FINANCIAL SUPERVISION COMMISSION
DOUGLAS, IOM - 26 SEPTEMBER 2001
Howard Davies
Chairman, Financial Services Authority

The Challenge Ahead

My remarks this evening will be focused almost exclusively on financial regulation and, in particular, on the impact of international developments on financial regulation in offshore centres like – and unlike – the Isle of Man. And in that context I can say that your invitation to me was very well-timed. Because the political temperature of the offshore centre question has risen sharply in recent months. Political leaders in the G7 economies, in particular, are very concerned by what they see as dangerous gaps in the world’s defences against financial crime and financial instability. The tragic events in New York two weeks ago, and the issue of who financed the terror which created them – and where – have accentuated that concern. The US decision on Monday to freeze the assets and transactions of international banks which fail to co-operate with the campaign against terrorism raises the stakes further. It will cause banks to look even harder at whether their branches around the world, and especially in offshore centres, are fully compliant with money laundering best practice. Those responsible for the governance and regulation of offshore centres would do well to be aware of the challenges they face. In short, offshore centres will need to do much more in the coming years to demonstrate that they can and do meet international standards of best practice. If that does not happen, then the future is bleak.

And pressure is not solely related to the tragedy at the World Trade Center.

3 weeks ago, before the hijackings, the FSA hosted the most recent meeting of the Financial Stability Forum. The Forum was set up a couple of years ago, on an initiative from Gordon Brown, to bring finance ministries, central banks and regulators from around the globe together with the international financial institutions, to focus on risks to the stability of financial markets worldwide. The agendas cover a broad front, from the activities of highly leveraged institutions like hedge funds, through the financial situation in crisis-hit emerging markets like Turkey and Argentina, to the health of the Japanese banking system. But it was striking that, at this month’s meeting, the subject which generated the most heat was the rôle of offshore centres. A number of representatives believed that such progress as has been made towards higher regulatory standards was simply inadequate, and that more political measures needed to be taken. So the heat is on.

I am very conscious that to most normal people, the language financial regulators talk is obscure. In particular, it is peppered with acronyms – the FSF, the FSA, the OECD, the FATF, the IMF, the FBI.

And, of course, beneath these multinational bodies with their overarching global initiatives, there comes a European tier of regulation, which is increasingly having a major impact on our own environment. And then, below that, we have national initiatives like the Home Office commissioned report from Andrew Edwards, or the work KPMG have been doing for the Foreign & Commonwealth Office on the Overseas Territories, which in some ways is a follow-on from the Edwards work.

My modest aim this evening is to try to offer you a guide through this treacherous landscape, to turn this alphabet soup, if you like, into a patchwork quilt whose shape and colour you can understand.

But, before doing so, let me propose one exclusion from this evening’s subject matter, an exclusion which may comfort you to some extent. I do not propose to talk about taxation. The OECD harmful tax initiative is not about regulation or money laundering, which are subjects of great concern to me, although that initiative is sometimes, perhaps even deliberately on occasion, mixed up with the Financial Action Task Force work.

Instead, I would like to discuss briefly four separate, though overlapping areas of work, all of which will, or should have an impact on the Isle of Man in the future. Indeed, they are already making a difference to the environment in which you work.

I will cover first, the Financial Action Task Force, second, the Financial Stability Forum, third the related work of the International Monetary Fund and, lastly the domestic initiatives taken by HMG and by the FSA itself.

Financial Action Task Force

The FATF’s main focus is, of course, on trying to improve anti-money laundering standards around the world. The need for such an improvement is not seriously contested these days. We all know something of the huge volume of criminal money, much of it arising from the illegal drugs trade, which swills around the world’s financial system. Clearly, if we can collectively make it much more difficult for criminals to turn bad money into good, we can have a serious impact on the incentives for criminal behaviour. So most financial centres have devoted a lot of effort in recent years to trying to "harden their target", and to make it much more difficult for dirty money to contaminate their system.

This has put many financial institutions, and their customers, to considerable cost and inconvenience. Suspicious transaction reports must be lodged with the National Criminal Service in the UK, for example, and most onshore centres have similar arrangements these days. Individuals must present several pieces of identity to open accounts, and answer intrusive questions on the source of any sizeable cash sums they deposit.

These intensive efforts to make life more difficult for money launderers have had some impact. But they are rendered ineffective, or much less effective, if banks in some jurisdictions operate according to quite a different set of procedures, with anonymous accounts, passbook accounts, or even with corrupt arrangements and connivance between the supposed regulators, the institutions and the launderers. So governments are trying, through the FATF in particular, to raise standards. The recent FATF work under the so-called Non-Cooperative Countries and Territories exercise has certainly generated some controversy. Although the exercise is not directed specifically at offshore centres, many have been caught within its scope. Some centres have strongly contested the evaluations of their performance, and some may have had a point on occasions. But few would deny that, overall, the work has achieved dramatic results. Several very important offshore centres have implemented significant reforms in very short order. And this, in some cases, after years of supposedly good intentions but very little in the way of delivery. The FATF process remains extremely active, with a well-developed process now of assessing individual financial centres, and a routine of promotion and relegation based on well calibrated and objective criteria.

As you know, the Isle of Man was reviewed by the FATF, but not blacklisted. You will be aware, though, that money laundering is not a static business. New techniques are regularly developed by the criminal classes, requiring constant vigilance and regular updating of one’s defences. So money laundering is an area which will justify continued attention in Douglas. And I will say a little more about developments in our own jurisdiction in a moment.

Financial Stability Forum

I have already briefly explained the mission and composition of the Financial Stability Forum. At its foundation, just over 2 years ago now, early decisions were made on the key priorities for the Forum’s work. We decided, as a first step, to focus resources on three areas. First, the question of capital flows around the global financial system, and the instabilities which those flows could create. Second, we looked at the impact of highly leveraged institutions, particularly unregulated institutions like hedge funds, on the world’s financial system. In the UK, we are all aware of the impact George Soros had on Sterling in 1992. There have been other similar, and in some cases even more disruptive episodes in other countries. And the third area of work was related to offshore centres. Was it the case, we asked, that the activities of offshore centres represented a threat to financial stability worldwide? Were those centres typically regulated to a standard with which we, as responsible authorities in major onshore centres, could be content?

The answer to the first question, was, it is fair to point out, that there was no evidence to suggest that OFCs have been a major cause of systemic problems. By ‘systemic’ I mean market turbulence which can threaten the integrity of the world’s financial system as a whole. But the study group, under John Palmer, then the Superintendent of Financial Institutions in Canada, nonetheless concluded that poor regulation in many centres created a weak link in the supervision of the increasingly integrated financial system. So the Forum working group organised a survey of regulators in major onshore centres, inviting them to give their evaluation of the quality of both regulation itself, and of co-operation with other regulatory enquiries exhibited in the major offshore jurisdictions. That survey was, by its very nature, somewhat impressionistic, which I know caused some centres to complain that they had been unfairly characterised. Those centres, like the Isle of Man, which were put in the top category by the FSF, in other words a category characterised by generally adequate supervisory systems and reasonable co-operation, did not complain so loudly.

But the key recommendation to emerge from the Financial Stability Forum’s work was that the IMF should undertake an assessment of the standards of regulation in offshore centres.

International Monetary Fund

It is important to point out, here, that this initiative reflects a general trend towards the enhancement of the IMF’s involvement in financial regulation. This has not, traditionally, been a principal focus of the Fund’s activities. But a number of factors have come together to cause the G7, and the IMF Committee to come to the view that the Fund needs to pay more attention to financial regulation, alongside its traditional focus on fiscal and monetary policy in member countries.

There are a number of reasons for this shift. Perhaps the most important is to be found in an analysis of the Asian financial crisis in 1997/98. We can see now, with the benefit of hindsight, that most of the affected countries were operating sensible monetary and fiscal policies, typically with low public sector deficits, which would not have suggested vulnerability to financial melt-down. But it is now clear that, while in many cases the fiscal position was sound, the financial sector was highly leveraged and poorly supervised. Banks may have formally been reporting capital standards consistent with international good practice, but the accounts in which that capital was supposedly reported were frequently not reflecting reality. Many banks had been allowed to run significant currency mismatches, borrowing in foreign currency at low interest rates to lend domestically at high rates, and were therefore fatally exposed when the currency concerned fell against the dollar.

So it became clear that any comprehensive analysis of the soundness of a country’s economy should include an assessment of its regulatory environment, including, perhaps even most importantly, the quality of the regulatory institutions, their independence, and the human capital – the quality of staff – in them.

That assessment, which is now part of what has become known as an FSAP (yet another acronym), standing for Financial Sector Assessment Programme, is now being extended to many countries around the globe. Indeed Gordon Brown has volunteered the UK for such an assessment next year, and the Financial Services Authority will be receiving a team from the IMF on several occasions over the next 18 months as they undertake a comprehensive assessment of the quality of our financial supervision. Obviously we are greatly looking forward to this exercise, and particularly to the publication of the results.

So what is proposed for offshore centres is not something to which we onshore folk are not prepared to submit ourselves. That is a point which I think has not been fully understood by those in OFCs who have objected to this programme. The IMF are now well under way, and intend to assess about 40 centres over a 3-year period. The benchmark they use will be the international standards of regulation drawn up by the various standard setting bodies, in other words the Basel Committee for banking supervision, International Organisation of Securities Commissions (IOSCO) for securities regulation and the International Association of Insurance Supervisors (IAIS) in the case of regulation of insurance. This programme is intended to produce an objective assessment in each case, and all the OFCs are being encouraged to publish the resulting reports so that the marketplace in general will be able to draw its own conclusions about individual centres.

I am sure that the Isle of Man will, as a well-developed and sophisticated centre, wish to participate wholeheartedly in this programme. Indeed its success will, in part, depend on the willingness of the more developed OFCs like the Isle of Man to lend their expertise, which is in short supply. We ourselves will be helping with the programme, in particular through Richard Chalmers, our own liaison expert with offshore centres, with whom your people I know have a close relationship.

United Kingdom Initiatives

Turning now to domestic matters, I know that you, along with your colleagues in Guernsey and Jersey, were thrilled and flattered when the new government, in January 1998, chose to focus early attention on financial regulation in the 3 Crown Dependencies. They asked Andrew Edwards, a former colleague of mine in the Treasury as it happens, to undertake the review, which was published later that year. Edwards, as you will remember well, ranked the three islands as being in the first division of offshore centres.

But in spite of this generally positive assessment, Andrew Edwards did find many areas in which improvements could be made. In most of those areas changes have now been implemented, consistent with his recommendations, in all three centres. Though I know that, contrary to the recommendation of the Edwards report, the chairmanship of the Financial Supervision Commission here continues to be held by a politician, and that no change in that arrangement is currently planned. That, of course, is entirely a matter for you.

Since the publication of the Edwards report the 3 Crown Dependencies have been increasingly working together to co-ordinate an approach to minimise the risk of regulatory arbitrage, and also to help rationalise the regulatory environment for institutions operating in two or more of the jurisdictions. It was discovered, for example, that institutions trying to centralise back-office functions in the Isle of Man for all three had been forced to have three operating manuals to accommodate relatively minor differences in the requirements of each regulator. Since the ultimate regulatory objective was the same in each jurisdiction, it was clearly a sensible move to develop a common approach in order to reduce regulatory cost for firms. It would probably be over ambitious to imagine that all three of you will introduce identical legislation. There are legal and constitutional differences between you which make that difficult. But we notice that you increasingly present a common position in international fora, which I think is helpful.

The most recent development here in the Isle of Man has been the introduction of legislation to bring the corporate service providers under regulation. That has long been regarded as a weak spot in the financial services sector, bearing in mind that most of the companies under management are little more than asset-holding vehicles, and that the quality of the service providers has been variable. Proposals to introduce new legislation to regulate the trust service providers on a similar basis are currently out for consultation. There, the approach proposed, focusing on fit and proper tests and on conduct of business rules, is probably more rigorous than is found in many other places. These measures can only help to reinforce the welcome message that the Isle of Man considers high quality regulation to be an essential feature of the offshore market.

The anti-money laundering legislation enforced in the Isle of Man generally follows the UK model, in substance if not in form. Furthermore, the co-operation between the Isle of Man and the UK authorities to combat financial crime is extremely close, and the island is a full member of the Financial Fraud Information Network, which plays a key rôle in co-ordinating our efforts to pursue fraudulently acquired assets, wherever they may emerge in the financial system.

It is particularly important that we do co-operate with each other effectively. The majority of the 65 or so banks on the island are UK based and much of the custom for your more than two hundred investment businesses and collective investment schemes comes from UK residents or through UK institutions. For our part, we are very pleased to have been able to offer one of your senior regulators the opportunity to enjoy a secondment to the FSA to see how we go about things.

So we are generally pleased with our co-operation with you. Though I have to say that some of our continental European colleagues frequently complain that they do not receive the prompt responses they sometimes want from the Crown Dependencies. It is hard for me to assess the validity of those complaints, since they largely relate to cases in which we are not directly involved. But it is right for me to report to you that there remains something of a selling job to be done in Europe, and that there is no room for complacency.

The FSA Regime

Lastly, I should just say a word about the changes in UK regulation which will finally take effect at midnight on 30 November. That is moment at which the Financial Services Authority comes into its inheritance, and assumes the responsibilities currently still formally held by 10 different regulators, which used to oversee our financial system.

Managerially, the change was implemented quite quickly, and most of us came together within one organisation on 1 June 1998. But the Financial Services and Markets Act, which finally reached the Statute Book last summer, took rather longer. That is because, as well as changing the organisational structure of regulation, we were also re-writing the statutory basis. So all of the previous legislation, the Banking, Insurance and Financial Services Acts, have been replaced by one single comprehensive statute.

You will not thank me for embarking, now, on a lengthy review of that legislation. But I should just make two points about it. First, it is based on four key statutory objectives, which for the first time tell financial regulators just what it is they are trying to achieve. We are told that we are to maintain confidence in the financial sector, to protect consumers – bearing in mind their own responsibilities for their decisions (an important caveat), to promote public understanding of the financial system (a new responsibility) and to fight financial crime.

Within that framework of objectives, the legislation gives regulators a considerable degree of flexibility to adapt and amend regulations to meet the objectives. But we must do so taking into account the need to be proportional in our regulation, to take account of the impact of regulation on innovation and competition, to have regard to the international nature of the UK’s financial markets, and many other good practice disciplines, which we call the principles of good regulation.

In my view this is an appropriately flexible and modern framework for financial regulation, which should put the UK into an extremely good position to respond to changing market circumstances rapidly and decisively, but without reducing the attractiveness of London as a place in which to do business. It was in part because of this flexibility been given to the FSA that the legislation required such lengthy consideration in parliament, as MPs reasonably wished to ensure that they were delegating responsibility to a body which was properly accountable, well constructed and that it would exercise its delegation within a reasonable framework. I believe that time spent devising the new Act was time well spent, and that we now have an excellent new framework.

Two other points to mention, very briefly. Our money laundering powers have been significantly strengthened. In the past our focus was exclusively on ensuring that banks had good systems in place. Now our money laundering powers cover the whole financial sector and we will be able to prosecute institutions which do not have proper controls in place. Sadly, the recent Abacha investigations demonstrate that there is a need for these powers, and that a number of banks – and not always the most obvious suspects – have been somewhat casual in handling funds from, frankly, dubious sources. In future, they will need to be more careful, especially in relation to money which may be associated with terrorism. You may have seen our press release last week reminding firms to be vigilant in this area. People will also be looking to the offshore centres to take a very rigorous approach to countering this appalling threat, and I am sure that it is currently at the top of the agenda here.

We also have new powers to deal with market abuse. In the past, it has been difficult to secure prosecutions for insider trading and other manipulative practices. In future the responsibility for deciding on prosecutions will rest with the FSA, and there will be a new civil offence, backed-up with a code of practice, which will guide us. I hope, therefore, we can thereby ensure that London’s reputation as a well-regulated financial centre remains high.

As we have devised this new régime, we have asked ourselves just why financial institutions choose to base themselves in one jurisdiction, rather than another.

The answer is not entirely straightforward. To hear some people talk, you would think that financial firms uniformly hate regulation, and would gravitate to the most casually regulated centre available. Yet it is observable that that does not happen. If it did, Europe’s financial centre would certainly not be London.

So it is worth looking at what firms say about why they choose one centre over another. One source of information on that question is the global competitiveness report, produced by the World Economic Forum – the people who sponsor the annual Davos conference. It is interesting to note in that survey, which aims to rank countries in relation to their attractiveness to business, than when they look at the financial sector, they include a number of factors. One, is what they call the sophistication of financial markets. There the UK typically ranks in the first two with the US. The second rating is the soundness of banks, where we are usually in the top ten – and note that banks soundness depends on how much capital they keep, over which regulators have a significant influence. Then there is the question of insider trading, where the lack of insider trading is seen as a competitive advantage. Indeed there is some academic work to show that insider trading significantly increases the cost of equity capital. On that measure we are usually in the top four or five.

Lastly, there is a direct question on financial regulation of supervision, where the statement with which respondents are invited to agree or disagree reads "the regulation of supervision of financial institutions is among the world’s most stringent". And those who carry out the survey regard a high score on that statement to be a sign of the attractiveness of the centre rather than the reverse. So on a list of 59 countries last year the US was top and Russia was last. The UK, fortunately, was in 4th place.

The offshore centres are not ranked in the same way, and I am quite ready to believe that there are some other factors, perhaps in the tax area, involved in the decisions made by firms considering an offshore location. But, in general, I believe that similar criteria are relevant. And that, certainly in the future, success as an offshore centre will involve being able to demonstrate a high quality of financial regulation and a high degree of co-operation with other régimes.

Some argue, and no doubt there is force in what they say, that the risk of criminal abuse in the Isle of Man and other offshore centres may be no greater than in many onshore markets. But the widespread perception is that this is a particular threat offshore, so such centres may need to go that extra mile in order to convince the world of their commitment.

For you, and indeed for us, the next key event will be the IMF assessment of our standards of regulation. We know that the team will begin to review us at the beginning of next year, and I gather that 2002 may be the key date for you as well. That assessment will put your system under close scrutiny once again, and will focus on how well the Edwards recommendations have been implemented. But I should emphasise that we, and I believe this applies to the Isle of Man as well, regard the IMF assessment as an opportunity, as well as a challenge. It is an opportunity because we, and you, have an opportunity to influence international policy development with our well-developed skills in an area where expertise is in short supply. Now is the moment at which to think about what you want to say to the IMF about how offshore centres should best be regulated.

So, looking forwards, although the quality of supervision in the Isle of Man has been widely recognised by international assessors, the pressure to maintain that quality, and improve it, remains strong. There is significant political pressure on offshore centres, and a strong current of opinion among world leaders that gaps in the world financial system must be closed, both to fight terrorism and crime and for more general financial stability reasons. A strong regulatory régime is therefore essential to maintain confidence in the market and to preserve the reputation of the jurisdiction. Furthermore, reputable financial institutions and their respectable customers now expect, and indeed want to work within a well-regulated, but not excessively bureaucratic environment. The competition among offshore centres is such that a loss of reputation, however caused, may lead to rapid outflow of business elsewhere. So it is preferable to bite the bullet on some of the more tricky issues and to be seen to be taking the lead, for example on corporate service providers and trustees, rather than waiting to respond to later pressure.

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