BBA – Regulating Banking in Britain Conference
The Barbican Centre, London
2 December 2003
Callum McCarthy
Chairman, Financial Services Authority

1.I am delighted to be able to speak here today, as the first of 3 FSA speakers in the course of the day, something which, if I may say so, displays excessive respect on your part for your regulator. I am assured that George Mathewson is likely to correct any imbalance when he speaks later this morning.

2. I have long been interested in the relationship between banking regulator and the bank being regulated. Until two months ago, I had seen that relationship exclusively from the viewpoint of the regulated bank. I have had the pleasure (I choose my words with care) of being regulated by the Bank of England in London (in pre FSA days), by the MoF in Tokyo, and by the New York Fed in New York. I now see the relationship from the other side. Let me start by setting out the main lessons which I have learnt, from both sides of the regulatory relationship – and, I would add, from the experience of regulation in energy.

3. My starting point relates to information, and the most productive relationship between regulator and regulatee is much like the most productive relationship between any of us and his or her boss: namely a desire to avoid giving unexpected shocks – the "no surprises" principle. Now the implications of this are quite wide. You can only avoid surprises if the person with whom you are communicating understands the risks that you run. Any account of what is expected which is of value needs to be accompanied by a discussion of the factors which could affect that outcome – up or down. Any intelligent discussions will also embrace some judgement as to the likelihood of any of these factors occurring. The "no surprises" principle is clearly incompatible with – is opposed to – a policy based on managing news, a policy which I have heard advocated by some as the basis for information exchange with the regulator. So a relationship based on "no surprises" in terms of information carries with it direct consequences for a bank's behaviour towards its regulator which are important and wide ranging.

4. Behind this principle is a confluence of interest between bank regulator and bank regulatee which brings advantage to both of us. We share a common interest in banks having adequate capital; in risk control being strong; in skilled assessment of counterparties; in internal systems which succeed in measuring and controlled credit risk; in fair treatment of customers in a way which reinforces the bank's brand; and in effective internal governance. I would add that it is a huge relief to be no longer charged, as I was when responsible for energy regulation, with any responsibility for price controls, as these inevitably add a tension, based on the divergence of objective between shareholders and customers in a price control environment, which makes managing the relationship between regulator and regulatee much more difficult. When I first became energy regulator, I spent some time explaining to energy companies that I hoped they would behave towards their regulator more like banks – or more like the way I would expect banks to behave. I am looking forward to being able to judge whether my confidence in the behaviour of banks towards their regulator is in fact justified. I am sure that it will be.

5. I should add that the "no surprises" principle should clearly run both ways. I regard it as a failure for the FSA when there are occasions when we give surprises; and I attach great importance to the process of consultation which is so central to the policy and practices of the FSA – almost to excess. There is a danger not of information overload, but of data overload: too much consultation, too many documents which collectively make it difficult for those affected by proposals to keep abreast of developments. We have made it clear that we intend to reduce substantially the number of Consultation Papers produced by the FSA next year. We also need to think further about how to make them easier to absorb. Our aim is more information and less data: i.e. an explanation of what really matters with as little clutter as possible.

6. Let me turn from this rather philosophical discussion to some more practical issues. I make no apology for having started with principles: they are in fact much more important than the detailed and transitory issues which we face at any time.

7. The starting point should be the state of banks operating in Britain today. It is always unwise for a bank regulator to be other than anxious – or if not anxious, certainly thoughtful. But there is little doubt that the capital strength of British banks has seen considerable improvement, despite quite a number of strains and shocks to which they have been subject. The largest UK banks produced a return on tier 1 capital of almost 20 per cent in the first half of this year. The provisioning charge remains at 63 bp or so of loans outstanding, in comparison with 66 bp last year, and some 80 bp in 1998, the last year I was directly involved in financial services. Tier 1 capital on average is about 8 per cent. Overall, the financial position of the banks is encouraging.

8. I am also broadly encouraged by what I see of the internal controls of the banks which appear to me, based on reading what I believe to be a fair sample of Arrow reports, significantly improved on the controls and management systems which were prevalent in banking when I left it in 1998. I say that I am "broadly encouraged". I would not want that to be taken as a blanket seal of approval. There are considerable and concerning differences in the effectiveness of treasury systems and controls between banks. In many of the largest organisations, these systems have been very significantly strengthened, but in a number of the smaller banks operating here – both domestic banks and building societies, and branches and subsidiaries of international banks – we have found a disappointing and often concerning range of material failures in treasury controls. These included inadequate segregation of duties; operations falling down a hole between different responsibilities; ineffective limits; and inadequate senior management understanding of risks. I am glad to be able to say that these failings tended to be isolated, in the sense that a particular institution might display one weakness rather than showing all. But it is concerning that these problems are so widespread, and they are a subject to which both the senior management of the banks, with whom the primary responsibility lies, and the FSA must both return.

9. This should come as no surprise to anyone here today. The problems we described at some length and in some, I hope helpful, detail in Philip Robinson's "Dear CEO" letter of 29 September. I know this letter has occasioned some controversy. I should make clear that I consider it entirely proper and constructive for the FSA to generalise our experience of particular inspections and supervisory experiences by pulling out the general lessons and making them available for all. We have done that before, and will do so again in the future. I should add that I do not regard it as clever to have relied on the post as the means of communication at a time of a postal strike. We have done this once, and will not do so again in the future. Apart from anything else, it runs counter to my "no surprises" principle. And I apologise for this lapse. But the practice of spreading the general lessons we learn, and the use of "Dear CEO" letters, are clearly sensible.

10. Against this background of improving financial strength, and broadly encouraging control systems, let me set out some of the main regulatory issues.

Basel II

11. The most far reaching change we face is Basel II. I am well aware that there are varying views on how Basel II has developed. I see no purpose in rehearsing those – I am tempted to say in rehashing them – today. What I believe to be productive is to summarise where we are, against a background of general recognition of the extent to which economic and regulatory capital were diverging under Basel I. The position is that, while we are still waiting for the US consultation process to come to a conclusion, the only prudent course for any bank is to assume that Basel II will be agreed in a form not dissimilar to what is now on the table; and that in Europe what will be implemented will be close to what is in Basel II. Although none of us can be certain as to the timetable, the only prudent course is to work on the basis that the present timetable will be achieved: implementation by the end of 2006. Even for those banks which have made most progress in terms of moving towards a realistic assessment of what their economic capital requirements are, the move to Basel II represents a major change. For those who have relied on less sophisticated controls it represents even greater challenge. The need for better data and new systems will prove demanding. The 2006 date will require very hard work, detailed consultation and close and productive working between the FSA and banks. We both have no time to lose. I very much hope we can put arguments about the why and the whether of Basel II behind us, and concentrate on the how.

Money Laundering

12. It would be surprising if I did not say something about money laundering – it is, after all, covered in your survey which we shall hear more about later on today.

13. First, I would like to commend the steps which the banking industry has taken to deal with money laundering over the last two or three years. The government and the enforcement agencies are appreciative of the help which banks are providing in the fight against terrorism. These steps were needed. It was clear at N2 that recognition by banks of their legal obligations, as well as the risk to their reputations, was lower than we, at the FSA, had expected. Since then, there has been a welcome shift to a higher level of senior management awareness, investment and resourcing. These measures underpin the recent improvements.

14. I recognise, of course, that cost and value for money are important considerations here. They are likely to remain so as new legislation comes on to the statute book e.g, the Proceeds of Crime Act. We need, therefore, to be realistic and risk-focused in our approach. The FSA took full account of the potential costs (and benefits) in deciding not to set out specific requirements for the way in which banks and other institutions should assess money laundering risks amongst their current customer base. At the same time, we fully support the focused and tailored work that the major retail banks and others are now doing in this area. We are also keen to look at new ways of targeting our anti-money laundering efforts. Transaction monitoring is one example; and Discussion Paper 22 asks for your views on this.

15. Looking ahead, we have a number of common goals. We all want an effective regime for detecting and reporting suspicious transactions, with regular feedback to the industry from NCIS and the enforcement agencies. How do we get there? Since N2, the FSA has done a lot. This includes the Money Laundering Theme; our cluster work; work with the major banks on the Current Customer Review; a raft of specialist visits; and several well-publicised enforcement cases. It should, now, be very clear what standards we expect. Also that we expect senior management to maintain and, where necessary, extend their involvement. It is, therefore, encouraging, that the BBA and major banks are taking the opportunity to participate in the revision of the Joint Money Laundering Steering Group Guidance Notes. It is important, too, that we start to tackle the other forms of financial crime. We shall be publishing a Discussion Paper shortly on financial fraud and we will look to you for reactions and views.

Retail issues

16. I have talked until now about prudential issues and wholesale issues (since I regard money laundering in that light). I know that many of the banks represented here today are exclusively wholesale operations, without direct retail consumer responsibilities. But there are also banks represented here which together will account for a large part of the retail market and for them, and for us, there are important issues.

17. The retail customer is central to the FSA's work. One of our principal aims is to allow the retail customer to obtain a fair deal. We want to do this through a competitive and efficient market, where customers buy wisely and where suppliers sell responsibly; and where regulation is unobtrusive or even unnecessary. The present position is far removed from this ideal. We have a financial product which is likely always to be complex – though not necessarily as complex as it is sometimes made to be. We have at present a customer who is too often not equipped to understand financial products, and whose judgement is therefore too often unreliable. And we have salesforces which too often have acted irresponsibly – and where that behaviour has historically been encouraged rather than discouraged by the incentives which their managers have used. Now each of these problems need tackling – the complexity of financial products via the FSA's work on devising and implementing standard templates which will simplify comparison; customer lack of confidence or competence through the work needed – a task which will extend over a generation rather than a single year – to improve financial understanding. Banks, and other financial institutions with retail businesses, can clearly contribute to both these sets of solutions. But they can, and must, take the principal responsibility to ensure that their salesforces sell financial products and services in a responsible manner through paying full and careful attention to ensuring that inappropriate products are not sold; that the basic requirements of understanding the customer's position and needs are met; that internal controls to police these principles are in place and are operated; and that the incentives for salesmen and women reward responsible behaviour. That is the central responsibility of the senior management of these banks with retail businesses. I stress this, because it is clear that more often than should occur this has not happened. These occurrences of failure to meet a basic standard are bad for the reputation of the financial services industry as a whole; and cause harm to consumers. They are unacceptable.

18. The FSA cannot prevent behaviour of this sort. That is down to the management of the firms themselves. But what we can do, and what you must expect us to do, is to seek ways of rewarding those firms which behave responsibly, and of making it increasingly costly for those who do not. We will therefore place a new emphasis when supervising and regulating banks on the way in which they treat their customers when providing financial services regulated by the FSA. And, when companies fail to meet their obligations, we shall use our enforcement powers actively. In the past year there have been five major fines for mis-selling. The fines came to £5 million. The associated compensation to customers came to more than £250 million. The damage to individual brands and reputation exceeded that.

19. There is clear evidence of too many companies being insufficiently concerned about their responsibilities towards those who purchase their products. Changing this position must be a priority for all of us – just as, and because, the present position represents a failure for all of us. You will note that I have stressed this is an objective for both of us. It is not in your interest that the value of your franchise and of your brand should be eroded as the result of failure to treat customers properly; it is not in the FSA’s interest in terms of our statutory responsibility for appropriate consumer protection that this should happen. Even here in contentious territory, you will see why I believe there is helpful confluence of interest between your and our objectives.

FSA organisation

20. The last subject I want to touch upon is that of the internal changes we are making at the FSA. I will do so briefly, because they should interest us more than they interest you, in that what you – and we – should be concerned about is how the FSA relates to the world outside, rather than our internal workings. In general, our reorganisation is aimed at ensuring that the FSA operates as effectively as possible, and that we make the FSA an easier place to do business with. The specifics of this are various, but I would in particular mention:

  • first, a determination to produce fewer consultation papers. We have set ourselves the target of halving the number next year. This clearly requires us to be more selective as to what we do – and what we stop doing. It is not simply a question of reducing the number of publications;
  • second, a development of the position which we already face under which we treat banks and others in different ways, depending on their size and the risk they present to our statutory objectives. As you know, we already distinguish between major financial groups, subject to "close and continuous" supervision, and smaller groups subject to much less intensive supervision. The new responsibilities the FSA will take on next year for some 20,000 mortgage and insurance brokers make it important for us to develop our techniques of supervising large numbers of small enterprises, and we are reorganising our structure and practices to achieve this;
  • third, we are reorganising to recognise the different emphasis of different institutions on wholesale and on retail issues. In future, we will divide banks – and other financial institutions – between those whose business is principally wholesale and those with a major retail component. We believe this will establish greater coherence in the way they are treated. This should not in itself involve changes in supervisory teams. Our aim is to maintain existing teams unchanged – or as unchanged as they would have been: we cannot avoid the normal staff movements which happen in any organisation.

As I say, these internal changes should interest us more than you. I hope you will see an FSA which is more focused on fewer objectives and hence easier to understand; and an FSA which is easier to do business with.

Conclusion

20. There is much I could have discussed: Europe, accounting standards, our further development of a risk-based approach. But I have deliberately chosen what I regard as some subjects which are either important or topical (or even both). I would be delighted to answer any questions.

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