25 November 2004
Speech by Kari Hale

Good morning. Thank you for inviting me to speak to you today about our strategic risk-based approach to regulation in financial services.

My objective today is clear - to help you think about our context, better to inform your own risk and compliance planning for the coming year, and set the scene for the more detailed discussions later in the day.

To achieve this I intend to talk for about 25 minutes and aim to cover three key areas before taking a few questions.

  1. First, I want to share with you what we at the FSA are planning to focus on from a strategic perspective in 2005. At the same time I will explain a little about our new structure – effectively what the new division that I head up is doing to help the FSA work in a risk-based way.

  2. Second, I want to share with you what we think are the key external challenges for the financial services industry in 2005 and beyond, which should be of interest to you in your compliance roles.

  3. Third, I want to talk about the types of policy issues which you need to be geared up for in your compliance planning. As these are largely driven by the international policy agenda, I will, in particular, be focusing on the international nature of these initiatives.

I should probably explain that in dealing with the second and third areas here - external events and key forthcoming policy issues - I intend to give you a sneak preview of two of our flagship publications: the Financial Risk Outlook; and the new International Regulatory Outlook. The 2005 editions of these will be launched early next year.

But first let me give you some context to my remarks.

Occasionally as a regulator one feels like the Greek mythical figure Sisyphus, condemned eternally to roll a heavy stone to the top of a hill, only to have it fall back each time.

Not that we feel the weight of a rock falling on us - except sometimes in Treasury Select Committees perhaps.

But we are continually applying ourselves afresh to the task of regulating effectively, promoting fair and efficient markets and seeking a fair deal for consumers. This does not mean however, that we aim to turn your world upside down. Indeed today as we discuss the issues that are likely to impact you in your risk-based compliance planning, I will hope you see a consistent strategic "thread" running through our initiatives and plans. Whilst the world of financial services, and the FSA as an organisation, seems to be constantly adapting, we recognise that consistency is vitally important for our stakeholders.

To illustrate my approach to this theme I should turn to Tolstoy who said "Everyone thinks of changing the world, but no one thinks of changing himself."

Tolstoy's insight is possibly a useful starting point to introduce the work of the new division that I am heading up inside the FSA.

We at the FSA continue to strive to make ourselves more efficient and better regulators both by minimising costs and being smart and more prioritised in our actions.

To this end some of you will be aware of internal changes to the FSA and the establishment of a new central division, Finance Strategy and Risk (or FSR), which I lead.

FSR combines risk/resource analysis and management, strategic planning and financial control, international policy co-ordination and support for the FSA Panels. I report directly into John Tiner, the FSA’s CEO.

One of my priority objectives is to ensure we have in place processes to identify and report upon the issues that really matter and to ensure that our resource allocation is aligned with our business priorities.

Our aim is to apply available resources to achieve the maximum possible net reduction of risks to our statutory objectives. To do this we need to be able to:

  • compare risks on a consistent basis; and

  • choose the most effective way to mitigate them.

Our work in FSR is now coming together within this context in developing our 2005/06 business plan. I will discuss this briefly, illustrating I hope, my point of consistency in strategic aims, even whilst we are all living through a period of huge regulatory development and change.

The FSA has three "flagship" external publications that we use to explain to stakeholders what we seek to achieve, and how we are performing.

These are:

  • The FRO in which we set out our understanding and analysis of the major risks in the operating environment for financial services for the year ahead. This is published in January;

  • Our Plan and Budget, also published in January, that sets out our response to those identified developments in risks and our investment priorities for the coming year; and,

  • Our Annual Report, published in May of the following year, in which we account for our revenues and costs and report upon our progress more generally.

Our plan for 2004/5 set out 22 investment priorities. These include strengthening insurance and reinsurance regulation, the listing review, action on mis-selling, and depolarization to name but a few. Around 15-20% of the FSA’s resources are allocated to these priorities, a proportion we expect to remain consistent in 2005.

Of the 22 priorities we are only winding up two in this financial year (2004/5): the enforcement review and high street firms authorisation projects.

In 2005, we:- expect to see the further development in and/or the implementation of several existing priorities including the implementation of the mortgage and general insurance regime and the launch of a lighter regime for some products (AKA Sandler) along with further modifications and improvements to our risk assessment process known as ARROW. We must also continue to prepare for the CRD and MiFID – of which more to follow.

I would stress it is not our intention to draw up a raft of new policy measures. Indeed, now is a period of implementation. As John Tiner said in his mansion house speech last year (23/9/03) "the changes at the top of the FSA … coincide with a natural evolution in the FSA's policy remit from policy development and reform to policy implementation". This focus has not changed, nor do we expect it to.

We are committed to the extent it is in our power to limiting the churn of change and the resulting compliance burden on industry. In practical terms we aimed to halve the number of CPs and DPs we produce this year – a target we are well on track to meet.

To illustrate our commitment to limiting the compliance burden I would also like to briefly revisit the philosophy that underpins our approach to regulation.

At our annual public meeting in July of this year John Tiner stressed that "we are absolutely determined that we will exercise our discretion to make new rules only where this can be justified by a robust market failure and cost benefit analysis."

Callum McCarthy has also stressed that determining the presence of a market failure as a first step rather than a sufficient condition for regulation - rigorous cost benefit analysis must follow.

After all, most markets have some element of market failure. Often those who favour intervention argue that any market failure justifies intervention. But, the real test goes beyond that: there must be both market failure and the prospect that intervention will provide a net benefit. This involves recognising that regulatory intervention has a cost; and that regulatory intervention, like reliance on market operations, has a non-zero probability of failure. The question of whether to intervene or not is a challenging question, which needs to be analysed on a case-by-case basis.

From this statement of principle, you will see the interest we have in encouraging efficient financial markets. Encouraging such markets is central to our work.

To keep us "honest" in this regard all new policy that is considered by our Regulatory Policy Committee must be supported by CBA and we are planning a major project next year to seek better to understand the cumulative cost burden of our regime to firms and across markets.

Where possible we will also attempt to quantify and compare the resulting benefits, in the context of our three strategic aims:

  • Promoting efficient, orderly and fair markets;

  • Helping retail consumers achieve a fair deal; and,

  • Improving our business capability and effectiveness.

You should expect to see these aims continued forward into our 2005/6 Business Plan, and operating as the context within which we determine our priorities.

 

I will now turn to the second element of my speech, the external challenges that we think will be key in 2005 and which will feature in our forthcoming Financial Risk Outlook, which is the other major input to the development of our 2005/6 Plan.

First, pension provision: The Turner report, published in October this year, highlighted the existence of a 'savings gap'. Consumers need to understand their needs (if necessary with the help of suitable advice), and have confidence in the range of financial products available to meet those needs if they are to make appropriate financial decisions for the long term. Therefore we will continue to focus on promoting consumer understanding and standards in financial advice. Firms have a significant role in this, not least because they contribute to improving consumer confidence in financial services by 'treating their customers fairly.'

Second, innovative retail products: The nominal returns on 'safe' investments (e.g. deposits) remain low. Many structured retail products attempt to meet the demand for higher returns and capital guarantees. But both of these are unlikely to be simultaneously available without elements of additional risk and/or cost, so firms need to ensure they do not misrepresent products, and consumers need to think about whether they are getting value for money, and whether guarantees are all they seem.

Third, the volume of regulatory reform, including EU legislation, to which I will come back later on…………..

Fourth, risk taking by financial institutions and hedge funds: There is some evidence that investment banks are taking on more risk through their proprietary trading activities. Furthermore credit spreads have fallen; this could suggest that investors are 'searching for yield' without fully appreciating the fundamental risks they are taking on. The hedge fund sector has continued to grow but investment returns in the last year or so have been disappointing. It is conceivable that hedge funds could increase their leverage and risk taking to generate higher returns - we think that firms with exposures to hedge funds (as prime brokers, investors or owners) need to maintain their vigilance in this area.

Fifth, I do not have to remind you that potentially adverse external events remain important on an ongoing basis. I am thinking here of the impact of discrete events, such as disorderly adjustment of international or domestic economic imbalances, further spikes in oil prices, or major terrorist attacks for example, all of which we would like to see feature in your regular scenario planning. These are the sort of high impact, low probability events, which in the current environment we consider all financial institutions should be prepared for.

Lastly, I would like to sound a general warning point that relates to the search for yield and the competitive pressures that will face your firms in 2005. We think that 2005 could prove a more challenging year for financial institutions. The economic environment may not remain as benign as it has been over some years now, given uncertainty in the international economic outlook and the potential for a slowing housing market and decreasing levels of consumption in the UK. In such an environment, there are question marks hanging over the drivers of earnings that have supported growth in recent years, and we know that firms may therefore have to look for other opportunities to make up margins. Cost cutting is one such avenue, whilst increasing risk appetite is another.

We consider it imperative in that context that the need to increase earnings and maintain top-line growth rates does not lead to the relaxation of risk management discipline. This is not the right time in the cycle for any relaxation of credit controls in particular and I want to give you a strong message to take back to your senior management that any changes in risk appetite must be looked at very carefully. As heads of compliance you will have the FSA's full backing in re-enforcing this message back in your firms.

 

And now for the final section in which I promised to give you a sneak preview into our view of the key international issues. As I alluded to at the beginning of this speech, we are looking to publish our new International Regulatory Outlook in early 2005 as part of our commitment to helping you understand and manage the impact of the current and prospective wave of regulatory developments.

New rules such as Basel II, and EU initiatives such as the conglomerates and prospectus directives present real challenges. I should stress these initiatives are driven by international co-operation and to this end the resulting agenda and timing for implementation cannot entirely be set by domestic factors.

In this context, one major concern I am sure we all share, and which our FRO will elaborate upon, is the balancing act required to secure the necessary commitment of senior management time required to ensure effective implementation of these initiatives, whilst keeping ones’ eye on the ball in maintaining sound day-to-day risk management.

First let me talk briefly about the strengthened prudential requirements we will see implemented in the next few years, without wishing to steal the thunder of colleagues later in this conference.

Basel II will be implemented in the EU via the Capital Requirements Directive (CRD) – a major step forward in achieving a more truly risk-based approach to prudential regulation. The EU published a draft of the CRD, incorporating Basel 2 in July of this year. You are no doubt aware that the provisions of the CRD will apply to investment firms as well as banks in the EU.

Once the CRD is adopted — currently expected sometime around September 2005 — a major implementation programme will be required in the period to the end of 2007. The FSA will accordingly publish a consultation paper, strengthening capital standards in January 2005 and subsequently another CP, based on the final CRD text in September 2005. We could then finalise handbook changes in October 2006 and bring the new rules into force in December 2006.

There are also challenges arising from the Markets in Financial Instruments Directive (MiFID). Implementing MiFID will require a significant rewrite of our conduct of business rules, with consequential major implications for firms.

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 areas will be affected. These include:

  • 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;

  • 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; and

  • the impact on our inter-professional regime (where advice can no longer be included and where there are more prescriptive requirements on the management of conflicts of interest).

However, I should stress that we hope and expect that CESR, the Committee of European Securities Regulators, will give advice on MiFID that will in the end 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.

International accounting standards conversion and implementation should also be on your radar for 2005. Under EU accounting requirements all listed companies will be required to use IASs for their annual consolidated financial statements from 1 January 2005.

The FSA announced in late October that it proposes to keep to a minimum the changes needed in its regulatory accounting rules in the light of new accounting standards.

The changes in accounting standards, and firms' application of them, are however, likely to shake down through the next couple of years. So we will look to revisit the implications for our rulebook on that timescale.

We have tried to take a pragmatic approach that involves the least disruption to firms within a policy context that our long-term objective is to promote the convergence of accounting, economic and regulatory measures of capital.
I understand that you will be talking about these issues later so I will leave the detail for those discussions.

Following on, I would like to say a few words about Anti-Money Laundering Activity. We work closely with other national authorities and international agencies to develop guidelines covering anti money laundering and counter terrorist finance (AML-CTF) activity. The main forum for advancing this work is the Financial Action Task Force (FATF), which issued a revised set of 40 recommendations in June 2003. There is also an EU dimension, seen in the work currently being undertaken in respect of the Third Money Laundering Directive.

To date the FSA has been successful in promoting the importance of taking a risk-based approach to AML-CTF (this is recognised in the FATF's recommendations): one that requires firms to be continuously vigilant as new criminal techniques and sources evolve rather than treating all transactions similarly. We believe that this is the right approach domestically and that it offers the best way forward internationally.

There are, of course, other regulatory developments which will have an impact on your businesses. The Market Abuse and Transparency Obligations Directives are now not that far off. At the same time, there are other EU initiatives on the horizon that could impact you down the line.

First, the Credit for Consumers Directive, which could potentially alter the way some lending activities are conducted

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. Although what it will actually look like in terms of scope and requirements is still very open.

I cannot talk about EU developments without noting that as part of our engagement with our EU partners, and our focus on the sensible implementation of existing directives, we attach great importance to the work of the Lamfalussy Committees in terms of their technical input as well as a forum for the discussion of best practice between supervisors. We are also committed to avoiding "gold plating" or super-equivalence in our implementation, except where clearly supported by a strong CBA case.

Lastly, I should mention supervisory co-operation across national borders. In other words home host issues; the growing impact of cross- border firms and activities in host markets, together with reasonable calls from the industry for greater efficiency, are forcing us to continue to address the pattern of rights and obligations in the global regulatory network. This is an area we will be continuing to give considerable thought to, along with our partners in the EU and beyond.

 

In conclusion

  • We recognise there are a lot of issues for you to consider in your strategic risk and compliance planning,

  • I hope that you have a better feel for our priorities as regulators in the coming year and recognise that our philosophical approach to regulation, in terms of market failure and cost benefit analysis, remains appropriate and aligned to the cause of more efficient markets

  • There are a number of challenges in the external environment facing you in 2005, which I have covered briefly. You will be able to get more detail on these from our Financial Risk Outlook, due in early 2005. But I would like to stress again, the importance of maintaining robust risk management practices in what might not be an altogether benign environment in 2005

  • On the international policy front there is also much food for thought. To this end I urge you to read our International Regulatory Outlook, currently planned for publication in early 2005. Basel II, MFID, International Accounting standards are all on the immediate horizon. Pursuing effective implementation of these initiatives without taking your eyes off the ball of day-to-day business conduct compliance will be a major challenge in 2005 and beyond. We will undoubtedly need to work together effectively, as regulator and industry, to ensure that this goal is achieved.

 

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