Philip Robinson
Director, Deposit Takers Division
Regulation of Banking Conference
London 30 June 2003

Good morning ladies and gentlemen. I am very pleased to have been asked to provide the keynote address for this conference on the FSA’s Regulation of Banking. For those of you who have not previously come across me, last October I took over from David Strachan as Director of the Deposit Takers Division of the FSA. As a "freshman", so to speak, I hope to be able to provide you with a slightly different perspective on some current challenges..

I will concentrate this morning on four of those challenges, and how they link to the FSA’s current regulatory priorities. .

First, I want to consider the risks to the FSA’s regulatory objectives arising from the current economic environment. Then I want to move on to the key elements of our prudential supervisory regime for banks – capital and liquidity. I know that you will consider capital later in the programme, but I aim to give you some pointers as to how we are intending to manage the change to the new regime. In contrast, liquidity and funding, have been somewhat overshadowed by the recent concentration on capital issues, so I hope to redress that. I will address the second half of my speech to consumer issues, and particularly how you to meet your customers’ needs in a way that is both fair and ethical. Finally, I will touch upon the role of senior management and the responsibilities that are placed on them by the FSA’s regime.

So, first Economics. This January, the FSA published its "Financial Risk Outlook" for the coming year. This document sets out key risks to our statutory objectives and describes the context against which decisions about the allocation of FSA resources are made: it informs the priorities in our Plan and Budget for 2003/2004.This morning I want to consider three of the priority risks that are of most concern to me, as a regulator of banks – and which I would assume will be of concern to you as managers of banks.

Household Debt

Our view in January was that the Household sector in the UK was taking on debt at an unsustainable rate. This trend was underpinning UK economic growth but our concern even then was that some consumers were finding it increasingly difficult to service their debts. Nothing that has happened since then reduces our concern - indeed the level of household borrowing has continued to rise to the equivalent of £34,000 per UK household: a 13.7% increase in 12 months to an all-time record.

We accept that consumers should be able to afford some additional borrowing as a consequence of the fall in nominal interest rates to a near 50 year low. but we at the FSA continue to have significant misgivings about this trend, especially against the background of a faltering housing market and a relatively sluggish economy and we are unconvinced that the true implications of a low inflation environment for repayment of capital have been properly understood – by borrower or lender. And of course, even allowing for the fall in interest rates, there is a risk that the one-off adjustment to low inflation may have gone too far. This is a subject to which I will return.

Even with a relatively benign economic climate, of low interest, low unemployment and stable economic growth, a good number of households find it difficult to repay their debts. Our research released in January that showed one in five households were struggling. Since then, a CML survey has found that nearly 40% of people were paying over 25% of their net salary on mortgage repayments, up from a quarter in 2001, despite the fall in mortgage rates. This with increases in debt problems reported by CAB and an increase in personal bankruptcy suggest to us that there could be problems in servicing debt building up, but not yet reflected in the mortgage and consumer lending arrears.

UK Economy and the Housing Market

Which brings me to the second priority risk I want to look at. The general consensus of economic commentators seems to be that the UK economy will avoid recession, that growth should pick-up over the second half of 2003, and that further momentum should be gained in 2004. Nevertheless, the UK economy looks vulnerable to a retrenchment in consumer spending, and if consumer confidence starts to falter, there is no obviously buoyant replacement factor to take its place.

Consumer confidence continues to depend on the housing market. Most professional financial commentators think that the rise in house prices will moderate to only 10% this year. For them it may be professionally sensible to continue to have a positive bias when discussing housing market prospects, but, for a professionally pessimistic regulator, there are certainly some straws in the wind.

I could cite the continued decline in the number of loans to first-time buyers, clear evidence of significant falls in the prices of the most expensive properties and the recent evidence of a drop in transaction numbers. A market with reducing volumes and fewer new buyers at the top or bottom does not sound particularly stable, even if the underlying product is still in relatively short supply. Market trends often overshoot, and a soft landing may be hoped for but may not be achieved. So, in my view, it wouldn’t be wise to rule out the possibility of more general house price falls – indeed we may already be seeing that in parts of London and South-East England.

But a fall in house prices on its own need not result in reduced economic activity – after all, householders can carry on living in, and paying for, a house, even if its price isn't rising. So to turn a correction in house prices into a probability of economic stress, something that affects confidence will be needed. The most obvious trigger is a growth in unemployment, and the figures over the past four months have not been particularly comforting on that score.

I’m not making a prediction that the downside risks I have highlighted will come together to deliver economic distress for the UK, but I think you should understand that the FSA has to be ready for the downside rather than hope for the upside..

Corporate Credit Risk & Commercial Property

The final risk I want to highlight is in corporate credit. In 2002, the prime suspects for credit default or downgrade were aviation, telecoms, energy and automotive sectors. To these, 2003 has added travel and tourism, industries particularly affected by the war in Iraq and SARS. But the sector that most worries banking supervisors (who tend to have long memories!) is commercial property.

Historically, property lending has been a key factor in bank failure. And the commercial property market is highly cyclical. So, when gross new lending on commercial property increases at around 20% per annum for 3 years in a row, we feel justified in displaying some nervousness. There is also a worryingly counter intuitive trend in rents and capital values – the former falling as supply outstrips demand, the latter increasing as institutional and private investors chase property assets in preference to financial ones. We should expect that the longer the decline in rents continues, the greater are the risks of a downward correction in capital values.

The latest de Montfort University study on property lending, shows significant new lending concentrations in UK banks and building societies. Some £42Bn (30%) of the debt currently secured on commercial property is due for repayment in the next five years. This combination of fewer lenders and a bunching of refinance requirements could be quite dangerous, especially if the sector loses its attractiveness in comparison with a recovering stock market. We will be looking particularly carefully at the credit appraisal and stress testing processes of those lenders offering aggressive terms for new lending despite deteriorating market conditions.

In closing this section of my speech I would summarise the economic environment as "uncertain", with significant downside risks and relatively few upside rewards. We may be okay if consumers keep borrowing and property prices stabilise rather than fall. However, we all need to be prepared in case recovery falters or the world economy suffers a further shock of the 9/11 variety.

Capital

In order to be prepared, banks need to have adequate capital, my second main theme this morning. You will hear more about this from others, but I thought it might be helpful to give you some pointers about how the FSA is planning to implement the new Basel regime.

We in the UK have always exercised supervisory judgement in setting capital adequacy requirements for banks, rather than just applying an 8% minimum risk asset ratio to all. So we are already signed up to the principles and philosophy of Pillar 2 of the new Basel Accord. Historically, we have used our supervisory judgement to set "individual capital ratios" that reflect our perception both of the risk appetite of a particular bank, and of how well that risk is being managed. We are continuing that under ARROW. Specifically, as we continue to complete ARROW assessments we will link the supervisory assessment of each bank, arrived at through ARROW, with the capital ratio we set. So when you are next in receipt of an assessment letter from us, it may also contain good or bad news on the capital front – depending upon what we have found. And, to reiterate, it is not just the inherent risk of the business that determines the individual capital but the effectiveness of controls over that risk taking. There are some implications here for senior management.

So, what of Basel 2? I think we all recognise that there needs to be a better match between risk and capital, which is what the new Accord seeks to achieve. So everyone is now becoming so much more interested in implementation.

FSA is about to issue a Consultation Paper on the implementation of the new capital regime, to follow up and incorporate feedback on the Discussion Paper we issued last July. The new CP will focus particularly on the requirements for Internal Ratings Based approaches for credit risk, with some coverage also of Operational Risk. I would encourage all of you to make sure that your firms look carefully at what we are proposing, because we would like feedback that will help us to agree benchmarks and standards for firms to work to. And I know that a number of your firms are actively involved in the discussions we are having on implementation through the catchily-named ORIAG and CRIAG groups. On the back of all this work, our intention is to consult in mid-2004 on the Prudential Sourcebook text that will implement the final regime.

But I wouldn’t want you to go away today thinking that you need do nothing for the moment except comment on a CP! If your bank has decided to adopt one of the "advanced" approaches for credit or operational risk, or if you have not even reached the point of being able to take that decision, there really is no time to lose. Even though the implementation date is December 2006, 3½ years is not a long time in which to build the processes that will be needed to support any of the new approaches, let alone collect all the data needed to construct the technically complex models demanded by the advanced ones. So unless you are preparing now, you risk missing the boat. Even if you do not expect to "go advanced", there may be implications for you in what your main banking counterparties intend to do, so my advice if you think you can relax for a couple of years is to do the planning now, even if this shows there is no need to do anything immediately.

Liquidity

On liquidity, I don’t want the focus on Basel 2 to blind us to the overarching importance of maintaining adequate liquidity in times of uncertainty. There is a link to capital but having adequate capital may not prevent a liquidity problem – even if inadequate capital is a often a big contributor to illiquidity.

The FSA is devising a new system for assessing, and setting regulatory limits for, liquidity risk that can be applied not just to banks and building societies, but to other financial institutions such as some securities houses and investment firms. This is no small task, but we expect to issue a consultation paper in the autumn setting out our initial proposals for a framework of quantitative requirements, and I would urge you to take an interest in the debate that will surely follow.

At the same time we have been working on the liquidity systems and control environment for the new Prudential Sourcebook. This has shown the need for limit setting and stress testing: All deposit takers should have systems and controls to avoid excessive reliance on individual counterparties. We expect all firms to arrange their affairs so that they are able to meet their liabilities as they fall due, and if that entails reliance on commitments from others, to review the extent to which these could be relied upon in stressful circumstances. And we expect you to have contingency plans for dealing with a liquidity problem.

You can expect us to ask about your policies and procedures in this area as part of our normal supervisory approach.

Meeting Customers’ needs

I want now to move away now from what supervisors call the "prudential" regime, and widen my comments to FSA’s consumer protection remit. My remarks here are directed mainly at those banks with a retail bias, but the attitude taken to customer service is crucial for the financial health of all banks.

The risks I have just mentioned (household debt, the housing market, even property lending with so much Buy to Let activity) are also risks for banks' retail customers. Take consumer indebtedness for instance: clearly you would not want to lend money to individuals who are unable to repay it. And clearly you could, and no doubt would, argue that you are meeting your customers’ needs by lending them the money they want when they ask for it. But is "meeting needs" only a question of identifying marketing opportunities and then designing products accordingly?

The British Household Panel Survey has identified that the growth in consumer debt has been particularly concentrated in low income households – who are also typically the youngest and most vulnerable to payment arrears or default. Lending to this sector may be servicing the financially excluded but is it really a service that meets their needs when you lend them money if they cannot actually afford the repayments? Of course, borrowers themselves (of whatever type) need to be responsible in their demand for credit, and to make a realistic assessment of their own ability to repay, and we don’t want to push them on to unregulated loan sharks, but how would you demonstrate that your lending was responsible, if called upon to do so?

This is not a purely academic question, of course, since those of you who work for banks that lend on mortgages will soon need to be getting authorisation under the new regime that starts in October 2004. As set out in our draft rules (CP186), lenders must be able to show that they take account of the consumer’s ability to repay the mortgage loan from income, and must keep adequate records to show that this was considered.

To widen the canvas, one factor that we see everywhere is the attitude to borrowing and saving that has been developed by years of living with high rates of inflation. Over and over again this leads to unrealistic expectations; about nominal levels of return on investments, about the funding of retirement schemes, about the real burden of debt repayment when inflation is not eroding the capital amount due. A concrete example of what I mean, may help.

 

  • Consumers continue to search for higher yield. For most consumers, there is confusion over the difference between real and nominal rates. In a high inflation world, the real value of the capital erodes over time, but in a low inflation environment lower interest rates are compensated for by a lower rate of erosion in the real value of capital.. Savers often concentrate only on the nominal income earned, not the real value of the capital. They may be happy to spend all the interest earned in a high rate environment even as their capital is eaten away by inflation, but they do not see spending capital as an option in a low rate environment – even though the two often come to the same thing. Banks play on this misunderstanding by dreaming up new savings or investment products that offer above average rates of return. Of course, we professionals all know that higher returns almost invariably come at the expense of higher risk to capital, but does the average consumer?. Banks sometimes even seem unable to recognise the risk reward equation for their own investments, so is it a valid strategy to expect a consumer to understand that earning 10% income on a bond may involve sacrificing some (or all) the capital invested without explaining that clearly?

  • There are other painful examples of consumers and firms misunderstanding the consequences of lower inflation in the areas of Mortgage Endowments and With Profit Funds.

My challenge to you is to consider whether your own banks’ product development and marketing strategies compound the problem of consumer misunderstanding or reduce it. If you choose to compete almost exclusively on the headline rate, is it any wonder that consumers continue to view that as the most important aspect of any financial product they are offered? And from your own point of view, if the bank apparently offering the best rate scoops the pool, what sorts of customer will it be attracting and what could the consequences be? It is not my role to devise your marketing strategies for you, but my observation is that many of the current approaches to gaining market share carry increased risks for both product providers and their customers. Again a few examples:

  • In the mortgage world, the marketing imperative for all but a few lenders has long been to acquire new borrowers by offering up front discounts and other incentives that essentially have to be paid for by long-standing borrowers, or those who are locked in by penalties. This general approach clearly favours those customers who understand the rules of the game and collect their incentives by remortgaging regularly. But with remortgages now representing half of all new lending and the net amount lent on mortgages each month often less than 30% of the gross total, the rate of "churn" appears to be increasing. And all that remortgaging carries high transaction costs that have to be met somewhere. So the questions you might ask yourselves if this is your business model (and I accept that it does not apply for all banks) are: is this a fair approach to meeting the needs of our borrowing customers? Are the redemption penalties on which it relies fair and justifiable in all cases? What would a model that was fair to all borrowers look like?

  • For those lenders where margins have been squeezed by up-front discounting or other price competition, the focus of promotional activity appears to be moving towards loosened credit requirements in order to attract more marginal borrowers who will pay a premium rate. Thus, we have seen lenders increasing the income multiples at which they are prepared to lend, reducing security margins by accepting higher loan to value ratios, accepting self-certification of income and extending loan terms out to 50 years. I do not seek either to condemn or to condone these approaches – indeed the legislation governing the FSA specifically requires us to have regard to the desirability of facilitating competition and innovation. My challenge to your banks is to explain how you will know when keeping up with, or outdoing, your competitors in these areas you have strayed across the boundary between responsible and irresponsible lending. I don’t believe it will be possible for you to go on loosening lending criteria forever without over-stretching your borrowers and putting your depositors’ funds at risk.

  • Turning to the liability side of the balance sheet, but staying with Treating Customers Fairly, you will probably have noticed the increased attention that we are paying to promotional material – and I should remind you that our rule that such promotions should be "clear, fair and not misleading" applies to deposit products just as much as to packaged investment products – and will apply to mortgages from October 2004. We recently took a close look at the product literature used to promote a range of deposits with equity-linked returns offered by different firms, and, whilst we did not find anything so bad that we had to take enforcement action, a number of the promotions fell short of the standards we are looking for. In particular, we noticed a marked tendency to emphasise the maximum possible rate of return, rather than providing a more realistic range of possible rates, and to bury bad news on conditions applying and charged levied in the small print. The firms in question have had our feedback, and we are expecting improvements for future offers. Again, my challenge to you is to think about the way that you promote your products and, if that is by quoting headline rates of return that would have looked generous 10 years ago, to consider whether the risks and likely outcomes have been given equal prominence.
  • Finally under this heading I would like to tackle the vexed issue of suitability. You are all no doubt aware of the need for financial advisers to consider, and then document, the suitability of products recommended on the basis of a sound knowledge of customers’ circumstances. Our rules for mortgage advisers will include a similar requirement from October next year. A suitable product should, by definition, meet the customer’s needs, leaving both buyer and seller content. So why is it that we often come across cases where the product sold seems to suit the seller’s marketing plan far more precisely than the customer’s actual requirements? We at the FSA wouldn’t like to think that firms were just developing new (and often extremely complex) products, and then trying to decide who to sell them to, because treating customers fairly starts with identifying the customer need, then selling only the products necessary to meet it. But is that how the process actually works in your banks?

Senior Management Responsibilities

Understanding how your banks work brings me to the final element of my paper – the role and responsibility of senior management. Taking the suitability example I have just mentioned, who should be held responsible if a product promotion results in significant sales that are subsequently found to have failed the suitability test? Should it be the individual salespeople, for failing to identify needs properly and then recommend the appropriate product? Or the ales Manager, for failing to monitor the activities of the sales force? Or the Compliance Manager, for failing to spot that the sales were non-compliant? Or the Training Manager? Or the Marketing Manager? Or the Product Manager?

As I’m sure you will have guessed already, the FSA view is that the senior management of the firm are responsible for ensuring that the interests of customers are properly considered and that control processes are in place to deliver a fair outcome. Senior managers are ultimately responsible for understanding the risks to their retail customers that arise from complex or high risk products; they are responsible for ensuring that the marketing strategy does not take advantage of low levels of consumer understanding; and they are responsible for understanding how far the performance of new products may be affected by major changes in market direction. If a firm’s senior management sets sales targets and sales incentive structures (of both carrot and stick varieties) that result in significant sales of the wrong products to the wrong people, it is them the FSA will be targeting rather than their sales force.

Of course senior management have responsibilities in addition to their duty to treat customers fairly, and you would expect the FSA to be particularly interested in high level systems and controls over all aspects of the business. However, it is not our role to second-guess your job as managers of your business, and we see acceptance by senior management of their responsibilities as a key aspect of our regulatory regime. We do not have the resources to follow up every issue we find as part of an Arrow assessment, and we will be looking in future to draw up risk mitigation plans where most items are left to senior management to deal with and report to us when resolved. We will also rely more on your internal audit and compliance departments for mitigation work, where we are convinced that they have the skills and resources to do so.

Summary

So, to summarise my messages and challenges to you today:

  • Firstly, the economic background in the UK continues to be relatively benign, but there are significant uncertainties and downside risks particularly in respect of consumer indebtedness and the property market, both residential and commercial

  • Secondly, even in a relatively benign market, there is still much to do to ensure that banks remain appropriately capitalised for the particular risks they take, and preparations for the implementation of the new Basel Accord should be at the top of your "to do list"

  • Thirdly, the FSA focus on delivering all our statutory objectives should be evident to you. In planning for the future, you should be sure that you have strategies for treating your customers fairly as well as strategies for ensuring that you have adequate capital and liquidity.

  • Finally we place particular emphasis on the roles and responsibilities of senior management for running a regulated firm properly. Where management takes up that challenge, you can expect us to be less intrusive. However, we have powers to deal with inadequate senior level engagement with this challenge, and we won’t hesitate to use them where we consider that to be justified.

Thank you for your attention.

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