BELGIAN FINANCIAL FORUM
AUDITORIUM, NATIONAL BANK OF BELGIUM
RUE MONTAGNE AUX HERBES POTAGERES N0. 61, 1000 BRUSSELS
15 April 2003
Howard Davies
Chairman, Financial Services Authority

My time as Chairman of the FSA has coincided with a major effort in Europe to create a single financial market. European heads of government committed themselves at the Lisbon Summit in March 2000 to the objective of making the European Union the most competitive economy in Europe by 2010. One crucial element contributing to that objective is the creation of a capital market which can rival the US market in terms of depth, liquidity and flexibility: a market which allows European companies to raise finance on competitive terms and which provides investment opportunities across the Continent which match the needs of investors.

This single financial market is supposed to be completed, in legislative terms, by 2005. As I begin to prepare for my departure from the FSA in September of this year, I might be permitted to reflect on progress towards these objectives, and of what more needs to be done. I should emphasise, at the outset, that I am entirely supportive of the aims set out by the heads of government. I believe that a broader and deeper capital market will be advantageous to all Europe’s citizens, both in terms of the additional choices open to them in meeting their financial needs, and in terms of the stimulus to economic growth. Some of the estimates of the growth impact might, perhaps, be taken with a pinch of salt. But there is persuasive evidence to suggest that more cross-border competition will stimulate efficiency and price reduction.

However, change is expensive and what began as a high-minded objective has become a very complex process, and a costly one in the short-term. So we regularly need to ask ourselves whether we are going in the right direction, and indeed whether the overall programme is properly balanced. There is always a temptation in Europe to focus on the production of directives and regulations, and to think that if we can just draft the perfect directive, everything else will fall into place. Of course we do need an appropriate legislative framework of regulation. That is a necessary but not a sufficient condition for an effective single financial market.

So I see progress on the Financial Services Action Plan as only one element of the development of Europe’s financial markets. Indeed, to assess progress in the round, I believe we need to consider five linked tests.

The first is indeed whether we are making appropriate progress with the legal and regulatory framework.

The second is whether that framework is actually being implemented and enforced evenly across the EU.

The third linked question is whether we have adequate and compatible regulatory structures across the EU to take this programme forward.

The fourth is whether our financial markets and financial institutions are in practice converging in a way which will mean that the opportunities created by the single financial market are taken up.

The fifth and last is, in a sense, an overall assessment. Are there signs that the programme is in practice delivering more cross-border financial activity, more competition and keener prices?

Test 1: The Rules

In the first case, we can measure progress quite accurately.

Of the 42 measures in the FSAP 32 have been completed so far. This represents the outcome of a considerable effort by DG Markt, in particular, on which they are to be congratulated. Member states have been prepared to reach compromises in many areas, and the European Parliament has adopted a constructive approach which has contributed greatly to the programme.

However, as is the way of these things, some of the most controversial elements have been left to the end. We still do not have an agreed Takeover Directive, for example. The Investment Services Directive remains in the negotiating process, and those negotiations are not always easy. The Risk-Based Capital Requirements Directive is another highly complex dossier on which a lot more work is required. And, as we look forward, we can see the European elections of next year beginning to loom large in our calculations. To me, it looks touch and go as to whether the remaining big ticket items will be settled in time, though the Commission is doing everything it can to ensure success.

And of course we have to recognise that, in some cases, a lot of work remains to be done below the directives to convert them into more detailed regulation. In some areas, such as the Market Abuse Directive, that work is well under way. But as we look, in the Committee of European Securities Regulators, at the volume of secondary legislation which we shall need to produce underneath the ISD, some of us go pale. And we have still not received mandates from the Commission – since the Directive remains under negotiation.

It is too soon to produce a definitive verdict on this first of my five tests. ‘So far so good’, might be a reasonable summary of the position at present. I suspect there will be some slippage on the original timetable but, for reasons I will explain in other parts of my examination, I doubt whether such slippage would in practice be crucial.

There is, of course, another question which the Commission will need shortly to address. What happens beyond the FSAP? Is there a need for an FSAP2, another raft of harmonising legislation? My own view is that the Commission should be very cautious in proposing more legislation in the short-term. There are some areas where further progress is needed, particularly in the insurance and reinsurance markets. But the Commission needs to take account of the digestive capacity of the market. And that would suggest to me that any further legislative activity should be very carefully considered and be very tightly focused. DG Markt should, in my view, readjust its internal incentive structures to move away from a focus on legislative productivity, and towards a focus on implementation and enforcement, which is the subject of my second test.

Test 2: Are the single financial market rules being enforced?

It is much harder to give a definitive answer to the question of whether the rules are being evenly implemented and enforced. There is no scorecard to hand in this area. But my judgement is that we are a long way from consistent enforcement at present.

This is partly a question of time. New European rules need to be implemented domestically. That can be particularly difficult where European rules often replace established regulatory requirements, that have evolved in response to market forces and consumer needs.

However, there is also evidence that in other countries companies continue to stumble on obstacles which stand in the way of cross-border activity in the spirit of the single market. In some cases companies are required to establish local presences, where that should not be necessary. They are required to seek local approvals, where they ought not to be required. And there are sometimes tax and other reasons which create domestic preference. UK companies regularly complain of these obstacles to us. And the Association of British Insurers has recently overseen the production of a useful paper which provides more detail on these complaints.

These defects fall into a number of very different categories – ambiguous directive texts, flawed national transposition, unsatisfactory implementation into rulebooks, failure to act within the spirit of the rules and outright protection. Not all of these are capable of identification or easy remedy by the Commission.

To some extent, therefore, the solution lies in companies’ own hands. Unless they bring particular complaints forward and prioritise them according to detrimental impact, it is very difficult for the Commission to act. Companies need to have the courage to complain and trade associations need to identify precisely what needs fixing and by whom.

The pan-EU networks of regulators also have a role to play. One of the roles of the Lamfalussy committees of regulators, apart from their role in devising Level 2 legislation, is to forge a consistent approach to regulatory action across the EU. Voices of doom can be heard predicting the failure of Lamfalussy, but the fact is that this second role has scarcely begun, so that its effectiveness will be incapable of assessment for several years.

But I am in no doubt that enforcement should be the major focus from now on. And the verdict on this second test can, at present, only be "must try harder".

Test 3: Are the regulatory structures in place?

There are, of course, those who argue that we will never see a single financial market until we see a single financial regulator, and that the regulatory structures in Europe are simply not compatible with the kind of financial integration which heads of government sought. That is the subject of my third test: do we have regulators who can implement the measures politicians agree?

This is a fraught area, and any national regulator commenting on it is bound to be vulnerable to the charge: "he would say that, wouldn’t he". But I begin from the premise that in other parts of economic life in the European Union, we agree law and rules at the centre, which are then implemented in member states. We agree rules on cleanliness of beaches, but we do not have inspectors from Brussels in Blackpool. It is also crucially relevant that enforcement takes place in the court systems of individual member states and, until we have a single legal system – which looks some way off – enforcement is bound to be local.

On the other hand, financial services are in one respect different. We have agreed a framework of mutual recognition of regulation. So that if a UK resident places a deposit in a French bank, she must look to the Bank of France for reassurance and protection, not to the FSA. And if that mutual recognition system is to work effectively we need to have confidence in each other’s work. Which, in turn, requires a greater degree of commonality of approach, and indeed some mechanism for assessing compliance across the Union. This does not, I think, amount to a case for a single financial regulator, in the sense in which it is normally understood. But it does mean there needs to be more joint working, and more collaboration on rulemaking and enforcement, than is typically the case in other areas of economic life. That is the case for the new "Lamfalussy" committees of regulators.

One of the difficulties, of course, is that the regulatory structures domestically in member states remain very different, from place to place. In some cases there are single regulators, as in the UK. In other cases countries have a three pillar structure: banking, securities and insurance are handled separately. In some places banking supervision is in the central bank, in other places it is not. In some countries considerable power is devolved to regulators to make rules and regulations, as in the UK. In other cases far more is done by finance ministries and parliaments.

It would certainly make life a lot easier if there were more commonality across the EU, and if there were authorities which had similar powers and responsibilities, coming together in European networks. That is a point which Alexandre Lamfalussy’s Committee made in their report, and this is sometimes forgotten as people focus on their recommendations for regulatory committees like CESR.

Can we see any signs of convergence in Europe, on a common model?

Until recently, it would have been hard to answer that question in the affirmative. But there are now signs that regulatory integration is finding favour in more and more member states, albeit not always exactly on the same model. There are now single regulators in Sweden, Denmark, the UK, Germany, Austria, Ireland and Belgium. Considerable integration has been achieved in The Netherlands, Finland and in Luxembourg and is under discussion elsewhere. Of the accession countries Hungary, Estonia and Malta have all recently moved to an FSA model.

But we are still a long way short of consensus. France and a number of other countries retain a three pillar structure, with banking supervision still in the central bank.

There is no point in my concealing from you my view that regulatory integration makes sense, and indeed I would argue that European regulatory collaboration will be made significantly easier if we can get to a point in which we have one regulator per member state, meeting in one room, reaching agreements on regulation? . After enlargement we will have 25 people meeting in CESR, we will have more than 25 in the parallel committee on insurance and pension supervision, and up to 50 in the banking Lamfalussy Committee, because there we have central banks as well. And there are some other competent authorities who need to be consulted.

So do we have regulatory systems in place which give us the best chance of completing the single financial market? No, Sir, we do not.

Test 4: Are market and institutional structures, in the private sector, developing on a pan-European basis?

My fourth test shifts the focus towards the financial markets themselves. Can we see signs that pan-European financial institutions are developing to exploit the single financial market? That would be one clear sign of success, in that firms themselves see the opportunity of expanding a cross-border.

A comprehensive answer to this question would take far longer than I have today. But if we look solely at the banking sector, a recent study has shown that of 19 major banking mergers in the last five years, only seven were cross-border within the European Union, and most of those were relatively smaller deals. The most obvious trend has remained continued consolidation within member states, instanced by the BNP/Paribas deal in France and the Royal Bank of Scotland acquisition of National Westminster in the UK. A number of other potential cross-border mergers in Europe, which might well have made economic sense, have foundered on either the unwillingness of the authorities to sanction such deals (not the case in the UK, I should add) or national sensitivities about head offices and cost-cutting. Several banks have attempted to pursue the goal of a pan-European retail bank, but have so far been thwarted in those ambitions.

There has been some cross-border activity in the insurance market, but again not on a scale which is likely to revolutionise the provision of financial services in Europe.

In the securities area, we are all aware of the high profile failure of the proposed Frankfurt and London merger. Euronext has, by contrast, made considerable progress in bringing a number of European exchanges closer together, albeit the model remains somewhat short of a single multicountry platform.

I remain of the view that further consolidation of trading platforms in Europe is likely to occur in the next few years. There are something like 25 equity markets in the EU, compared to 3 or 4 in the US, for a much larger overall market. We would certainly not stand in the way of further consolidation, which is largely a commercial matter as far as we are concerned.

My conclusion here cannot, therefore, be particularly favourable. There is a long way to go. And I hope that the Commission’s Competition Authorities will continue to be alert to signs of protectionism which are preventing the kind of institutional consolidation which is bound in the long run to be a component part of the single financial market.

Test 5: How much cross-border activity is there?

The ultimate test, of course, is whether the market is responding, in terms of cross-border activity. Just how much evidence is there that this is happening?

We find different answers for wholesale and retail markets.

In the wholesale markets there is evidence of growing consolidation of activity in a smaller number of centres, notably of course in London. Most of the investment banks operating in the European Union have centred their activities in London, and that applies both to American owned and Continental European owned institutions. Though it is hard to prove, my suspicion is that most sizeable cross-border M & A activity in the EU is handled in London, one way or another. And most major capital raisings are run out of London, too, since the potential investor base which can be accessed there is very large. But there is also some evidence of consolidation of German and Eastern European business around Frankfurt, for example.

These trends have, however, been under way for some time and it would be hard to attribute them very directly to any particular element of the FSAP. Though perhaps the Action Plan does simplify legal and regulatory processes to some degree.

If we look at cross-border banking, the picture is very patchy. One interesting measure is the total assets of branches of banks from European economic area countries in each individual European country. So, for example, in the UK the total assets of European, non-UK banks in London in 2001 was around 1.4 trillion Euros, some 25 per cent of the assets of the UK banking system as a whole. That seems to show quite a developed degree of European integration.

But the total assets of all other European banks in all other European countries was only 650 billion Euros, so two thirds of the cross-border activity in bank branches is taking place in the UK. The picture is slightly different if you look at subsidiaries, where the numbers are larger in other countries, but that partially shows that in other places banks have either chosen or been obliged to operate through domestically capitalised institutions.

If we come to the retail markets, then for the time being we would have to acknowledge that the amount of genuine cross border business is relatively small. The picture varies from sector to sector. The UCITS directives have stimulated cross border selling of mutual funds. But there is very little cross border retail banking so far, in spite of the initial promise of internet banking. And there has been relatively little in the way of cross-border life insurance or pensions business. That may be partly attributable to regulatory obstacles, but also of course to different tax regimes, and to different structures of long term savings which in many cases have cultural roots which are not likely to be altered in the short run by regulatory changes.

We have recently undertaken research on cross-border shopping which confirmed this view. It showed that a broad distinction can be drawn between countries which focus on product regulation (for example, France) and those which focus on sales/provider regulation (for example, the UK). On the provision of advice, tied advice is reasonably common across the EU, but the UK’s dual system of tied and independent advice is not widely operated elsewhere. On pensions, the nature of state provision elsewhere in Europe means that many consumers are unused to private pension products (for example, only 5-7% of the working population in Portugal), which contrasts, as one might expect, with the experience in the UK.

The overall conclusion would have to be, therefore, that we are a long way from a single financial market for European consumers, and my suspicion is that regulatory harmonisation in itself is unlikely to deliver that single market. More pan-European financial firms will also be needed.

Conclusion

Overall, this might seem a rather downbeat assessment. In fact, I do not interpret it in that way. Old habits die hard. Consumers of financial services are in many cases rather cautious – and perhaps rightly so. It is also the case that some of the key regulatory protections which comfort consumers domestically are either not in place, or not easily accessed across borders. I am thinking, in particular, of deposit protection and compensation schemes, or of Ombudsman schemes.

But what my assessment shows, I think, is that the next phase of activity in Europe needs to have a different focus. We need less new legislation, and more effort on practical implementation. The Commission needs to spend more time on enforcement, crucially with the help of the industry itself. There needs to be more analysis of just what the barriers to cross-border mergers and acquisitions and cross-border selling really are. Many of them are not to do with drafting harmonised regulations. Some of them are to do with inconsistent additional requirements imposed at local level, and indeed straightforward protectionism. And we need to think about how consumers make decisions, and whether we are really providing the kind of protections which consumers think important when making investment choices. If we really want a pan-European retail market, somehow we need to look at things from the consumers’ perspective, not from the viewpoint of a tidy-minded legislator.

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