Sir David Arculus - In the Spotlight

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Speech By Sir David Arculus, Chairman of the Better Regulation Task Force, to staff of the Financial Services Authority
29th June 2005

Introduction

I’m delighted to be here today at Callum’s invitation. Given that both of us have the privilege of Deirdre Hutton on our boards, the FSA is a regulator I’ve always had a strong interest in. I’m going to spend the next twenty five minutes talking about how emerging trends in regulation affect the FSA.

Regulation is controversial because few businesses or individuals want their freedom constrained. That said, the ability to exercise much free choice is dependent on regulation as a guarantor of security and fair play. In the pre modern world life was simpler and, the constraints of religion and poverty excepted, much was left to the individual. It is worth recalling that the first regulations against duelling were consistently ignored as an outrageous infringement of liberties and the Prime Minister (Wellington) decided that such petty regulations should not apply to him as late at the 1820s. Indeed, it was not until 1829, possibly in response to the PM’s activities, that the case for a standing police force for the capital, capable of enforcing some regulation, was accepted.

That such regulations and regulators were eventually accepted was, in part, a consequence of society becoming more complex. The industrial revolution of the late 18th Century created a new middle class while the Great Reform Act of 1833 gave that middle class access to political power for the first time. In this increasingly meritocratic and urban society, where birth no longer determined rights and responsibilities, it became increasingly necessary to regulate conduct for the common good. This trend towards regulation has continued to this day. As wealth and complexity increase, more regulations are demanded by society to achieve social goods. Our challenge is to ensure that the regulations we create and enforce actually increase the common good rather than merely damaging individual freedom.

Parliament has devolved significant powers to many regulators. The FSA, with its autonomous rule making power, is one of the most powerful. In contrast to Ministers, the FSA’s leaders are appointed, not elected, by a process which, although much improved in terms of openness and public scrutiny, remains pretty opaque. This creates issues around how you discharge your duties without being accused of arrogance or of being undemocratic, or merely the poodles of Ministers. Matters may improve if Lord Norton’s recommendation for a Parliamentary committee which takes an overview of all regulators is implemented but even then the situation will still be far from perfect. I think that such a committee, properly resourced, could do rather better than the existing select committees.

The BRTF and its Work

The BRTF’s role is to help fill some of the gaps in parliamentary scrutiny and increase public confidence in regulation by examining government departments, independent regulators and regulations. We are not here to second guess regulators but to help ensure they have good governance and processes which will ensure good regulations are created and poor ones abolished.

I hope that most of you will have heard of the five principles of better regulation which we developed. I’m glad to say that these principles of Proportionality, Accountability, Consistency, Transparency and Targeting have been widely adopted. The Task Force has worked to offer advice to the government on putting our principles into practice through a series of reports which made specific recommendations to the government on fields ranging from e-commerce to one on social care which asked the government to remove regulations which prevented those in care having hot baths. The government has accepted and implemented the vast majority of our recommendations leading to a variety of changes including a great improvement in the quality of consultations and regulatory impact assessments.

The BRTF has been helping to design a system to improve the performance of Government Departments and other regulators. For example:

Regulatory Impact Assessments – these have to be made at the start of a legislative proposal, kept updated throughout its development and published as part of the formal public consultation;
Public consultation must take place, normally for a minimum period of 12 weeks;
Alternatives to regulation must be considered;
Government Departments now have to report on better regulation activity in their annual reports;
Regulatory Reform Orders are used (which make uncontroversial changes to amend primary legislation without taking Parliamentary time);
There is a cabinet Minister with overall responsibility for better regulation, and Ministers with this role in each Department;
I and the head of the Better Regulation Executive in the Cabinet Office engage with management boards of all Government Departments, and each management board has a civil servant explicitly responsible for better regulation;
Poor Regulatory Impact Assessments are referred by me to the National Audit Office.

The things that really matter to the Task Force are:

Keeping our labour markets flexible and efficient, because that is how jobs are created;
Getting Government to come up with alternatives to regulation;
Ensuring that regulators themselves are subject to the highest standards of corporate governance;
Helping small firms, who are often hardest hit by regulations, to cope;
Encouraging productivity, and
Influencing the European agenda.

It is critical that, as a Task Force, we do more than catch the leaves as they fall off the regulatory tree. Rather we need to ensure that the tree itself is healthy if we are to make a real difference. Faced with this challenge , I spoke to the Prime Minister and was delighted when he agreed to sponsor our report 'Regulation – Less is More'. We used this study to investigate whether the approach adopted by the Dutch to reducing administrative burdens could be adopted in the UK and whether measures could be taken to encourage a better balance between the introduction of new regulation and deregulation – we called this 'One in, One out'. We concluded that there were great economic benefits – an increase in GDP of more than one percent – from adopting the Dutch approach and that a “One in, One out” approach would encourage far more disciplined policy making leading to higher quality regulation.

We were delighted that both the Prime Minister and the Chancellor accepted all our recommendations on the same day that we published the report. Properly implemented, these recommendations will ensure a positive culture change throughout Whitehall and the regulators. Our next challenge is to ensure that our recommendations are delivered. As a result of our report the BRTF will be transformed into a Better Regulation Commission at the end of the year and one of its key roles will be to assess the progress which both departments and regulators are making towards the goals we have set out.

What I’m trying to do with One In One Out and the Administrative Burden initiative is to completely change the culture of regulation in the UK.

The first thing to confirm is that we have already made considerable progress in the UK with Regulatory Impact Assessments and variants of those such as your own CBA’s. These essentially equate the costs and benefits of the flow of new regulation. What we have never done before in the UK is to attempt to measure the cost of the whole stock of regulation.

Various other advanced economies have made some educated guesses at doing this and have come out with a total cost of regulation for their economies of about 10 – 12% of GDP. I find it inconceivable that the UK would be markedly outside of this range which probably means that we are spending about £120 billion on regulation each year, equivalent to the tax yield of income tax. Of this, about two-thirds is spent on policy outcomes, clean air, clean water, health and safety, prudential financing and the like and about one-third on the administrative element of checking that all these things are done. You might almost divide these two into good regulation and bad regulation.

What the Dutch have done rather successfully, is to measure the administrative or red tape costs of regulation across their economy. These came to 3.6% of GDP. Then they decided to reduce that figure by a quarter thus saving about 1% of GDP in total. This is not a substitute for RIA’s or CBA’s, it actually tries to give greater precision to one cost element within the RIA and to sum this up across sectors of the economy. So it is complementary to existing work but I think when applied across the economy, it will result in some outstanding savings.

This of course is not the entire cost of the stock of regulation. Why does it not measure the policy costs as well? Well, I suppose one day it might lead to the kind of full regulatory budgeting that the Conservatives have been asking for but for now it seemed to me that to measure the red tape cost as opposed to the policy cost was both an attainable objective and also more important. After all, many of us would disagree on the merits of individual policy outcomes. What none of us could disagree with is that cumbersome bureaucratic procedures from overlapping distant or unaccountable regulators, inspectors or even ministers should be avoided.

There will be many ways of effecting these reductions, Philip Hampton suggests some in his study, for instance, less frequent inspections and pre-populated forms – you yourselves have already identified a number which I will touch upon later.

I suppose the central thought behind our adoption of the Dutch model is, ‘What Gets Measured Gets Done’.

The other topic - One In, One Out - perhaps has a different thought at its core and that is, “Don’t just do something, stand there” i.e. it’s much too easy for politicians or regulators to react to events – let’s say a train crash or a tragedy involving a school party by producing yet another equivalent of the dangerous dogs act. Most times, there is already a law in place which is perfectly adequate but which is not being followed properly. Sometimes of course, there does need to be a change in the law and when that is the case, we are asking that a compensatory, simplification measure be brought in.

Simplification might mean deregulation or it might mean consolidation of existing regulation or it might mean rationalization – using horizontal regulation (such as a general duty not to trade unfairly) to replace a variety of sector specific regulation. Alternatively, it might mean a targeted sectoral guide. One In, One Out will cause a fundamental change to the regulatory culture. It will of course contribute to the reduction of both policy and administrative costs. It will mean a switch of resources from new regulation to reducing the stock of existing regulations and it will aim to create a stable equilibrium in the stock of regulation.

It will also need careful monitoring as will the administrative burden reduction project. This will be done by the new Better Regulation Executive, the Better Regulation Commission and the Prime Minister’s Regulation, Bureaucracy and Risk Cabinet Committee.

Competition and FSA Policy Making

As well as producing Regulation – Less is More, we have worked through cross sectoral studies such as our October report Avoiding Regulatory Creep which examined the way in which regulation can be misinterpreted and over applied by companies fearful of the consequences of non compliance. That report highlighted the problems of over implementation of money laundering regulations – many customers, including no doubt a good number of FSA staff, had to verify their identity to their own bank when the intention of the regulation was probably to catch international criminals rather than the banks’ regulators. I’m glad that the FSA is now working with the financial services sector to introduce a more risk based and proportionate approach to customer ID checks and, in general, if I look at your policy making functions, I find much to praise:

Your adoption of slimmed down IFA requirements for mortgage advisors with an ex post facto review strikes me as a balanced approach to a new responsibility.
Your objective of cutting the number of consultations in half, in response to industry concerns, is a step in the right direction. It is necessary to consult on important matters but also to appreciate that, given other consultations, there are limits to what the industry can cope with. I don’t think there is an issue of consultation fatigue so much as fatigue with legislative change.

I was very interested to hear about the requirements of the Regulatory Policy Committee that policy makers explain the market failure they are trying to counter, consider the perverse effects of each new regulation and justify why the old regulations in the same sector should not be repealed. This seems to be One in, One out in practice – I congratulate you on getting there first.

Similarly I am excited by the resources you are putting into your broad based study of the costs of regulation which you announced on 3rd March. I know that your practitioners’ panel has had a long standing concern that your cost benefit analyses were not sufficiently robust and that you underestimated costs. I am hoping that your study, when combined with ex post assessment of CBAs, will enhance understanding. These are areas of particular interest for us because they mirror recommendations we made to the government in 'Regulation – Less is More'. In these technically challenging areas, the rewards for developing robust methodologies are high.

One issue which you may like to reflect upon when developing new policies is the degree of competition between financial services firms. I am aware that promoting competition is not one of your primary objectives under FSMA but you are required to have regard to four competition like principles under FSMA. In addition competition is an issue for the Financial Services Authority because competitive markets are those which are most likely to ensure consumer protection (one of your primary objectives currently represented by your campaign to encourage firms to treat customers’ fairly).

I think that most people in the FSA do have regard to the need to encourage competition and innovation but there is some empirical evidence that there is insufficient competition in the markets. For example, the spread a retail bank enjoys between the interest rate it pays on deposits and the rate at which it lends has remained at a more or less constant 200 basis points for a number of years. Commission levels in wholesale markets have equally proved sticky on the downwards side. In a truly competitive market, I would have expected some erosion to have occurred.

I would encourage all of you, in whatever part of the FSA you work, to think about the effect of your actions on competition. If the markets (and I mean all markets, not just traded exchanges) are working efficiently there should be less need for non prudential regulation as competition should ensure that the consumer gets the best deal. Indeed, there is some evidence that the weight of regulation itself is damaging competition. Switching is a good indicator of the level of competition in a market and in retail banking this figure is notoriously low - partly because of the complications involved with multiple products, partly because of identity verification rules. By contrast the regulations surrounding credit cards, where a great deal more switching takes place, clearly facilitate more beneficial competition. That said, the credit card market is still very different from the mobile ‘phones market where 30% of customers switch each year in what must be one of the most competitive markets - encouraged by Ofcom’s regulations which allow all customers to retain their telephone number while switching.

Financial systems are constantly evolving. It can be argued that much of the credit risk traditionally borne by the banks is shifting to pension funds, hedge funds and insurance companies and from them to households. As an integrated financial regulator, you have the ability to adapt the regulations to suit new developments. This may mean less prudential regulation for basic banking services – which would encourage competition – and more prudential regulation of credit risk derivatives to ensure that those purchasing them understand the risks they acquire.

The Economist recently argued that bank supervisors preoccupation with systemic risk has made them quite tolerant of anti-competitive behaviour by banks. I don’t go as far as that, though avoiding systemic risk has been a historic preoccupation of the Bank of England which has calculated that full blown banking crises cost countries on average 16% of their GDP. Systemic failure would be hugely damaging to the British economy and I am not advocating wholesale reductions in prudential controls. What I am asking is that you consider working with the Bank of England to determine how your legitimate concerns about systemic failure can accommodate initiatives to reformulate regulations to increase competition.

I appreciate that the Tier 1 & 2 capital requirements which you set for banks are not that which the market would choose and that this may create barriers to entry but similar barriers to entry exist in other markets which have rampant competition. In mobile telephony the main barrier to entry is access to a network yet well structured rules mean that those companies with networks have to compete to keep customers. The same is not necessarily the case in retail banking.

The Importance of Size in Regulation

Some speak of you as “the Leviathan” but conversely your size and the scope of your mandate puts you in a position to tackle competition across financial services. This is something that the collection of smaller regulators that preceded the FSA would not have been able to do. I hope that you will continue to use your unique position to look at the whole financial services market and tackle competition issues.

Lack of scope is only one problem afflicting small regulators. While they can become centres of expertise, they do not benefit from the sharing of experience and expertise that larger organisations can offer. Statistics also show that their inspections are much less efficient and that their staff cost more. Unlike the FSA, which is of a size where it can offer many of you a varied career or the opportunity to specialise, options for those working at smaller regulators are limited.

Of course, there were initial doubts about the FSA, which challenged the status quo when it was established. Five years on, I think you have become an example of how to integrate disparate regulators with the CBI concluding that, “The presence of an integrated regulator in the FSA … is felt to be a positive feature of the UK system.” I hope that you will be able to share the lessons of your integration process with other regulators as they merge in the near future in the wake of the Philip Hampton’s report which advocated combining 31 business regulators into seven. Likewise, I hope that you can increase your interchange programmes with banks and other financial service providers as this will enhance understanding of the twin challenges of regulating successfully and running a profitable business in a regulated environment.

Regulators’ Articles of Incorporation

As I have mentioned, FSMA gives the FSA exceptionally broad rule making and enforcement powers. This means that you perhaps feel less need than other regulators to reform your founding statutes. Nevertheless I believe that all regulators should feel empowered to suggest reforms to their founding statutes and am glad that the N2 + 2 review run by the Treasury gave you some opportunity to do this. 'In Regulation - Less is More' we recommended that the government introduce a Deregulation Bill in the second session of this parliament and the Chancellor confirmed the government’s commitment to this in a recent FT article. I hope that regulators such as yourselves may feel empowered to suggest reforms for inclusion in this bill.

Risk in the FSA

Turning back to matters which are are firmly under your control, I am a great admirer of your Arrow risk framework which looks at firms in terms of the probablity of their failure and the impact which failure would have on the financial system. I hope that, as part of the government’s regulatory reform process all regulators are persuaded to copy your lead and take a risk based approach to enforcement - particularly the local authority trading standards officers who inspect over 300,000 spirit measures each year only to find that 98% are correct with the other 2% are biased in the customer’s favour. Persuading middle managers in these regulators to adapt and implement real changes will be difficult and I hope that the senior management in other regulators will provide the same leadership as those in the FSA have done over the past few years.

In the academic world, there has been general agreement that risk assessment should form the basis for regulatory interventions since the early 1990s and that scarce resources should not be used to inspect or require data from low risk businesses that are inherently safe or which have good risk management systems in place.

I know there are concerns in the industry that, too much of the time, regulation intended for the retail market leaches into the wholesale market. Maybe an improved Arrow process could also allow for explicit consideration of the proportion of a firm’s revenues which came from the wholesale business. If most the revenues were generated by wholesale customers the firm would receive a lower risk profile as its customers would be better equipped to defend their own interests.

Simplification in Financial Services

Turning from the principles of the Arrow process to the practicalities of supervision, your Grey Panthers have a good reputation in the board rooms of large firms. Judging the inherent profitability of a firm’s strategy and hence the long term viability of the firm is always a fine art and having Grey Panthers allows you to do this much more credibly than would otherwise be the case. Having the right level of expertise has allowed you to simplify processes and focus on high level reviews of firms.

In 'Regulation – Less is More' we highlighted the importance of thinking small first and see at a glance regulatory guides. Small firms pose a unique challenge and I am pleased that your recently enhanced tailored handbooks are effectively simplifing regulation while the courses, workshops and seminars which you run are a more constructive alternative to a box ticking inspection once every few years. Further, your use of the same form for basic data collection as Companies’ House helps reduce replicative administrative burdens and is an example which should be emulated by others in government as we highlighted in 'Regulation – Less is More' when we advocated increasing co-ordination between government bodies regulating the same sector to avoid wasteful multiple requests for the same data.

Engaging with Europe

I am encouraged to hear that, when implementing MiFID and other financial services directives, you will be adopting the simplification principles we set out in 'Regulation - Less is More' and looking for rules to remove at the same time that you implement the new ones.

Dealing with European legislation is a challenge faced by most parts of the British government and it is an area where we need to improve. The Task Force has put most of its resources over the last year into its European work programme. It launched a report on European Simplification in December which has been well received by both the Dutch presidency and the new Commission. We are currently working on two other EU reports – one about how the European Union consults with its stakeholders and the other about the consideration and implementation of alternatives to classic EU legislation. We will be publishing both these reports in the latter half of the year during the UK Presidency. Achieving change will be a long process but the Six Presidencies’ Initiative (where six countries, including the UK, with consecutive presidency’s of the European Council have agreed to make better regulation a priority) has been a force for culture change in Brussels. It was encouraging to see some dividends in that the Commission’s new five year plan for the financial services industry rules out sweeping new laws for banks, insurers and other financial companies.

We are also making progress with European Impact Assessments with the number and quality of Impact Assessments that the Commission produces improving.

The Commission has stated in its recent Communication entitled “Better Regulation for Jobs and Growth” that all proposals published in its annual Work Programme will be accompanied by a ‘Road Map’ and all will be subject to an IA – we welcome this. The Work Programme contains legislative commitments so it is vital that a thorough assessment and consideration of all methods of delivery has been undertaken before such a commitment is made. Officials must be sure that intervention is absolutely necessary and that an alternative regulatory tool is inappropriate before they decide to legislate.

The Commission now has inter-service groups to work on Impact Assessments. We approve of this arrangement as it gives other Directorates General the chance to challenge the lead officials’ assumptions, to offer a wider perspective and to share best practice. It is also important for stakeholders to contribute to the process. An Impact Assessment should always be included as part of a public consultation to facilitate this.

A common criticism of the IA process is that IAs are not revised following amendments to proposals by the Parliament and Council. This is a concern as substantial changes can be made and it is poor practice to implement legislation without analysing its potential impact. All three institutions have signed up to the institutional agreement in which they support the use of IAs. The actual buy-in to this differs between the institutions and it is important that all three main bodies who are responsible for the legislation coming out of the EU (the Parliament, Commission and Council) take their commitments seriously.

The FSA works hard to ensure good outcomes for the UK at EU negotiations and I hope you will be able to take advantage of our forthcoming presidency to further the better regulation agenda in financial services. The Lamfalussy process offers you some opportunities to deploy your expertise to advantage. That said, any process which ends up with an FSA cost benefit analysis which assesses the effect of a directive as negative, when you have no option but to implement it, cannot be optimal.

The FSMA requirement that you produce a statutory cost benefit analysis of new rules was intended to bring empirical work into the decision making process which led to new regulation. It would be useful to have cost benefit analyses at an earlier stage in European policy formation so that the direction of the policy, not just some of the finer points of implementation, could be influenced. British departments have found partial Regulatory Impact Assessments to be a powerful negotiating tool at an early stage in European negotiations. I would like to encourage you to consider how you and the Treasury could work together to use your expertise in Cost Benefit Analysis to make an empirical contribution to EU decision making at an earlier stage in the process.

Conclusion

So, I suppose the central focus of what I have talked to you about today is Less is More – the reduction of administrative burden and the One in, One out principle and, of course, the general principles of good regulation.

What I am trying to do is not to second guess regulatory decisions or departmental judgments but to help create a framework which produces good regulatory outcomes.

We have regularly been placed in the first division by both the World Bank and the OECD in terms of having both good regulation and a competitive economy. It’s a constant struggle to keep there – but I believe we can get even better and become a true exemplar to the rest of the world and to the rest of Europe. In this context, I was pleased to see the emphasis the PM put on better regulation and risk acceptance in his speech to the Institute of Public Policy Research on 26th May although I think his speechwriter was perhaps overtaken by the power of his own eloquence in places. We have a good framework in place of which you are an important, even a leading, part. You must continue to steer a middle course between your critics in the financial sector and the demands of consumer representatives for greater protection. What we need now is not more announcements but hard work and a relentless focus on the detail.

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