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Speech by Hector Sants
FSA Annual Public Meeting
21 July 2005

Introduction

In my brief presentation today I would like to focus on how we are preparing for the implementation of two key European Directives. The first is the Markets in Financial Instruments Directive, the so-called "MiFID", one of the major elements in the EU's Financial Services Action Plan. The second is the Capital Requirements Directive which is the vehicle for implementing in Europe the new Basel Framework for capital requirements.

On MiFID, I shall first set out the overall timing for implementation and where we are in the continuing European negotiations of the "Level 2" implementing measures. I will then say a few words on the challenges that MiFID raises for the industry and update you on the FSA's approach to domestic consultation.

Introduction and implementation timetable

MiFID

MiFID is intended to promote a single market for wholesale and retail transactions in financial instruments. For the first time there will be European requirements covering investment advice, operation of multilateral trading facilities and services related to commodity derivatives (all being areas already regulated in the UK). Benefits for UK firms will accrue chiefly to those wishing to do business in other Member States on a "passported" basis which, under MiFID, can be performed across a wide range of services and on a firmer footing than under the current Investment Services Directive, which MiFID will repeal and replace.

MiFID is one of the first batch of Directives to be legislated according to the "Lamfalussy process". The framework provisions, constituting the "Level 1" text, came into force on 30 April 2004. Last month the Commission formally proposed 30 April 2007 as a revised implementation date for firms. To give industry at least a clear 6 months to finalise their preparations for implementation, the amending Directive sets October 2006 as the revised date by which Member States must have transposed MiFID requirements into domestic law.

The continuing debate over the MiFID "Level 2" measures – which are the more detailed requirements hanging off the Level 1 framework - has been a major claim on the capacity of the FSA teams, involving approximately 40 policy staff on a full-time basis. Industry and other stakeholders have also devoted heavy resources to that process. We all know that the stakes have been high on some issues and in some areas remain so. Getting the Level 2 requirements right is crucial. As far as is possible we need clarity about what the implementing measures require, whilst avoiding the dangers of a "one-size-fits-all" approach.

Level 2 negotiations

CESR advice on Level 2 measures was submitted to the Commission in January and May. The action has moved to the European Securities Committee (ESC) as it reviews CESR advice. We, together with other stakeholders, continue to work very closely with HM Treasury. The aim is to help them, in the discussions with the other Finance Ministries and the Commission, to get an acceptable package of recommendations on Level 2 defined by October. The final Level 2 outcome as approved by the Parliament is not expected before January 2006.

I should like to say that the trade associations, exchanges and many individual firms and other stakeholders have provided us and HMT with tremendous support throughout this process. Special consultation machinery put in place by HMT and ourselves has helped to inform UK positions, and good trust has been built as we have shared, and respected, our various perspectives.

Key areas of change

So much for the Level 2 process. In terms of the practical impact of MiFID on UK industry and consumers, I highlight the following as areas where it is expected to bring substantial change:

• A broader definition of "investment advice" – particularly if this were to include generic, as well as specific, recommendations;
• Client classification criteria, particularly in relation to wholesale markets business;
• A revised approach to dealing with conflicts of interest;
• A new approach to best execution;
• New requirements in relation to equity market transparency, including specific provisions for "systematic internalisers"

Much of this is still subject to negotiation at Level 2.

Markets

In relation to the markets aspects of MiFID, the new directive brings benefits in potentially enhancing competition between different types of trading platform – exchanges, multilateral trading facilities and investment firms. It also provides for the first time for a “passport” across the EU for multilateral trading facilities and firms dealing in commodity derivatives. But there will be a requirement for all equity transactions – including those done OTC – to be reported to the market; and there will also be a new pre-trade transparency regime for those investment firms which internalise client orders on an organised, frequent and systematic basis. How significant these elements are will in part depend on how firms respond to the new regime and the choices it allows.

COB

MiFID imposes specific obligations on firms in relation to organisational requirements, conflicts of interest and conduct of business. In broad terms, there is likely to be little that is entirely new for UK authorised firms. But in several areas the standards are likely to be tougher or less flexible than is currently the case in the UK. In addition, there are changes to regulatory processes such as authorisation, enforcement and co-operation, which may increase FSA costs directly.

Costs

There have been no estimates of the costs and benefits of MiFID at the EU level. None were made by the Commission when it tabled the original proposal, nor were any produced during the subsequent negotiations. The FSA has a statutory obligation to produce a cost-benefit analysis of any new rules, and we are still working closely with industry stakeholders to establish as clearly as we can just what the costs and benefits are likely to be. In our consultation on UK implementation, which we plan to publish by the end of the year, we will give a straight account of these UK costs and benefits, following the further work we are doing with industry.

From our preliminary discussions, up-front implementation costs for UK firms could be significant. We do not underestimate the deadweight cost of revamping existing, or introducing new, systems, procedures and business or trading models, particularly given the understandable desire of firms to minimise their legal and compliance risk. We recognise that many firms are concerned about the possible scale of these costs- concerns which we share. As Callum said this morning, it is far from clear that the benefits to the UK will outweigh the costs.

Clearly, the precise costs will depend on the ultimate outcomes at Level 2, and on decisions about application and interpretation. As Callum said earlier this morning, it is therefore vitally important that the level 2 measures now under discussion in Europe are not disproportionately burdensome. And in our domestic implementation, we intend to be as pragmatic and helpful as possible – consistent with proper implementation of the Directive. We will only impose requirements that are tougher than MiFID where there is clear market value in doing so. And we will not expect firms to implement Rolls-Royce solutions where something fit-for-purpose would suffice.

Domestic Consultation

I should conclude on MiFID with an updated outline of our current planning for consulting on UK implementation.

Of course, HM Treasury themselves have an important role in transposing the Directive in the UK. They will be consulting on necessary changes to primary and secondary legislation in the autumn.

As far as the FSA is concerned, we have begun drafting the required Handbook amendments and Consultation Paper text so that the main weight of consultation can commence by year-end. We announced last month that mid-November was our target publication date for the CP. To the extent that the final Level 2 legislation to be endorsed by the European Parliament in January/February 2006 contains changes, a second CP might be required in Q1 2006. But - to respect the norms for domestic consultation and meet the October 2006 transposition date - we have no choice but to commence drafting of Handbook/CP text before the final Level 2 text is adopted, based on the recommended package emerging from the ESC. Following consultation, we hope to adopt our rules by mid-2006, to give the industry as much notice as possible of the final Handbook requirements. But obviously much depends on when the Level 2 measures are agreed. Any slippage there could now make full implementation by April 2007 very difficult for firms, particularly where late changes have substantial systems implications.

Approach to Domestic Implementation

In terms of how we propose to implement MiFID, in particular, I confirm that:

1. As in many cases Level 2 measures may take the shape of Regulations bearing directly on firms, the foundation of our approach is to tailor the Handbook around those measures and the Level 1 text.
2. Our approach to implementation is intelligent "copy-out" of the MiFID text, with requirements tougher than the Directive only where this can be justified by on cost benefit analysis.
3. We will be using MiFID implementation as an opportunity to rationalise existing rules. In some areas, the contrast between what the standards MiFID sets for some firms and activities and our current standards for adjacent business will be pretty stark. So we plan to address major issues that arise from that, with any levelling up or down properly justified by cba and the principles of good regulation. But we need to avoid consultation overload, and to assess properly, in discussion with our stakeholders, the full significance of the final MiFID benchmark. So we shall phase consultation of wider COB Handbook review through 2006.
4. We will be ready to provide sensible amount of guidance in the Handbook in the case where Level 1 and Level 2 provisions would require some explanation as to FSA's view of what they exactly mean in a UK context. FSA's guidance will ultimately be subordinate to the European Court of Justice's view, but we are ready to provide the industry with pointers.

Capital Requirements Directive

I will now make some comments on the Capital Requirements Directive. This topic is of key importance to banks and investment firms as we move closer to the implementation of the new rules. Time is short, so I will highlight the key points and then leave time for discussion and questions.

FSA'S overall approach

As we – FSA and firms - get closer to the detail of implementation it becomes increasingly important not to lose sight of the bigger picture. The new regime will give firms the incentive to improve risk management standards, not just at the point of implementation but over future years as well. This improvement is welcome, but we recognise that it is not cost free. For this reason we are committed to being pragmatic and proportionate in how we implement the CRD.

Communication is central to its successful implementation. Domestically and internationally we are working with industry and other regulators in a range of fora. And I urge all relationship-managed firms to keep their FSA supervisor up to date with their CRD implementation plans.

Update

A quick word on where things stand on policy and negotiations. Based on current expectations for the European timetable our intention is to publish a second CP early in 2006 reflecting intensive dialogue with the industry since the Strengthening Capital Standards CP last January and taking account of the final CRD text. All that would be with the aim of having our final rules in force in time for the 1 January 2007 start date of the CRD. There are of course some potential uncertainties over the timing of the final adoption of the CRD text. Nevertheless we continue to plan and maintain the momentum of our efforts for a 2007 start date.

Some of that uncertainty has been reduced following the outcome of the vote on 13 July in the European Parliament's Economic and Monetary Affairs Committee. Those of you who have been following the CRD closely will know that some 887 amendments were tabled and voted upon by MEPs. Many of these amendments either replicated the Council's position as agreed by ECOFIN in December or were designed to correct typographical or cross-referencing errors. But there remain a few technical issues that need to be resolved . Following the referenda in France and the Netherlands on the Constitutional Treaty, a key issue concerns the use of so-called 'comitology' (or delegated decision-making) powers under the directive and the role of the European Parliament in that process. We remain optimistic that solutions to these issues can be found and that prospects for agreement on the directive in a single reading under the UK Presidency are on track.

A further step closer to the CRD being finalised was taken on 18 July when the Basel Committee and IOSCO published their joint paper on the Trading Book Review. The successful completion of this work within such a short time is in no small part due to the tremendous co-operation received by supervisors from the industry over the last year or so. The fact the work has been completed on time means that the proposals are expected to be incorporated into the CRD as a single bloc of amendments at the European Parliament plenary session at the end of September. The FSA welcomes this, having long advocated that it was essential for these proposals to be incorporated into the CRD before it comes into force.

Advanced approaches

Now, turning to issues relevant to firms planning to apply for advanced approaches. FSA has been open since 1st July to receive applications. So far we are still waiting for our first application but have had indications that about a dozen will be with us by Christmas. Any firm wanting to use advanced approaches on day one of the new regime – 1 January 2007 – will need to apply to FSA by the end of this year. Of course application does not imply automatic approval. Where a firm has an overseas link we will work with other supervisors and adhere to the CEBS and AIG principles.

I encourage any firm considering making its application to take a look at our website where we have posted information to help firms understand what we will be expecting from them. One example is the "Use Test". Compliance with the use test will be important in our decision on whether or not to approve an advanced approach. Equally, senior management engagement and involvement is important. Although we are not looking for all Board members to be rocket scientists, the senior management needs to understand enough to challenge the quants and the limitations of modelling alongside its benefits.

Pillar One

I turn to Pillar One. The industry/FSA Standing and Expert Groups are providing a valuable means to build understanding of current industry practice and advance thinking on a number of credit and operational risk issues. For example there are groups looking at low default portfolios for credit risk, and on the operational risk side an expert group looking at "expected loss" and other AMA modelling issues. The full list of these groups and details of their activities are set out on our website.

To prepare for practical implementation of Pillar One, we have undertaken thematic visits over the past year. The results have been posted on our website. In general firms appear to be making good progress in building their credit rating systems but we have seen less work being done on validating the models. Firms need to set out clear standards on validation and perform regular tests against these standards. Most firms we visited did have plans for model validation, but they now need to be turned into reality. Firms had also started to consider stress testing but a lot more work needs to be done. Another priority for firms centres on documenting and embedding the ratings systems in the business planning and decision-making of the firm.

On the operational risk side of Pillar One, we were encouraged with what we saw during our thematic visits. But considerable progress is still required particularly for those firms with AMA ambitions. Firms need to think through the relationship between data collection, interpretation, and risk mitigation, in other words how Op Risk feeds through to decision-making.

Pillar Two update

On Pillar 2 we continue to work closely with industry to develop a sensible approach. We have established a Standing Group, and have started some work with individual firms to develop our thinking about how the Supervisory Review and Evaluation Process might work in practice. We are also heavily involved in discussions in CEBS to secure early consensus on practical approaches, recognising the problems that disparate practice could pose for groups with entities in various Member States.

While some larger and more sophisticated firms will use economic capital models for Pillar 2 purposes, we have indicated, in response to industry comments, that alternative approaches are entirely acceptable. Whatever method is used, common concerns include the treatment of diversification benefits and the role of stress testing/scenario analysis. For smaller firms, the main recurring theme has been that Pillar 2 should be proportionate and not over-engineered and to this end we are working on pragmatic solutions, in discussion with industry groups and Trade Associations.

Investment firms

Before I conclude, some comments on the position for investment firms. For some investment firms there remain uncertainties due to the interaction between the provisions of CRD and MiFID, as they crystallise, and the Regulatory Activities Order. We recognise that this causes difficulties for some firms in finalising their plans. Pending the Treasury's consultation on the RAO we are working with them and with Trade Associations on the best possible mapping of firms' permissions to the CRD categories. Meanwhile firms should in any event be speaking to their relationship-manager about the scope of the CRD and the progress of their implementation plans.

We are aware of the practical challenges for investment firms in implementing the CRD. I have indicated some – but by no means all – of them on the slide. We intend to publish information that will be helpful to this sector, and are sending a "Dear CEO" letter to all relationship-managed investment firms.

Conclusions

The preceding slides have covered a selection of the key issues facing FSA and industry in respect of CRD implementation. They have shown that the FSA's approach – of pragmatism, proportionality, and working closely with industry is being applied to all aspects of the new regime.

I leave you with the following closing thoughts. The new regime is fast approaching, and we will maintain momentum in our implementation activities and dialogue with firms to be ready for a start date of 1st January 2007. Second, for those firms planning to use advanced approaches, the FSA is now open to receive applications. Our resources are in place to deal with these. And finally, whilst much of the detail up to now has been focused on Pillar One issues, we are now moving to discuss the detailed approach to Pillar 2. For all firms – whether you plan an advanced or standardised pillar one approach – there is a need to turn attention to what you need to do to meet your Pillar 2 obligations.

Thank you. I hope this has been useful.