3rd March 2004
Speech by John Tiner

Mr. Chairman, Ladies and Gentleman

Thank you very much for inviting me here today to present the latest in the series of IEA and Cass Business School seminars. As an integrated regulator responsible for the whole of the UK Financial Services Industry, it is sometimes quite difficult to narrow down what topics to cover on occasions such as this. And so illustrating the diversity of our regulatory portfolio I thought I would cover the following:

  1. A few words about our regulatory principles, aims and objectives and how these have driven our business plan which we published in January;
  2. the reforms we are implementing in how we regulate the life insurance industry, focussing specifically on, the now much talked about, realistic balance sheets and risk-based capital;
  3. how we are tackling the important issue of conflicts of interests; and, finally
  4. the challenges for all us emanating from developments at the European and International level. If I am not exhausted by then, I would be pleased to discuss any matters on which I am qualified to comment, although I should be grateful if Leeds United could be left for another day.

Business Plan

A month or so ago, we published our Business Plan for 2004/2005 in which my Chairman, Callum McCarthy and I set out our priorities for the coming year, the timing and forthcoming milestones of major projects, and the resources we had allocated in order to do that work.

Our work and priorities remain close to those we have previously established. And we continue to have the same overall aim as before: To maintain efficient, orderly and clean financial markets, to help retail consumers achieve a fair deal and to make the FSA a more effective organisation to do business with.

We have also not changed those basic principles that underpin the way we work and that remain central to all our thinking at the FSA. These continue to be that:

  • We will work with the grain of the market rather than against it;
  • We will restrict our regulation to those circumstances where the market itself does not provide adequate answers and where regulation can do so at a reasonable cost through our statutory use of cost-benefit analysis
  • We have a risk-based approach to regulation of UK financial services;
  • Accepting that we do not and can not operate a regulatory system where there are no failures: such as firms going bust or consumers being unfairly treated. We will, of course, work to limit and minimise these failures within our resources by regulating intelligently and with a healthy sense of market nous and speed of action.

To help me to execute these principles more effectively, you may have noticed that I am putting in place a new organisational structure and operating model. From 5 April the internal reorganisation will be complete, and the organisation will begin operating in three new Business Units – Wholesale and Institutional Markets, Retail Markets and Regulatory Services. Although we are an integrated regulator, and I commend strongly the benefits of integration, it remains a fact that many specific issues still emerge in sectors of the industry and there are also some generic issues which apply across the whole industry. That is why I have set up, what I call sector teams to cover banking, capital markets, insurance, asset management, retail intermediaries, financial stability and continuity, consumers and financial crime.

As Callum McCarthy has said in his Chairman's statement in our business plan, the FSA derives its legitimacy from the Financial Services and Markets Act, which provides us with our objectives and powers, and from the effectiveness with which we discharge our responsibilities. I am convinced that the changes we are making at the FSA will contribute significantly to the second of these.

This changing environment in which we operate is something we are very conscious of and to this end each year we produce a document called the Financial Risk Outlook (FRO), which I am happy to commend as essential reading. The Daily Telegraph indeed has referred to this as "the FSA's equivalent of the annual State of the Nation address".

Other commentators have said that a strong stomach and/or a sharp intake of breath is needed before reading it, to find out what dangers lie ahead in these tricky waters we are navigating. But remember we are regulators - accustomed to looking on the darker side, although of course we must not overdo that in a way which damages market confidence. Our purpose in preparing the Financial Risk Outlook is to set out where we see the risks to our objectives of market confidence, consumer protection, financial crime and public understanding of the financial system, and therefore where we need to target the deployment of our resources in the coming year. We actively and widely publicise our FRO as we believe that it sends out some important messages to consumers and firms alike, to consider the risks in their financial decisions and for firms, those we identify in their strategic planning and risk management. For the first time this year we have set our outlook in the context of a central planning scenario. But we have also looked at four other scenarios: a strong recovery; financial market instability; fiscal and interest rate pressures; and, a sharp slowdown in consumer spending.

I won't spoil your reading of that document with too much detail, but I would just like to alert you to some of the priority risks we have identified as those that are most likely to affect our ability to meet our objectives in the short and medium terms. We believe some of those key risks to be:

  • That financial decisions are being taken by consumers on the basis of inadequate understanding – in this statement I particularly highlight recent difficulties experienced by consumers with products such as mortgage endowments; precipice bonds; split capital investment trusts…….and the list doesn't end there. That is why I am committed to improving financial capability and why I have set up a steering group including the Financial Secretary to the Treasury, Ruth Kelly, The Chairman of the Prudential, Sir David Clementi and Ron Sandler amongst others to look specifically at this issue.
  • The second I would highlight today is our observation that while corporate sector credit risks for firms have moderated, UK household sector credit quality could deteriorate. We have seen household debt in the UK accelerate rapidly, and although credit losses have so far been small, rising interest rates can and probably will put this issue firmly in the spotlight.
  • Thirdly, we all know that the life insurance industry faces continued challenges. Despite the upturn in equity markets, many life insurers have been unable to re-build their capital base and sales of new with-profits policies have dropped sharply. Our new regulatory reforms such as introducing realistic reporting and treating customers fairly will introduce transparency and will, I believe, provide a basis for restored consumer confidence. I will say more about this in a minute.
  • And I could go on, there remains the impact of reforming retail regulation; a new wave of (especially European) legal, accounting and regulatory reform; the issue of burgeoning financial crime and the threat that still looms over us from terrorist groups.

But I don't want to go over ground on which I have touched before on many occasions, so I will move on to my second main topic, namely the modernisation of the way in which insurance firms are regulated in order to improve risk-management, transparency and consumer protection in this sector.

Insurance

The background to this has its origins in the creation of a single regulator for financial services. This highlighted significant differences between the regulation of insurance and that of other sectors, such as banking. In short, it revealed that the regulatory regime for insurance which we inherited had not kept pace with developments in the sector and was insensitive to changing market conditions, such as the move to a low inflationary environment and the volatile equity markets of the last 3 years. So we initiated a radical reform programme based around three main themes: securing a fair deal for policyholders (in both open and closed funds); sound risk management and adequate financial resources for life insurance companies; and delivering smarter regulation of the insurance sector.

I would like to dwell on two areas of the reform package that have drawn particular attention over recent weeks as they have begun to affect the decisions made by a number of insurance firms. The first is the move to a more realistic basis of accounting for insurers' with-profits liabilities. The second is the new requirement for with-profits firms to produce a document called the Principles and Practices of Financial Management (PPFM). The introduction of PPFMs will make the discretion that exists in with-profits funds and the way in which this is exercised by the Board and senior management, more transparent and promote the fair treatment of consumers.

The life insurance sector is a competitive market place. In the past that competition has focused too much on sales and marketing and too little on the delivery of quality service and value to policyholder after the point of sale. Our reforms seek to shift that focus. Both PPFMs and realistic reporting will help life insurers to distinguish themselves from their competitors both within the life insurance sector and the savings industry more generally. Customer-friendly PPFMs direct the policyholders' attention to the risks and potential rewards of with-profits life insurance. All savings involve some risk. The key feature of with-profits life insurance is that it gives policyholders access to the potential for investment gains when equity, property and other investment markets rise without being exposed to the full down side risk if those markets fall steeply. This protection from full downside risk takes the form of contractual promises such as guaranteed minimum benefits and less tangible, but not necessarily less real, non-contractual promises or practices of smoothing benefits. However, whatever their form, these promises or practices are only of real value to policyholders if a life insurer has sufficient financial strength to deliver on them when needed, i.e. at the time when the life insurer itself is under heaviest financial strain that is when equity, property or other investment markets are falling sharply. Realistic accounting forces life insurers to be honest about the financial consequences of the promises and practices they have described to policyholders in their PPFMs and to hold sufficient financial resources to be able to deliver on them even in a wide range of adverse circumstances.

It may come as a surprise to many but the regime for life insurance regulation that the FSA inherited, the so-called statutory accounting regime, did not require life insurers to back their promises and smoothing practices with hard financial resources. It ignored some significant non-contractual promises or practices completely, such as policyholders' expectations that they would receive a fair terminal or final bonus. For other promises such as contractual options or guarantees to pay minimum annuities or other benefits, the requirements of the statutory accounting regime were at best ambiguous. Contractual options or guarantees were often also ignored unless they were actually in the money or at least close to the money. So for example in the early 1990s guaranteed annuity options were ignored because at the time current interest rates were in excess of the guaranteed minimum interest rate implicit in the guaranteed annuity. This is at best a dubious practice for options or guarantees that only have short life but is sheer financial illiteracy for long dated options or guarantees. The longer a contractual option or guarantee lasts the greater the uncertainty and so the greater the need to hold financial resources to cover that uncertainty and the greater the cost to the life insurer and ultimately, if life insurers are to trade profitably, to policyholders. This real economic uncertainty and cost does not disappear simply because outdated accounting methods are used, which ignore it.

Given what you have read in the press lately, it may surprise you to know that 12-18 months ago, the captains of the UK life industry were almost literally knocking my door down to introduce a solvency regime along the lines of the realistic approach, and to do it quick. I was pleased to see, the strong endorsement today by one senior industry figure, Keith Satchell, CEO of Friends Provident, who said during announcing their results that "We have long desired a move towards realistic accounting …… such figures will increase transparency in complicated life businesses, which will benefit investors". The Norwich Union CEO, Gary Withers also said last week "We think realistic solvency is a better way to look at the financial strength of a life company and we have a strong realistic solvency position".

Finally on this issue, I'd like to add a word about the impact of this on mutual life insurers. Contrary to some suggestions, there is no conspiracy against the mutual sector. I have mentioned that we are seeking to shift the focus of competition in the life insurance sector to service and value to policyholders especially after the point of sale. This is an area in which many mutual life insurers with their strong customer focus should be well equipped to compete. Some aspects of our reforms may require some life insurers to increase their financial resources. This is of course a little easier for proprietary companies who may seek to raise funds from shareholders. However access to the capital market is not ruled out for mutual life insurers. All life insurers may within limits raise subordinated debt or other forms of innovative capital. They may also make appropriate use of reinsurance under which some of the capital strains of the business are shared by the reinsurer.

We have no view one way or the other about the merits of a mutual structure compared to a proprietary one. What is clear though, is that life offices, across the board, need the financial resources to back their promises to their policyholders regardless of their governance structure. Ultimately mutual and proprietary life insurers will compete on the basis of their ability to deliver service and value to policyholders. On that basis I see no reason why well-run mutual life insurers need fear the future.

Conflicts of Interest

I would like now to touch on another subject that many of you will have been following with interest, and about which I would like to expand further tonight. And that is the issue of conflicts of interest.

In a hard-hitting speech last September, the Director of SEC Enforcement challenged firms to conduct a ‘top to bottom’ review to identify conflicts systematically, with the goal of addressing conflicts of interest of every kind. I aim to convince you today that we are no less committed than our colleagues at the SEC to ensuring that firms take this task seriously. This is informing a large part of what we are doing in revising the standards we require of firms as well as supervision and enforcement work.

We talk a lot at the FSA about our principles-based regime. Firms tell us they prefer a flexible approach that gives them the elbow room to develop specific solutions tailored to their particular circumstances. But, at the same time, firms do expect clarity from us as to what is expected on particular issues. One of these has been conflicts management in investment research.

Since we first opened that issue up in our discussion paper in 2002, we have been looking to develop a solution that provides sufficient clarity and rigour for the big end of town and their institutional clients, without sending niche businesses to the wall by imposing detailed requirements not relevant to their business model. We also thought it was important to have a single set of principles that could apply across the piece; to both the sell-side and the buy- side, to independent research houses as well as the big investment banks and to different market sectors, not just equities research.

We are now confident we have settled on the right approach, and plan to unveil our final rules towards the end of this month, and have them coming into force on 1st July. Our final rules will, subject to final Board approval, be closely modelled on CP205, although we’ve made numerous nips and tucks in response to comments received. We are also working with trade associations and firms to ensure the changes are bedded down.

I should say we are not doing this to ape the Americans, or because we have nothing better to do with our time and yours. We are doing this because of our conclusion, based on the solid evidence we’ve laid out in our various papers, that market practice has fallen short of what investors have a right to expect. This has arisen through firms failing to manage adequately their conflicts which have a bearing on investment research. Too often, firms have implied that their research is objective and impartial, when it has been biased by conflicting interests, such as those arising from investment banking or sales and trading. We see this as amounting to a significant market failure impacting on our market confidence and consumer protection objectives. Standing idly by just hasn’t been an option.

We’ve given firms broad flexibility to develop policy which reflects their business activities. This includes fixed income and commodities markets, and it includes the buy-side. We just don’t accept that there are no conflicts that can impact on research objectivity in these sectors – and neither do the more thoughtful of the trade bodies.

On 1st July, our conflicts management proposals will take effect. Before then firms will need to start revising or preparing conflicts identification and management policies, in a form suitable for publication. In exercising the discretion we have provided, firms will need to have a close look at the range of their research output, and make the distinction between research held out as objective or impartial and other material, far clearer than it has been in the past.

But right now, firms are engaged in modifying their compliance systems to take account of provisions, commencing on 1st May, which cover dealing ahead and personal account dealing, as well as the management of conflicts during allocations and IPOs. It’s probably no secret that our tightened rules, which will further restrict firms from dealing ahead of their clients’ receipt of research, have been contentious. Privately, some firms have been saying that the only reason they provide research to clients is to generate sales, so why shouldn’t they be allowed to pre-position themselves to have inventory on hand to sell into that demand? The reason is that, on both sides of the Atlantic, dealing ahead of research is seen as clearly contrary to standards of fair dealing for clients. Research that is presented as primarily for the use of clients should not be a marketing tool for the firm’s own trading book. We will of course keep market impact under review, and will carry out benchmarking and post-implementation work to ensure that costs (to the market as a whole) do not outweigh the benefits we think will be achieved in terms of cleaner markets and consumer protection.

After intensive discussions with us, on 9th February four major trade associations with members in the investment banking industry published guidance to their members on applying the new dealing ahead provisions in practice. This is available on the British Bankers Association’s website. We think the industry guidance accords with the intent of the new rules, and we are happy for that to be stated. This was a useful initiative from the industry; in a sense it is the flip-side of our wanting to keep Handbook provisions focused on principles, rather than laden with detailed guidance which can obscure as much as clarify.

But strategies for managing conflicts of interest go beyond research. Given the discovery of poor practices at some firms, regulators are rightly focusing their attention on how firms manage conflicts of interest – not just for investment research, but across the full range of their activities.

Firms will need to get used to continuous and enterprise-wide holistic conflicts management. Management of firms that fail proactively to look at all their activities, all their client groups, and all their profit centres, and to have adequate management tools for their conflicts, will find it harder and harder to manage their regulatory risks within acceptable tolerances.

Under the new Investment Services Directive we may well indeed see an obligation on all firms to develop their own comprehensive conflicts identification and management plans across the whole of their business. These will provide a foundation for compliance with particular rules on conflicts such as those relating to investment research, softing and bundling, or inducements.

Going forward, if we see market practices which suggest firms are not properly recognising and managing their conflicts of interest, we shall be ready to intervene.

International Environment

While, as you would expect, most of my time in my first 5 months as CEO has been spent on domestic issues, I see an increasingly important part of my job as being to contribute to and influence development of policy and practice at an international level. My final subject, therefore, will be the emerging European and International environment.

Naturally we need to consider how our domestic regime fits into the broader international regulatory environment. We must be aware of the potential risks that this environment poses to our objectives and our principles of good regulation, and we must seek, where possible, to develop strategies to mitigate these risks. There are two main reasons for this:

  • the international character of the UK market both in terms of firms and their customers; and
  • an increasing amount of our overall domestic regime is decided at EU level.

The EU environment

In the EU, the regulatory environment has been re-shaped over the past 4 years by the European Commission's Financial Services Action Plan (the EU "eff-sap"). The overall objective of the FSAP has been to deliver an integrated EU financial market with the target of Europe becoming the most dynamic and competitive economy in the world by 2010. The plan focused on three specific objectives: the creation of a single EU wholesale market, achieving open and secure retail markets and revisiting prudential rules and structures of supervision. The action plan has now been largely completed, although a few remaining elements are yet to be agreed, for example the Transparency Directive and ISD.

However, agreeing legislation is only the first step. Increasingly, the focus of regulators’ attention is shifting from the drawing up of legislation to its consistent and prompt implementation and effective enforcement. Inconsistent application and enforcement of legislation undermines the economic benefits that the FSAP was intended to deliver and it can create considerable uncertainty for firms and consumers. Guidelines are currently being drawn up at a European level to help improve implementation and enforcement, and we are closely involved in these discussions.

EU changes

For the foreseeable future, the EU will remain a major source of changes to the UK regulatory environment. One of our priorities is to ensure that initiatives are, as far as possible, consistent with our principles of good regulation. Achieving this should be assisted by the recent extension of the so-called ‘Lamfalussy approach’, currently used for securities regulation, to banking, insurance and pensions.

The ‘Lamfalussy approach’ involves greater participation by national regulatory authorities in drawing up the technical detail of EU law in European committees, enhanced dialogue between national authorities regarding consistent implementation of EU legislation and the convergence of supervisory practice. This approach comprises four distinct levels, represented by the Council, the Parliament, the Commission and the regulators. In my view the approach has been successful in the area of securities regulation, so I very much welcome the extension to banking and insurance. With the decision to locate the regulators' committees for banking and insurance in London and Frankfurt respectively, the Lamfalussy process has been given four more years to demonstrate what it is capable of before the arrangements are subject to review. We all need to put considerable effort into making the work undertaken at each of the four levels of activity, and the interaction between them and between each of the sectors, as effective as possible. Implementation of EU-originated legislation is a considerable task for firms across Europe, mainly for senior management, IT, training and compliance. But, with careful forward planning, prudent, well-managed firms will be able to cope with these changes.

In May 2004 ten new states will join the EU. By 2007 the number of EU member states will be 27. From the time of accession, UK-authorised firms will be able to passport their services into new member states without the need for a separate local authorisation. This will create opportunities for them. Similarly, firms in new member states will be able to use the passport arrangements to set up UK branches or provide cross-border services into the UK. They will continue to be supervised by their home regulator. In the meantime, the Commission is working to ensure the accession countries have supervisory standards that meet EU requirements. Good common standards are important to ensure that these passporting arrangements work effectively, and with minimum impact upon our market confidence and other objectives.

As I mentioned earlier, there are still a number of outstanding FSAP measures which must be completed, but we must now take some time to evaluate the results and the process involved before going ahead with new legislative initiatives not already in the pipeline. This should now be the clear focus for the Commission, the Member States and the competent authorities. For all of those proposed measures and future ones, there needs to be a more comprehensive approach to regulatory impact and cost benefit analysis so that it informs our view of the practical consequences of proposed legislation at the outset and guides the development of HMG's negotiating positions. We also need to demonstrate how CBA can work effectively at the wider EU level.

It is important to increase understanding of the extent to which a single market in financial services has already been achieved and where the main gaps and barriers lie. These barriers then need to be prioritised and thought given to the most appropriate non-legislative as well as legislative methods of dismantling them. Some progress has been made in identifying the remaining gaps and barriers in the single market. In most cases, bilateral action or the use of competition tools are likely to be more effective than further legislation. There is also a need to understand whether firms from other Member States feel they encounter barriers in the UK and, if so, how these might best be addressed. On the retail side, we are pressing for the many remaining barriers in this area, the vast majority of which are country-specific and often cultural in origin, and do not therefore lend themselves to being legislated away, to be identified carefully, prioritised and tackled in the most sensible way only when a net overall benefit can be clearly demonstrated. This will require commitment and practical action from Member States, the Commission and firms if sensible conclusions are to be achieved.

However, there are a few additional areas where there is general acceptance that EU legislation is required. Some examples include key prudential measures such as the Risk Based Capital Directive (which will be the EU implementation of Basel 2 when it is finalised), insurance solvency and reinsurance. These are all examples where it is highly desirable to reach comparable standards with the major non-EU market places. Some EU action may perhaps also be required in the areas of clearing and settlement and corporate governance, but an assessment of this needs to be based on robust cost / benefit and regulatory impact analysis. Companies listed in the EU will also be required to prepare consolidated accounts in accordance with International Accounting Standards from 2005. Which leads me on to a number of global developments.

The Global environment

The FSA is affected by developments beyond the scope of the EU-led initiatives. A recent example, of which I am sure you are all familiar, would be the Sarbanes-Oxley Act in the US, over which the UK did not have a direct influence, but which had extraterritorial effects affects on all US listed firms, and their auditors, irrespective of the location of their operations or supervisory responsibility.

More broadly, you will hear echoes on the international stage of many of the themes I have just raised in a European context: effective implementation; transparency and disclosure and convergence to name just a few. The FSA is affected by decisions reached across a range of international fora, including the sector standard setters. These institutions are currently undertaking work on issues as diverse as identification of vulnerabilities in the global financial system, developing international accounting standards, looking at insurance and re-insurance disclosure issues and insurance company solvency standards in light of the capital adequacy revisions contained in Basel 2. Although there are always difficulties in reaching agreements on complex and far-reaching issues at a global level, and here International Accounting Standards and Basel 2 are particularly vexing at the moment, it is important we are active, creative and engaged on the international scene in order to avoid the more serious implications that would accompany regulatory divergence if we fail to reach agreement.

To give one example, the lack of a single set of comparable International Accounting Standards (IAS) remains one of the major obstacles to the successful globalisation of international financial markets. IAS is a major element in restoring market integrity and lifting market confidence following the major corporate scandals in the US and now more recently in Europe. The European Commission formally endorsed 32 of the 34 extant IASs at the end of September 2003 for use by all European listed companies in 2005. However the two most contentious standards on Financial Instruments (IAS 32 and 39) have not yet been endorsed because of continuing disagreements between parts of the banking and insurance industries, supported by some national authorities, and the IASB on key aspects of hedge accounting and fair value for financial instruments. The FSA believes that resolving this issue is critical and we will continue to work with all of the regulatory groups to develop constructive international input.

Global changes

Globally, the financial sector remains one of the most innovative and fast-moving areas. These developments pose particular risks and challenges for regulators, many of which are better tackled collectively rather than on our own. Some of the issues that continue to demand the attention of regulators include the domestic and international consequences, and their interplay, of risk transfer from institutions to individuals, increased activity in the unregulated sector including transfer of activity from the regulated sector, the consequences of misalignments of foreign exchange rates, persistent pockets of weak corporate governance, growing household indebtedness and exposure of financial firms to the household and commercial mortgage markets. In addition there are risks stemming from possible regulatory disharmony in areas where I have already flagged such as International Accounting Standards and Basel 2. To address these risks we have groups such as the Financial Stability Forum continuing its advance warning exercises of risk identification and mitigations. Where potential risks are identified the appropriate technical groups such as the Joint Forum, which looks at issues across all three sectors, are encouraged into action as happened recently on credit risk transfer. In addition, if an issue is largely located within one sector, the sector standard setter can be called upon as happened when the FSF asked the IAIS to jointly look into reinsurance disclosure standards. Also worth noting is the similarity between our global standard setters and their European counterparts – increasingly the key issue is not setting the standards, that work has mostly been accomplished. Rather it is in ensuring that the standards are effectively, robustly and appropriately implemented. In some ways this is a much bigger exercise than establishing the standards in the first place.

Overall our current assessment is that singly, none of these risks outlined above is alone of sufficient magnitude to pose a threat to domestic or global financial stability. Nevertheless, regulators continue to assess the strength of these individual risks and work continues at the FSA, as well as in other fora such as the Financial Stability Forum to identify triggers which could provoke such a coming together of risks. The ongoing challenge for the FSA and other regulators is to ensure that we identify the right risks, that we deal with them through the appropriate channels, and that we apply the correct and proportionate tools to ensure successful risk mitigation or management.

Conclusions

So finally I would like to reiterate what these activities means for the UK and for our EU and international work.

Implementing recently agreed EU legislation effectively and enforcing legislation already in place will go a long way to reducing the need for further legislation in future.

As we move forward on our broader agenda, we must continue to make sure we understand what European and international issues need to be addressed and avoid creating domestic legislation without considering EU and international developments. Two recent decisions on the European front underline this point. First, it has been decided to postpone further domestic policy work on issues such as transaction monitoring and best execution because they will be covered by the revised EU Investment Services Directive. I think it important that this approach now becomes the norm, so that domestic work is developed in parallel to EU or international work with a view to influencing the latter proactively rather than being required to amend our domestic policy after it has already been put in place. Second, we have reviewed our policy on super equivalence (i.e implementation by more stringent provisions than those called for in the underlying European directives) and agreed that our approach needs to be strongly grounded in an understanding that we will not take a super equivalent approach to implementation unless there is a demonstrably convincing case why we should do so in relation to individual aspects of EU directives.

Well, this has been something of a canter around some parts of the landscape on which I spend my working hours. Thank you.

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