THE BOND MARKET ASSOCIATION ANNUAL MEETING
WALDORF ASTORIA, NEW YORK CITY 10 APRIL 2003
Howard Davies
Chairman, Financial Services Authority

I last spoke to the BMA at your Legal and Compliance Conference in October 2000. I remember the day very well. It was the last day of the so-called "subway series" - as it happens. But from my personal point of view it was more memorable because I took my teenage son, who had accompanied me on the trip, to the top of the World Trade Centre in the afternoon. The memory of that visit, on a bright clear beautiful autumn day, has returned to me many times over the last 18 months.

We are, of course, still living in the aftermath of the September 11th attack, and now in the aftermath of war. I cannot say how the geopolitical situation will now resettle. Like most of you, I imagine, I am hopeful, but nervous.

That nervousness is clearly felt in financial markets, which have been in a highly volatile condition for some time now. Of course the fixed-interest markets have benefited from the equity market collapse. But perhaps even some of you may wish that your markets were robust for a rather different set of reasons.

In these troubled times, it is a little difficult to focus on one’s day job, so to speak. But life goes on, and so does regulation, sadly. When I spoke to you last time I gave you an overview of regulatory change under way in the UK, and in the European Union as a whole, before focusing on a few topics of current interest, which then included the future structure of exchanges in Europe, and the regulation of alternative trading systems.

I also find, from looking at my text then, that I spent quite a lot of time talking about baseball.

I will take a similar approach today, though there will be a bit less about ball games: it’s too early in the season to speculate on why the Mets are going to have yet another disappointing year.

My task is, however, made a little more difficult by the fact that I am the only spokesman for Europe on the programme of the conference. This is a surprise to me. I would have thought that the administration would have explained to you that these days you need at least two spokespeople from Europe, one old and one new. I will have to do my best to speak for both.

Starting, however, in the UK, our regulatory reform programme is now largely complete - in structural terms, at least. The FSA has formally been the single regulator for the UK’s financial firms and markets since December 2001. I would say that the reform was going reasonably well. Technically, the transition went smoothly as 12,000 firms were grandfathered into the new regime, and the old regulators passed quietly away. There were few celebratory parties on Lombard Street. At least, if there were, I was not invited. But a number of surveys of industry practitioners show that the market remains of the view that integrated regulation is a competitive advantage for the City of London. Firms do not, of course, agree with us on all points. I would be worried if they did. And they complain about compliance costs, in particular. I guess that is not unknown here. But they certainly like the new architecture.

Interestingly, since imitation is the sincerest form of flattery, a number of other countries have now followed our lead. Indeed there is a growing group of nations in what we call the coalition of the willing regulators. Japan and Korea copied our example very quickly. More recently there have been a number of new single regulators set up in the European Union. There was already integrated regulation in Scandinavia. In the last couple of years Austria and Hungary (two regulators - not one Hapsburg entity), Ireland and Germany have taken the plunge and Belgium joined in only 10 days ago. The German change, in another very large market, was of great significance for the future of financial regulation in Europe.

Further afield, quite a number of other countries have now separated banking supervision from their central banks. A couple of weeks ago the Chinese did so, setting up a banking commission alongside their insurance and securities commissions - and they have talked about a merger of the three in the longer-term. In all of this regulatory reform, and particularly in the changes to banking supervision, two major countries hold out in favour of the more traditional central banking model: the US and France. It is nice to think that on this very fundamental point that particular transatlantic alliance remains solid.

Will we see any change in the US? I was interested to see press reports that two congressional committees plan to look into the US regulatory system. Congressman Oxley is quoted as saying that "the inefficiencies in the current system and the increasingly competitive nature of the international market are going to eventually collide and put US financial services firms at a potentially serious disadvantage". It is of course too soon to say whether any change will result from those enquiries. I have my own views on the realistic priorities for reform here, though they do not include a single regulator anytime soon. But I have made it a rule not to go abroad and argue for regime change elsewhere. It is not polite to my hosts.

At European level, the position remains far more complex.

As far as the structure of regulation in the Union is concerned, we are working towards yet closer co-operation between the regulators, on what I would describe as a network model. We have accepted that there will not be an effective single financial market in Europe unless regulators operate in reasonably similar ways from country to country. One of the conclusions of the report by Alexandre Lamfalussy a couple of years ago was that the structures of regulatory co-operation needed to be further developed. As a result, we set up a new committee, modestly known as CESR, which stands for the Committee of European Securities Regulators. In its relatively short life, that Committee has made considerable progress in improving the consistency within which European regulations are enforced across the Continent, though I would be the first to recognise that there is still a long way to go.

The Committee is also responsible for what one might call secondary legislation, in other words the rules and guidance which underpin individual directives.

The initial experience with CESR has encouraged Finance Ministers to decide to set up parallel structures for both banking and insurance supervision. They should be in place very soon.

These structures are particularly important at present, since we are engaged in completing a heavy legislative programme, known as the Financial Services Action Plan, which includes no less than 40 different measures. The European heads of government committed themselves three or four years ago to completing this action plan by 2004. The ambitious aim is that by next year there should be a genuine single financial market in Europe.

Of course the BMA, by comparison with many other US based associations, is very familiar with developments in the European Union. And it set up a London office 3 years ago as a listening post. I recall welcoming the establishment of that office at the time. We were pleased at your choice of location.

I am now not so sure that I should have welcomed it. Because, as a result, you have bombarded us, and indeed our European colleagues, with very helpful advice on how to do our jobs.

Recently, there has been no shortage of issues for you to address. But let me focus attention, briefly, on two of them where you have made particularly forceful representations, and where there is clearly some concern about the possible impact of regulation on the fixed interest market.

The first is the difficult question of how to regulate alternative trading systems.

They have made less progress in competition with the exchanges in the European equity markets than they have in the US. I believe this is partly, probably largely, because the exchanges themselves have for some time operated electronic systems, and moved away from floor-based to screen-based trading rather earlier than in the US. Nonetheless, there are markets in which ATS have achieved a sizeable share of trading, and the fixed income markets are one area where this is the case - although largely at the expense of over the counter trading rather than exchange-based trading. I think one has to acknowledge that the issues of how to ensure a level playing field between these new systems and the existing exchanges, and to ensure that market transparency across the whole market is sustained (and where possible enhanced), require regulators to consider the appropriate framework for these new platforms.

On the basis of responses we received to an early FSA discussion paper on these issues in the UK, we decided that this should be done, if at all possible, at European level to promote the celebrated level playing field. As regulators, after wide consultation, we developed and agreed a set of framework standards around 3 years ago. After two rounds of consultation and resulting changes, they were then adopted by the new committee - CESR - in June last year. The issue we (and indeed other European regulators) now face is how to implement those standards domestically. And this is a particular problem for us in London, since 20 odd of the approximately 45 ATSs operating in the European Union are based on our doorstep.

This task of implementation is made more complex by the fact that the Commission, and member governments, are currently in the throes of negotiating a new Investment Services Directive which, among other things, will create a regulatory framework for ATSs. Though, just to make things a little more complicated, in the new directive, they are described as MTFs = Multilateral Trading Facilities.

We recently issued a consultation paper on how this implementation should be managed. In response to the paper the BMA wrote a book - or rather a 21-page missive. Who says the art of letter writing is dead? It was one of those letters which began by noting how supportive you were of good quality regulation, of level playing fields, of transparency and motherhood and apple pie. But it then went on to list 365 reasons why the proposals should not go ahead in their proposed form.

Well, we are having some second and third thoughts on parts of the package. We do not think that it would be right to delay implementation of any changes until the Investment Services Directive is completed, which might take several years. We believe there are issues which need to be resolved now, and indeed as new ATSs come to us for authorisation, we are having to address the questions embodied in the proposed standards in any event. In other words we are having to look at their systems and controls and their price discovery mechanisms. The substance of the standards is largely good practice, we believe. In order to deal with those issues in a consistent way we need, for fairness purposes, a set of guidelines and principles which promote sensible decision-making. I would also say that I believe this part of the current ISD proposals is much less likely than many others to suffer further changes in the negotiating process, so I think we have a fairly good idea of what the regime will ultimately have to be, in any event.

But we agree with you on the need for a slightly longer timetable for the implementation of the standards. And we can see the case for some greater differentiation of required transparency standards between different asset classes. Clearly there is a strong argument for greater transparency in relation to equities than to bonds - though it is fair to note that there is growing retail involvement in bond markets in Europe.

When we produce our regime shortly - and my Board will not be considering final proposals for a couple months - I hope we can, therefore, address your major concerns. I will not quite say that we plan to meet you halfway between London and New York. Perhaps we can settle on somewhere a little further in our direction, like the Azores, perhaps.

The second, area in which you have been very active in the last year is on the ISD itself.

Here, I believe there is very little between us. You are obviously more interested in the impact of the ISD revision on the fixed income markets, where - certainly as far as transparency is concerned - the ‘threat’ from Europe is not as imminent. The ISD proposals concentrate on greater transparency in the equities markets as a first step. But as it envisages a review of extending provisions to other asset classes 4 years after entry into force of the new Directive, I would suggest you do not go to sleep now. The issues will not go away and there are certainly countries which would like to see extension of post- and (indeed) pre-trade transparency to bond markets sooner rather than later.

As you know, the British authorities were very unhappy about the late introduction into the Directive of a change to Article 25, with its obligation on internalising firms to make and quote retail prices, even if they are not handling retail customers. We are opposed to a continuation of concentration rules, and we believe that best execution requirements, conflict of interest management and broad post-trade transparency requirements can, and in London do offset any potential risks to investors from internalisation of trades. And indeed I think we were comfortable with almost all the points made in your major submissions to the Commission and the European Parliament.

In your submissions you argued for the right balance between investor protection and efficient markets and the need to promote a competitive market place. We agree. Like you, we think that not only Article 25, but also parts of Article 20 - the so called client order handling rules - may restrict the competition between different trading venues and push trading back into a monopolistic structure - as it currently is in those countries where the concentration rule applies.

Another area where I believe we see eye to eye, is the concern about the narrow restriction of access to regulated markets and multilateral trading facilities. Some important (and very experienced) operators in today’s markets will not necessarily be categorised as eligible counterparties and therefore could see themselves prevented from gaining direct access to regulated markets and MTFs. It does not make sense for market participants, such as big pension funds and large corporates, to be automatically stopped from becoming members/users of such trading platforms.

But, as you know, we are one voice among 15 in these discussions - albeit an influential one, I hope. There are others in Europe with less experience of internalisation, and, indeed, of wholesale markets generally, who are adamant that there must be greater pre-trade transparency if it is to be allowed. They argue somewhat confusing analogies with the US situation and, if I may say so, it would be helpful for associations such as yours to be more persuasive in explaining how and why the US requirements are somewhat different.

We are working hard in negotiations in Brussels, but it is simply too early to say how the final directive will look.

There are two other regulatory developments in prospect on which I would like to say a word or two. Firstly, the review of the Basel Capital Accord - which seems almost a permanent item on our agendas.

There has been a considerable volume of comment and speculation recently about the future of the Basel Capital Accord reform programme, imaginatively entitled Basel 2.

Some of that comment was stimulated by the decision by the US authorities only to mandate the new proposals for a group of the largest US banks, leaving much of the US system on the domestic ‘well-capitalised’ approach built on Basel 1. I will frankly say that there was some confusion in Europe, and elsewhere, about the implications of this announcement. Were the US authorities signalling broader concerns about the architecture of Basel 2? If only the Advanced Internal Ratings Based approach to credit risk, and the Advanced Measurement approach to operational risk are to be implemented in the US, what would this mean for overseas banks operating here on other versions? What would it mean for US banks not on the Advanced approach yet operating overseas? And indeed what does it imply for the principle of global competitive neutrality, which the Basel Committee holds dear?

On Wednesday of this week in a speech to the Risk Management Association, Vice Chairman Roger Ferguson of the Federal Reserve Board helpfully clarified some of these issues in what he characterised as a realist’s view of the Accord.

I am happy to share in his realism. Like Roger, I agree that we must move forward from Basel 1, which is increasingly divorced from the reality of how banks set their own capital needs, and of how supervisors view them. Like him, I am supportive of the overall architecture of Basel 2 - the three pillar approach. I also, and Jerry Hawke of the OCC has been particularly eloquent on this point, wish the new Accord were simpler than it is. But 21st century banking is complex and, to paraphrase Pascal, we have not had time to make it shorter.

So I share the Federal Reserve’s determination to press ahead with the third Basel Consultation Paper in May, and to reach a final Accord by the end of this year. The alternative is not attractive. Of course there must be more consultation about the details, both internationally and domestically. But we have heard most of the major arguments of principle already, and that further consultation should proceed on the basis that the world’s major regulators are supportive of the proposals put forward.

I also welcome Roger’s clarification of the implications of the US proposals for the functioning of Basel 2 internationally. Competitive neutrality is an important principle, and we need carefully to watch the way each major country implements the Accord. His undertaking is that the standards imposed here in the US will not be allowed to compromise the international level playing field. And I note his undertaking that the US authorities will work with other supervisors to ensure that anti-competitive burdens are not placed on overseas banks operating in the US who may be using other versions of the Accord. For our part in the UK, we are ready to work with the US to ensure that outcome.

I will not hide the fact that we propose to operate somewhat differently in Europe. We believe that the Standardised Approach in Basel 2 is preferable to Basel 1, even for simpler banks, in particular because of the greater risk sensitivity that it brings. But that, as Roger Ferguson says, is partly because the EU and the US start in different places, and because the structure of the US banking system is very different. For other countries which do not currently operate the US ‘well-capitalised’ standard, Basel 2 will be a great step forward.

What is important, as we move forward, is not absolute uniformity, but broad consistency. We must all work for arrangements which promote prudence and fair international competition.

The last specific topic to which I would like to draw your attention is the Financial Groups Directive, née the Conglomerates Directive.

Just one short point to make. It will require US financial conglomerates operating in the EU to demonstrate that they are subject to an equivalent form of consolidated supervision here - if they are not, the Directive subjects the EU entities to its full consolidated supervision requirements, or alternative measures which could include sub-consolidation down from an EU holding company. That is the kind of sentence that gets regulators a bad name. In effect, it means that the big investment banks will need to be subject to the Gramm-Leach-Bliley Investment Bank Holding Company regime, under the SEC, or some other form of consolidated oversight.

I believe this is increasingly understood in New York and Washington. We are ready to work with the major firms - since about all of those affected have their European headquarters in London - to ensure they comply in the most sensible and least costly way.

Finally, I may diffidently offer a word or two on transatlantic relationships more generally.

It is perhaps a British understatement to say that they are suffering some strain at present. We all know why.

In the UK, we find the situation awkward and difficult. On the one hand, our markets are bound in with those of North America to a greater extent than is the case anywhere else in Europe. Our local investment banks are called things like Merrill Lynch and Goldman Sachs. The events of September 11 showed just how far the integration between our two centres had gone, as a considerable amount of business was switched from one to another, with minimal disruption. Of course there are differences in approach. We believe our regulatory system is somewhat different and, we modestly think, somewhat simpler. But essentially we are two nations divided, as the cliché goes, only by a common language.

On the other hand, we are bound in to the European Union by strong legal, political and economic ties. As I have explained today, we have to see our markets in a European context - and increasingly so as the single financial market takes shape.

So we are very aware of the problems that could be caused for our financial markets if there is a continued hiatus in top level political relationships, and if that tension were to be allowed to spill over into trade, economic and regulatory issues. There are always a number of difficult problems around, which can become a source of tension if both sides want them to be.

In these circumstances, it is more than ever important to maintain a strong dialogue between decision-makers in both continents, if only to ensure that new misunderstandings do not develop and fester. It is in that spirit that I am pleased to be with you here today, and am grateful to you for your invitation, and your attention this morning.

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