30 September 2004
Speech by Callum McCarthy

  1. I am grateful to Reuters for assembling such a distinguished audience. I want this evening to talk about what the FSA is seeking to do to make markets for financial services – retail and wholesale – work as effective markets.

  2. I want to do so because success in getting markets to work effectively makes it unnecessary to pursue regulatory interventions. I am a believer that the best results come from efficient markets – both for producers and for customers.

  3. In the FSA's work, a principle we have enunciated – but have not always found it easy to translate from principle into practice – is that regulatory action should only be taken when there is market failure. Now this is in fact a weak definition of the circumstances of when regulatory action is justified, since all realistic markets – that is all markets which exist in practice – have some elements of market failure or market imperfection. It is an argument too often deployed by those who favour intervention that any market failure justifies intervention. The strong – and to me correct – test goes beyond that: there must be both market failure and the prospect that intervention will provide a net benefit. This involves recognising both that regulatory intervention has a cost; and that regulatory intervention, like reliance on market operations, has a probability of failure. Identification of a market failure should not lead to the assumption that regulatory failure is less likely, or less costly. It is an open and empirical question, which needs analysis on a case by case basis.

  4. From this, you will see the central interest the FSA has in identifying what can be expected from the financial markets, and the interest we have in encouraging efficient financial markets. Encouraging efficient financial markets is central to our work.

  5. I want to concentrate on the behavioural, not the structural, questions of efficient markets: what are the features that any efficient market should have, as it will help to understand what is lacking in financial services markets? I would stress three characteristics for successful markets:
    • Competent customers
    • Relevant information
    • Responsible producers

  6. Each of these presents problems for financial markets. Financial products are typically long-term in nature (it is difficult to decide for many years whether an investment is a good one – although recognising a calamitously bad one may be much easier and faster); they are often tested only intermittently (I think I have made two general insurance claims over 40 years as a householder, and have no view at all on how the service I received from my insurance company compared with the industry norm); they are difficult to measure since return, which can be measured for any particular investment, has to be seen in the context of risk, which needs a wider statistical analysis both of the instrument being offered and of the issuer; and they are often complex. As a result of these characteristics, a number of market practices have developed – some sensible, some less so, but each with a number of problems for efficient markets. First, there is a heavy use of brokers and intermediaries. As you would expect with complex and rarely tested products, the end customer who typically has little experience and little expertise relies heavily on intermediaries who have – or profess to have – expertise, and also profess in some but not all cases to give independent advice. The market for financial services is therefore characterised by a heavy dependence on intermediaries – brokers and advisers. Second, and again understandably, there is a natural tendency to rely on what can be measured, even when the relevance of the measure is unclear – hence the emphasis on return without any or much recognition of risk; and the extensive use of past performance by funds when there is much evidence that past and future performance are not positively correlated.

  7. Faced with these problems, what can and what should a regulatory organisation seek to do? I'll set out my view on the retail and on the wholesale markets separately; and I'll illustrate the general issues by looking at some particular mainly British examples.

  8. Let me start with the retail market. I said that an efficient market needs competent customers, relevant information, and responsible producers. We need to make significant progress on each of these. Let me set out the reality of consumer capability: In Britain, 23 per cent of adults, if presented with the Yellow Pages directory and asked to give from it the name of a plumber, cannot do so; over 20 per cent cannot do simple percentages – ie are unlikely to understand either of my last two statements. Yet as a country we are moving a number of the most important financial decisions – for health provision, for education, for pensions – from institutions to the individual, even when many individuals are poorly equipped to take those decisions. Nor is the position a good one in terms of relevant and comprehensible information being given to customers by providers of financial services: too often the product, already complex, is made still more complex by a specialised and difficult to understand vocabulary – I suspect that not many here this evening will admit to understanding what a reversionary bonus is. Nor is the record of financial providers as responsible providers a distinguished one: the compensation paid for pension mis selling in Britain stands at more than £11 billion; there have been some other spectacular mis selling of products, perhaps most noticeably the selling of precipice bonds to customers with no experience of the equity market.

  9. Faced with this set of problems, there are two possible paths: one is to accept that the retail market needs greater intervention and regulation to make up for its inefficiency, and to accept that the information asymmetry between provider and customer is so great that caveat emptor cannot apply; the other is to identify and make effective those actions needed to improve the market.

  10. You will, I hope, not be surprised that the FSA is determined to follow the second route. We are therefore working both on the demand side (the improvement of customer competence) and on the supply side (better, more comprehensible information). The work on customer competence involves acting as a catalyst: how to encourage government so that the £22 billion spent annually on preschool, primary and secondary education results in more financially competent individuals; how to encourage financial firms to recognise the advantage in having properly informed customers, and to act to educate them accordingly; and how to encourage individuals to recognise the importance of the financial decisions they make, and the need either to think hard about them or to seek – and, where necessary, pay for – competent advice. This educational task is a huge one. It will require a generation to make the necessary progress.

  11. Progress on the supply side should be quicker. We are requiring firms to provide basic information in standard form (to make comparison of competing products easier), and requiring fuller and clearer disclosure (of life products, for example). So we expect progress towards clearer, relevant information. And we also see progress towards better standards of responsibility – partly driven by enforcement action (about which more later) against firms which act irresponsibly; partly driven by encouragement to firms to act responsibly towards their customers: to treat complaints seriously, and as a source of information about problems to be solved rather than as simply a nuisance; to devise incentive systems for sales forces which encourage responsible rather than irresponsible behaviour; to look at a retail customer on a longer term basis than simply an immediate commission sale.

  12. It is important that we succeed in creating this market in retail financial services since the alternative is deeply unattractive. It would be a world where caveat emptor was replaced by compensation; where the transactions were governed by regulation which would become more intrusive; where the costs of doing business would therefore increase; and where financial products were therefore available to a smaller proportion of society. You will see why I am so determined to make the alternative – an efficient retail market for financial services – a reality.

  13. Let me turn to the wholesale markets. Again, I will consider them against requirements for competent customers; information; and responsible producers. The problems of the differences in knowledge and expertise between customer and provider which are such a marked feature of the retail market, while not totally absent in the wholesale market (you will remember the famous Bankers Trust litigation with Gibson Greeting Cards on derivatives, or the systematic exploitation in the US of relatively naïve savings and loans institutions), is much reduced. Caveat emptor is therefore a much more powerful and real concept. Similarly, the problem of information is very different. There are some specific and to some extent technical questions of importance: what information should be presented in a prospectus is one example, which will affect both the cost and the effectiveness of IPOs – which is the reason we at the FSA are reviewing the rules concerning both initial and continuing information requirements for British quoted companies, under the Listing Rules. There is a much wider information set of issues, illuminated in different ways by problems in companies as varied as Enron, Parmalat and Shell, of the quality of information generally, where – quite apart from the questions of fraud that arise in relation to Enron and Parmalat – there are wider questions about both internal and external audit, and about accounting conventions.

  14. The major behavioural challenge to a regulator to a responsible wholesale market lies neither in customer competence nor in information questions: it arises from the conflicts of interest which are endemic and unavoidable in financial services. Many, though not all, of these arise from the same institution acting as principal and as agent; many of the conflicts reflect benefits which well-capitalised financial institutions bring to their customers. But all of the conflicts require managing, and recent experience shows that they have too often not been well managed and in some instances have been exploited. Dealing with these problems is the theme behind the FSA's work on research analysis, on softing and unbundling (where we are pursuing a market based approach) and on our work to tackle misuse of information under the market abuse regime.

  15. This leads me to the question of how to deal with those instances when institutions or individuals fail to act as required by the principles and rules to which they are subject – the subject of enforcement. This is, you will have noticed, a subject of some public interest, and I should explain the principles which govern our policy.

  16. First, we are not an enforcement led regulator. Indeed, one of the challenges of any enforcement policy is to make sure that it does not disturb the openness and candour which are essential for day to day supervision. The majority of our work and our staff are focused on the business of regulation – meeting firms, analysing risks, monitoring markets – and the majority of our firms are, we believe, getting on with running their firms perfectly properly and without any need for enforcement action on our part. But there can be no doubt that enforcement action is necessary from time to time and when it happens it is high profile.

  17. Second, we want to be selective. This means two things. We are pursuing fewer enforcement cases: the number of enforcement cases has fallen from 600 in the year 2000 to 350 in 2002 and we estimate some 170 this year. And we are selective in pursuing enforcement cases which support our main aims. Enforcement aimed at discouraging breaches of listing rules, at preventing money laundering, stopping insider dealing or other market misconduct contributes to the work on efficient, orderly and clean markets. Enforcement aimed at preventing mis selling, or misleading advertising or dishonest provision of financial services equally clearly contributes to the work on achieving a fair deal for the retail customer.

  18. Third, we want the message associated with enforcement to be clear: what is the behaviour we want to discourage; the need for senior managers to take responsibility for their actions; the behaviour we want to encourage; the specific firm we wish to identify with an offence, not the industry as a whole. For the message to be clear, it is important that the event which gives rise to enforcement and our decision in relation to it should not be delayed longer than is necessary – hence our concern to streamline our enforcement procedures, where we have put in place steps to reduce the time taken by our internal procedures by some 30 per cent.

  19. This brings me to the Tribunal – an essential and I should make clear welcome part of the enforcement process. It is clearly right that both individuals and companies should be able to take their cases to a body wholly independent of the FSA. Natural justice demands it. I welcome it. I look forward, over time, to Tribunal decisions clarifying the reach and the appropriateness of FSA enforcement decisions. I do not expect all Tribunal decisions to support the line previously taken by the FSA. This does not reflect any lack of confidence in the decisions we have made. Rather it reflects the realities of the British legal system. This is something which anyone who knows anything about the working of that system should expect. And when decisions of the Tribunal are made – either confirming or changing FSA enforcement decisions – we in the FSA will reflect on their implications for future decisions and for our decision making process: if systems here are shown to have failed or to be capable of improvement we shall of course want to put them right or to make changes. I hope that the result of the involvement of the Tribunal will be an improved enforcement process, and greater credibility for the internal FSA process – despite, and in part because of, the inevitability that some challenges to that process will have succeeded.

  20. What I would regard as a concern is if the Tribunal were to be used not as a proper challenge and clarifying process, but as a deliberate spinning out of procedures, or became a vexatious process. As I have said, and repeat, Britain has much to lose by becoming as litigious a society as the US – just as we all have much to gain from the proper use of the Tribunal process.

  21. My message this evening is our concern to make markets work. Markets, rather than regulation, are the principal means of delivering value to customers, wholesale and retail. I have set out what we believe are the main ways regulation, selectively applied, can help in both the retail and the wholesale markets, and I have touched on how – within a much broader canvass of regulatory activity – enforcement plays a part in this. I will be happy to answer questions.

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