9th November 2004
Speech by Kari Hale

Good morning. I'm very pleased to be here today to talk to you about the challenges that we at the FSA see as facing the banking sector. The conference today is intended as a 'Practitioners Guide to FSA Regulation of Banking'. I'd like to set out where we see the main risks and challenges to banks arising in their business and the current operating environment, not least from regulation – given where we are in the EU integration programme and the Financial Services Action Plan.

The focus of banks' risk management has developed and evolved over the past few years. The focus is now increasingly on reputational, regulatory, operational and strategic risk, as well as the more traditional credit and market dimensions of risk.

This is conditioned by a combination of factors including:

  • globalisation;
  • the relatively favourable economic environment – such that the UK banking sector has made record profits again this year, it remains highly capitalised and asset quality remains strong;
  • the fact that most banks' market and credit risk management has improved significantly in recent times;
  • the reputational impact that high profile regulatory issues are seen to have had – on both the retail and wholesale side – and the shift in the regulator's focus towards governance and control issues; and
  • the unprecedented volume of regulatory change that we are all facing

As you may know, I took on the role of Banking Sector Leader at the FSA when I joined as Director of Financial Strategy & Risk in June this year. I was previously the Global Head of Governance and Regulatory Compliance Services for the Financial Services Industry at Deloittes. So I come at these issues both from a consultant's perspective but also with the benefit of the FSA's overview of the risks facing the sector as a whole.

With that background, I shall begin with a very brief outline of what we're doing in our sectoral work and why. Then I propose to address the challenges banks face in four main areas:

  • First, to review the health of the banking sector at this point in the cycle;
  • Second, to look at some of the strategic and other business risks it currently faces;
  • Third, to look at the current risk management challenges including the types of issues our supervisory visits are throwing up in this area; and
  • Fourth to set out the main regulatory challenges that face both the industry and the FSA in implementing what is a very ambitious programme of regulatory change in such a short space of time – and the risks associated with that change.

The FSA reorganised earlier this year around three strategic priorities: maintaining market confidence; helping consumers achieve a fair deal; and making us easier to do business with. The functional structure of FSA was aligned with these objectives. The FSA also established a number of Sector Leader roles with the intention of

  • internally: binding the organisation together better on cross-cutting issues; and
  • externally: getting better at identifying risks on the horizon – spotting early warnings, being closer to developments in the market, and making sure we act appropriately to deal with these risks.

So we're running several internal discussion groups and also getting out and about in the market. – we've set up meetings with risk directors at a range of banks, and are developing a dialogue on emergent and significant risks.

 

Two other issues I should mention here:

First, a key element of our sector role is ensuring that communications to stakeholders are clear and co-ordinated, for example through our relationship with the BBA

And second, we will be looking to improve our staff's skills – to ensure that they are appropriately skilled for the full range of issues identified relating to banks' business.

 

'Where' is the banking sector?

So, where do we see the sector at this time? Both the UK and world economy continue to benefit from a sustained period of consistent growth. The banks have benefited from this economic health, producing a strong financial performance over the last few years and in the first half of 2004. They remain well -capitalised and there are no signs of any serious deterioration in asset quality. But (as ever) downside risks to the macroeconomic outlook exist.

Firstly, the move to slightly higher interest rates. To state the obvious, higher interest rates will increase the cost and reduce the affordability of both the stock of consumer lending and new loans. Although the monetary authorities both here and abroad are managing the turn in the interest rate cycle with great care, as regulators we must acknowledge the risk that the shift to a more moderate rate of growth in consumer borrowing may not be universally smooth.

Secondly, the decline in lending margins. A long period of strong personal sector credit quality, coupled with strong competition for lending business, has helped squeeze margins to historically low levels. The effects of this on the bottom line have been disguised by strong volume growth. There are two downside risks for the sector here. The first is that, as I have just mentioned, the period of strong volume growth may be coming to an end. The second is that a downturn could expose banks as having under- priced risk through the cycle.

Thirdly, commercial property. Growth in lending to the commercial property sector remains high. Office property has shown evidence of pressure in capital values and rents in recent years and, although there are tentative signs of an improvement, a downturn in the economy has the potential to expose lenders to properties that are difficult to sell or re-let.

Commentators have been calling the peak in domestic lending growth for some years, so the precise timing of any slow down remains uncertain. But the move to a higher interest rate environment may have increased the chances that it will occur over the next twelve months.

 

Strategic challenges for banks

The medium term problem that we see for banks is a strategic one. As I outlined previously, there are many indicators of a potential slowdown in asset growth at this time. If this were to crystallise, earnings growth could be compromised. Cost cutting has gone a long way, but – as a consequence – further significant improvements in efficiency may now be harder to achieve. Additionally the high concentration of the market and the influence of the competition authority has restricted the scope for further major scale domestic mergers.

Banks will nevertheless continue to be under pressure to maintain top line growth, and, of course, one way that they could achieve this in the short term is through a reduction in credit quality standards. Such a response would be a mistake at this point in the cycle. That said, there is no evidence as yet of firms adopting this approach.

Some of the major banks have responded to these challenges by diversifying and/or expanding internationally – through acquisitions, as well as through organic growth of existing businesses. Sometimes, it can look like a dog-eat-dog world in this respect, and the recent acquisition of Abbey simply highlights the situation.

Of course, it is not the FSA’s job to pass judgement on the commercial aspects of such international activity: that is a matter for each firm’s management and shareholders. Our responsibility is to ensure that such deals are structured, managed and financed in such a way as to ensure that prudential standards are not undermined, and that sound systems and controls are in place over all of the UK -supervised elements of the business.

 

Challenges to Risk Management

In our current analysis, the central economic outlook in the UK is still generally benign. But in the domestic and wider environment there are plausible scenarios that can be described which that need careful consideration. These include the possibility of significant adjustments in the value of the dollar, and increases in US interest rates, associated with the trade and government deficits there. The price of oil is an on-going source of uncertainty, as are the questions of whether house prices in this country are over-inflated, and whether consumers are becoming over-stretched in their borrowing commitments.

And we must be vigilant to the risks of terrorist activity. Banks will need to be alert to the possible impact of these scenarios on them, directly or indirectly. And this is notwithstanding the lower probability attached to them, not least because any new falls in the equity markets could damage consumer confidence further and put additional pressure on balance sheets.

Operational risk features increasingly heavily in our supervisory risk assessments. The operational risks commonly originate from the risks associated with outsourcing key business functions, and with weak or untested business continuity planning. Other common causes of operational risk are problems with IT legacy systems, and with IT security as well as from risks arising from global banks having operations in politically and economically unstable countries.

In many ways, management of operational risk is the least developed/in its infancy. Partly, this is because operational risks are difficult to measure and predict, and management of them is – to a large extent – about culture and appropriate management oversight. But operational risks are also affected by developments in the wider business environment. They should be considered in that context too. In particular, in times of stress, market and credit risks can be compounded by operational ones.

Some of the more significant risks we see within the wholesale banking sector are very much interlinked. For example, the slowdown in equity markets challenged many of the investment banks' existing business strategies. This has resulted in more aggressive trading risk strategies and has encouraged moves into new business areas, which have generally led to an increase in the risk profile of the banks' portfolios. These strategic shifts also give rise to many of the issues that we have flagged under operational risk, and are associated with necessary IT developments and with the ability of those firms to recruit staff with the required expertise to deliver their strategic growth targets.

The risks falling within 'Nature of Business' relate primarily to our concerns about financial crime occurring within the UK financial community, and we will continue to be diligent in identifying and seeking to mitigate these risks.

On the retail side, we have seen broadly the same operational and financial crime risks being picked up by supervisors, though unlike on the wholesale side, there has not been any great change to strategic focus amongst the banks. There are, unsurprisingly, many more consumer risks within the retail banking sector, which has resulted in Product and Customer risks featuring in first and second place respectively. These have arisen out of a range of issues to do with firm's' product characteristics, selling practices and also from concerns about the quality of complaint handling.

 

Regulatory developments

We are all facing a huge amount of regulatory upheaval and consequently regulatory risk has been escalated up the banks' own risk agendas. This also creates its own operational and business risks for banks, and we are without doubt currently facing an unprecedented 'spike' in these risks that is consuming a significant amount of time, - both for you and for us. However, it is important to keep hold of the underlying rationale behind these changes. Essentially, this relates to the longer-term aims of making European markets, in particular, more integrated:

  • On the prudential side, changes are designed to make capital better calibrated to risk (CRD);
  • On the wholesale side, accounting convergence should contribute to greater efficiency in capital markets (IAS);
  • On the retail side, information asymmetries should be better addressed and consumer competencies enhanced (TCF, Financial Capability); and
  • European markets should become more transparent and open for competitive access (FSAP, MiFID).

With that as background, I'd like to turn now to the regulatory challenges that banks face. – For convenience, I will group them under four headings:

  • Prudential;
  • Wholesale;
  • Retail; and
  • Outlook.

 

Prudential challenges

The biggest challenge we face on the prudential side is clearly the implementation of Basel / the CRD.

There are significant risks around the implementation process, not least because many details have yet to be finalised. Negotiations on the CRD are still proceeding at a rapid pace. As the landscape continues to shift, it is difficult to provide an accurate assessment of where the negotiations will eventually come out.

But our implementation plans are continuing apace alongside the EU process and we are taking a pro-active stance across the range of our responsibilities.

We have published details of our own implementation timetable, as well as application packs. We have been active in assessing firms' levels of preparedness – firms were asked to give us details of their plans for implementation for the end of last month. Responses are coming in now and we are assessing them. And our Risk Review Team has been very busy visiting firms under several thematic headings to make a general assessment of the state of preparations and the issues arising. The FSA has also now held several meetings of the Basel Implementation Advisory Group, chaired by Hector Sants to discuss high-level issues with senior industry representatives, which is designed to ensure that the process moves forward most effectively.

Second, there remain some significant issues of substance to resolve: the trading book review I know is of particular concern to investment banks. Without it, the CRD is not going to offer them much of a gain. The challenge here will be ensuring that the output of this work is fed into the CRD in good time, otherwise it risks not forming part of the initial EU legislative framework and banks would not have time to prepare properly for implementation. Home-host responsibility for model approval is another issue and I'll return to that in a minute.

We have committed to producing two consultation papers (CPs) on our implementation of the CRD. The first CP will be published in January. This will focus on:

  • our overall approach;
  • the policy choices we believe we should make in respect of national discretions;
  • the scope of application; and
  • in so far as is possible, a sample of rules where we plan to copy out the CRD text so that firms can see what this means in practice.

The second CP will be published as soon as is practicable after the agreement of the directive text in Brussels and will contain a full set of our implementing rules.

Third, the next big step will be recalibration of the Framework during 2006, to be done with end-2005 data from institutions. This exercise will be based on field tests and a further quantitative impact study in which we expect UK firms will be contributing.

We are also actively developing the approach we propose to take towards Pillar 2. This work has two main elements to it: the first is through active dialogue and exchange of views with UK firms and trade associations; and the second is contributing to parallel work being undertaken by the Committee of European Banking Supervisors, which is aimed at delivering the necessary degree of convergence of supervisory practice across the EU.

We will include our latest thinking in the CP to be published in January, but more work has to be done (both domestically and via CEBS) in developing the detailed draft rules and guidance which will have to span the full range of firms, both in terms of size and complexity, and business type.

In our recent discussions with a number of major firms, we welcomed the fact that Pillar 2 has become fully imbedded in their Basel Projects and that the challenges of relating internal capital processes to the optic of regulatory capital are recognised

We appreciate the demands that all this work is placing on your senior management (who need to understand the effects these changes will have on their institutions' risk control), on your business models, on your systems and on your risk managers. This gives rise to significant operational risks for firms during the transition and in the longer term to potential 'black box' risks – as the regulatory requirements in the CRD for example become more technical it remains essential that banks' senior management engages with the underlying risks and how they are being monitored and controlled.

The CRD is also posing challenges to us and to firms on how regulators operate home and host responsibilities. Let me say at the outset that we are sympathetic to the need to simplify and streamline regulatory arrangements for large cross border banking groups. But the position and implications of a bank with a minor presence in a host country differs from that where the presence is significant, especially where it is material to financial stability or poses systemic risks within the host country. We also need to recognise that a resolution of Home-Host issues must work for EU legislation generally – not just for the CRD (eg Clearing and settlement) - and must work both within Europe and internationally.

Going forward, we need to recognise the variety of institutions and situations we face, and devise a flexible approach within which regulators can best co operate across national borders. In some cases, it may well be appropriate to place extensive, if not exclusive, reliance on home supervisors. But in others the host supervisor will need a major role. Our primary concern here is the potentially limited responsibilities given to host authorities of branches under the CRD. And our concern is heightened when those branches play a potentially systemic role. So we will be seeking to encourage enhanced co-operation and information sharing for branches which will have a high impact on the UK markets. Other countries who host banks which are systemic for them, but not necessarily so for the home country, have very similar concerns.

 

Wholesale challenges

We are committed to ensuring that London remains a good place to do business. – in terms of regulation, London still tops surveys on where business can be done most efficiently (eg CSFI). As part of this, we believe it is essential to maintain the UK's reputation as a fair place to do business – where markets are clean and efficient – and that we remain proportionate and sufficiently flexible in our work, so that we can keep pace with all the changes in cross-border business, and innovation isn't stifled.

We have two real priorities here at present.

First we will be undertaking review work on both the management of conflicts of interest and on firms' arranging of structured transactions. Our intentions here were set out in Hector Sants 'Dear CEO' letter in September. Recent cases such as Parmalat have highlighted the need for us to know more about the nature of many structured transactions. And on conflicts of interest, we have highlighted the need for greater senior management engagement in: the identification and management of conflicts; and in embedding the management of the issues identified better within their management information systems and the firm's culture.

Second, we are undertaking some work on hedge funds and firms' prime brokerage arrangements. This is driven by changes in the competitive dynamics within the industry and the need to ensure that firms' credit risk management arrangements are adequate. To this end, we held a series of high-level meetings with the major players and more recent entrants earlier this year. We have identified a number of risks as a result, including: the growth of potential for leverage, given greater competition; possible conflicts of interest given the importance of hedge fund clients in generating revenue (eg via their trading activities); and risks associated with the growth of multiple prime brokerage relationships (lack of oversight of whole-fund risk profiles, insufficient margin requirements etc). We are now working with the LIBA Prime Brokerage Cttee to collect data on hedge fund exposures across all business lines.

 

Retail challenges

Our key retail priority is to help ensure that consumers of financial products get a fair deal. With this in mind we are focusing our efforts on what we believe are the three main elements of an effective and efficient retail market:

  • Capable and confident consumers
  • Clear, simple and understandable information, available for consumers and
  • Responsible firms who treat their customers fairly.

I want to highlight two aspects of our work here:

First on TCF, we published a paper in July, reviewing the progress firms have made in implementing the FSA principle that requires firms to treat their customers fairly. We also looked at the next steps we and firms must take to build on improvements made and to address shortcomings.

In this initiative, we are focusing on insurance, investments, and mortgages – not on deposit taking. The Treating Customers Fairly requirement applies here too, but where the Banking Code is implemented effectively, we can afford to focus on other areas. And we now plan a number of clusters of work on: management information and what it tells firms about their customers, how firms design products, how staff are remunerated when selling products, the interface between product design and product distribution and complaints handling. This work will be undertaken between now and March and we intend to publish our findings in the middle of next year – of good and any bad practices we identify and then consider whether this approach could help us is our reconsideration of the rulebook. We have also established a consultation group to help us take this work forward.

Firms often express concern about wanting more clarity on what we are seeking from this initiative and what they can do to have a 'Safe harbour'. But this work is part of our desired movement towards Principle-based regulation – as a consequence, we don't consider it appropriate to provide the type of detailed rules you would need for a 'Safe harbour'. We will though be trying to achieve a consensus on what TCF means as part of the project.

And second, Depolarisation

Banks have also had a long time to prepare for the depolarisation changes which are now imminent. Our last CP appeared in February setting out the draft rules for the 'menu', a new form of disclosure for the cost of advice. We expect to publish the final Policy Statement around the end of November (following the November Board). Then the plan is to implement the rules almost immediately (1 Dec) with a permissive 6 month transitional period. Firms have the flexibility to adopt the new rules immediately – though clearly there may be significant practical issues for them in doing so.

There will be other business and practical issues for the banks to pursue. Where do you pitch your business offering for example? Do you stay single-tied or offer the products of a number of providers? As well as looking at your own business models, what approach is being taken by your competitors? There are significant investment decisions to be made in the training of advisers across an expanded product range – the scale of banks' operations is such that the logistics of this should not be under-estimated.

Our new rules will bring greater transparency to an area where consumers have perhaps not fully appreciated, or valued, the cost of advice and where partly as a consequence firms have not wanted to itemise the costs associated with different parts of a deal. Greater disclosure may lead to changed consumer behaviour over time – consumers may look more widely for whole-of-market offerings for example, or perhaps we will see consumers more inclined to negotiate over the cost of advice.

 

Regulatory outlook

Most of our regulatory agenda at this time is being driven by the EU and specifically the FSAP. In a minute, I will come on to MiFID and a number of other initiatives on the horizon.

In this context, we have set ourselves the constraint of a very hard test against the introduction of own initiative policy developments, and have reduced the number of CPs we produce by a half. The best way to deliver this outcome is to apply our Market Failure and CBA tests rigorously.

We are also seeking to reduce the size of our handbook and the burden of our regime wherever possible – one example being the proposed simplification of ID and verification checks. We continue to look for areas to shorten as parts of the rule book come up for review. It has to be recognised that in many cases industry has asked us not to over-simplify – for example, in the Listing Review where there was huge support for retaining some existing requirements which were super-equivalent to the Prospectus Directive.

The challenges from the Markets in Financial Instruments Directive (MiFID) are, if anything, potentially greater than those of the CRD. Implementing MiFID is -- among other things -- going to require a significant rewrite of our conduct of business rules. This will have major implications for banks, both retail and wholesale. In the retail sphere, there are potentially significant issues on the new basic advice regime for example, and for wholesale business there are some significant issues in client classification and know your counterparty and on the treatment of market intermediaries as systematic internalisers.

Much of what is in MiFID is recognisable from what we have now: e.g. emphasis on senior management responsibilities, the fair, clear and not misleading standards for financial promotions, risk disclosures and so on. But some significant changes are inevitable.

In particular, CESR has now issued its consultation on the second round of mandates. It will be providing its advice to the Commission on the first round mandates at the end of January next year, with advice on the second round mandates following at the end of April.

It is worth highlighting here that there could be some significant changes in a number of areas:

  • In the first round of mandates, there are potentially high impact proposals on: the independence of the compliance function; the criteria for outsourcing investment services; the requirement for two-way client agreements for all investment services with retail clients; and on tape recording requirements (to record telephone orders and keep the tapes for 12 months).
  • And in the second round of mandates, MiFID's proposals will affect: the definition of investment advice; the nature of the 'know-your-customer' and suitability requirement where a firm provides investment advice or portfolio management; the nature of the appropriateness assessment that a firm is required to carry out when providing other types of service (for example, execution or transmission of client orders); the range of non-complex products that could be sold execution-only, without requiring either suitability or appropriateness assessments; the criteria for including corporates in the eligible counterparty regime; and on the definition of systematic internaliser and the transparency standards that should apply.

We are hopeful that the draft advice will be flexible enough to be capable of proportionate application to different types of investment service and lines of business. And that it will avoid a prescriptive, "one size fits all" approach - particularly to know your customer and suitability obligations.

We are seeking to be proportionate in the rules we apply to regulatory problems, as we must balance our statutory objectives with the imperative that London should remain an attractive place for firms to do business. To meet this objective, we adopt three principles in orienting our regulatory work:

  • first, to work with the grain of the market, not against it;
  • second, by placing responsibility for standards with the senior management of the firms which are regulated by the FSA;
  • and third, striking a balance between, on the one hand, the benefits of an efficient, orderly and clean market and, on the other, the costs of regulation and the impediment to innovation which can too easily flow from excessive or the wrong kind of regulation.

In practice, this has led us to an approach where we may largely copy out certain of the Directives as they are implemented – as the most efficient way to translate them into our rulebook. This is one means to ensure that we do not ordinarily impose additional burdens on the UK market. We have set ourselves against the gold-plating of Directives unless there is a strong cost-benefit argument to do so and a clear regulatory failure that needs to be addressed by the additional material.

We are also seeking to have as early engagement as possible with the banks on issues as they hove into view

There are, of course, other regulatory developments which will have a significant impact on your businesses. The MAD and Transparency Obligations Directive are now not that far off, while there are even more on the horizon.

First, the Credit for Consumers Directive, which could potentially alter the way many lending activities are conducted and could overlap with the new mortgage regime.

Second, the Unfair Commercial Practices Directive, which will introduce a new consumer protection regime with a duty not to trade unfairly.

Both of these are due to be finalised next year.

Third, the Payment Services Directive: this is still at the earliest stages and there will probably be no legislation before 2006. The draft legislative text is very wide -ranging however. It envisages regulation of both payments and payment systems -- so that COB rules would be applied to electronic payments for example.

And fourth, the Clearing and Settlement Directive is also at embryonic stage, but there's strong sense that this will happen as the Commission is doing a regulatory impact analysis. Al, though what it will actually look like in terms of scope and requirements is still very open (e.g. will is it be just Central Securities Depositories or will it cover custody?).

It is against this backdrop that we are considering publishing an International Regulatory Outlook, which would focus on Directives coming over the horizon, to help the industry focus its attention on the right issues and make its voice heard at an early stage.

 

Summary

So what then are the key messages I want you to take away?

First, that the prudential risks to banks at the moment seem relatively low, but given the types of potential risks lurking on the horizon, there is – as always – a need for vigilance.

Second, that reputational and operational risks are high up our agenda – as indeed they seem to be for banks themselves Third, TCF remains a high priority for us on the retail side, as does our conflicts of interest work on the wholesale side. And last, it's clear we face a huge amount of regulatory change, most notably arising from European initiatives which implies a consequent spike in operational risk in the near term. It's also clear that both we and you, the industry, must work together if we are to achieve the desired benefits and the best possible outcome at the end of this challenging period.

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