult on a code, indeed we have already done so. I would not pretend that it was easy to produce a code which defines, beyond reasonable doubt, those practices we regard as illegitimate. But we have made a stab at it, and are currently discussing the details with market participants.

I think it is vitally important to introduce a new and effective market abuse régime. There are vital issues at stake, both of investor protection, and of market confidence. We must not forget that the experience of the last decade has demonstrated embarrassing gaps in our regulatory armoury. It has been difficult, in some highly publicised cases which have been very damaging for the reputation of London’s markets to bring to book those whose behaviour was ultimately responsible for the damage done. As we look at the difficulties of devising a regime which is clear and fair enough, we must not lose sight of that. We are all losers from abusive practices, which affect individual investors or groups of investors in the short run, and all market participants and their clients in the long term.

6. A world-leading regulator

My sixth and, you will be glad to know, last competitive advantage of the new system is more general. We aim to produce what I loosely and perhaps grandly call a world leading regulator.

What do I mean by this lofty claim?

First, the very fact that we have an opportunity to update our legislation is, in itself, a competitive advantage. US markets have been handicapped by the difficulty of getting regulatory reform through congress. And, surprising though it may seem, legislatures around the world have limited appetite for engaging in the time-consuming task of reforming financial laws. The fact that the Government here have been prepared to find time for reform is a great help. And the fact that they have proposed a new legislative framework which incorporates a high degree of freedom for regulators to make rules within a legislated framework also offers the prospect of our being able to keep the regime up to date, in response to market changes. Financial markets, and the products traded within them, evolve rapidly and often unpredictably. Technology alone, especially internet technology, is going to set major challenges for even the best-equipped regulators. But, for a marketplace to remain attractive to leading edge participants it needs constantly to renew its regulations. We shall have the opportunity to do that, in the future.

Also, while it is easy to be pre-occupied by the difficulty of merging nine different organisations, with all the practical and cultural problems that brings, it is also an opportunity to introduce modern management methods. We have been able to flatten our hierarchy and improve the flows of information around the regulatory system. We have adopted the symbolism of an open plan environment. I do not have an office of my own, and am in constant eye contact with, and earshot of my key lieutenants. I believe that contributes to a culture of open communication within the organisation.

Also, and more importantly for the long run, a single regulator with the breadth of responsibilities we have is better placed to invest in professional development. The individual component regulators have not always had the opportunities we now have to invest in their staff. Financial institutions tell us that they attach the highest importance to dealing with regulatory staff who know what they are talking about. There is nothing worse than regulators who do not understand the business properly, and therefore take refuge in an over-rigid and literal interpretation of the rulebooks. Well trained people, with the confidence to make judgments, are better able to cope with the demands of a fast changing environment.

Of course I recognise that these are all theoretical advantages at present; they are all tries that need to be converted, if you like. But I am encouraged by the signs so far. And it is certainly true that many regulators elsewhere in the world are envious of the opportunity we have. We will have no-one but ourselves to blame if we do not seize it.

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