St Helier, Jersey, Monday 12 July 1999
Howard Davies
Chairman, Financial Services Authority

I was greatly honoured when, a few months ago, Richard Pratt invited me to deliver this lecture to mark the first birthday of the Jersey Financial Services Commission.

It is particularly pleasant to be able to do so, since I can look down on you from a position of great height and seniority. At the FSA we celebrated our first birthday fully six weeks ago.

I plan, first, to say a few words about where we are in the process of regulatory reform in the UK. Then to tell you something of how I see developments in the international regulatory scene, which I will ensure leads subtly and sinuously into a discussion of the particular challenges facing offshore centres like, and unlike your own. So there will, in musical terms, be a theme, some development in the form of a few exotic variations, and a coda bringing us back, I hope, to our starting point of prudence and financial stability.

The Financial Services and Markets Bill, which will reform the legal basis on which we supervise, was given an unopposed second reading in the Commons two weeks ago today. That is not to say our reform is wholly uncontroversial; it is not. But the controversy does not conveniently reflect any party or ideological division. I will say a word about the controversies there are in a moment, but, first, a few explanatory words about the way we have put the FSA together.

The first key move was the transfer of banking supervision from the Bank of England to the new Authority, which took effect on 1 June 1998. The Bank of England Act last year gave the Bank full responsibility for monetary policy, and it is not widely known that the one prior condition on which Gordon Brown insisted was that I was personally no longer involved in the decisions.

But the Bank of England Act merely transferred responsibility for banking supervision. It did not in any way reform the basis of bank regulation. That reform had to wait until the Financial Services and Markets Bill, which repeals the Banking Acts, Insurance Acts and the Financial Services Act. But that, inevitably, was going to take some time, if it was to be done properly. And it seemed unwise to all of us involved to leave the existing regulatory system in a state of uncertainty and limbo for, perhaps, three years. So with the willing and even enthusiastic collaboration of the Boards of the different self-regulators, and indeed of ministers who were responsible for building society, friendly society and insurance regulation, we constructed the new Authority at the same time as the banking regulators moved across. That is why our first birthday was 1st June 1999, and we shall keep 1st June as our birth date from now on, unless of course it falls on a bank holiday.

So last year we created an integrated regulator. And we put it together in a form which was intended to reflect the new world, rather than the old. No organisational structure is forever. But our aim was to create a new style of authority, right from the start, organised on functional lines, at the highest level. So we have a single authorisation department, a single supervision function – though for practical purposes sub-divided at present into something resembling the old sectors – and a single enforcement division. We also have a single consumer affairs directorate, of which more anon.

I could wax elegantly about the interesting challenges posed by the merger of nine different regulatory bodies into one. I have become, now, a world expert on nine-way mergers, a skill which, sadly, does not seem likely to be in very high demand when I retire from this post.

But I find that outsiders have a limited appetite for war stories about cultural change within organisations, and I think it more relevant to you and your concerns to talk about the aims of the new Authority and then perhaps a little about the areas of controversy we have encountered, issues which I am sure will find an echo in this jurisdiction, if they have not done so already.

The Bill as it stands envisages four objectives for the new Authority, together with a number of factors which we must take into account in pursuing those objectives. The four objectives are first, protection of consumers, while bearing in mind that consumers have some responsibility for their own decisions – the caveat emptor clause, as she is known.

Second, we are required to maintain confidence in the stability of the financial system. While there are some who argue that prudential regulation targeted at the second objective, and conduct of business regulation focused on the first, are potentially incompatible, I have to say that we do not find that is so. And my prudential regulators are clear that one of the main purposes of ensuring appropriate capital adequacy for our banks and insurance companies is to ensure that their depositors and policyholders interests are protected.

But we are to have two more objectives, also. We are required, thirdly, to seek to ensure that regulated firms are not used for the purposes of financial crime – which mainly involves guarding against money laundering, though not only that.

And we will also have a new fourth responsibility to promote consumer understanding of financial markets and financial products and services. This is a new objective for a regulator, and one we are pursuing with some enthusiasm. We are trying to persuade the curriculum authorities to include more elements of financial literacy in the national curriculum, which must be the right place to start in building consumer understanding of the financial sector. And we are finding a lot of interest in those ideas, as people gradually realise that the financial decisions which individuals will face in their lives in future are far more complicated than those they have faced in the past, as the state is gradually retreating from the provision of basic financial security from cradle to grave.

We are also engaged in a direct outreach programme to investors. It is quite hard to achieve publicity for this worthy activity. But I think we are already having some success, and somewhat surprisingly we are finding that people are keen to come out, even at night, to hear from us about financial planning and how they should think about the financial choices they make.

These objectives have been widely supported across the political spectrum. And indeed, to come onto the points of controversy, the arguments about our objectives have typically surrounded the possibility of giving us additional responsibilities. It has been suggested that we should also seek to promote the competitiveness of the UK financial services sector. Or that we should be, in a sense, the competition authority also, with a duty to promote competition. At present we are required only to take account of the impact on competition in our regulation, but that debate continues.

A second area of controversy, and which remains a matter of lively debate, concerns the scope of our regulation. In other words, what kinds of financial products and services should be subject to our delicate attentions? At present we impose conduct of business requirements on the sale, with advice, of long term investment products. We do not regulate the terms of deposits, nor do we regulate the terms of liabilities such as mortgages. The Parliamentary Committees who have already looked at our legislation have tended to argue that our scope should be broadened, certainly to include, for example, long term care insurance and the sale of mortgages. So far the government has not reached a firm view on those possible extensions. It has also been argued even that we should even regulate the sale of general insurance, something which I have to say I am not enthusiastic to do, though of course we do prudentially oversee general as well as life insurers.

A third area of considerable debate has centred around the accountability of the new Authority. It is fully accepted in the UK, as it is now here, that regulatory authorities need a high degree of independence from the political process. The dangers of political interference in financial regulation have been very amply demonstrated in the financial crises which hit Asian countries in 1998, in particular. But while a high degree of independence from political interference is necessary, regulatory functions nonetheless need an appropriate accountability framework. Financial regulators are typically endowed with a serious armoury of weapons, including a fining power and the power to deprive firms and individuals of their means of earning a living. It is right that those powers should be circumscribed in various ways. Less dramatically, financial regulators may impose financial burdens, or make rules which affect the nature of markets and the transactions with take place within them. There is a need for some kind of control on the exercise of that discretion, too.

The basic accountability framework of the FSA is now, I think, generally accepted. Of course the cornerstone of it is our statutory objectives, against which we can be held to account by Parliament, and indeed by the courts through a process of judicial review. We also have a Board, dominated by non-executives, appointed through a Nolan process of public advertising, nowadays, but ultimately by the Chancellor of the Exchequer. I have ten non-executive directors, and one ex-officio member in the form of a Deputy Governor of the Bank of England, alongside my two executive Managing Directors who, between them, run the business from day to day.

Then, in addition to the main Board, we are to have, established by the legislation, a consumer panel and a practitioner panel whom we must consult on important regulatory decisions. There is also a requirement on us to consult on new proposals, to prepare cost-benefit analysis of those proposals, and to publish feedback statements on the results of our consultation, including the reasons why we did not take notice of representations made to us, if we did not.

We are required to hold an open Annual General Meeting, and to put a wide range of detailed information in our annual report, including information on the costs of our regulation by comparison with the costs in other overseas financial centres. All this architecture of accountability has been put in place to buttress the Authority’s position and to make it account for its actions, while leaving us independent in the key areas. Ministers, for example, do not have a power to direct us in the use of our regulatory authority. And in corporate form we are a private company, limited by guarantee. This is significant in that it allows us some freedom to pay salaries competitive enough to allow us to recruit individuals from the industry we regulate. That is something which regulated firms regard positively.

A last area of controversy I will mention – it is not the only one remaining, but why should I beat my breast for too much longer – concerns our enforcement processes, and the legal framework within which we operate. In this area the government have been persuaded, by political and particularly legal argument, to row back a little from the original proposals they tabled for consultation twelve months ago. At that point the idea was that the FSA’s own enforcement committee, albeit with outsiders on it, should make decisions on disputed disciplinary cases, and that those decisions would be appealable to an independent tribunal set up as part of the core system by the Lord Chancellor. The government have now decided, in response to concerns about this provision, that while there will be every encouragement in the legislation towards settled cases, between the Authority and regulated firms, if no agreement can be reached then it is the Authority which must be the plaintiff in the tribunal, rather than the accused firm or individual. So we will be required to argue our case from scratch in front of an independent court where either the facts or their interpretation are disputed.

The government has also made an important change in the area of market abuse. One important aim of the new legislation is to improve the Authority’s ability to tackle insider dealing and other forms of market abuse which have blotted London’s copybook somewhat over the last decade. There have been very few cases of insider dealing brought, and even fewer successful prosecutions. The numbers have been remarkably small by comparison with cases in the US. Perhaps London’s traders and dealers are inherently more honest and law abiding than those in the US, but it is hard to believe that that is the only possible explanation, particularly when in many cases the firms concerned are exactly the same. The requirement in London to bring criminal prosecutions only for market abuse has made it very difficult for the authorities to tackle even some of the more obvious and egregious cases. So the government planned to introduce a civil régime for market abuse, which covered both authorised firms and others who took advantage of regulated markets. This was intended to be a purely civil régime. But over the last twelve months legal opinion has developed and, crucially, the government have also announced that they plan to introduce the European Convention on Human Rights into British law. The juxtaposition of these two developments created, for a while, the legal version of gridlock – a nasty sight to behold.

The government have now acknowledged that where non-authorised people are concerned the so-called Saunders protection should be introduced. In other words, there can be no use of compelled evidence, and there must be a provision for subsidised legal assistance if we bring market abuse cases against those outside our authorisation. This, again, is a point which may well be of interest to you here in the future, and perhaps even today.

So we press on now with the committee stage of our Bill. That stage is perhaps a little less unpredictable than normal because we have been through a Joint Committee process, a constitutional innovation involving a Committee of both Houses of Parliament, put together on a cross party basis, which has already subjected a large part of the legislation to in-depth review. Though the expectation is that there will, as usual, be a wide range of amendments proposed by both sides. In 1986 there were 1,000 government amendments alone when the Financial Services Act was passed. I expect fewer this time. And I expect the Bill to receive Royal Assent around Easter of next year, with full implementation following in the autumn.

So the regulatory scene is in a state of some movement on the other side of the channel. And it is fair to say that we are not alone. Many countries are considering reforming the structure of regulation, just as you and we have done. The Australians have reformed their system, introducing two regulators, one prudential and one conduct of business under an over-arching single board. The Japanese have set up an FSA, quite similar to our own. The Koreans have done the same. A committee of enquiry in Ireland has just recommended a single regulator there, outside the central bank. There have been mergers in Iceland, in Estonia, Latvia and Luxembourg, to name but a few.

You will be pleased to know that I do not plan to take you through the 180 members of the International Monetary Fund to describe each of their regulatory systems in intimate detail.

Perhaps more important than this spate of structural reform is the great and growing interest among politicians in the quality of financial regulation around the globe.

That interest has, I would say, taken two main forms so far. First, the regulatory groupings, the trades unions of regulators as I like to describe them, have been overhauling and upgrading their rules and principles. IOSCO has published a set of principles of securities regulation, which are being followed up in many countries around the world. They followed of course the Basle Committee’s core principles of banking supervision promulgated in 1987. The IAIS (the insurance supervisory group) has done something similar.

So in the main areas of financial regulation we do now have a corpus of internationally accepted good practice against which we can judge regulatory systems around the globe.

And this judging process is now rather more than a theoretical possibility. The IMF has begun to take considerably greater interest in financial regulation in its article IV reports, and has established a unit within the Fund now which is undertaking focused in-depth reviews of financial systems in many emerging market countries, and probably in some developed economies, too. This exercise is not without its political sensitivity, of course, but I think it not unreasonable that the Fund, particularly where it is either engaged in, or envisaging support programmes for particular countries, should be interested in assessing the robustness of the financial system. We have learnt to our cost that large-scale financial support to countries with fragile banking systems can be so much money down the drain.

And the growing political interest in regulatory issues has been reflected in other ways, too. Successive G7 communiqués have referred to the importance of exchanges of information between regulators, and regulatory co-operation to fight financial crime, in particular, but also to raise standards of supervision generally. There were strong conclusions in that sense at the Birmingham summit in 1997, for example, and again more recently at Cologne.

These are not simply summit conclusions, about which I know it is possible to be somewhat cynical, and perhaps justifiably so where the communiqué is drafted beforehand, circulated narrowly, the subject of 1½ inches coverage in the Wall Street Journal before being quietly forgotten.

It was precisely to guard against his initiative suffering that fate that Gordon Brown made some concrete proposals for change in the architecture of international financial co-operation last year. His initial thoughts were that the G7 should set up a Standing Committee on global financial regulation. And Hans Tietmeyer of the Bundesbank (as he then was) was asked to go away and investigate the viability of that idea.

His conclusion was that something slightly different was needed, perhaps a little short of Gordon Brown’s initial proposition, but in my view rather important, nonetheless. He proposed the establishment of a Financial Stability Forum, grouping together finance ministries, central banks and leading national regulators from the G7 countries, together with the international financial institutions and the regulatory trades unions. Since its first meeting in April, the Forum has also added one or two other members, in the form of Hong Kong, Singapore, Australia and the Netherlands.

I see the Forum as having two main functions. First, to improve the ability of the world regulatory community to anticipate crises and at least prepare reactions to them, if we cannot realistically think of preventing them. Financial markets will always tend to overshoot from time to time, and we should not think as regulators that we can eliminate that volatility, or blunt the animal appetites of the financial community. We can, however, hope to be less surprised by seismic shifts in the markets when they occur, and perhaps to be a little better prepared with a co-ordinated response when crises hit us.

The second key function for the Forum is to work on resolving those problems which do require a co-ordinated response, involving finance ministries, central banks and regulators, from both developed and developing markets alike. At present there is no other forum in which all of those players come together.

Interestingly, at the first meeting, there was no shortage of ideas about topics which could be usefully addressed in this way. It was not so much an issue of beating the bushes to find an appropriate topic, rather of cutting a rather large list down to manageable proportions. After much debate the Chairman, Andrew Crockett of the BIS, concluded that there were three areas in which work was urgently needed.

The first, which is perhaps a little ahead of the other two, concerns the activities of highly leveraged institutions, and the risks they pose for financial stability, following the near collapse of Long Term Capital Management in New York last September. This is a particularly difficult problem. It has two dimensions. First, a regulatory one – how does one know what these largely unregulated institutions are up to, and how does one get a handle on the interaction between regulated institutions and unregulated funds? But there is also a macroeconomic dimension. Is it the case that hedge funds have targeted particular economies or particular currencies and created unstable market conditions through their aggressive trading strategies, particularly in small to medium sized open economies? And, if so, what can and should be done about it?

These are very delicate and awkward questions, on which reasonable people may hold widely diverging views.

Reflecting this difficulty, 29 of the 30 people on the Forum were smarter than me, in that they all avoided being invited to chair that group. I am spending a considerable amount of time on that initiative at present.

The second group was charged with looking at the problems created for small open economies by short term capital flows. It is apparent that inflows of capital into Asian economies reversed very rapidly when the crisis struck, leaving a number of countries speculating as to whether they might have been better off without them in the first place, and indeed whether there was a case, perhaps on the Chilean model, for some grit in the oyster, perhaps in the form of taxes on short term capital flows. That group is assessing the arguments for and against.

And a third group was set up to look at the issues surrounding off-shore financial centres. That group is chaired by John Palmer, the Superintendent of the Canadian office of supervision of financial institutions. It leads me, as I said it would, to your concerns, here in Jersey, as you assess the future of your own regulatory system.

The remit of the group is cast in rather general terms. They are required to take stock of the use made by participants in international financial markets of off-shore centres and to consider the impact of such use on financial stability. Furthermore, they are to review progress made by off-shore centres in enforcing international prudential and disclosure standards, and in complying with international agreements on the exchange of supervisory information, or information relevant to combating financial fraud and money laundering. And they are to assess the scope for improving compliance and co-operation through technical assistance to off-shore financial centre authorities, and such other steps as may be appropriate, including supervisory reactions in the case of non-compliance and non co-operation.

It is far too early to say with certainty how this work will develop – the group has met once only, so far – but, as ever, the terms of reference give some kind of clue as to the direction it might take. There is no doubt that there is some frustration among G7 finance ministers, and indeed amongst some regulators, about the co-operation they get from some, and I emphasise the word some, off-shore financial centres.

You are better aware than I am of the diversity of customer practice in off-shore centres. And indeed the Edwards review began with the simple and encouraging observation that the Crown dependencies are clearly "in the top division of off-shore finance centres". As he said, "compared with other offshore centres, they have developed reputations for stability, integrity, professionalism, competence and good regulation". He added "the critics also sometimes object to secrecy, poor regulation and poor co-operation of offshore centres. Such criticisms, if applied to the Crown dependencies, would generally in my opinion be quite wide of the mark". If that conclusion is correct, and I have no reason to question it, then you have little to fear from this heightened interest among global decision makers in the activities of financial institutions offshore. But, of course, standards could change. And my general forecast would be that the standards of regulation which will be demanded in the future will be higher than they were in the past. Furthermore there will be more pressure to make international regulatory co-operation work more effectively. Almost every financial crisis of recent years has been international in scope and has pointed to gaps in the interstices of the global financial system, and to the need for more developed relationships between regulatory authorities. There will be much less room in future for so-called unco-operative jurisdictions.

So, if we are talking about the need for ever rising standards, then I believe that in retrospect the Edwards report (whose announcement, at the outset, may not have been universally welcomed here and in the other Crown dependencies) looks to have been well timed and well judged. Indeed I think both that Home Office initiative, and the parallel Foreign Office white paper on Britain and the overseas territories, which similarly made important proposals for upgrading the standards of regulation in the far offshore centres have put the United Kingdom into a much better position than she would otherwise have been to respond to this heightened interest in offshore finance.

It is not for me, I think, to trundle through the 185 recommendations which I gather you have culled from Andrew Edwards’ report. Apart from anything else, I would not wish to steal Richard Pratt’s own thunder as he gradually, indeed not so gradually, ticks off all those which have been implemented. I am sure he and you understand the need for a well thought-through response to the report.

From my point of view it is I think more important, perhaps more helpful, to step above the detail and to pull out some key principles which I think we need all to hold firmly in mind as we review our systems of regulation. They are principles which apply just as much to us at the FSA, as they do to you and your FSC.

Let me then quickly leave you with my own ten commandments for regulatory authorities, or perhaps I should say for regulatory regimes.

First, regulation should be vested in a properly constituted authority which should be operationally independent from political and commercial interference, but also openly accountable in the exercise of its powers. I have explained in some detail how that balance is to be set in our new régime in London.

Second, the authority should have a clear, adequate, achievable and consistent framework of objectives and powers set by legislation, with fair, consistent and transparent processes geared towards achieving those objectives. Again, I have talked about our approach in that area. Our new legislation is based on a set of explicit objectives.

Third, the authority should have adequate funding to enable it to acquire the resources to fulfil its responsibilities, and that funding should come in such a form that does not compromise the authority’s independence from political and commercial pressures. In our case we levy fees directly on regulated institutions, though we must consult them on our budget. We do not receive public money. I think that is as sensible a funding method as one can find.

Fourth, the authority should require institutions to maintain minimum standards of corporate governance, internal controls and operational conduct with the aim of protecting interests of clients and ensuring proper management of risk. In our case we build our regulatory régime on a set of principles for regulated firms, which incorporate those requirements at the highest level.

Fifth, there should be well-understood procedures for dealing with the failure of a market intermediary to minimise damage and loss to financial consumers and to contain systemic risk. In the UK we have a published Memorandum of Understanding between ourselves, the Treasury and the Bank of England which sets out in a clear way how that responsibility will be fulfilled in the new environment.

Sixth, the authority should have comprehensive and credible inspection, investigation, surveillance and enforcement powers, with appropriate remedies for ensuring compliance with regulatory requirements. I believe our legislation contains such powers.

Seventh, market regulation should promote transparency of trading, be designed to detect and deter manipulation and unfair trading practices. Again, that is a key objective in our new legislation, to provide more effective policing of and remedies for market abuse of various kinds.

Eighth, the authority should have powers and procedures to ensure that regulated firms take action to protect themselves against criminal misuse and that they maintain appropriate systems to comply with anti money laundering regulations. That, again, is a prominent feature of our new legislation, and one to which the government attaches the highest importance.

Ninth, the regulatory laws and the procedures in a jurisdiction should seek to ensure that no institution operating across national boundaries escapes supervision. That means ensuring that firms cannot create corporate structures which put them outside effective consolidated supervision – the lessons of the BCCI affair, in a nutshell.

And, tenth, the authority should be in power to collect appropriate regulatory information and to share it in accordance with international principles with other domestic authorities and with foreign counterparts. We are committed to such regulatory information sharing and it is likely to be a strong theme of the work emerging from the Financial Stability Forum, both in the highly leveraged institutions group and, quite clearly, in the group on off-shore centres.

Beneath this level of principle, there is clearly much scope for different legal and organisational structures of regulation. I do not believe that there is a single template that one can impose on any and every financial centre around the world as the uniquely right solution to the complex problems of maintaining financial stability. But if one hangs on to the spirit of those ten commandments, then I think one should not go far wrong.

At the risk of spoiling the symmetry of my final lesson, and at the risk of introducing a softer, less policeable factor into the equation, let me make one last plea. It is that regulatory authorities should also think and speculate. It is very easy to become pre-occupied with today’s problems, or indeed, even more frequently with yesterday’s problems. The past remains a little more predictable than the future, and it is often more comforting and more certain to spend one’s time mopping up previous messes than thinking about where the next will come from.

But a leading edge regulator will also be thinking about future problems. It will also be, literally, looking for trouble. We are paid, at least in part, I think, to look on the dark side. When others see a bubble, they want to blow it up a little more. Our impulse is to take out a pin. Where others see an exciting bull market, we draw attention to the risks of irrational exuberance, to coin a phrase. When a market participant, as Peter Baring famously said, finds it remarkably easy to make money in securities markets, we should think that something nasty is brewing in the back room.

And one aim, as I have already mentioned, of the Financial Stability Forum, is to bring together those worries on an international basis, in a timely way, to see if they are justified or not. So my own rallying cry for international regulatory co-operation amounts to "party poopers of the world unite". Not, perhaps, something which is going to win an advertising association award, but it captures the spirit of what we ought to be trying to achieve.

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