CABOT HALL, 17 JULY 2003
HOWARD DAVIES
CHAIRMAN FINANCIAL SERVICES AUTHORITY

Today’s annual meeting will be the last under my chairmanship. It is therefore a good opportunity to reflect on the way the Authority has developed since it was formally established in 1998. It is also a good opportunity to welcome my successor as chairman, Callum McCarthy, and his new chief executive John Tiner, whose appointment was announced on Monday of this week. I wish them both every success here. They take on their new roles on 22 September. The transition will be smooth : Callum is already attending Board meetings and John, of course, is in-house already.

It is entirely clear that the Government’s decision to replace the previous patchwork quilt of financial regulators with a single entity was amply justified. The trend towards financial conglomerates has continued, both in the UK and elsewhere. The need to understand the interactions between different types of financial business has become more pressing as risk is more easily transferred through the derivative markets. And the reasonable demand of consumers to benefit from the protection of a regulatory system which they can easily understand has become even stronger.

Among financial firms support for a single regulator has remained very strong, and a recent survey of international firms shows that the very large majority believe that the London regulatory system is now the best able to cope with the demands of global markets. In a recent survey for the City Corporation, international firms were asked if they agreed with the proposition that "a single regulator is a big advantage for London." 174 agreed while only 31 dissented. And on more general questions about the attractiveness of the regulatory environment, London scored consistently highest, above New York and well ahead of Frankfurt and Paris.

The benefits of integrated regulation are now widely understood around the world, and a number of countries, including Japan and Germany, have copied the FSA approach.

When the Authority was established there was some concern about the way in which it would interact with the Bank of England, which retains responsibility for the stability of the financial system as a whole. Those concerns have proved groundless. That is partly attributable to the structured relationship established under the Tripartite Standing Committee, which allows the Treasury, the Bank and the FSA to monitor trends in financial markets, and potential threats to their stability. But it owes just as much to the determination of the recently retired Governor, Eddie George, to make the new system work well. He was an enormous source of strength to the FSA, and to me personally. His wise advice and sympathetic ear have been invaluable, and his advocacy has greatly helped to establish the credibility of the new Authority abroad. I am sure the relationship between Callum McCarthy and Mervyn King will be just as strong.

The reform announced in 1997 was much more fundamental than a simple stitching together of the previous regulators. The Financial Services and Markets Act 2000 reformed the entire legal basis of regulation. One unsought accolade is that it was the most amended piece of parliamentary legislation in history. But we benefited, in the end, from an intense degree of parliamentary scrutiny, and the new Act is working well.

Of course there have been criticisms. While the legislation was under discussion, it was commonplace to argue that the FSA would be insufficiently accountable: "judge, jury, executioner and sexton". We hear much less of that rhetoric today, as the rigorous accountability procedures of the new Authority have become more widely understood. Indeed we are now more frequently criticised for the steady pace of our disciplinary procedures, which is dictated by the Act, so recently approved.

We have also noticed that support for a non-zero failure regime, which was very evident during the debates on the approach the FSA should take to markets in the future, has been much less evident when individual failures, or near failures occur. I shall say more on that subject in a moment.

And we have to acknowledge that some firms have indeed failed, creating losses for investors, not all of which have been compensated through the Financial Services Compensation Scheme. While market conditions in the first 2 years of the FSA’s life were extremely benign, the last 3 years have been difficult. Not since the 1930s has the UK experienced three consecutive years of falling share prices. That has put considerable pressure on a number of financial firms, notably life insurance companies with a large proportion of equities in their portfolios. Given the scale of the market fall, it is surprising that there have not been more failures, but that is no consolation for those investors who have experienced losses.

I am satisfied that the FSA has acted appropriately during this difficult period, and that no actions we could reasonably have taken would have significantly altered the outcome in the most difficult cases we have encountered. On many occasions we have had to make difficult balancing decisions, bearing in mind our overall market confidence objective, and our duty to protect consumers. In some regulatory regimes these objectives rest with different regulators, who, in some respects, have an easier task in that they are able to pursue their aims single-mindedly, with the inevitable reconciliation of conflicting objectives taking place in the political domain, or in the courts. Some of those decisions need to be made within the FSA itself, putting considerable burdens on the staff and the Board. But I am persuaded that the overall outcome is likely to be better balanced decisions.

In some specific cases where our judgement has been questioned, others have reviewed our work. On Equitable Life, the recent Parliamentary Ombudsman report reached the conclusion that the FSA acted reasonably, and could not be held responsible for the losses suffered by those who complained to her. As the earlier Baird report did, she pointed to things we could have done differently, but agreed that the die was cast, as far as Equitable was concerned, before the FSA took over its prudential regulation.

The Ombudsman also drew attention to what she characterised as a mismatch between the expectations policyholders have of regulators, and what those regulators are empowered to achieve.

I am pleased that she opened up this debate. It is not possible, or even desirable for regulators to seek to guarantee the survival or prosperity of all financial firms. Banks and insurers, in particular, are in the business of taking risk: that is their economic function and their social value. And risk brings with it the possibility of failure. A reasonable aim for the FSA is to reduce the incidence of firm failure and market disruption, through its prudential supervision in particular, to the minimum compatible with open and dynamic markets. There is, of course, a qualified safety net which provides compensation where failures occur.

My view is that we have calibrated the system appropriately in setting our requirements, and the terms of the compensation arrangements. To try to do more, and to seek to ‘ensure’ that all firms are safe at all times would impose huge costs and rigid constraints on the system. It would be damaging to the financial system and to consumers’ interests in the long run.

To return to Equitable for a moment, the Parliamentary Ombudsman review looked only at the last period of the life of the Society. We await the broader review by Lord Penrose, which will consider a longer period, including the actions of the Society itself, and the previous regulators. I know that Equitable policyholders, for whom the last three years have been enormously stressful, are particularly anxious to see his report.

On split capital investment trusts, the Treasury Select Committee carried out an enquiry. Their final report acknowledged that, in this area, the FSA’s powers were limited, but they enjoined us to be more vigilant in future, even in relation to financial products which do not, as investment trusts currently do not, come within our regulated regime. The Committee’s most important recommendation was that we should regulate them in future. The Treasury are considering that proposal.

But the problems of past sales, and the predicament of those investors who were misled on to the risk characteristics of these products and who have incurred serious losses, must also be addressed.

We are carrying out a series of major enforcement investigations, covering allegations of mis-selling, misleading marketing, and of collusion leading to market manipulation. This is by far the largest enforcement project we have under way, and it is moving forward well. It has been extended to cover a number of additional firms, and individuals within them. The extensive enquiries we have made so far, involving enormous volumes of documentation and the review of many hours of taped conversations, have not discouraged us in our view that there is a serious matter to be investigated.

We are today publishing a paper which summarises progress on various strands of work related to splits. At the same time, the Financial Ombudsman Service is releasing a further update on its own work on cases put forward by individual investors. We and the FOS, are determined to secure justice for those investors whose interests were damaged by this mis-selling, or collusive behaviour.

The general point made by the TSC about our market surveillance is well taken. We fully acknowledge the need for vigilance on our part, and our new operating arrangements do allow us to look beyond the confines of regulated product regulated sales, to seek to identify risks across the financial sector which could impose significant losses on groups of consumers. We have developed a framework of risk-based supervision which involves both individual risk assessments of each firm we oversee, and an overview of trends in financial markets. The Financial Risk Outlook we published earlier in the year shows that we are now seeking to identify potential risks across a broad front.

We are also now more active in reviewing financial promotions, a point put to us strongly by the FS Consumer Panel. We recently released the first in a series of updates on our work to promote better and clearer advertisements and marketing material. We have also issued a number of consumer warnings, where particular products cause us concerns.

However, the regulator cannot be an all-purpose Cassandra. There are circumstances in which any investment may under-perform, or even fail, and little purpose would be served by our issuing serial warnings, which would only be likely to damage market confidence - which of course it is one of our statutory objectives to maintain. We need to strike a balance, once again.

Nonetheless, I would acknowledge that over time we ought to be able to do more to help consumers make good decisions for themselves, and better to understand risk and the benefits of diversification. We must do more to encourage firms themselves to think harder about the appropriate markets for their products and services. Many of the products which have caused difficulty in recent years, and so-called precipice bonds are another example, are not inherently wicked constructions. The problem is that they have been sold to investors for whom they are unsuitable, and sometimes in circumstances in which investors have been encouraged to put all their financial eggs in one particularly fragile basket. Split-capital investment trusts, too, had their place in the market, for those who want leveraged stock market investments - indeed some have performed very well in normal times.

A key challenge for the future, therefore, is to expand our work on financial literacy and consumer information. In particular, while we have prepared an enormous amount of material which could help consumers make better decisions, our readership is not yet wide enough. We must find ways of reaching more people. Similarly, while we have developed an imaginative suite of teaching materials for financial literacy in schools and colleges, the task now is to encourage more institutions to incorporate it into their curriculum. The Authority will be bringing forward some proposals in that area in the autumn. Our thinking on that is now quite well advanced

We must also do more to promote the benefits of wise and compliant marketing to firms themselves. The biggest disappointment of my time at the FSA has been the failure of firms, and particularly their senior management, to learn the lessons of past mis-selling. Sadly, the recent history of the British retail financial services industry is proof of the adage that those who fail to understand the mistakes of the past are condemned to repeat them. Though the pensions mis-selling debacle, which cost the industry over £11 billion in compensation, should have been a stark lesson of the dangers of uncontrolled and unsuitable selling, it is hard to see evidence that that lesson has been widely understood. Again and again we find examples of High Street firms disregarding the suitability requirements in our rule book, requirements which merely, in my view, describe what most service companies would regard as good customer service. Unfortunately, much of the industry remains focused on short-term gain from "shifting product". Indeed many firms are happy to see themselves described as "product providers", terminology which in itself distances them from their customers, many of whom assume that they are being given advice which takes their personal circumstances into account, and who see their relationship with their bank or life insurance company as one for the long-term, and not solely transaction-based.

Some in the industry understand the problem well, and the ABI’s "raising standards" initiative is one worthy response. But there is still a very long way to go.

Solving this retail market failure is not, however, assisted by those who appear to believe that every loss to investors, whatever the cause, should be compensated. That way, madness lies. Some firms complaints systems are currently snowed under by indiscriminate claims for compensation by endowment mortgage policyholders. Many have little prospect of success, and merely delay the resolution of other, worthy claims.

There are those who conclude, on the basis of this experience, that a radically different approach to the retail market is required, based on government designed low risk products and price controls. I understand the analysis which leads to that conclusion, though as I have said before, I have personal doubts about whether product regulation and price controls are the right way to go. These are not, however, primarily decisions for the FSA. Our role, which I am sure the Authority will continue to perform, is to design an appropriate regulatory framework for whatever shape of retail market emerges, which maintains strong standards of investor protection.

There are challenges ahead, too, in the wholesale and professional markets. The experience of the last few years, especially in the United States, shows that companies and their directors too often ignore or forget their disclosure obligations, that auditors can be too easily distracted from their public interest responsibilities, and that investment banks are not always good at managing the conflicts of interest which are inherent in their business models.

We have been spared some of the worst excesses in London, though we are not complacent. There are too many cases of poor compliance with our listing rules. Investment banks have operated management structures here which, at the very least, leave them vulnerable to the charge that they do not handle conflicts of interest in the way their customers would hope. We have proposed a series of reforms to address these deficiencies. Some firms argue that they would require inconvenient changes to their business models. That may be. But those firms need to ask themselves whether, in the long run, they do not need to work harder to restore investor confidence, which has been sadly dented in recent years.

I therefore call upon the industry to take a more longsighted view of the need for change.

In this area, and many others, we need to see our markets in a global context. Much of the work we do on the future of our regulatory environment has to be done in co-operation with regulators overseas, and particularly in Europe. That is the third major challenge which I have faced, and which will remain high on my successor’s agenda. Heads of Government in Europe have committed themselves to the creation of a single financial market, which they see as an important contributor to the dynamism of the European economy in the future. I do not doubt that a single deep and flexible financial market will promote economic growth. But some of the routes we are required to take to get to that happy destination seem to involve changes to our regulatory environment which are not obviously beneficial to firms or to investors. In part, that is because the markets in different European countries begin in very different places. In particular, Europe’s wholesale markets are heavily concentrated in London, and the regulatory needs of wholesale markets are not always taken into account when directives are first drafted in Brussels.

I have spoken extensively, here and elsewhere in Europe, about the need for a proportionate approach to the development of European regulation, and particularly for one which is sympathetic to the needs of wholesale markets, where the competition for London is in New York, rather than in Paris or Frankfurt. By comparison with the position I inherited in 1997, the UK is much better able to articulate its case in Brussels, but we need to continue to make our voice heard. Fortunately, we now have a better developed set of regulatory networks in the European Union, and relationships between regulators themselves are generally constructive and harmonious. The Committee of European Securities Regulators, modestly known as CESR, is working particularly well, and is a model for co-operation in other areas. At this point, we see no case for moving further, to a single European regulator.

Our Annual Report for the year just gone shows how we have been pursuing our objectives over the last 12 months. I believe it demonstrates a record of which we can be proud. Inevitably, much of what a regulator does is in the "good by stealth" category. We have headed off a good number of potential problems for consumers and for firms, and I believe our actions are one of the reasons why there have been relatively few failures during this very difficult time. We made timely changes to the insurance solvency regime, for example. But we recognise that we need to do more to explain our regime, and to measure our effectiveness. There is more material in our report on service standards this time, but gaps remain, which we must work to fill.

In management terms, the FSA is in good shape. Staff turnover is low, skill and experience levels, which have concerned our Practitioner Panel, are improving. Costs are under control, in spite of the pressures arising from a larger number of problem cases in difficult markets.

Our accounts show that, like many other companies, we face a sizeable deficit on our pension fund, though one which would not crystallise for many years. The main reason is the decline in the value of the scheme’s investments over the last 3 years. We took the most important step towards controlling that deficit in the future when we closed the final salary scheme to new members in 1998. But falling markets have obliged us nonetheless to increase our contribution rate, and to adopt a new approach to pay which takes full account of pension costs in awarding increases.

Stewart Boyd, my deputy chairman, will say more about the governance of the authority. He will be followed by the chairs of the statutory Consumer and Practitioner Panels, Colin Brown and Donald Brydon. However, before they speak I have an opportunity to get my retaliation in first.

As the two Panels reports make clear (in fact there are three reports since the Small Business Practitioner Panel also reports on its own account) we do not always see eye to eye with them. That is, perhaps inevitable in view of the structure of accountability we have been given. However, over the last year each of the panels has exerted significant influence over the policies of the FSA. My Board and I are in no doubt that the quality of our work has been better as a result. The members put in considerable effort on our and your behalves, and we are grateful to them.

Our report also includes the Board’s response to the report of the Complaints Commissioner. None of the complaints on which she reported during the year justifies particular comment at this meeting.

The reports of our two associated entities, the FOS and FSCS have also been published recently. I am grateful to the Board and staff of those bodies for their hard work over the last 12 months.

Overall, my conclusion is that the new regime is now functioning as Parliament intended, with this Public Meeting at the apex of a robust accountability structure. I am sure the efficiency and effectiveness of the system can be improved further. That, however, is a job for my successors.

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