Mansion House speech
Speech by Callum McCarthy, Chairman, FSA
20 September 2005
My Lord Mayor, My Lords, Aldermen, Sheriffs, Ladies and Gentlemen. For an institution as recently established as the FSA, it is indeed a particular privilege to be afforded an occasion to speak here, at the heart not only of the City as a historic institution, but also of the City as the symbol of one of Britain's most successful industries, the financial services industry. Tonight, my Lord Mayor, combines both the history of the City, and the future of the City – just as you, in your activities as Lord Mayor and in your personal capacity as a financial services practitioner combine the two seamlessly. I thank you for all that you are doing during your period of office to promote both the City and therefore financial services more generally; and I thank you for having assembled such distinguished guests this evening.
Last year, on this occasion, I used the opportunity to set out the three themes of the FSA's work: promoting efficient, orderly and fair markets; helping the retail customer of financial services to get a fair deal; and making the FSA itself more efficient and hence easier to do business with. Those themes remain, and will remain, at the centre of our work. If there were such a thing in regulatory policy as an eternal verity, they would be our eternal verities. But, you will be relieved to know, I do not want to reprise what I said last year. Instead, I would like to use this occasion to review the present position of the financial services sector, and consider two of the many challenges which it faces. And, having described the challenge, I will set out how we at the FSA will respond.
Harold Macmillan, when Chancellor of the Exchequer, famously remarked that the most difficult thing to predict was the recent past – something which has not changed, as revisions to ONS statistics remind us. In the spirit of starting by tackling the most difficult of forecasts, namely where are we now, let me start by looking at the state of financial services in the UK.
From the industry's viewpoint, the position is one of strength: business and financial services make twice the contribution to the UK economy of manufacturing industry; financial services show strong and growing net exports, up 9 per cent in 2004; the very fact that the UK has a positive balance of trade in financial services is worth stating – it distinguishes the UK from the US, Japan or France. The banking sector is thriving, with British banks showing high returns on equity, and capital ratios healthily above any required by regulation. The life companies, which suffered from their exposure to equity markets when the FTSE halved, have benefited both from the recovery in equity markets and from the rebalancing of their assets. The realistic reporting of assets and liabilities, which we have required, shows significant improvement in their underlying financial strength. For general insurance, London continues to be one of the largest insurance markets in the world for wholesale risks. I would add that general insurers and reinsurers, having until recently enjoyed a benign stage of its cyclical life, may well - post Hurricane Katrina - provide a vivid illustration of Harold Macmillan's dictum. The British asset management industry remains a global leader, with profitability improving, in part in line with rising markets, in part in response to the often painful measures taken to reduce costs. The markets and exchanges based in the UK remain attractive targets for investors, just as – and because – they remain attractive trading venues.
All these are, of course, indicators of the profitability and international competitiveness of the financial services industry. We at the FSA are much concerned that the British industry should be and should remain profitable and successful. That is part of our statutory responsibility for preserving confidence in the financial system. But we are even more concerned that the industry should serve its customers well – which is also part of our statutory duties, in terms both of confidence and of consumer protection. In a competitive industry there is no conflict between the two objectives, which is why we at the FSA are committed to promoting efficient, orderly and fair markets, and always seek to guard against the danger that regulation acts as an impediment to innovation or competition.
As a broad generalisation, I would say that the wholesale financial services markets are characterised by significant, even fierce, competition, with a range of providers of services competing for the business of for the most part informed and competent potential customers. These happy circumstances allow us to adopt lighter touch regulation where we can rely on the precept of caveat emptor – a principle which has informed our recent statements on the trading of debt instruments; and has enabled us to encourage the industry to develop its own solutions (as we have done with bundled services for asset managers, and are doing for contract certainty in the insurance market), and generally to keep regulatory intervention as a backstop.
The position in retail financial services is very different. There is often a disparity between the knowledge and capability of the provider of the retail financial service and of the user of the service such that much less reliance can be placed on the principle of caveat emptor, and there is a correspondingly greater requirement for regulatory intervention in the retail compared to the wholesale market. I should make clear that the FSA's aim is to promote an efficient market for financial services in the retail market just as in the wholesale market – hence our concern to improve financial capability, to promote relevant and understandable information about financial services, and to encourage responsible behaviour on the part of those who provide those services: the behavioural conditions needed to make an efficient market. But until these conditions are met there will be a stronger case for regulatory intervention in the retail than exists in the wholesale market.
That then is my starting point: a financial services sector which is one of Britain's most successful sectors in terms of international competitiveness and profitability; a wholesale market which is for the most part both efficient and competitive, and where regulatory intervention can therefore be – and is – limited; and a retail sector with real obstacles to developing an efficient market, where our regulatory interventions are aimed both at moving towards a more effective market and in the meantime providing in various ways a measure of consumer protection which is much needed.
We are also acutely aware of the costs imposed on the sector by regulation and its consequences for industry and consumers. We know that, to the firms affected, it does not actually much matter where particular regulatory initiatives originate. What matters is the cumulative cost and strain placed on management teams to cope with the aggregate impact.
Where it is within the FSA's discretion to do so, we continue to be concerned to reduce regulation where its existence is not matched by its benefits. Most recently, this has involved our suggestions for removing prescriptive requirements in the areas of individual authorisation, training and competence and anti-money laundering in favour of a more, but not exclusively, principles-based approach. And early next year, our cost of regulation study will enable us to focus on other areas where the costs of the regime may not necessarily be justified by the benefits.
There is a clear shared interest between regulator and regulated in achieving a regime pitched at the right level. We need the help of the industry in defining that level. That's why I have challenged the industry to also come forward with views on the areas which could benefit from re examination. I am pleased that the Association of British Insurers, for example, is responding with what promises to be a thoughtful and constructive analysis of how regulation might evolve to the benefit both of the industry and consumers. I hope that this will also examine the role that the industry too must play in delivering a more competitive retail financial services market. I repeat my encouragement for others to take a similarly constructive approach.
Both sides have much to gain from this sort of constructive engagement. We will get better regulation. But there will also be a wider benefit. Too often we overlook the common interests of those who provide financial services and of those who have the task of regulating financial services. Too much of the comment on the relationship between regulator and regulatee represents it as an essentially adversarial relationship. The comment concentrates on enforcement – although enforcement is a small part of the regulatory relationship. The central contention that lies behind much of this comment – that regulation by its nature is and must be bad – is a gross oversimplification. There are enormous advantages, for both practitioners in and customers of markets, for markets having rules – indeed markets cannot exist without rules – it is the rules which define the market. There are great advantages, for both counterparties and customers, in knowing that there are capital requirements which mean that banks, insurance companies and securities firms have adequate capital. In short, there are enormous advantages for all of us in living in a society under the rule of law, and not living a Hobbesian life "nasty, brutish and short".
We as a regulator are conscious of the need for regulation to be confined to actions which the market will not provide itself; and to be confined to actions which are cost effective. We are keen to enlist the industry's help in defining this area better. But we are also keen, as part of these discussions, to encourage a constructive engagement on the reality of regulation which goes beyond what is too often a simplistic adversarial model. We all have much to gain from this.
Let me now discuss two further issues which will shape the future of the financial services industry. The principal response to these issues will of course rightly come from the industry itself. But it will I hope be helpful if I indicate how we at the FSA, with the industry and other parts of government, intend to respond to these issues.
First, I should start with a challenge of a special nature. It is one which we face every day, and which the tragic events of 7 and 21 July this year have made us all more conscious of – the threat of terrorist activity, and its potential to disrupt financial markets. The City stood up well to the test of 7 July: information flowed smoothly between institutions, the FSA, the Bank of England and the Treasury; back up arrangements, when they had to be used, worked; markets operated without interruption, and accommodated high levels of trading. But we should not be lulled into any complacency: 7 July, for all the heartbreak of more than 50 people murdered and still more maimed, was not an extreme, or even a very taxing, test of financial stability. It was neither aimed at, nor did it have a major impact on, the financial services sector. We cannot count on any future attack being of this nature. It is therefore important we learn lessons from 7 July, and apply those lessons to circumstances which can easily be envisaged and which would constitute a much more severe test.
The principal responsibility lies with the firms and exchanges themselves, to establish and to test – repeatedly – the necessary back up arrangements. But we at the FSA, with the Bank of England and the Treasury, will play our part in three ways: first by ensuring that the three of us individually and collectively are well prepared to respond to disruption; second through identifying and promoting high standards of business continuity planning among regulated firms; and third by strengthening the ability of key participants in the financial markets to co ordinate their responses to disruption through the ambitious programme of annual market-wide scenario exercises we instituted last year.
Dealing with the terrorist threat is to deal with a negative challenge. Let me turn to a different set of challenges, namely the international challenges. Now by this I do not mean the competitive dimension of non British firms competing with British financial institutions, nor that of London as an international capital market centre being challenged by other centres. On both these tests, the UK is doing well. But there is a general set of challenges arising from the increased cross border nature of the financial services sector – a trend we expect to continue.
In this international context, there are two particular initiatives which we at the FSA seek to advance. The first is to ensure that the principle of risk based regulation is adopted when international regulatory initiatives are contemplated, so that there is an obligation on the institution proposing an initiative to first identify and then quantify both the benefits and the costs. The FSA, by conviction and by law, is committed to this in practice. We are keen that this principle is adopted and turned into practice both in Europe and more generally. We support Commissioner McCreevy in his determination to adopt analysis of the costs and benefits of new proposals, and will, with the select but growing band of financial regulators in Europe who share our beliefs, seek to make this the norm. If we succeed, there will be an important implication for the speed with which new initiatives can be introduced. Analysis of costs and benefits, if done properly, cannot be rushed. To incorporate meaningful impact assessments of new initiatives will take time, since – to be meaningful – the assessment would have to cover not only the original Commission initiative, but amendments to the original proposal as it is subject to negotiation with both the Council of Ministers and the European Parliament. It should also assess the impact of detailed implementation measures as they emerge from the Lamfalussy Committees.
This will inevitably mean that the process will take longer – and no bad thing either. A longer process, which produces better results, is justified in itself. And a longer process, which allows the industry adequate time to plan for compliance with the new regulations, so that the transitional costs of any new measure can be contained and the risks reduced, has wider advantages. Those who face a rapid introduction of a measure, the Market in Financial Instruments Directive, which has been subject to no analysis of costs and benefits, and whose implementation costs are substantial, will require no persuasion of how much would be gained if Commissioner McCreevy succeeds.
I should add that the FSA is working to spread the gospel of risk based regulation beyond Europe. I am glad to say that IOSCO has at our initiative started considering how to apply risk based approaches. There is much to be gained if we can make this a discipline on all regulatory initiatives, whether Commission, IOSCO, Basel Committee or IASB.
There is another challenge posed by cross border firms. We at the FSA are faced with the task of regulating financial services firms which operate in many countries – and therefore have regulatory burdens not only in the UK. We are determined to devise ways of co operating with other national regulators in a way which both enables each regulator to do this job given to it by its legislature, and also lightens as much as possible the regulatory burden which financial service companies have to support. The growing number of firms that operate across Europe – and indeed across the world – are rightly critical of the fact that they face overlapping and duplicative demands from a multiplicity of national regulations. This has significant implications for their costs and distracts them from their core business.
There are some who argue that the lightening of regulatory burden can be achieved simply, by vesting regulatory responsibility in the hands of a single national or ‘lead’ regulator for each firm or, more radically still, passing it to some sort of pan-European single regulator. I do not share this belief: the legal, political and economic realities are more complex than this simple solution would suggest, or would accommodate. But I do believe that the problem faced by our major banks, securities houses and investment managers, of multiple regulation in very many countries is one which we as regulators must help solve – with practical solutions.
We at the FSA are working closely with other major regulators to devise ways of pooling knowledge and developing common approaches which will reduce the burden for those major international companies. The international colleges of regulators we are creating will I believe provide a useful development for both firms and regulators. It is a contribution in an international context to what we seek to do in all our activities, namely to avoid unnecessary burden on those we regulate.
My Lord Mayor, there are many challenges which the financial services industry and the FSA face. I have indicated our response to these challenges – all designed to advance the security and the continuing good health of the industry, and all based on the condition that efficient, orderly and fair markets are the best means of serving both customers and providers of financial services. I am confident that the industry will respond to these – and other – challenges with the same flexibility which it has always displayed, never more so than in the sometimes turbulent, always dynamic, two decades since Big Bang.
One common feature of this period has been the unstinting support and worldwide advocacy which you, and your predecessors in office, have given to the City of London, and therefore to the whole of the British financial services sector. This evening is an occasion to thank you, and the Lady Mayoress, for all that you have done in your year in office.