MIDDLE TEMPLE HALL, MIDDLE TEMPLE – 14 MAY 2003
Howard Davies
Chairman, Financial Services Authority

One of the aims I set for the FSA was that we should be able to maintain a frank and grown-up dialogue with the different sectors of the industry we oversaw. In some cases, that dialogue was already well established. In the case of the Investment Management Industry, if you think back to ’97, relationships were a little strained following the Morgan Grenfell affair.

I think we can say that, at present, the relationship between the industry and its regulator is a reasonably healthy one. Indeed Alan Burton confirmed that in his speech. There are disagreements, of course, some of which he mentioned, and I shall respond on a few of them this evening. But there is no shortage of communication. And I would say that that communication has been improved as a result of the merger, and the creation of the IMA. Under Dick Saunders the Association has assembled a very talented team on Kingsway. And that is absolutely crucial to the relationship with the regulator. We need qualified and knowledgeable people with whom to talk about the industry’s needs, and its problems. In the case of the Investment Management industry we do have that and the IMA is certainly what the French call "an interlocuteur valable".

In business terms, the last 3 years have been quite a difficult period for the industry. Though the bond market has done well, of course, 3 years of falling equity prices have left their mark. The most recent industry survey shows that there have been some sharp falls in business volumes recently, and demand is not expected to improve greatly in the short-term. As a result, some firms are having to make difficult decisions on staffing.

However, through this difficult period the industry here has certainly maintained its competitive position in global terms and I would be guardedly optimistic about the prospects in the medium-term.

The main determinants of the vitality of the sector will certainly be the quality of the people employed in it, and the strategic decisions which senior management make. You drive the business, not me. But a number of surveys have shown that, in terms of the competitiveness of the financial market, the quality of regulation typically comes second in the list of key success factors, after the availability of suitably qualified staff.

So we recognise the importance of creating and sustaining a regulatory environment which allows the industry to prosper, which recognises the international dimension of competition, yet which at the same time meets the objectives which Parliament have set for the FSA. Those objectives are to maintain market confidence, protecting consumers – bearing in mind their own responsibilities – and promoting public understanding of the financial system. It is those objectives on which I must report progress every year to Parliament. That is the background against which our regulation will be assessed.

With that in mind, let me say a few words about 4 subjects on which we are working at present, and which all affect your business in one way or another.

The first is the vexed question of the use of past performance in advertising and promotional material.

Over the last 5 years, I think it is, we and the industry have been engaged in an exciting debate about just how significant past performance is for the future, and therefore how much weight should be put on it by retail investors.

Well of course we have heard a bit less about the crucial importance of putting past performance on advertisements just recently. The strapline "our fund has fallen by only 40%, compared with an industry average of 42%", does not exactly have people rushing for their cheque books. And the one bit of persistent performance on which the academics working for both sides can agree is that bad performers seem to achieve some degree of consistency in their performance. The same is sadly not true of good performers. In those circumstances, it is hard to see that we are dealing with an earth shattering issue here. However, we need to find a way forward. That certainly doesn’t involve banning the use of past performance – something which we have never suggested, in spite of what has frequently been reported in the press.

So tomorrow we set out our plans, having listened at length to the industry’s views. We propose that, in future, standardised information, set by us, would have to be included alongside a firm’s own information, and no less prominently. The format for those standardised measures will be a table showing the terms for up to five rolling 12-month periods. We will also put out some guidance on the prominence past performance can have in advertising; though we accept your argument that simply to say that it cannot be the dominant message will not work. Essentially we will rest on the requirement that what firms say about performance should be clear, fair and not misleading. That is an overall standard which we use widely. Its meaning, I think is, becoming quite well understood, and is backed by a certain amount of case law.

I hope that, on the basis of these new proposals, we can all quickly agree to move forward.

The second big issue is the future capital requirements set for the industry.

As some of you will know, the Basel Committee of Banking Supervisors put out their near final proposals for a revision of the international rules on bank capital a week or so ago. That matters to you, because those rules will be incorporated into a European Directive which affects investment firms as well.

Some firms have argued to us that, on their reading of the Directive, they may face very large increases in capital requirements, which might even cause them to think about relocating elsewhere.

I very much hope it will not come to that, and indeed I am reasonably confident that it will not. Though these things are not entirely in the gift of the FSA, since we are required to interpret the directives which emerge.

What we have argued in Europe is that we need an approach which is based on proportionality. Not all firms are alike. Investment firms are not banks, and do not carry the same risks. Furthermore, within the investment firm community there is great diversity, ranging from large firms able to conduct a full range of investment activities, to firms with limited scope and which often do not hold client assets.

I think we are making progress with our European colleagues in getting them to understand that capital requirements need to be adapted for different types of institution – and that we need to recognise the bio-diversity of the European financial services community.

One of our difficulties is that, in most other countries, capital requirements tend to be expressed in black letter legislative terms, while we have had a long tradition of reaching judgements about the position of individual firms and setting requirements accordingly.

If we can get that principle more generally accepted, we should be able to solve this problem. I would not want to pretend that there won’t be firms who will need to hold more capital. Indeed in some cases it is probably right that they should. But I do not believe that we will end up with a system which produces very large increases where they are not justified in terms of the risks.

The third area, which may be more controversial, is the problem of soft commissions and bundling.

As you know, this subject was put firmly on the agenda by Paul Myners, one of your own, in his review for the Treasury. Paul argued that the opaque practices of paying management fees which have developed over the years are not in investors best interests. And research we commissioned from an economic consultancy has supported that view.

Our proposed solution – and I emphasise that it is a proposal and we are listening hard to the responses to our consultation – is to tackle the way in which soft and unbundled services are paid for. We do not propose to go as far as Paul suggested. Rather than proposing a single, higher management fee we propose to require fund managers to deal with the softing point by limiting the goods and services, beyond trade executions, that can be bought with commission or order flow. Here we are talking about screens, conferences and tickets to Glyndebourne. And we propose that the cost of acquiring other services in a package along with trade execution should not be passed through automatically to the customer. That would apply to investment research, for example.

This doesn’t affect the fund manager’s ability to pass on costs, but she would need to do so in a more transparent way.

I note that the same issue is currently under investigation in the US, where the Chairman of the House Banking Committee has recently come out strongly against soft commissions. Congressman Oxley (of Sarbanes fame) recently said that the lack of transparency in the way fees are disclosed "is unacceptable".

We look forward to receiving your considered comments soon on that and on research, where you clearly have more concerns. We need your answers by the end of August, which will provide an opportunity for you to use the laptop which you take on holiday with you.

Please also ensure that you think about the possible longer-term effect on the market, and particularly on the provision of research. There may be incentives for new providers to emerge, offering better value and sharper analysis.

The last subject is the topic of our collective investment scheme rules. It’s always a good idea to save the most exciting bits of a speech for the end.

As you know, we have made one or two changes recently, notably to allow the new method of pricing, the swinging price.

But we are now looking to make some more changes. The aim in each case is to increase flexibility. We want to allow mixed funds on a non-UCITS basis. We want to introduce non-retail schemes, with light-touch regulation, to allow performance related fees and to improve the information given to investors. Our main proposal here is to require, shorter more relevant information to be sent out.

The informal consultations we have held with the IMA and others suggest that these changes ought to be welcomed by the industry. I hope, therefore, that we can move ahead quite promptly. It is in all our interests to keep product offerings up to date.

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