SEOUL, KOREA, WEDNESDAY 10 NOVEMBER 1999
Howard Davies
Chairman, Financial Services Authority, United Kingdom

I am very grateful to the Korean Securities Dealers Association and the Korean Stock Exchange for their hospitality today, and for their joint agreement to host this event. I am delighted that both Chairman Bae and Chairman Park have both welcomed me here.

I am delighted to be back in Seoul. And I am pleased to have had the opportunity while here to sign an agreement with the Financial Supervision Commission which marks a new phase in the co-operation between our two institutions. As I will hope to demonstrate this morning, the United Kingdom and Korea have a lot to learn from each other in financial regulation, and indeed a lot of opportunities to work together. We are moving forward together on parallel lines at present. I have been particularly pleased to note that the FSC have recently established an office in London, which further helps to reinforce the relationship between our two countries. Their representative, Mr Choi, called on me last week. And I hope this visit, albeit a short one, will work in that direction, too.

This is either my second or third visit to Korea – I cannot easily tell you which.

You may think this suggests an uncomfortable degree of vagueness in the mind of your speaker. Why can I not tell you exactly how many times I have been in your country? Is my memory that bad? Surely a financial regulator ought to be accurate with figures?

The reason is a slightly complicated one. What might have been my first visit took place some 15 years ago. I was in Tokyo on business, at the time when I worked for McKinsey and Company, the management consultants. And I decided that, on my way home from Tokyo, it would be fun to drop into Seoul, which I had never visited before, to have a look around. But it was a hectic trip and I can only afford to be here for the inside of a day.

On arrival at Seoul airport I was directed to the transit lounge, since my ticket was from Tokyo to Seoul to London, leaving the same night. When in the transit lounge I looked for a way out, pushed through a couple of doors and, to my surprise, found myself in the arrivals area, on the wrong side of the immigration desks. So I hopped into a taxi and took a ride into town, looked around the park, had a lunch, bought some Kimchi and took a taxi back to the airport for my flight.

When I tried to check in, and to leave the country through immigration, I was told that I couldn’t do so, because there was no record in my passport to show that I had ever entered. This created an awkward situation, which required the intervention of a senior officer from the immigration service, who took me into the kind of side room reserved for drug smugglers and money launderers.

I told my story several times and explained that my flight to London was about to leave. If I was not released, then Korea would certainly have an illegal immigrant on its hands.

Eventually, at the very last minute, the official decided on an appropriate solution to the problem. He went out of the room and returned with two stamps, one marked "entry to Korea", the other marked "exit from Korea" and firmly stamped one page of my passport with both. He then rather unceremoniously pushed me onto the plane.

This struck me as a splendid example of Korean pragmatism, a quality much admired by the British, and caused me to feel that I had been in a country with which I had a lot of understanding and sympathy.

My other visit, as Director General of the Confederation of British Industry, was less exciting but perhaps more business like. I led a delegation here, to hold talks with the Federation of Korean Industry and others, and visited the Daejon expo.

But now, of course, I find myself here as the Chairman of the Financial Services Authority, Britain’s new single regulator.

And as such, I begin by asking you one question. What do the following countries have in common? Denmark, Iceland, Japan, Korea, Norway, Sweden and the United Kingdom. I am sure you all know the answer. They all have a single integrated regulator for the whole of the financial sector, outside the central bank.

There are other countries which have brought together financial regulation in different sectors. The Canadians and Australians, for example, have pulled together the prudential supervision of banking and insurance companies into one institution, leaving the regulation of securities markets to another. There are also other countries, notably Saudi Arabia and Singapore, where there is also, effectively, a single regulator, but one which is a part of the central bank or monetary authority. In small countries, or countries with relatively undeveloped financial markets, this may well make a great deal of sense.

And there are a number of other countries which are bringing together financial regulators in various different ways. The issue is under discussion in Israel, South Africa and Mexico, among other places. Luxembourg has brought together banking and securities regulation. There have been integration moves, too, in a number of other countries like Peru and Turkey and the Netherlands. You will be pleased to know that I do not propose to go through all 150 or so countries in the United Nations, to tell you precisely what is going on in financial regulation in each case – though I could – since we monitor these things quite closely – tell you about at least 50 or 60 of them, if I felt so inclined.

What I think would be more useful would be to say something about the underlying trends in financial markets which are causing this increase in collaboration between regulators of different sorts and, in a number of instances, bringing about institutional integration.

I identify four key dynamics which are forcing this process of integration.

First, there is the increasing trend towards the construction of financial supermarkets, with banking, securities and insurance business being brought together under common ownership.

Second, a point which relates to the first, there is the increasing trend for institutions of different kinds to produce products which have similar characteristics, and which therefore compete with each other, even if the institutions offering them are in what we used to think of as different market sectors.

Third, it is increasingly clear that systemic risk can arise in non-bank financial institutions. I know this is a controversial argument, which I shall hope to prove to you as we go along.

And, fourth, there is pressure from financial institutions themselves to reduce the costs and burdens of regulation.

Let me say a word or two about each of these four points.

Institutional integration

The process of institutional integration has moved at different speeds, and taken different forms, in different countries. Many countries still impose severe restrictions on the extent to which banks may undertake securities business, or may sell insurance. In other countries the environment is more liberal.

In the United Kingdom we are very much at the liberal end of the spectrum. There is no barrier preventing a bank buying an insurance company, or indeed vice versa. Banking and securities business can also be done together. We have never had the equivalent of the American Glass-Steagal legislation.

So we find that Lloyds Bank, one of the largest and most profitable institutions in the world, has recently bought Scottish Widows, a very large mutual insurance company. And the Prudential insurance company has opened a large and successful bank, operating mainly on the Internet, known as Egg – which has attracted some £7bn of deposits since its creation little over a year ago.

Our banks, too, have long been allowed to transact securities business, and most of them do so quite actively. Barclays owns its own stockbroking firm, as do many other British banks.

And of course this trend is not only observable in the United Kingdom. Across Europe there is the development of what is generally known as Bancassurance. And in the United States we have seen the merger of Citibank and Travelers, along with Salomon Smith Barney, creating perhaps the first global financial hypermarket, but no doubt not the last. Against that background it seems increasingly anachronistic to operate financial supervision systems which are organised on industry sector lines. And, more importantly, doing so makes it very difficult for the authorities to understand the true nature of the risks being run by these huge integrated institutions.

In our view there is a crucial need for each major financial institution to be subject to consolidated supervision. In other words, for each major institution there should be one supervisor which accepts the responsibility for overseeing the safety and soundness of a major institution, co-ordinating with the regulators of other parts of it, in other countries. Consolidated supervision is much easier to arrange where there is a single regulator covering all parts of the financial sector in one country.

Product substitution

A related point is that traded markets themselves are becoming so sophisticated that the traditional risks undertaken by different kinds of financial institution can be transformed through financial instruments. A securities firm can be made to look, in terms of its risk, rather like a bank, if it acquires the right combination of credit derivatives. At the extreme one can put together, in the derivatives market, a balance sheet which looks like a bank, or even perhaps like an insurance company.

From the point of view of the corporate customer, debt can be bought and sold either in the securities markets, or through banks. From the point of view of the retail customer, similarly, there are different products which offer the same sort of combinations of risks and returns available from banks, securities firms or insurance companies. So at the product level the old sectoral divisions are no longer so relevant.

Systemic risk

But of course the traditional argument for banking supervision being kept separate from other types of supervision, and being undertaken by a central bank, is that banks are special, in that systemic risk emerges only in the banking system.

There are clearly some respects in which banks still remain special. Their rôle in maturity transformation, turning short term deposits into long term assets distinguishes them from other financial institutions and makes it particularly important for regulators to keep a close eye on the state of their balance sheets. In principle a securities firm does not face the same risks from a run on bank deposits. Even a collapsing securities firm should have liquid assets which can be realised, so that the losses may be precisely measured and realised in a straightforward way.

But while all that is true, it is not quite the end of the story. And it has become increasingly obvious to us in recent years that systemic risk can arise elsewhere in the financial system, too. Some life insurance companies are so large, and their influence on the financial sector so crucial, that their failure can certainly bring about consequences which affect the whole financial system.

And the near failure of Long Term Capital Management in the summer of last year showed that the same could be true of a large highly leveraged hedge fund. It is clear that the large consortium of banks and securities firms which intervened to recapitalise LTCM and support it did not do so because they felt affectionate towards its owners. They stepped in because they believed that its collapse would bring such chaos to financial markets, and inflict such losses on other participants in those markets, that it could not be contemplated.

It is interesting to note, too, that the consortium which rescued LTCM consisted of both banks and securities firms, whose dealings with the fund were very similar in character.

In those circumstances it is our view that it makes good sense for one regulator to be able to develop an overview of the way in which risks in different markets are interacting with each other. And for that single regulator to have a close relationship with the central bank, which may act as lender of last resort.

That does not mean that the lender of last resort safety net is extended to all financial firms. It seems right to me that financial support via a central bank should be very difficult to secure. Financial markets will only work well if there is a genuine risk of failure. Once a government intervenes to prevent poorly managed institutions from failing, then the incentive on others to manage their risks well is significantly reduced. So, before the event, there must be no implicit guarantee by the public sector of support for a failed institution.

But occasionally after the event it is necessary to provide such support, to prevent a meltdown of the financial system as a whole.

I might add, in passing, that getting the structure of regulation right does not guarantee that the decisions taken by the regulators will be correct.

We know from bitter experience that bankers often exhibit a dangerous herding instinct. And when things are going well, they are not inclined to speculate on what might happen if the position changed. Regulators must be the grit in the oyster. They must in British terms be professional wet blankets. Paul Volcker of the Federal Reserve once described the rôle of the banking supervisor as being the man who decides to close the bar just as the party begins to get going. The financial collapses of South East Asia, with whose consequences we are all still living, have been a terrible warning of what can happen if banks are allowed to lend too aggressively and indiscriminately. If they are allowed to borrow foreign currency and on-lend in domestic currency without hedging the currency risk. If their connected lending is not policed. If their large exposures are not carefully monitored.

So courage and determination on the part of regulators are just as important as structure. But that courage will be easier to exercise if regulators are endowed with the right amount of political independence, and if they are powerful enough to be able to get a good view of the nature of risk in the financial system as a whole, which a single regulator can more easily do.

Regulatory costs

The last important argument for regulatory consolidation is that it should reduce both the direct and indirect costs of supervising financial institutions. Indeed the impact on indirect costs ought to be rather larger than the reduction in direct costs.

It is, in fact, not easy to measure the costs of regulation at all precisely. Of course at the FSA we know what our total budget is. This year it will be around £150mn (nearly 300bn won) to supervise a financial sector which represents around 6.5% of British GDP, or somewhere around £500bn (100,000bn won). In other words, the cost of regulation is around 300ths of 1% of the turnover of the financial sector, or .003%.

This may seem a small sum. But it is typically estimated that the true full costs of regulation are some 4 or 5 times the direct costs of the regulator, when one takes account of the costs of compliance within financial firms themselves. So in total in the UK we might be talking about somewhere around £0.75bn.

Even that, in percentage terms, is quite small. But we know that quite small taxes, and regulation must be considered as in some sense a tax, can affect the way business is done, and indeed where it is done. We all know that, these days, financial centres compete with each other for the right to play host to mobile financial business.

London has, so far, been successful in attracting such mobile business.

London is by far the largest global centre for foreign exchange, with around 32% of foreign exchange business transacted through London. London handles a large proportion of internationally mobile insurance business, such as marine and aviation insurance. London handles some 19% of cross border bank lending, and is a very large centre for international equities and derivatives business, too. Part of the reason for all this is that London’s regulatory costs have remained quite low, even while, we believe, the market has been quite well regulated, overall.

But we cannot possibly afford to be complacent about London’s position in the world. We have no divine right to be the largest international financial centre. We will only remain in that fortunate position if we continue to ensure that our businesses themselves are competitive, and that our regulatory environment is both efficient and low cost.

We see the introduction of a single regulator as being one way of staying ahead of the game, and ensuring that our financial regulation is cost-effective and represents value for money for the consumers of financial services who, after all, ultimately pay for it.

It is for these reasons that we in London decided to bring all our regulators together into one institution, 2 ½ years ago. Before then we had, by international standards, a rather complicated system of regulation, with eleven different financial institutions overseeing different parts of our large financial system. Since the summer of 1997 we have brought all of these nine institutions together into one organisation, the Financial Services Authority, and indeed even into one new building in London’s Docklands.

From there, and bringing together the skills of the best people from all the different regulators in London, we think we can best keep an eye on our large and expanding financial market, including the nine Korean banks in London, who together form a significant part of our financial community. We try to look after them well, and to ensure that they keep out of trouble. To do that we need good contacts with our Korean opposite numbers the FSC under Chairman Lee. I am pleased to say that we have that good communication, and indeed communication is particularly easy between London and Seoul because of the existence of a single regulator in each case.

The relationship is a two way one, of course. Because there are important financial institutions from the United Kingdom in Seoul also, notably Standard Chartered and HongKong Shanghai Banking Corporation. Indeed for a while this year it looked as though HSBC would become an even more significant participant in your markets. But, sadly, that has not happened.

Nonetheless, whatever the fate of an individual deal, there is very little doubt that we are living in a world in which the interdependence of financial markets is growing all the time. That lesson was brought home to us in London in a very important way in 1997 and 1998, when events in South East Asia sent shockwaves through London’s financial markets. We rode that crisis rather well. But there are particular factors which brought that about. And the overriding lesson we learned was that we could not possibly think of isolating ourselves from events in this part of the world. Similarly, the Korean economy is significantly affected by economic events in the United States, Europe and of course in the UK, where Korean companies have some significant industrial investments, as well as a large financial presence. We welcome that presence, and hope that – as the Korean economy returns to health, and if the financial sector returns to a sound position – it will develop further.

We see this interdependence most obviously in the private sector, as firms undertake cross-border investment and operate in each other’s markets. But – and this is perhaps my most important point today, which is why I leave it to the end – it is absolutely vital that as these commercial links and financial links develop, so regulatory links develop hand in hand. If the world is to be a safe place for investors and savers, they need to be sure that regulation is robust and appropriate in each market. And that risks cannot be moved around the world without regulators understanding what is going on.

This lesson is increasingly understood globally and there are new structures being set up to bring regulators and central banks together for regular exchanges on the development of markets, and the identification of risks before they become extreme. But bilateral links are a crucial element in the equation, and those between the United Kingdom and Korea need to be developed further. I am encouraged to think that both the FSA in London and the FSC in Seoul understand that need, and I have been grateful this morning for the opportunity of setting out our view of the development of regulatory systems around the world. I know that on this point our authorities see things in a very similar way to yours, which is a good basis on which to build the economic and financial links between our two countries.

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