The road to better regulation
Speech by Andrew M. Whittaker, Director of the General Counsel Division, FSA
Financial Services Skills Council inaugural conference
14 October 2005
Introduction
I am pleased to take part in the first conference of the Financial Services Skills Council here at the QE2 Conference Centre. I very much support the work of the Skills Council in developing skills in the financial services industry. And it is right that, in the title of this conference, you immediately link skills to productivity, for improving skills is a key way to improve productivity.
The FSA's Commitment to Better Regulation
The title of my presentation today is: 'The Road to Better Regulation'. The FSA as an organisation is committed to regulating better. Our responsibilities and statutory objectives – the what and why of regulation - are set by Parliament. But in very large measure it is left to us to determine how we should regulate. That, and its contribution to productivity, is the focus of my presentation today.
Better regulation is not simply a concern within the financial services sector. Following the Hampton and Arculus reports, the Government has committed itself to issuing a Better Regulation Bill, and has a better regulation initiative looking at the costs of regulation across the whole of the UK.
In parallel, Charlie McCreevey, the European Commissioner for internal market and services, set out in a speech on 24 January this year why in his view 'less is more' in Community legislation. And as recently as Tuesday this week, the Financial Times ran a headline that Gordon Brown would be urging cuts in EU financial services red tape. So there is a clear recognition at the political level that regulatory costs can impact on productivity.
Yet in parallel, the problems which regulation is designed to tackle remain with us. We continue to rely on the integrity of the financial system to make savings for the future. We continue to rely on the financial soundness of individual institutions. We recognise the massive loss individuals can suffer as a result of ill-informed financial decisions. How can we tackle these issues, delivering worthwhile outcomes, while remaining sensitive to costs and their impact on productivity?
Our answer to this question is that we should aim to be:
- risk-based;
- cost-sensitive; and
- principles-based.
Let us start with, risk-based. No regulator can eliminate all risk. First because risk is inherently connected to reward. Second, because risk is even more inherently part of life. Third, and more mundanely, because regulatory resource is limited. So any good regulator must focus resource on the areas of highest risk. In our case, we assess risk on the basis of a system which looks at both impact and probability, aiming to focus on those risks which we assess as both high impact and high probability. We do this both to inform the allocation of our own resources, and, through cost-benefit analysis, to look at where we would be justified in imposing costs on the industry.
That takes me to the second key element to which we attach importance, the need to be sensitive to the costs we impose on others. We do this primarily through cost-benefit analysis, which must accompany proposals for new rules. Cost benefit analysis is an imprecise science, both because costs can vary from their estimates, and because benefits are dependent on many variables, not least the effectiveness of the regulation put in place. So we aim to back up the cost-benefit analysis we do when introducing rules with targeted consideration, after the event, of what the costs and benefits actually are.
Finally, we aim to be principles-based. By this, we mean relying on general principles, rather than detailed rules, where we can. This has two advantages. The first is that it provides flexibility for firms to decide how to comply, so long as they deliver the result. The second is that in our view it provides better quality regulation than simply a mass of detailed rules, of the kind so effectively avoided in the Enron case.
Principles v. Rules
As part of this principles-based approach, we establish general principles to encapsulate what we believe is important in a readily understood and remembered form. Sometimes, we will back these by detailed rules, where we consider that the principle alone does not give sufficient clarity as to the standards we expect. Sometimes, we will leave the principles to stand alone, and stand back from writing detailed rules, unless it is clear that this is needed. Where we do so, we will if necessary be prepared to take enforcement action on the basis of the principle alone, so long as the action being disciplined could reasonably be predicted to be in breach of the principle. We also use guidance to supplement the principles, where we think that this would be helpful in setting out the standards we expect, or in assisting firms to decide what action they need to take to meet the necessary standard.
Let me give some examples. We have set eleven general principles for firms we regulate, at a high level of generality. Principle 1, for example, requires a firm to 'observe high standards of integrity and fair dealing'. Similarly, we have set a set of six 'Listing principles' for listed companies. We have regularly taken enforcement action for breach of principles, as well as for breach of detailed rules. We have stood back from making detailed rules in areas which are not well-suited to them, such as corporate finance. Our 'treating customers fairly' initiative encourages firms by a variety of ways other than detailed rules to treat customers fairly. Finally, we have supplemented detailed rules on softing and unbundling with more general rules, backed by industry guidance.
But we need to recognise that, even under a principles-based approach, there will be times when we continue to use detailed rules. We will need to do so, for example, in order to implement detailed directive requirements. We may choose to do so to set standardised approaches to allow comparability (eg. on calculation of APRs). We will sometimes need to do so to allow implementation through electronic systems or on another basis standardised across a wide group. We may do so to require specific conduct across a whole class of people, for example to ensure a level playing field. And we may do so because we want to achieve a specific linkage with some other requirement, for example so that stabilisation rules provide a safe harbour from the market manipulation offence.
In addition to taking this approach as between guidance and detailed rules, we will also consider alternatives to rules, such as relying on existing standards, issuing guidance, exhortations or alerts, supplementing the standards we set with 'how to comply' guidance issued by trade associations, and use of own initiative variations of permission to set particular standards for particular firms.
Impact of the European Union
But, you may say, isn't the idea of principles-based regulation unrealistic given the extent to which UK financial regulation is set in Europe, in the form of detailed directives? And surely, anyway, the UK traditionally over-implements directives, gold-plating directive requirements or adding 'super-equivalent' requirements on top? What are the options open for implementing directives, and how can they best be used to secure better regulation?
The reality is that, in the UK at least, most directives are not implemented on a green field site, but against the background of existing regulation, often extending in some respects more widely than the directive. So the conundrum is how to balance existing standards with the new Community level standards, which may be higher in some cases and lower in others, and whether to do this only for business covered by the directive, or also for closely related business done by the same firms, in the interests of allowing them to operate standard systems for both product lines.
One traditional approach which has been adopted in the UK has been 'minimum change implementation', where we make only those changes to our pre-existing rules which are strictly required by the directive. At first sight, making the minimum change to implement the directive is appealing and defensible, because all that is being done is what the directive requires. In practice, it can often result in an unhappy combination of two different sets of requirements which is much more complex than it needs to be.
We are, therefore, much more commonly now adopting what might be called 'Community standard implementation', which means going over to the community standard in a particular area, in place of, rather than in addition to, any pre-existing UK rules. To achieve this, we adopt an approach of 'intelligent copy-out', using the language of the Community rule itself. We take the position that any rules going beyond the community standard should be independently justified in their own right. To assist consultees, we therefore identify which proposed rules simply set the Community standard, and which are additional requirements which we propose should accompany them.
To give you an example of where this has been done in practice, we recently reviewed our rules for listing of securities. As part of this, we used intelligent copy-out to implement three European directives. Where there was widespread support, we kept in addition some aspects of the UK regime which went beyond the directive requirements. But we still managed to cut the full text of the listing rules by some 40%.
Wider Better Regulation Initiatives
Our strategy for applying better regulation to our Handbook is, in general, to take an opportunistic approach, focusing on those areas which need to be changed anyway, in order to implement Community requirements, or because they are closely related to Community requirements which we will need to change. So our implementation of the Markets in Financial Instruments Directive will take the opportunity to drop existing conduct of business rules which are made redundant by the new directive requirements. Similarly, we are reviewing our financial promotions regime, to focus it around the high-level requirement to be clear, fair, and not misleading. and we have a 'conduct of business simplification project' designed to simplify those parts of our conduct of business rules which are not directly impacted by MiFID, but where it may make sense for similar rules to apply.
Handbook Review Project
But we are not being purely opportunistic. In addition, we have identified some areas for targeted deregulation in our Handbook Review project. As part of this, we set out our proposals in July this year for change in three areas. In the first area, we proposed deleting from our Handbook the entire money-laundering sourcebook, and replacing it with strengthened rules requiring firms to have their own risk-based systems and controls against money-laundering. This does not mean that we are going soft on money-laundering, but that we think that it is better to focus on a risk-based approach to identifying likely cases of actual money-laundering, in place of emphasis on account-opening procedures, which will in future be governed by the existing Government regulations and accompanying industry guidance.
Second, we proposed a series of changes to our approved persons regime. Under this regime, in addition to regulating firms, we also require approval of some individuals within firms. We did not propose to make any change affecting the senior management of firms, or those who deal direct with members of the public. But we suggested that those who deal only with other professionals should no longer need our approval.
Third, in parallel with this, we proposed to liberalise the training and competence arrangements for individuals who are neither senior management, nor in contact with members of the public. These proposals would allow firms to decide for themselves how best to ensure that these staff have the skills needed for their jobs. It is in this area, perhaps, that our proposals most directly impinge on the work of the Financial Services Skills Council. But I should emphasis that this is not because we do not value training and qualification. It is because, as between professionals, this might be something that can be adequately addressed by firms themselves, supported by training providers and accreditation processes, rather than requiring detailed intervention by the regulator.
These proposals remain open for consultation until the end of October. The same consultation paper also asks people to let us know if there are other areas of our Handbook where in their view the benefits do not justify the cost. I hope that you will take the opportunity to respond to this consultation, so that we can ensure that the restrictions and costs we impose on your industry are fully justified. Only on that basis can we ensure that better regulation contributes to better productivity.