Cabot Hall, Wednesday 16thJune 1999
Howard Davies
Chairman, Financial Services Authority

We are living in a period of remarkably rapid change in the regulatory environment for financial services businesses. That is true internationally – both globally and in the narrower European context. It is also true on the domestic scene, where the creation of the FSA and the overhaul of the legislation underpinning financial regulation could have a big impact on the way you do business.

This change is, of course, part of our daily lives here. But I am not so embedded in regulation that I believe it to be a preoccupation of yours from day-to-day. Indeed it would be a sad world if that were the case. I hope that you spend most of your time thinking about how to exploit, sorry serve, your clients.

But from time to time it is important to take stock of the regulatory environment and changes underway within it. And our aim this morning is to present a kind of bluffer’s guide to developments in financial regulation, which should allow you to score brilliantly high marks in any cocktail party chat on the subject, and would even give you just about enough material for a dinner party conversation, if you should be unlucky enough to find yourself placed next to a regulator on table 76, where we are generally to be found.

Part of the global regulatory change we are seeing owes its origins to the financial turmoil in Asia which began in the summer of 1997. Michael Foot will talk about the shocks in emerging markets at that time, and about their implications for financial markets elsewhere and, in turn, the implications for the regulatory environment.

You will all be aware that those shocks stimulated considerable debate internationally about the appropriateness and solidity of the international financial architecture. There were those who argued, and indeed some still do, that the powers and responsibilities of the IMF and the World Bank have been revealed to be inadequate and even inappropriate, and that what was needed was some kind of world financial authority to watch over international financial markets and, perhaps, impose additional controls on them to reduce damaging volatility and the risk of contagion.

There have been a number of useful consequences resulting from that lively debate, even though we have no World Financial Authority, for the time being, at least. There is the new contingent lending facility at the IMF, for example. And a couple of months ago the G7 Finance Ministers set up a new Financial Stability Forum with the twin aims of looking for trouble, on the one hand: trying to identify early warning signals of impending market turbulence. And, on the other hand, to try to promote enhanced co-ordination of the responses by regulators to disturbances in financial markets.

Andrew Crockett of the BIS is now the Chairman of the Forum. The early work was done by Hans Tietmeyer of the Bundesbank, but he handed over the baton to Andrew at the first formal meeting. So this morning you can hear from the horse’s mouth about what the Forum will attempt to achieve. But I might perhaps offer a couple of thoughts from the FSA perspective. First, we are keeping very close to this work. Each of the G7 countries is represented by its finance ministry, its central bank and its leading financial regulator – which, in the UK, is us.

And some of the issues debated at the first meeting were very close to our own day-to-day concerns. The Forum decided, for example, to set up a task force looking at the activities of highly leveraged institutions, and the appropriate regulatory response to the risks they can pose for financial markets generally.

Of the thirty members of the Forum, 29 were smarter than me and all avoided being asked to chair this group. I am therefore spending quite a bit of time now trying to make sense of the various different initiatives which have been launched in response to the temporary collapse of LTCM last September. The Basle Committee has looked at the implications for banking supervisors. IOSCO is assessing the implications for securities regulators. The President’s Working Group in the US, which includes the Treasury, the Fed, the SEC and the CFTC have made recommendations. So has the BIS Committee on the global financial system.

Making sense of all this, which is only accidentally co-ordinated so far, is quite a challenge. And one crucial dimension is to understand what the market thinks may be an appropriate response. On the private sector side the leading edge work is being done by the Counterparty Risk Management Policy Group under Gerry Corrigan of Goldman Sachs and Steve Thieke of JP Morgan, with the involvement of a wide range of large financial institutions, from the US and elsewhere. Steve Thieke, as many of you know, is a member of the FSA Board. He will be talking later this morning about the conclusions his group is reaching. They plan to produce their report in the next few days, so this is a particularly good opportunity to get a sneak preview of their proposals.

These two groups – the Financial Stability Forum and the CRMPG – are new creations. But some more venerable bodies have also been very active in recent months.

You will have seen that the Basle Committee under Bill McDonough of the New York Fed produced a consultation paper on a revision of the capital accord a couple of weeks ago. In fact it was launched at the FSA. It was not the easiest birth, and some of you will have seen press reports on internal debates at the Committee about the treatment of commercial mortgages, the use of external rating agencies, the place banks internal credit risk models might have in capital allocations in the future etc, etc.

Oliver Page, who is our permanent representative on the Committee, will give you the low-down on these debates, and will introduce the substance of the proposals in the consultation paper. This is a subject of the highest importance and one on which it will be vital for banks to offer their views in the coming months. We aim to promote an open consultation process, focusing on the key issues. I cannot emphasise enough that the next six months will be crucial. It is absolutely vital that we agree a revised capital accord before too long. The drawbacks in the existing accord are too serious and too obvious for them to be allowed to persist for much longer. And a capital accord is not something you can reasonably revise every year or so. So this year’s debate will be crucial in setting the scene for the next decade. That is why we have been providing briefings to the London banking community already, to ensure that you get up to speed quickly and can input effectively to the process.

I said at the start that we wanted to describe some global changes, some at European level and some nationally. I will be brief on the European dimension since Clive Briault, our Director of Central Policy, will take you through the detail shortly. But it is very important to acknowledge that there is more to the development of policy in Europe than the exciting topic of the withholding tax on eurobond dividend payments. Commissioner Monti has been very busy in recent months on other topics, while withholding tax has hogged the headlines.

He has put forward a range of measures to promote the completion of the single market in financial services, most of which are, in our view, quite welcome from a UK and a City of London point of view. A programme of action was recently endorsed by finance ministers, so we can expect some measurable progress from now on.

There have also been some debates about the future structure of regulation in Europe. Some have argued that the eurozone needs a single banking supervisor, perhaps at the European Central Bank. Wim Duisenberg himself has advanced such an argument.

One might think that the ECB had enough other problems to contend with, as it is. But a more serious point is that, in our view, it would be quite wrong to recreate at European level a structure of banking supervision which is progressively being abandoned nationally. Country after country, as I shall show, is moving towards more integrated financial supervision, reflecting the ways in which sectoral boundaries within the financial services industry are becoming less and less meaningful. So it would be curious to introduce a eurozone banking supervisor.

There are others, notably in Paris, who argue that Europe may come to need a single capital markets regulator. This, in my view, is an argument that cannot be dismissed out of hand, and certainly not for all time. But a genuine single market platform for equity trading across the European Union may be a little way off, and even if it arrived, we would need to address the non trivial question of the legal basis for such a regulator. Regulators do not exist in the abstract, floating above the legal system. How would a regulator enforce its decisions if there were no court system underpinning it? And we are a long way from a single legal jurisdiction in the European Union at any but the highest level.

But I do not take the view that no changes are needed in European regulation. Far from it. And it is clear that as the cross-border trade in financial services expands and as pan-European institutions develop, there will be a need for much enhanced co-operation and collaboration between regulators in different countries of the Union. That is one reason why, with my securities regulator hat on, I was closely involved in the creation of the Forum of European Securities Commissions, FESCO, at the end of 1997. In that context we are working to promote more harmonisation of market practices around the EU, so that we can have more confidence in the integrity of each other’s markets. I have been chairing, for example, an expert group on standards in regulated markets, building on the rather vague terms of the Investment Services Directive. I shall be sending out a draft consultation paper on that subject very shortly.

But of course most of our own time at the FSA in the last two years has been devoted to the construction of a single regulator, and to work on the development of the new legal régime which will underpin it.

Managerially, the new FSA is now broadly complete. And we have put it together more with an eye to the new régime, than to the old. That is not to say that we will not need to change and adapt as time goes by. I am sure we will, as you frequently do. But we have begun to try to achieve the benefits of integration, ahead of the new Act. Perhaps the most visible example of that is the establishment of the Complex Groups Division under Oliver Page. In that area we are developing our concepts of lead supervision and beginning to work on pilot group supervision projects. The difference between the two is that, under a lead supervision régime, the lead supervisor is matrixed across the FSA to others who regulate different parts of your business. That set of matrixed relationships should be increasingly active. In other words the lead supervisor and others should plan their regulatory activity in a coherent way. But they would remain separately managed.

Under group supervision, we would bring together a multi-functional team in one place, with all the skills necessary to supervise the different parts of a single group’s business. The potential advantages of such an approach are obvious. But there are potential drawbacks too. Would specialists in fund management, for example, lose contact with their former colleagues and therefore lose leading edge experience, if they are brigaded with colleagues from other disciplines. Would we lose economies of scale, and end up with more costly regulation? These are issues we will need to address in our pilot experiments, which will begin very shortly.

But while we have been able to take advantage of some of the benefits of an integrated regulator already, we cannot fully capture those benefits until our new legislation is enacted, and we can dismantle the old regulatory régime. At the moment, while we employ all the staff of the old regulators, the SRO Boards, the Building Societies and Friendly Societies Commissions, and all the rest, remain in existence and form a separate set of reporting lines for regulatory staff. That is not an ideal arrangement, and not one which can sensibly endure for too much longer.

So we are keen to see the new legislation enacted as soon as possible.

At this point I am uncomfortably conscious that most of you will, by now, be hopelessly confused as to where the legislation now sits. I regularly come across people who think it is all done and dusted, and who make the reasonable assumption that if we exist altogether in one building, with FSA on the front, and a marble plaque saying the Queen carried out the opening ceremony, then we must be legal already. At the other end of the spectrum I find those who believe our legislation has become hopelessly enmired in political controversy, and may never see the light of day.

It may be helpful, therefore, if I explain the formal position, as I understand it.

The Financial Services and Markets Bill was published in draft last July, and put out for consultation in the market until October. Then the Treasury Select Committee carried out a brief review of the Bill over the winter. Both the consultation process, and the Treasury Committee report, revealed a high degree of consensus about the main principles of the change. In other words, there was broad support for the principle of a single regulator, and for the idea that the regulator’s task should be governed by a set of statutory objectives, giving the regulator a high degree of discretion as to how to set rules, principles and guidance in order to meet those objectives.

On the first point, the principle of a single regulator, it is interesting that the idea, which seemed rather extravagant in May of 1997, has attracted increasing support internationally. A number of countries have followed our lead, as far apart as Iceland, Korea and Japan. We expect more to follow before too long. And indeed there is a general trend internationally towards regulatory consolidation, and towards moving banking regulation outside the central bank.

But to return to the legislative process, the Government announced in the Queen’s speech for this Session that our Bill would be subject to two constitutional innovations. First, there would be pre-legislative scrutiny carried out by a Joint Committee of both Houses of Parliament and, second, the Government aimed to complete the passage of the Bill over two Parliamentary Sessions, subject to what is formally known as the carryover procedure, whereby a Bill may be revived in the next Session without falling, as public Bills now typically do.

The first of these two constitutional innovations is now complete. A cross-party bicameral Joint Committee chaired by Lord Burns, the former Permanent Secretary to the Treasury – but also including people with financial experience – reviewed the Bill between March and May and produced two quite detailed reports on it. They made a number of recommendations. They argued for some changes which would enhance the accountability of the new Authority, and made some important recommendations about the disciplinary régime and, in particular, the new provisions on market abuse. But, again, the general principles remained intact.

I would like to have been able to summarise for you today the changes in the legislation that would result from that report. But I am not quite able to so do. It turns out that this is a big week in the life of the Bill. We expect, imminently, the Government to respond to the Joint Committee’s recommendations, and we also expect the Bill to be formally tabled in the Commons tomorrow. So the timing is delicate, and I must be careful not to prejudge what Ministers may say. I do not want to end up in the Tower. Though of course if you work in Canary Wharf, being sent to the Tower is being sent that much closer to civilisation.

I would nonetheless like to take this opportunity to comment, from the FSA’s perspective, on four areas which have generated some debate in recent months.

First, there is the question of the differentiation needed between the regulatory régimes which apply to wholesale and retail business. I can appreciate the concern of those in wholesale markets who are anxious that the types of protection appropriate for retail consumers would be unrealistic and unnecessary in the wholesale environment.

I hope that what we have said recently about our proposed régime will reassure those who have expressed such concerns. Of course it is the case that regulators in the past, notably the SFA, have had to cope with both wholesale and retail customers within their régimes. And our proposals that we should adopt a three-way classification system for counterparties, with market professionals, expert end-users and retail investors given distinct and different sets of protections, has attracted a good deal of support.

The Bill itself, as drafted, pushes us in this direction, requiring our regulation to be appropriate and risk-based. I hope, therefore that the wholesale/retail question will not be an issue of great substance during the passage of the Bill.

The second major area of controversy has concerned the enforcement processes envisaged in the new legislation. Indeed, one or two people who have not followed the debate seem to remain concerned. But those closest to the issue, and I include the major law firms in that number, are now generally content with what is proposed. The Joint Committee also declared that it was broadly satisfied with the enforcement processes we had set out.

It is important to note that some significant changes to the procedures have been made since the draft Bill was published. The aim has been to preserve a system in which there is a bias towards rapid, cheap processes – a bias towards agreed outcomes – yet which protects the rights of firms and individuals to a fair hearing and to independent adjudication of disputed cases.

We now envisage that there will be an FSA enforcement committee, composed of people external to the Authority, with both practitioner and public interest representatives on it, with voting rights. That Committee will oversee cases and will guide the FSA’s own staff on the terms of acceptable settlements. There will also be an opportunity for mediation while a settlement is being discussed.

If it proves impossible for the two sides to agree on the appropriate discharge of a case, then it will become a matter for the independent tribunal, which will be part of the court system, under the Lord Chancellor’s department. It is crucial to note that that tribunal is not an appeal tribunal. In other words, if a case goes to it the FSA will need to prove its case from scratch. The tribunal will not be aware of any settlement discussions that may have gone on. And of course decisions from that tribunal may be appealed through the rest of the court system, in the normal way.

My own view is that these arrangements meet the reasonable concerns that have been expressed about the powers and responsibilities of the new Authority. They embody considerably enhanced protections when compared to the existing régime. Those who continue to float the canard (if that is what you do to a canard) that we are going to be prosecutor, judge and jury in our own case have simply not read the papers.

The third area of some difficulty, which has kept a number of Silk in champagne for the last few months, concerns the nature of the proposed new market abuse régime.

There are, I think, two key issues here. First, whether the régime is sufficiently certain, and whether the Code, which we published in draft last year, is appropriately specified. And, second, whether the nature of the misconduct is such that they should be regarded as criminal in nature, especially since they apply beyond the regulated community.

On the first point, I have to say I am not persuaded that there is a need to expand considerably on the proposed definition in clause 56 of the Bill which, to those of you who have not yet memorised the full text, includes behaviour which is likely to mislead or distort the market and damage confidence that the market is true and fair. Clearly this is a general approach to defining market abuse, but there are many other examples in the law of general definitions which are helpfully and satisfactorily amplified by cases, in due course.

The question of the Code is rather different. We certainly accept that the draft can be improved, and we are working on that in some detail with market participants, who are helpfully devoting time to the effort. Gay Wisbey will talk more about that process a little later this morning.

I also can see the case, which was articulated by the Joint Committee, for making the Code a "safe harbour". If firms have sought to comply with it, they should not face subsequent regulatory action. That recommendation is one now under consideration by the government.

I also think we have to accept, in the light of the legal advice available to the Joint Committee, and to the government, that there is a risk of the market abuse régime being regarded as criminal in European Court terms. The government have therefore now announced that the key criminal protections – limits on the use of compelled evidence, and the right to (means tested) legal aid, should be built into the régime.

These changes are, I think, quite a comprehensive response to the market concerns we have heard.

The last point of controversy I wish to cover this morning concerns the nature of the rest of the disciplinary régime, where there is perhaps less consensus at present. Some have argued that it would be right to consider the normal disciplinary processes of the FSA as being in the nature of a criminal régime.

The government have made it clear that they see no legal argument for so doing, and that there is a clear distinction between the market abuse régime and the rest of the FSA’s proposed disciplinary processes. I agree. And, furthermore, I really beg leave to doubt whether the interests of London’s markets, and the institutions active in them, would be best served by a regulatory régime based on criminal procedures. My impression is that most institutions want a régime which is fast and, within reason, cheap. I do not think most chief executives want their organisation to be engaged in lengthy litigation.

Of course, you may say, were criminal protections to apply in all disciplinary cases, there would be fewer of them. Perhaps that is so, but given our other responsibilities I do not think you could safely assume that we would abandon enforcement process altogether. So the likely outcome would be a series of costly cases with little benefit to either side. I have to say I have been slightly surprised at the apparent enthusiasm shown by some in the market for this outcome. It would take us much, much further away from the regulatory environment which has operated in London over the last fifteen years, and which has been consistent with the continued development of London’s markets as the most dynamic and flexible in Europe.

The clear risk, of course, is that, with inflexible and hard to use enforcement processes, we could be required to introduce much greater precision and detail into our rulebooks. That could well be the consequence were it to be impossible for us to exercise discipline on the basis of our principles, another point which some have argued. I suggest that, once the full Bill and its explanatory memorandum have been published, the market and its trade associations should reflect on whether it is sensible to continue to press for further changes to the enforcement régime, which could produce, in overall terms, a much less satisfactory regulatory environment.

It is important to recall that – while some of the rationale for regulatory reform lay in an assessment of the international environment, and of the way markets are coming together, there is also a need to be vigilant, and to promote better standards of risk management, and – on the retail side – of customer care.

We should recall that the 90s saw more problems than we ideally needed in London.

Barings and BCCI on the banking side. Morgan Grenfell’s fund management problem. The Maxwell and Guinness affairs. Home Income Plans. Personal Pensions mis-selling – involving the largest customer compensation programme ever undertaken anywhere.

Together these problems have created a public perception that the City is not terribly good at keeping its nose clean. Unfair, perhaps, if you measure these problems against the scale of business undertaken. But it is in all our interests to correct that perception.

What we have sought to do is to create an FSA which delivers for the domestic agenda, but does so while making appropriate distinctions between wholesale and retail, is proportionate, cost-effective and allows for the free play of competition and innovation.

I believe the legislation helps us to set that balance, and incorporates appropriate checks and balances which give the market the comfort it needs that our regulatory powers will not be used inappropriately. It should therefore be supported.

I hope therefore that people in the City will conclude that it is in their interests to give the Bill a fair wind. I am concerned that, if it is held up, we may find more unwelcome bells and whistles being added to it. And while the Joint Committee – with strong City representation – has looked at it one way – let’s not forget that the House has a large Labour majority, with backbenchers who have quite a different set of interests, and who are keen to add new duties to those we have, and to extend the scope further.

The next few weeks, as the Bill starts in parliament, will be a crucial time. And my own view is that the City’s interests will be best served if the legislation makes rapid progress. Continued uncertainty is not in anyone’s interests.

Here endeth the lesson.

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