BRUSSELS, MONDAY 20 MARCH 2000
Howard Davies Chairman, Financial Services Authority

Twelve months ago, here in Brussels, I gave a lecture entitled Euro regulation, to the European Policy Forum. At that time, our preoccupations were with the effect the introduction of the Euro would have on financial markets, and the challenge of regulating them. The other major development in the background was the projected alliance between eight European stock exchanges. I noted that there was considerable speculation about the possibility of further banking consolidation in Europe, and that we were beginning to see the creation of domestic financial hyper-markets, with cross-border hyper-markets perhaps the next phase of development. And I went on to argue that regulators and the Commission would have to work hard to keep up with all this activity.

How do things now look, twelve months on? And are we any clearer about the longer-term structures of regulation needed to make the single market work well?

I think it is fair to say that while some of the trends we identified last year have developed in broadly the way we expected, there have been some surprises, too.

There has, of course, been banking consolidation and, as we forecast at the FSA, that consolidation has moved fastest in domestic markets. Even before the dramatic Deutsche/Dresdner deal announced a fortnight ago there was the French attempt at troilism last year, leaving BNP and Paribas slightly uncomfortably together in the same bed. In the UK the Royal Bank of Scotland has snatched NatWest from under the noses of its neighbour the Bank of Scotland. And consolidation has continued elsewhere, from Italy to Scandinavia. So far, outside Benelux at least, no mergers with a significant effect on national banking systems have yet been effected, though our view remains that when this domestic consolidation has run its course it is highly likely that there will be more cross-border deals.

A development we did not forecast twelve months ago is the rapid arrival of Internet banking, some of it across borders. The fastest growing Internet banks in the UK are domestic, but First-e, based in France up to now, but with its operations largely in Dublin, has been making some in-roads into the market. And there are a number of other banks, both British and of other nationalities, which are on the verge of launching Internet banking on a European scale. Twelve months ago that seemed a relatively remote prospect. Now it is on our doorstep.

On the securities front, things have also not worked out as foreseen. The proposed eight exchange European alliance has not developed as rapidly or as concretely as was envisaged twelve months ago. More modest ambitions were substituted for the grander plans launched in the summer of 1998, at least for the time being. And other alliances may be coming to fruition rather earlier, notably a Franco/Belgian/Dutch deal of which we have heard so much in the press over the last few days.

The eventual outcome in terms of exchange structure in Europe remains very unclear. We have seen announcements from NASDAQ who wish to establish a new exchange in London, and from JIWAY, a joint venture between OM Group of Sweden and Morgan Stanley, offering a pan-European exchange targeted at retail investors. A number of exchanges are demutualising, to allow them to strike commercial deals more quickly and decisively in the future. And of course we now have the arrival on the scene of a number of alternative trading systems, in both the equity and bond markets, which seem well placed to attract business away from traditional exchanges, though little business has shifted yet. There has also been parallel activity in clearing and settlement, where integration offers the biggest potential for lower costs.

In the insurance sector there has been further consolidation, notably in the UK where CGU and Norwich Union recently announced a merger. Lloyds TSB acquired Scottish Widows, showing that bancassurance retains its supporters. One consequence of the Deutsche/Dresdner deal seems to be that Allianz will become a major player in the retail banking sector in Germany, not so much bancassurance as assurabanking.

There are many other developments and deals I could cite. But the questions we ask ourselves are:

- what does this all tell us about how the European Union should respond? And

- in particular, what conclusions should we draw about how financial regulation should move forward across the Union? We all know that in five years time EU financial regulation will have to be more ‘joined up’ than it is now, but can we yet say where and how the joints will need to be made?

The first conclusion one must draw is the need for a degree of humility in seeking to forecast the future. We are living in very uncertain times. The markets themselves are highly volatile. I haven’t even yet mentioned the .com stock phenomenon. And there is more uncertainty in the minds of market participants about how both the trading and institutional structure of financial markets will develop in Europe than at any time I can recall.

So we need to be cautious about jumping to conclusions about the way in which markets will develop in the future. We genuinely have no idea whether, in five years time we will be looking at a single pan-European stock market, trading European blue chips across the continent on a single platform. Or whether we will see a range of competing trading systems, some located in Europe, some outside Europe, and some in cyber space. In the banking sector we do not know whether there will, by then, be a small group of large pan-European institutions competing with each other in all the major markets, or whether retail banking and investment business will remain largely domestically based, with wholesale business only transacted on a European scale. Indeed we do not know whether there will still be an activity which we can easily describe as banking.

And we certainly cannot yet model the impact which the Internet will have on the delivery of financial services. There are those who think the Internet is simply another delivery mechanism, and others who think the Internet will change everything. A regulator should never be at one extreme on any spectrum, but I am closer to the "change everything" pole. I think we have not yet begun to see the way in which the Internet will alter the competitive dynamics of the financial sector.

So, on the part of regulators and public policy makers, humility is in order together, I think, with a high degree of caution. The competitive stakes in today’s financial markets are very high indeed. The possibility for business to shift location in the face of legal or regulatory obstacles is dramatic. Countries which do not ensure that their legal and regulatory environments are conducive to the development of e-commerce could lose a whole generation of new businesses, and find themselves left behind and seriously disadvantaged in economic terms for years to come. That is one reason why we at the FSA have been proceeding very cautiously in devising our new regulatory environment, consulting the market carefully at every point, and trying to ensure that we do not unwittingly create barriers to sensibly innovate new business development, while nonetheless being vigilant in maintaining our key regulatory objectives.

But while it must be right for regulators to be cautious in present circumstances, that caution cannot mean immobilism. We have to react and plan. We have to adapt our structures to the changing market. We have to upgrade our skill base, which is just as important. And it is entirely clear to me that we must do all this nationally, at the European level and globally. Today’s financial markets are not great respecters of national boundaries, particularly not in the single European market.

It would hardly be consistent with my twin themes of humility and caution this evening if I then went on to present a fully worked-through blueprint for the development of financial regulation in Europe for the next Millennium. So with a heavy dose of caveats and health warnings I will instead suggest six directions of effort which, it seems to me, should all be pursued.

First, at the member state level there is a need to ensure that regulators are practically equipped to understand the business and respond to change. The most important thing for any regulator is to have the right people, people who understand the markets well and can operate effectively in them. But they will only be able to do so if the legislation within which they operate is up to date and flexible, so that they can protect consumers effectively, police new markets properly and cope with technological change.

All these characteristics of a thoroughly modern regulator are more important than institutional structure. You will all be aware that in the UK we have concluded that a single integrated regulator makes sense, in our very open markets, and we certainly have no regrets about that decision. It has attracted near universal support in our markets and in Parliament, and institutional developments since the change was announced have reinforced its logic, in my view.

But if you look around the world you can find many very different models of regulation, and other structures which clearly work well for countries with different types of financial market, and different political structures. The fact that there are almost as many different models in Europe as there are member states is something of a problem when it comes to harmonising arrangements within the Union. But it is quite impossible to say that one model is unambiguously right for everyone.

The second important task for regulators today is to improve their ability to assess and prioritise the risks to market confidence and to consumers of financial services. They must do so in order to focus protection where it is most needed. That implies a clear understanding of the different protections needed by wholesale and retail investors. (A common EU definition of the distinctions would certainly help). The one single initiative on which we are spending the most time at the FSA today is on the development of a common risk model across all the institutions we supervise, and all the markets we regulate. The aim is to identify where we think the risks to consumers – or to the financial system as a whole – are most likely to arise. Without such a model we cannot use our scarce resources most effectively.

These are both dimensions of change which apply primarily at the domestic level. The top priority at European level – my third point – must be to overhaul the financial services legislative framework. So we strongly support the thrust of the Financial Services Action Plan articulated by the Commission, and I take every opportunity both domestically and internationally to emphasise its importance.

But while the action plan is an admirable endeavour, there is a risk that the time and detailed work demanded by legislation will mean that even new provisions for setting standards, by the time they are enacted, may very well be out of date. So how do we manage that risk without cutting corners and reducing democratic input or transparency? There is no simple answer, but we believe it would be possible for the European institutions to meet the challenge by the use of so-called framework directives which can enable regulators to fill out detail, and change it when necessary, in a process which is itself transparent and open to challenge. Efficient use of comitology would help, as would the use of experts at the service of the Commission and the European Parliament.

But however perfect the legislative framework, there will be an important need – my fourth direction – to improve day to day monitoring and supervision. That means we need strong methods of communication between individual national regulators in their ongoing work. And it is quite clear to me that we need to enhance that co-ordination now, to match the market and institutional developments I have briefly described. That enhanced co-ordination needs to deal with the development of links between supervisors of different parts of the same group. It must also bring together front line regulators and the institutions concerned with systemic risk – by which I largely mean central banks, of course. That does not mean that systemic oversight and regulation need to be in the same institution. There are excellent models, in Switzerland, Canada and Australia – as well as in seven EU countries – where the central bank is not also the regulator. But there must be a close dialogue.

The fifth priority is closely related. We see a need to focus on increased convergence of practice by regulators in member states. The action plan aims to harmonise regulatory requirements in a number of important areas. But you can have the same rulebook and yet, if it is enforced 15 different ways, then you might as well have 15 different rulebooks. So regulators need to work on harmonising or achieving convergence in their approaches to supervision and the way they enforce requirements.

The Forum of European Securities Commissions (FESCO) is already working on harmonisation in a number of aspects of investment business. I chaired a working group last year which produced a set of common standards for regulated markets, published in December. I am now chairing a similar group looking at the ways in which we might oversee the development of alternative trading systems in Europe, on a common basis across the Union. There is considerable scope for further work of that kind, and there are already other initiatives under way in the areas of market abuse, customer classification and prospectuses, to name but three.

The Conference of European Insurance Supervisors is also starting to look at harmonised supervisory approaches. And in banking the Groupe de Contact has for many years done good work in comparing supervisory practices and sharing experiences across the European Economic Area, though that work has perhaps proceeded at too low a level for it to acquire the significance it needs.

These are all areas in which there is considerable scope for further constructive work, and at the FSA we devote a considerable amount of effort to these activities.

But we often ask ourselves whether all the effort we put in is adequately focused and organised. Is there a need for new structures, or even new institutions to enhance, and make more efficient, the co-operation between regulators in member states? So my sixth and last area is that of structural improvement.

I am a natural sceptic in the area of architectural change. I believe that in many aspects of life, and the management of financial markets is certainly one of them, the need is frequently more for enhanced plumbing than for changed architecture. Indeed at the FSA we recently published a paper on the international scene called Plumbers and Architects, where it was clear that our sympathy lay more with the former than the latter. In other words, we are keener on practical work on real life, day to day problems of co-operation and collaboration, than on grand schemes for designing new world financial authorities, or the like.

And while I am quite sure it is right to reassess institutional structures in Europe from time to time and to examine the case for new European institutions carefully, caution is required here, too. There is an obvious attraction in the argument that we need new institutions at European level to ensure common standards and harmonised implementation. But until we have a common European legal system, much, perhaps all, implementation and enforcement is necessarily going to place at member state level. Furthermore, a great deal of the financial activity undertaken by individual consumers will take place locally for some time to come, which argues that regulators themselves must have local roots. They must be close enough to their own institutions and markets to understand them well.

We must also be careful not to set up structures which make co-operation and collaboration more rather than less difficult. I have already pointed out that there are almost as many different structures of financial regulation in Europe as there are member states. For example, there are three fully integrated single regulators, two states where regulation is mainly concentrated in one institution, one with what one might describe as a confederal system, six with a tripartite structure of one sort or another and two where the existing system is in the process of change. Looking at the involvement of central banks, there are seven states where banking supervision is in, or closely related to the central bank, five where it is entirely outside the central bank, two where it is mainly outside and one where the position is under review.

It could be a costly mistake to set up at European level a system of pan-European sectoral regulation: a Euro banking supervisor, a Euro securities regulator etc, which might ossify the sectoral approach to regulation which has already been abandoned in a number of member states in the face of market developments.

So it may be better to proceed somewhat cautiously at European level, at a time when it is by no means clear what institutional structure will be appropriate in the longer term. Rather than seeking a grand unified theory of regulation today, it might be preferable to seek to move forward on a number of different fronts, assessing progress as we go along.

In the banking area we might, for example, seek to strengthen the work of the Groupe de Contact, perhaps by upgrading its own membership, or by establishing for it a steering committee of the heads of banking supervision across Europe, which would give the attempts to seek convergence of approaches in banking supervision greater impetus, and ensure that inter-supervisor information exchange is constantly kept up to the mark.

At FESCO I believe we must find ways of achieving better implementation of the common standards to which we all sign up. A good step forward would be for the members of FESCO to disclose the extent to which they meet the agreed common standards. But, overall, I believe FESCO has generated a degree of momentum already, which is likely to be sustained as long as the commitment from its members remains strong.

We might also think about developing a European version of the joint forum of banking, securities and insurance supervisors. Meetings between the chairs of the relevant European committees have already begun, and that could go further in a practical way. The outcome of the revision of the Basel Capital Accord could be one important area in which a common approach will pay dividends.

And we could ask ourselves whether there is a case for a European version of the Financial Stability Forum, established last year to bring together finance ministries, central banks and regulators in the major global financial centres. One of the aims of the Financial Stability Forum is to look ahead to identify potential risks to financial stability, whether arising within the financial system or from macro-economic developments, and to devise ways of offsetting those risks, or anticipating them. There may be a case for something similar at European level, to ensure that the arrangements for handling potential pan-European problems, whether arising in individual institutions or in markets, can be expeditiously handled.

There may be a case, too, for thinking about the creation of some kind of body to oversee the development of common standards across the Union. One model which might be considered is something along the lines of the European Medicine Evaluation Agency, which operates with a small secretariat as a forum for European pharmaceutical regulators to meet and take collective decisions on standards which are then implemented nationally by regulators. The potential relevance to financial regulation is clear.

One could obviously go further if a treaty amendment were envisaged, to create a new institution with formal powers. But that is not an easy option to achieve in short order, and requires greater certainty about just exactly what we need in this area than we currently have.

One should, finally, not underestimate the sheer difficulty and complexity of reform in this area. Even at member state level change is difficult and time consuming. In the UK fully three years will have elapsed between the government’s announcement of regulatory reform and the passage of the Financial Services and Markets Act, whose provisions will not come fully into force for a few months beyond that. And while this may seem an extravagant length of time for a reform programme, the pressure we face from financial institutions just now is more to slow down than to speed up. The consultation process required to get rules right and to ensure that they respond to the realities of a changing market place, is highly complex.

If that is true within one member state, it can only be more true at European level. So I reiterate my view that, in the institutional area, we should proceed with caution. The one thing worse than no reform in Europe would be hasty and bungled reform.

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