6 July 2004
Speech by John Tiner

As you may know, my main objective on starting as the new chief executive of the FSA almost twelve months ago now was that I was, and still am, determined to raise the regulatory performance of the organisation, building on the undoubted strengths of the FSA’s early years. I have been especially keen to get on with the implementation of the substantial regulatory reforms coming out of Europe and UK government policy over the past few years, while keeping a tight reign on new, discretionary policy making initiatives. I promised to halve the number of consultation papers this year, and we are on target to achieve that. We are also working hard to make the FSA easier to do business with from the perspective of regulated firms and consumers in line with our published objectives.

To support these overarching objectives, I decided early on in my job to restructure the FSA along Wholesale and Retail lines. In a way this should not be too surprising – UK financial services regulation from the start has sought to distinguish between the sort of regulation that is appropriate for market counterparties, and that which makes sense for retail consumers of financial services. Indeed the FSM Act itself requires the FSA to take into account the knowledge, experience and understanding of consumers in exercising its regulatory powers to protect them.

The new FSA structure I have implemented from April of this year has three important business units, each headed by a managing director reporting to me. They are Hector Sants for Wholesale and Institutional Markets, Clive Briault for Retail Markets, and David Kenmir for Regulatory Services. If you look at the FSA Business Plan for 2004-05, published in January, you will see that clear chunks of it fall to each of the business units. So we have strong alignment between our strategic priorities and how the organisation is run. But crucial to our success will be a much stronger emphasis on teamworking at all levels within the FSA to deliver these challenging objectives. Some of you will recognise the challenge here from your multi-disciplinary firms.

I understand that institutional demarcation lines are never crystal clear – there will be some large authorised firms for example, whose business encompasses both wholesale and retail aspects. Such firms will be supervised from one team within the FSA, depending upon the predominance of its business. That team will need to understand the full scope of the firm’s business and I believe that we are already some way down the track to achieving this.

I have also created a new function at the FSA – that of Finance, Strategy and Risk, with its head reporting directly to me. I have always seen a lot of common ground between the functions of strategy, risk and finance, as they are all about how we deal with the management and allocation of resources to deliver strategy and manage risk. And I am delighted that Kari Hale of Deloitte and Touche has agreed to join us in heading up this area, and indeed that he has begun his first month with us in such a vigorous fashion.

It was clear also to me that the FSA needs the ability to take a cross-cutting view of each of the major financial services sectors, hence I have created the Sector Leader roles. There are eight of them: Asset Management, Banking, Capital Markets, Insurance, Retail Intermediaries, Consumers, Financial Crime and Financial Stability. The structure of their core functions is similar - the Sector Leader role comprises four basic objectives:

  • risk assessment/mitigation;
  • staff development;
  • representing the FSA on sectoral issues;
  • and overview of the coherence of FSA regulation of the sector.

I am very pleased with the way the sector leaders I have appointed have taken to these new roles and I believe many areas of financial services that have hitherto been perhaps under-represented at the FSA, for example in the area of Asset Management, now have an identifiable FSA sector 'champion' to represent them both externally and internally.

I would now like to talk a little about Financial reporting in the UK – and indeed around the world. It seems to me that we are in the midst of the most radical and important change for a generation. From January 2005 we will have International Accounting Standards for all EU listed groups (the biggest change in financial accounting since the introduction of the 4th and 7th Company Law Directives). At the same time, the European Commission is moving rapidly towards requiring the use of International Standards on Auditing across the EU, and the UK Auditing Practices Board will pre-empt that change by introducing ISAs in the UK, with some additional UK specific rules, from 1 January 2005.

There are also changes to the standard setting and enforcement regimes in the UK. The Financial Reporting Council has new powers and responsibilities, and we can now safely say that all aspects of accounting and auditing standard setting and oversight are independent of the profession, while retaining a strong input from those in the profession who are best placed to understand the issues. It is early days for the new FRC structure, but already we are seeing the development of ethical standards for audits, by the APB; a proactive risk based regime for enforcing accounting standards, from the Financial Reporting Review Panel; the development of a standard on the Operating and Financial Review, from the ASB; and of course a revised Combined Code on Corporate Governance.

So there is a lot going on and today I would like to comment on three areas:

  • the FSA's interest in financial reporting;
  • the move to International Financial Reporting Standards and the issues related to IAS 39 in particular;
  • and, some of the challenges the audit profession faces in returning the value proposition to the capital markets

I think it is worth reminding you why the FSA has any interest in these issues. The first and most obvious point to make is that we have no responsibility for any aspect of financial reporting. That is for the FRC, which is overseen by the Department of Trade and Industry. The FSA has a seat on the FRC (a post now held by my colleague Hector Sants) and we work closely with the FRC’s key Boards, but we have no direct influence over the process. However, we are a major user of financial information, and have an interest in market confidence in financial information. Let me give some examples

  • As a prudential supervisor we require firms that we regulate to retain levels of capital that reflect the risk of their business. Those capital requirements are drawn from the audited financial statements, and we need to be confident that the accounts are relevant and reliable and have been independently audited
  • Again we frequently use firms’ auditors or another independent accounting firm to undertake reviews and investigations for us under Section 166 of FSMA (the so-called "Skilled Persons Reports"). These reports can be of four types; monitoring, diagnostic, remedial or preventative. The areas covered vary enormously and areas covered over the last year have included money-laundering, information security, Treasury activities, underwriting, high-level controls, the quality of compliance and specific past business issues. A common feature is that the reviews are not box-ticking exercises and that they require quality inquiring minds to undertake them.
  • With our responsibility for overseeing markets (most particularly as the UK Listing Authority) we have an interest in high quality relevant and reliable financial information in order to maintain market confidence and the stability of markets. I should take this opportunity to correct some media reports that we are about to require auditors to opine publicly on governance and internal controls systems of listed companies, along the lines of 5.404 requirements in the US. This is not the case. We are intending to update the Listing Rules to require auditors to review the "comply or explain" statement given by the directors in relation to the annual review of the company's internal controls, as set out in the Higgs Code. Our discussions with the APB suggest the review of this statement imposes little or no additional burden on the auditors and therefore should be, broadly, cost neutral.
  • London is often described as the world’s largest host market. Many of the participants are subsidiaries or branches of overseas holding companies, and we need to be confident that the overseas holding company (and often the group as a whole) is adequately capitalised. It is therefore in our interest to have a single set of globally applied high quality accounting and auditing standards
  • Finally we should not forget that the FSA has a responsibility for financial crime. We therefore need to be confident that financial information provided to the market is reliable

And so as you can see the FSA is a heavy user of the accounting and auditing profession. We value the relationships we have with the professional services firms, both large and not so large. Partners in the profession often ask me what the FSA is looking for in its dealings with the profession. The most important attributes we value are openness, candour and timeliness in the way professional services firms communicate with us, founded upon high quality analysis and sound professional judgement. Of course, we do not have routine conversations with the auditors of the firms we regulate and so such communications often only arise when difficult issues have been identified. We very well appreciate the responsibility a firm has to its client, but nonetheless we consider auditors have an important role in helping us to understand particular issues when regulatory concerns arise.

As I have already said, the changes to financial reporting that we are seeing in the UK are being replicated in all of the major financial markets around the world. Much of the work to foster development of international standards is done by the various international organisations of regulators, most notably IOSCO (the International Organisation of Securities Regulators) and CESR (the Committee of European Securities Regulators). IOSCO endorsed International Accounting Standards for use in cross border offerings in 2000, and has a similar project underway on International Standards on Auditing. It had developed principles for oversight of auditors and for auditor independence, and has started work on developing a mechanism for co-ordinating work on enforcement of accounting standards.

CESR has a standing committee on financial reporting (CESRfin) which I chair, and which has a similar agenda to IOSCO but with the more immediate objective of facilitating consistent application of IASs in the EU from 2005. CESRfin published late last year recommendations on the information that companies should provide in their 2003 and 2004 annual accounts to explain the transition to IASs in 2005. Essentially there are four elements to this:

First, companies should explain in their 2003 accounts the steps they are taking to prepare for the change of accounting framework. Secondly, in 2004 they should – if possible – publish a reconciliation from local GAAP to IASs. Thirdly, their 2005 interim accounts should be based on IAS measurement and presentation principles, and finally, 2005 year end accounts should – of course – follow IASs.

I think the recommendations are clear and practical, and they have been reasonably well received. However, it is still not absolutely clear which standards will be applied in the EU next year. The IASB met the timetable it agreed with the European Commission and completed the set of standards to be applied in 2005 at the end of March. The standards have to be formally endorsed by the Commission’s Accounting Regulatory Committee before they can be required to be used, and the mechanism for completing that endorsement is now well established and working efficiently.

However, there are continuing problems with the two standards on accounting for financial instruments – IAS 32 on disclosure, and IAS 39 on measurement. The Commission has urged the IASB and the European insurance and banking sectors to work together to resolve the remaining difficulties with the standards and the version of IAS 39 that was published on 31 March dealt with a number of the concerns. The European insurance industry seems prepared to see endorsement of IAS 39, in order not to derail the broader EU programme of adopting IASs from 2005 onwards, but then working urgently with the IASB to improve the standard in parallel with the standard on insurance accounting. The banking industry on the other hand seems more determined to resist its endorsement. Now is not the time to debate the detail of macro-hedging, hedging of core deposits, or the banking industry's proposal for interest rate margin hedging nor the consequent effects on earnings or equity volatility and whether such volatility is real in economic terms or is accounting induced.

But time is now running out. We are now less than six months away from 1 January 2005, the date on which IFRSs will become mandatory for listed groups. The process of formally endorsing an IASB standard takes five to eight months, and we cannot be certain that the process will be complete in time for the 1 January 2005 deadline. There are, of course, potentially significant strategic, business planning, systems and internal controls issues which will arise from the standard on measuring and recognising the value of financial instruments. This is a growing concern for the EU securities regulators including the FSA.

It seems as though there may be three options available to the Commission.

(1) Propose the standard, as written, for endorsement.

(2) Propose the standard for partial endorsement, with some key aspects being disapplied for a year or more, while the IASB and the European banking industry try to agree an accounting solution for certain hedging transactions that satisfies the banks' risk management concerns and is consistent with the IASB's accounting framework.

(3) Delay endorsement altogether until the problems have been ironed out.

The FSA has argued consistently, that the 7000 EU companies required to apply IFRSs need to know what standard they will have to follow on financial instruments, and that the continuing delay and uncertainty at this late stage is potentially very damaging to market confidence. That view is supported by CESR. The Commission has indicated previously that it is minded to propose the standard to member states for endorsement in September, and CESR supports that proposal. We agree that IAS39 is not perfect, and we welcome the IASBs commitment to begin work immediately to improve the standard for the longer term.

The FSA is uncomfortable with the principle of a partial endorsement of the standard. We consider that it would be damaging to the standard setting process and to the quality of financial reporting for the following reasons:

  • Accounting standards are needed to foster the integrity of financial reporting of public companies and so protect investors. To achieve this, standards must be set, following consultation, by technically expert persons who are independent. We are concerned that the process in this case may undermine that independence and so harm the credibility of the accounting framework which all listed companies will have to follow from 2005 onwards.
  • Consistent with the above, partial endorsement could create an unsatisfactory precedent for future endorsement of difficult standards and encourage other sectoral interests to press for disapplication of standards
  • In terms of the specifics, the proposed disapplied elements of the standard are among those that are likely to provide more relevant information to investors.
  • It is quite possible that if there is partial endorsement, there remains the possibility that individual member states or individual listed companies may be able to select whether or not to implement the full standard. This would undermine the whole objective of moving to consistently applied standards across the EU.
  • The compromise approach will greatly reduce the possibility of converged international standards between the IASB and the US standard setter, FASB. With this convergence the US SEC has said it will consider allowing European companies access to US markets without a formal reconciliation to US accounting standards. Removing this reconciliation could be an important prize of the convergence project, particularly for the many major UK companies with a US listing.

In the event that member states will not support full endorsement, the FSA believes it would be better to delay endorsement, and allow companies to apply the standard on a voluntary basis than to accept this form of partial endorsement.

I understand a recent development has been for the Commission to produce its own proposal on measurement of financial instruments and that it has sent this proposal to some member states and to the European Financial Reporting Advisory Group (EFRAG) for comment. Given its circulation we must assume that this is a serious attempt by the Commission to unblock the impasse with the banking industry. But an eleventh hour initiative such as this raises major concerns about process and the transparency of consultation. It also risks undermining the whole IASB Governance process and suggests that this may be the first step towards the creation of European generally accepted accounting principles, surely a major step backwards in promoting and securing open and transparent capital markets globally.

Putting this development to one side, if the Commission does not conclude that it can put the standard forward for endorsement in the very near future then companies will start 2005 with no clear guidance on the accounting principles to be applied to financial instruments, a several trillion euro business. This means that the EU banking and insurance sectors, which are highly reliant on the confidence of markets in their financial reporting, will not know how to measure and present the most important assets and liabilities on their balance sheets. That is not a healthy basis on which to embark on a programme of harmonised accounting across the Union.

Let me now turn to the important issue of principles based standards. This is a major issue for UK standard setters. We have long been accustomed to a standard setting regime where the standards describe the principles to be followed and expect preparers and users to exercise judgement in applying the standards to their particular circumstances. That framework has been used for accounting and auditing standards; it underpins the Combined Code on Corporate Governance; and it is the objective of the FSA’s work on reviewing the Listing Rules. For reasons I have already explained, the FSA’s declared long term objective is a single set of globally applied accounting standards that are capable of consistent application, interpretation and enforcement, and such a set of standards can only be made to work if they are principles based. It would not be possible to develop a set of rules that would work in every capital market in the world, and in any event experience in other markets is that detailed rules either stifle innovation or promote financial engineering – or sometimes both.

The UK system of corporate governance has developed to foster the consistent application of principles based standards, and the changes introduced by the FRC last year reinforced that approach. Essentially, I think there are three elements to this. First, we need company executives who are committed to provide relevant and reliable information to investors and who want to comply with the spirit of the standards – in accounting terminology to provide a true and fair view and to represent the substance rather than the form of transactions.

Secondly, we need strong minded independent auditors who can see the bigger picture and who will apply the principles even if they do not specifically address the specific issue – again in accounting terminology, auditors who believe that the true and fair view is paramount.

Thirdly, we need high quality independent non-executive directors to monitor the relationship between the executives and the auditors, and make sure that the auditors’ independence is not compromised.

You could argue that there is a fourth element to the process – a mature capital market that expects transparency from companies and penalises those that do not provide it.

All of the above elements need to work for the current UK system to operate effectively, and I would like to close my remarks by addressing the second of these on the role of auditors. Recent crises and scandals in financial reporting have turned the spotlight on the work of the external auditors, and the collapse of Andersens, it goes without saying, radically changed many stakeholders’ views of the audit profession. The auditors have done a lot to restore confidence – the profession has reacted positively to the changes in oversight in the UK, and the proposed new oversight arrangements for IFAC will help at the global level. However, it remains vital that auditors continue to be prepared to confront clients on points of principle. They shouldn't go looking for a rule to justify their opinion – it is the principle that matters. As I have explained, my view is that the UK financial reporting tradition largely depends on auditors standing up for the true and fair principle even where standards are silent, and auditors need to go on resisting clients who say “tell me where it says I can’t…” rather than “help me find the right answer”.

The profession has argued that it is unwilling to commit itself to take difficult decisions because it has unlimited liability for its actions. I do not wish to debate that issue here, as the DTI has consulted widely on the merits of changing the current regime. However, I am concerned that the profession needs to resist any tendency towards a box-ticking mentality. As I noted earlier, that is not where we at the FSA think value is added and other clients will in the long-run probably take the same view. Importantly, this is also not an attractive platform on which to recruit and retain the bright graduates that you need if the profession is to thrive. Job satisfaction and the opportunity to learn about business at the sharp end are just as important in determining who you attract and retain as whether or not partners' liability is capped.

Professional judgement is your mantra. Don't lose it.

Thank you.

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