Translating Europe into the UK
Speech by Callum McCarthy, Chairman, FSA
British Bankers' Association 9th Annual Supervision Conference
18 October 2005
There is of course a whole range of major FSA initiatives which impact BBA members: treating customers fairly and our work on financial capability are two obvious and important issues. What I plan to do this morning is to set out the position which we at the FSA believe faces the banking industry; to consider the special position of the UK within the EU in relation to financial services; to review two particular European initiatives; and to draw some general conclusions about aspects of how European initiatives should be dealt with by British financial institutions and by the FSA. This is quite a heavy agenda.
The British banking industry today
Let me start with the position of the British banking industry today. If I had to summarise this position in a phrase, it would be "as good as it will get" – a phrase which has both reassuring, but equally some concerning, implications. The good news is the present strength of banks: a high level of profitability, strong levels of capital, and risk management which has clearly been substantially improved over the last decade. The bad news is the existence of a series of factors which are likely to challenge each of these favourable indicators, and which banks will disregard at their peril. Let me set out some of these.
First, we live in a world economy characterised by substantial imbalances, notably between a region – SE Asia in general, China in particular – of extraordinary, by historic standards, levels of savings, but low consumption, and a nation – the US – where personal saving has effectively disappeared, but whose consumption remains a main driver for world economic growth. There is a universal agreement that these imbalances cannot continue indefinitely, still less continue to grow as they are at present; yet there is no consensus as to the steps to be taken to manage an orderly unwinding of those imbalances, and a consequent danger that the corrections, the necessity for which is agreed, will be more abrupt and more damaging than is desirable. The imbalances are marked by levels of liquidity which have depressed credit spreads: it is hard to believe that the credit spreads for either sovereign risk or for corporate risk adequately reflect the true difference between less risky and greater risk nations or firms. In due course, this will need correcting.
The second effect of the present levels of world liquidity has been what normally falls under the heading of "the search for yield" – the effort to create instruments with risk characteristics and volatility which justify a higher yield. I should make clear that the FSA is in no way opposed to the development of such instruments as means of disaggregating credit risk into more differentiated classes of risk. Indeed, we see advantages in enabling risk to be disaggregated and distributed in new forms – provided that those involved, both as issuers and as investors, know and properly understand the risks they are incurring; and provided that the systems needed to carry through these transactions are up to the task.
There is a cause for concern on both fronts. I am far from clear that all those who invest in the more complex credit derivative instruments properly understand the risks which they are assuming when investing in, for example, a tranche of a collateralised debt obligation, still less in what is called a CDO squared. This is not only a problem for the investor. It is also a problem for the issuer. The concept of caveat emptor holds sway in the wholesale market because the assumption holds sway that the vendor and the purchaser are making a transaction which occurs between parties of equivalent knowledge and competence. But as instruments become increasingly complex, the assumption that trades are taking place between counterparties of equal skill becomes tested, and the responsibility placed upon the vendor to assess the suitability of the investor becomes more important. There have already been a number of cases where the inability of an issuer to demonstrate that it had properly explained the risks involved in complex credit derivative to the investor has led to substantial damages awarded against the issuer. Managing this risk will become increasingly important to banks which originate and distribute these products. Treating customers fairly is a set of principles which applies in both retail and wholesale markets.
Nor can we have confidence that the systems needed to carry through transactions have grown at a pace which matches the growth in those transactions. Indeed, we know that they have not: in the credit derivatives market, we have seen a huge growth in outstanding confirmations as back office investment has not kept pace with the growth of the front office. This has been exacerbated by the growth in the assignment of trades by hedge funds without obtaining the consent of the original counterparty – such that frims have to 'fly blind' in not knowing who their counterparty exposures are to for significant periods, thus creating legal uncertainty with regard to default events. This has been exacerbated by the growth in the assignment of trades by hedge funds without obtaining the consent of the original counterparty. We at the FSA are much concerned to see the position improve as soon as possible. To this end, we wrote in February to the CEOs of the firms concerned, bringing to their attention both the problem and the need to solve it. We surveyed the major trading firms over the summer regarding the growth of trade volumes and the level of outstanding confirmations. The results show that the volume of trading continued to rise rapidly in the first half of the year but that the volume of outstanding confirms grew even more rapidly. We have subsequently been working closely with the Federal Reserve Bank of New York to advance this by establishing with major banks and investment banks the actions they will take to first reduce and then eliminate the number of confirmation delays, and to establish an agreed methodology for assignments. For both, we need a plan, so that we can identify progress and take action if necessary, if progress is not being made. We are encouraged by the initial reply, received last week, from the 14 banks which attended the 15 September meeting in New York. We now need to see the actions set out in that reply translated into practice. We, like the New York Fed and other regulators, stand ready to help in that process. The present inadequacy of systems simply cannot be allowed to continue.
There are other challenges to the banking sector which are obvious: the likelihood of higher interest rates in the US; the response in Europe to the inflationary effects of continuing high oil and gas prices; the possibility of significant change to the path of property prices; the managerial challenge of dealing with a range of accounting, corporate governance and regulating initiatives – IFRS, IAS 39, Sarbanes-Oxley, the FSAP agenda in general, CRD and MIFID in particular: the array of initials is in itself daunting, and the pressures on management very real.
So, for all these reasons, we view the present position for banks being "as good as it gets". The prospects are for a future where less benign conditions than have been experienced recently may prevail. There is a growing chance that the improved risk management of banks will be tested, and use made of the banks' strong capital. This should be a time for preparation.
UK banks within the EU
The forces which I have described apply to banks across Europe, if not across the world as a whole. It is worth looking at the special features of British banks within Europe; and of the British financial market within Europe.
The most notable feature of British banks is their relative success. The return on equity of the top (by size) four British banks in 2004 averaged 17.2%; whilst the five largest Continental European banks averaged 11%. The success is also reflected in scale: amongst the global superleague British banks account for 5 of the world's top 20 by market capitalisation, while there are 7 in the rest of Europe, 6 in America, and the remaining 2 are Japanese.
This success owes nothing to government protection. The Colbertian tradition of seeking to create national champions has been conspicuously absent in the UK – at least since the days, now far off (both temporally and policy-wise), of industrial planning in the Labour government before the Thatcher administration: economic patriotism in the UK has taken the form of seeking to provide the economic, social and regulatory environment which enables banks which choose to operate here to prosper if they are competitive, irrespective of the nationality of their shareholders or of their management. I can say without any qualification that we at the FSA treat all banks on an equal footing, without regard to nationality. It is a source of great pleasure that this policy has been accompanied by, and I would claim has contributed to, the development of a number of world class British-based banks, whose success is based on their own competitiveness, and not on any degree of government subvention or protection.
A consequence of this is that London is, and is likely to remain for at least some appreciable time, the most international of capital market centres. The UK accounts for 60 per cent of primary international bond trading, and 70 per cent of secondary. There are more companies listed on the London Stock Exchange than on either the New York or Tokyo exchanges. In the OTC derivatives market, the UK accounts for over 40 per cent of global trade, compared with 24 per cent for the US, 10 per cent for France, and 3 per cent for Germany. Our fund management and insurance industries are both the third largest in the world, behind those of the US and Japan.
London is both home to the world headquarters of the major British banks, and the host to major trading activities of both US and Continental European banks. This has very significant implications for the FSA as regulator. It makes us particularly aware of the issues involved in regulating internationally active banks; how to discharge our responsibilities as the home regulator for British-based institutions which also are subject to host regulation in literally a host of countries; or how, as the co-ordinator for the purposes of the Financial Groups Directive for almost all the main US banks and investment banks, to find ways of working closely and productively with both the main US supervisor – one of the Federal Reserve Banks, SEC or OCC – and with other bank regulators across the EU.
In either direction, our aim is the same: to find effective and practical ways of discharging our responsibilities in a manner which limits the regulatory demands on the international bank as much as possible in terms of management resources and costs. Significant progress has been made in establishing regulatory colleges for some of the most important banks: thus for UBS and Credit Suisse we are members of a small group of regulators led by the Swiss Federal Banking Commission which meet regularly to compare information and assessment; and, for a number of international groups whose headquarters are in the UK, including HSBC, RBS and Standard Chartered, we have established college arrangements to facilitate the exchange of information between us and the overseas regulators. To date these have focussed on overseeing these groups' Basel implementation plans. We see such arrangements as invaluable and would hope that they will be extended and broadened going forward.
There is a further implication for the FSA – and, I would add, for the British industry – of London's position as the most important wholesale market in Europe. That is the responsibility for both regulator and financial services industry to make clear the effects of European initiatives on the activities of wholesale firms and of wholesale markets, about which we jointly are likely to have particularly informed and detailed knowledge. At all stages, from initial discussion of a potential initiative to the decisions on detailed implementation of a Directive, the FSA and the financial services industry needs to be heavily engaged – with considerable resource implications, not least for senior staff. These demands need repeated assessment, to ensure we are influencing the debate in a manner commensurate with the importance of the British market.
MiFID and CRD
Against that background, let me now consider two from the array of initials I quoted to you a moment ago – MiFID and the CRD.
MiFID
First MiFID. It is hard to exaggerate the pervasive effect which MiFID will exert over financial markets and financial institutions. It will reshape important elements of equity markets trading; it will introduce new client classifications, notably in relation to wholesale markets; it revises the rules for conflicts of interest; it introduces a new approach to best execution; it will limit outsourcing; and it sets out a new definition of "investment advice". So no-one should be in doubt as to the importance of the changes which are due to be brought in on a present timetable which requires the FSA to have made all our rules by October 2006 – 12 months from now – and firms to implement these by April 2007.
This is not the occasion to discuss the content of those rules. Instead, I would like to discuss two elements – both problematic – of the process which has led to the present stage of MIFID implementation. The first is the timetable. MiFID is the most significant Directive so far to be developed under the Lamfalussy process, in which the Level 2 implementing measures are to be prepared and adopted following submission of advice by the relevant Level 3 committee – CESR. For MiFID, the Level 2 provision will be absolutely crucial in defining, for example, what activities should be subject to restrictions on outsourcing, and if so what restrictions? Or what information should be given to retail clients? Or how should derivatives be defined? CESR, against a tight timetable imposed on it – a timetable of such tightness that it precluded CESR from carrying out cost:benefit analysis of important implementation choices – delivered the last tranche of its advice to the Commission back in April, and reflecting both the importance and the complexity of the issues involved, consideration of key Level 2 issues still continues within the European Securities Committee, which comprises the European finance ministries with the Commission in the chair. It now seems that we will not have sight of the Commission's recommended package - reflecting lengthy debate in the European Securities Committee - much before the end of next month. And it could well be April next year before the Level 2 measures are adopted in final form. Given the wide scope of MiFID and the fact that all the players have been on something of a Lamfalussy learning curve, it is perhaps understandable that the process is proving so long drawn-out. But the unwelcome, and indeed unsatisfactory result is to put renewed pressure in the timetable.
From the FSA we will do all we can to make the timetable pressures more manageable. To help give focus to firms' preparatory efforts, pending publication of the Commission's recommendations and then of our CP on implementation, we plan to publish later this month something of a "prospectus" on what MiFID is likely to bring. Drawn up in consultation with trade associations, it will highlight the key areas of change - particularly those likely to carry the greatest costs and systems challenges - to help boards make the scoping decisions necessary as they draw up their budgets for the coming financial year.
I should pay tribute to the quality of the close collaborative working between the FSA and the industry through the successive stages of the Level 2 process. Both through the CESR Advice process and subsequently in backing HM Treasury through the ESC discussions we have had good thoughtful input from the industry, encouraged by a pretty much open door policy in which we and the Treasury have sought to take you into our confidence. That confidence has been respected despite all the frustrations and pressures and that is very much to the industry's credit. But the timing of the process leaves much to be desired, with the benefits of the 12 months extension of the MiFID timetable, as proposed by Charles McCreevy back in January, now severely eroded.
The second aspect of the MiFID process on which I must comment is the lack of any cost:benefit analysis. There have been no estimates of the costs and benefits of MiFID at the EU level. None was made for the original proposal, nor was any produced during the subsequent negotiations. This has been deeply unsatisfactory, and it is encouraging that the Commission, under Charles McCreevy's leadership, and the Council have now clearly committed to undertake impact analysis from the earliest stage for future Directives. The FSA has a statutory obligation to produce a cost-benefit analysis of any new rules, including those which we must introduce to implement Directives. We continue to work closely with industry stakeholders to establish as clearly as we can just what the costs and benefits of MiFID are likely to be. In our consultation on UK implementation, which we still aim to publish by the end of the year, provided the Level 2 recommendations are published in time, we will give a straight account of these UK costs and benefits, reflecting the work we are doing with industry (and where we again appreciate your assistance).
From our preliminary discussions with firms, the initial implementation costs in the UK 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. Even in those areas where the substantive requirements prevailing in the UK are not hugely changed by MiFID, the changes to the detailed form of the standards can be costly to deliver. We recognise that many firms are concerned about the possible scale of MiFID's costs- concerns which we share. It is far from clear that the benefits will outweigh the costs for the UK.
CRD
Let me turn to the second international initiative which will fundamentally affect banks, namely the Capital Requirements Directive, the EU implementation of the global agreement on capital requirements for banks more generally known and loved by us all as Basel II.
It is worth pausing for a moment, and remembering what the bigger picture aims of the CRD and the Basel Framework. It is sometimes easy to lose sight of this. I started this talk by referring to the improvements made by banks to their risk management. One of the key achievements of the revised Framework and the CRD is to allow for the recognition of the significant improvements that banks have made in their risk management processes in the calculation of regulatory capital requirements. We and firms, particularly those that are adopting the more advanced approaches available under the CRD, welcome this step forward.
Let me set out our approach to implementing the CRD. First, we recognise the significant cost and efforts that are involved in the implementation of the CRD. And that has underpinned our overall approach to implementation – in that we aim to be pragmatic and proportionate. So, for example, to give firms a reasonable basis for planning we have defined an interim 'policy baseline' which they can use if they choose to apply for IRB or AMA status in this calendar year. In the same vein, we recognise that firms may have a need to proceed now with fit-for-purpose solutions reflecting the current limitations of data and techniques. Where we agree it is reasonable for them to proceed in that way then we shall want to see necessary further improvements to firms' rating systems in due course.
This pragmatic approach has to be applied consistently while ensuring that the move to a more model-focused regime is done in such a way that maintains high prudential standards. There are therefore some key areas that we will focus on as part of our review process of the new regime. For instance, we will look to gain assurance that firms themselves have confidence in the outputs of their credit and operational risk models. This is the basis of the so called 'use test'. The more we can see that a firm is willing to trust and 'use' the model outputs for some key elements of internal decisions and processes, such as setting credit limits, the more confident we will be in allowing the models to be used as the basis of regulatory capital decisions. We therefore expect to see model estimates play an essential role in decision making and risk management.
That point obviously then has clear implications for the role that senior executives need to play both in the oversight of CRD implementation, and also, and even more importantly, in the operation of the systems once they have been approved. We clearly do not expect all senior executives to have a detailed and in depth knowledge of how the models have been built. But we do expect a level of understanding sufficient to provide adequate challenge as modelling systems are developed and also to ensure proper monitoring of the effectiveness of those systems in operation.
We expect firms, in their self assessment work, to acknowledge any shortcomings and to adopt a conservative approach while further improvements are made. This applies to both qualitative and quantitative dimensions, particularly where features have a significant impact on the overall regulatory capital figures. We are not interested in implementing the CRD such that a pre-agreed number of firms can achieve IRB or AMA status. The waiver process will not be a formality. If after due and careful consideration we consider that firms have not made sufficient progress in key areas, we will not grant them waivers. You can therefore expect relationship managers and our Risk Review Department to focus and challenge these areas of the new regime with a good degree of rigour.
The CRD impacts on a wide population of firms – not just those going for advanced approaches under Pillar One. As we get closer to the implementation date I would encourage all firms to start thinking now about how the new rules will affect them. For example we have flagged in our September Feedback Statement that (with only limited exceptions) we will not be Grandfathering any existing waivers or concessions in areas where the CRD is replacing our existing rules. And our proposals for reporting requirements will be issued for consultation in late February. Firms should start thinking now about whether these changes will affect them and if they need to take any action.
Implementation of the CRD will also, of course, bring the Pillar Two regime into effect. I encourage all firms covered by the CRD to start thinking now about how they will meet the requirements on them to perform their own Internal Capital Adequacy Assessment Process (ICAAP), so that they are ready when their supervisors perform the supervisory review.
In terms of both timetable and policy decisions, we are better positioned on the CRD than on MiFID. The European Parliament approved the CRD at the end of September, and a firm, albeit deferred, timetable has been published by the US authorities. I recognise that EU banks with significant US operations – like US banks with significant EU operations – will face problems from different timetables, which we will wish to see eased or solved if possible. The challenge for all of us is to use the time until January 2007 – a touch over 300 working days – effectively.
Implications for EU initiatives
I have described in some detail where we stand on two of the most important EU initiatives, MiFID and the CRD. Let me suggest some general lessons for the EU process, for the FSA, and for the financial services sector.
First, for the Commission, Ministers from Member States and the European Parliament. The Financial Services Action Plan provides some examples of how, without sufficient discipline, an initiatives designed to improve Europe's competitiveness can lead to a rush to introduce legislation whose main effect is to promote further and more costly regulation. To prevent this happening, we need to create a European framework of discipline which challenges the assumption that legislative and regulatory response is the solution to every, most or even any problem. Instead, regulation should be reserved for those instances when the market is manifestly failing, and when the costs of regulatory action do not outweigh the benefits. We therefore welcome Commissioner McCreevy's determination, set out in his recent Green Paper, to require impact assessments – which should cover not only the Commission's proposals, but also amendments from either Ministers or the European Parliaments as well as the work of the Lamfalussy committees. If carried out properly, this would be a major force for good in shaping EU legislation. It would have implications for the timing of initiatives. We would have fewer initiatives, and they would take longer to come into force – but they would be much better. It is a trade-off much to be desired.
Second, for the FSA, we need to implement EU legislation with care: avoiding going beyond the terms of a Directive only when – as does occur, for example in relation to a particular aspect of the Market Abuse Directive – there is compelling case; striking the correct balance between the simplicity on the one hand of direct "copy out" of the EU Directives and the simplicity on the other of seeking to implement by principles rather than specific rules; and avoiding the pursuit of legal and logical certainty if less elaborate but cost-effective solutions will suffice. And, separately we need to support those – in the Commission, and in other financial regulators in the EU – who wish to implement the principles of cost:benefit analysis, so that the British and FSA voice is not alone.
Last, for the financial services sector. It is essential that you remain involved in the EU process, to ensure that the realities of Europe's most successful wholesale market are recognised. But it is important that this is done in a way which makes clear that, and why, a successful wholesale market is good for Europe as a whole, not simply for London, or the UK. I hope that it will not just be the BBA, but equally the US and German banks to which London is so important as a trading centre, who will bring these realities to the notice of decision-makers.
I warned that this was a heavy agenda. I hope it has given scope for questions.