Keynote address on regulatory cooperation
Speech by Hector Sants, Managing Director, Wholesale & Institutional Markets, FSA
SHCOG / SIA Cross Borders Conference
15 November 2005
Good morning and thank you to SHCOG and the SIA for inviting me to speak to you today.
I would like to use this opportunity to discuss three main issues. First, I want to briefly cover the FSA's regulatory philosophy in order to set in context our approach to international regulatory co-operation. Second, I would like to say a few words about the extent and pervasiveness of international issues affecting the FSA's regulatory agenda. And thirdly, I would like to look at some of the more prominent trans-Atlantic issues affecting financial services regulation and how we are collaborating closely with US supervisors to take forward issues of mutual interest.
FSA regulatory philosophy
A lot of work has been undertaken by the FSA since its formation to articulate the purposes of regulation given the objectives we are set by the Financial Services and Markets Act. And we have looked equally closely at the most efficient means of achieving these objectives given that we have limited resources to set against the range of our responsibilities and the diversity of our regulated community. In doing this, we need to guard against the risk that we take successive micro decisions without considering what might result from a steady accretion of rules and decisions.
The first thing that all regulators need to remember is that while regulation should bring benefit, it is also is a source of cost to the financial sector. We are very mindful of this and determined to keep this cost to a minimum. In assessing the case for regulatory intervention, our starting point is to determine whether the market is able to deliver acceptable outcomes – or alternatively whether there is a significant market failure. Identifying whether or not there is a market failure is a first step – not a sufficient condition – in weighing up the case for regulation. Most markets operating in real-world conditions, including those for which we have oversight, will exhibit some form of market failure. As Callum McCarthy, the FSA chairman, has previously outlined [Reuters speech Sept 2004] the correct test must go beyond this.
For the FSA to consider regulatory intervention, there must be a market failure that relates to the objectives of financial regulation and the likelihood that such intervention will provide a net benefit. We have to assess the costs of action and the probability that we might fail to achieve our target outcome. Even where there is a plausible case for regulatory intervention, there is often more than one option available to us. It is a mistake to imagine that regulatory intervention always means the introduction of new rules. It doesn't – media alerts, communication, collaboration with the industry, and consumer education are equally valid and indeed in many ways preferable ways of solving problems. We are required to undertake cost-benefit analysis when we introduce new rules but we aim to make continuous use of a similar sort of calculus – albeit more informally – in deciding on the most proportionate means of achieving our objectives.
Closely linked to our aim of being a market-oriented regulator, is our determination to be risk-based. We have an almost infinite number of potential calls on our resources, but of course these are limited. We therefore aim to focus our resources where they are most effective, in terms of the amount of attention we pay to individual firms and markets or to market-wide issues. This risk-based approach applies equally to enforcement where we aim to be strategic to ensure that our limited enforcement resources achieve the maximum possible effect. And given the competing claims on our resources, we need to prioritise these cases so that we concentrate on those that present the greatest threats to consumer welfare or market confidence.
At the same time, we have a responsibility to look for ways in which we can maximise the effectiveness of our resources, achieving the broadest oversight of the risk environment. There are various ways in which we do this. One is the use of our Arrow framework to form risk-based firm assessments that are used to set the degree of regulatory attention that we give to financial institutions. Another way is by maintaining a continuing dialogue with the regulated community to understand better the risks inherent in particular sectors and to make evidence-based policy-making a reality. A third approach is our collaboration with overseas regulators, bilaterally and through international committees, to develop common solutions to cross-border issues. And it is on this aspect that I should like to focus for the remainder of this session.
Drivers of regulatory change: international aspects
International co-operation and policy work is a significant call on the time of many staff at the FSA – and particularly for senior management. There are good reasons why this should be so. First, there is the range and depth of overseas firms' participation in UK markets – something that should be readily apparent to members of this audience. One of the principles of good regulation embedded in FSMA is a requirement that the FSA should have regard to the international character of UK markets. Similarly, many UK-incorporated firms are participants in foreign markets, with all the opportunities and risks that this brings. And even for primarily domestic players, market connectivity ensures that they may have material exposures to international developments.
As regards policy development, the majority of changes to our Handbook in recent years have resulted from new requirements at the EU level, many intended to facilitate the Commission's Financial Services Action Plan. We have, for some time, been pressing the European Commission to adopt the kind of policy making disciplines that I described above. I am pleased to say that they have now accepted the need for these and will, for example, subject all new measures to an impact analysis. This should greatly improve the quality of European policy-making. We intend to scrutinise new proposals to ensure that they are delivering on this commitment and I would urge the industry to do likewise.
Looking ahead, both the Capital Requirements Directive and the Market in Financial Instruments Directive, to name two prominent cases, will ensure that a heavy EU-related implementation schedule will continue during 2006/2007. For those following these issues we will publish shortly our International Regulatory Outlook providing an overview of the EU and other external measures that will affect our stakeholders. We shall also be publishing a Planning for MiFID document designed to help firms get to grips with their planning for implementation despite the continuing debate over Level 2 measures.
Regulatory co-operation with the US
Turning now to the US dimension of our international work. The structure of regulation in the US is clearly rather different to the model the UK has adopted. The US authorities include several sector-focused regulatory bodies at the federal level, as well as various state regulators, who continue to play a prominent role, particularly in respect of insurance. This means that we have a number of important US interlocutors, including but by no means confined to: the Securities and Exchange Commission, the Federal Reserve Board, the Office of the Controller of the Currency, the Commodity Futures Trading Commission and the National Association of Insurance Commissioners. Given the importance of US and UK based markets and firms – and their propensity for innovation – it is essential that we have, and maintain, close links with the US regulatory community. And I am pleased to say that relations with our US counterparts are good, based as they are on mutual respect and a number of common goals even though we do from time-to-time approach these from rather different perspectives and traditions.
One long-standing feature of this co-operation is the extent to which we rely on the work of the Federal Reserve and the OCC in respect of the various US commercial banks operating in the UK. When the FSA authorises an overseas bank branch (e.g. Citibank) it is granting that authorisation to the whole entity and not just to the UK branch. For the FSA to seek to monitor and supervise every aspect of a US bank's global operations would be extremely resource intensive quite apart from being duplicative and raising difficult jurisdictional issues. We therefore work with the Federal Reserve and OCC to understand the risk profile and challenges facing US commercial banks operating here and we gain considerable reassurance from their role as lead regulators for these entities on a solo and consolidated basis. Our ability to rely on them is based on trust built up over a number of years. One traditional gap in our ability to place reliance on the US authorities has been the fact that the SEC did not undertake consolidated supervision for the major US investment banks. As we all know, they have now – with the introduction of the CSE regime – addressed this issue. This is a very welcome development which strengthens still further our ability to rely on the US regulators.
Consolidated supervision
A major task for the FSA during 2005 has been rolling-out the provisions of the Financial Groups Directive, which introduces an enhanced prudential regime for financial conglomerates operating in the EU. The FGD also amends the Banking Consolidation Directive to include requirements for EU regulators to assess whether banking and investment groups with non-EU parents are subject to equivalent consolidated supervision to that applied within the EU. If they are not, these firms may be subject 'alternative measures' – which could, for example, include the establishment of an EU holding company. The FGD also imposes requirements for consultation between EU supervisors and the home supervisor of financial conglomerates operating within the EU.
US firms of all kinds – commercial and investment banks, insurers and financial services conglomerates with non-financial parents are very active throughout Europe. This means that many European regulators have an interest in the operations of the FGD. But it has fallen to the FSA to be the 'coordinator' for almost all of the major firms, given the scale of their operations in the UK. That means that we have a central role in assessing whether the SEC meet the 'equivalence' standards in respect of their consolidated supervision of the major investment banks. We are well advanced in this demanding task, in respect of firms from the US and a range of other countries.
There are two aspects of the FGD that I want to mention here. The first is capital adequacy and the second is information exchange.
It is a core condition that a financial group needs to have enough capital to support its operations at a global level and that this capital must be readily available wherever in the group it is needed. The FGD reflects this view, together with the requirement that a single consolidated supervisor should be responsible for monitoring group-wide capital adequacy.
The SEC's new regime for the regulation of Consolidated Supervised Entities also reflects this key principle for the major US investment banking groups. Increased oversight of group-wide capital adequacy by the SEC is a major step in the direction of ensuring that firms have enough capital in a form that global regulators recognise and are able to rely on. This is one of the reasons that we welcome the CSE regime.
But the CSE requirements need to operate alongside the SEC's continuing 'net capital rule' requirements for the US broker dealers and in conjunction with group-wide liquidity arrangements. The principle that capital is available wherever it is needed in a group is a fundamental one that we cannot lose sight of.
The second area I would like to touch on is information exchange. The SEC has made it clear that they intend to leave most of the day-to-day regulation of the European activities of the major groups to the 'host' regulators concerned – the FSA and our European colleagues. We are broadly comfortable with that.
The FGD rightly recognises, however, that there needs to be free and effective communication among the regulators of groups subject to global consolidated supervision. Quite a bit of thought has been given recently to what that means in practice in respect of the US investment banking groups.
Let us be clear at the outset about what it does not mean. It does not mean that EU regulators will aim to interfere with the home state regulation. Neither does it mean that these 'host' regulators will routinely seek access to examination reports or any other highly sensitive material. There are rightly strict requirements governing the basis on which such information can be shared and no-one is suggesting that these should be weakened. More fundamentally, information exchange does not typically centre on this highly formal material. It tends to be about having a sensible and often informal dialogue with regulatory counterparts in pursuit of the information and assurances that we need to do our jobs.
In terms of what appropriate information sharing does mean, the principles are reasonably clear. In carrying out their 'host' state responsibilities, it is reasonable that EU regulators should have some access to the home regulator to be informed and to ask about relevant group-wide issues. Conversely, it is likely that in carrying out their host responsibilities, European regulators will uncover information that is relevant to the consolidated supervisor. Channels need to be established to allow such information to flow efficiently.
This is focusing minds in Europe on what effective arrangements should look like. It is clear that getting the balance of information flows right will require the establishment of some ground rules. We would, for example, only expect information to flow where it is relevant and material. Materiality in this context requires us to recognise that while the operations of firm X in an EU Member State may be quite modest in relation to X's total business, they may be highly material in the context of that Member State's financial market. We need to be sensitive to that. We also need to ensure that 'college'-type arrangements focus on issues that are of interest to several countries – such as European strategy or financial strength. Bilateral issues should continue to be covered through bilateral channels.
Working our way through the requirements of the FGD has proved pretty challenging. And these challenges have by no means been confined to the US regulators. We have now undertaken just over 100 equivalence assessments for non-EU firms. But to the extent that it has forced us to think about good regulatory practice and how we relate to fellow regulators around the world, it will have been a worthwhile exercise. There has been some discussion for example about what information exchange is formally required under the FGD. I see some value in such a discussion. But from a common sense point of view I would argue that having proper channels for information to flow would be a requirement even if the FGD had never existed. To that extent, the FGD has acted as a catalyst to help us achieve something that we have been aiming for for some time.
Basel 2/Capital Requirements Directive
The Basel Committee's work to revise the capital standards for international banks represents a huge effort in international policy-making, involving banking supervisors from all major international centres, including the FSA and various US federal bank regulators. This work culminated in the publication of a revised Capital Framework in June 2004. But in many ways this marked the start as well as the end of a process as various national authorities then stepped-up work directed at implementing the new Framework.
In an EU context, implementation will take place through the Capital Requirements Directive. The CRD closely mirrors the provisions agreed in Basel. But it varies in two important ways. First, the CRD will apply to all credit institutions (regardless of size or international presence) as well as a large number of investment firms. Second, it is a statutory instrument, and therefore subject to a formal legislative process.
There has been some notable progress with the CRD in recent weeks, which allows us to move ahead with our own implementation plans. Following the European Parliament's approval of the CRD in September and subsequent endorsement of the European Parliament's amendments by EU finance ministers on 12 October; we plan to produce our second CP on UK implementation in February 2006. It will take account of discussions with stakeholders since we issued our initial CP – Strengthening Capital Standards – in January and also of changes arising out the final text of the CRD. Our intention is to put final rules in place by the third quarter 2006.
However, as has been widely publicised, in October the federal authorities announced a postponement to 1 January 2009 of the implementation of Basel 2 in the US. Within the US, particular issues have arisen as a result of the decision by the federal authorities to require only the largest international players to move to a Basel 2 methodology, while the remaining 8,500 or so banks and savings institutions will remain on a modified version of Basel 1.
This has no impact on the European timetable for implementation via the CRD. But in consultation with the US authorities we shall be examining means of easing the practical problems that could arise for UK-based groups having significant operations in the US and for US-based groups with significant operations in the UK.
The process of implementing the Basel agreement has also focused our minds on the key issue of home and host relationships. Most discussion of this topic has taken place in a European context – where home/host relationships are prescribed to some extent in Directives but where we also have mechanisms such as the Committee of European Banking Supervisors to help us interpret these requirements in a sensible way. But whether we are dealing with European or global firms, the FSA's priority is the same. That is, to reduce regulatory overlap and duplication to the maximum extent feasible. I doubt whether we will be able to eliminate it completely in the short term but we are committed to exploring ways of collaborating effectively with fellow regulators to make as much use as we possibly can of effective communication, joint working and mutual reliance. If we are able to operate more intelligently, that should significantly reduce the burden on the regulated community.
Softing and bundling
Soft commission and bundled brokerage arrangements (in the UK) and soft dollar arrangements (in the US) have been a matter of concern for the FSA and the SEC recently. Having consulted the industry over a two-year period, we finalised our rules in July. Our basic analysis was that a market failure existed in relation to bundled brokerage and soft commission arrangements. This arose because the use of such arrangements to pay for services other than exeuction lacked accountability transparency and gave rise to a potential conflict of interest. Our new requirements, together with industry proposals, will limit investment managers' use of dealing commission to the purchase of 'execution' and 'research' services. They will also require investment managers to disclose to their customers details of how commission payments have been spent.
The profile of this issue was raised in the US following various mutual fund scandals in 2003. Work by SEC staff resulted in a decision by the SEC in September to consult on a revised interpretation of the soft dollar requirements applied in the US and to clarify the scope of permissible research services. SEC Commisioner Annette Nazareth recently noted that: 'A constructive dialogue between Commission and FSA staff on these issues helped us craft a consistent regulatory approach to the extent possible. I believe that each agency benefited from the work of the other.' From our side we have welcomed the opportunity to discuss this issue with SEC staffers given the interaction between firms operating in the US and London markets.
Hedge funds
Hedge funds are increasingly important players in global financial markets and a significant source of liquidity and market depth. Most major regulators are now having to consider whether and to what extent hedge fund activity should fall within the regulatory perimeter – and it is important to consider this question from various angles: direct versus indirect prudential oversight, market liquidity, volatility and confidence as well as issues of investor protection and growing retail exposure.
Last summer, we issued a Discussion Paper 'DP05/4 Hedge funds: A discussion of risk and regulatory engagement' setting out our assessment of the risks arising in the sector and outlining current, planned and potential actions to mitigate those risks. In the DP, we identified several key potential risks, including:
- the possibility of serious market disruption and erosion of confidence as a result of the failure of a fund or funds of sufficient size;
- the possibility that market liquidity could be disrupted as a consequence of several funds making concentrated investments in complex financial instruments; and
- whether conflicts of interest are giving rise to valuation weaknesses.
Market participants had until late October to comment on the issues raised in this document and we are now reviewing the responses received to see whether others feel there are potential market failures and, if so, the best ways of addressing these.
We have also been working closely with other regulators in international fora, sharing findings and best practice. Hedge funds will remain for the foreseeable future on the agenda of these international committees. In parallel to these regulatory initiatives, a number of industry bodies have sought to contribute to debate on best practice. The Alternative Investment Management Association, the Managed Funds Association and the revived Counterparty Risk Management Policy Group (CRMPG2) have all recently published helpful documents that aim to raise standards in the industry. It is important that in addressing risk issues of this type that the industry remains engaged to ensure that risk mitigation does not unduly impede the action of markets.
Meanwhile the SEC's new hedge fund adviser registration regime will start in February 2006. The introduction of mandatory registration of US hedge fund advisers will be an important change to the regulatory environment in which hedge funds operate.
Credit derivatives
The credit derivative markets are another area we and US regulators have focused on recently. This is because we have seen a rapid growth in outstanding confirmations as back offices have struggled to keep up as trading activity has increased. A particular feature of this has been the growth in the assignment of trades by hedge funds without obtaining the consent of the original counterparty.
In the light if this, we issued a 'Dear CEO' letter in February 2005, drawing attention to a number of operational issues arising in the credit derivative markets, including the development of significant backlogs in the confirmation of credit derivative trades. After we published this letter, supervisors incorporated these issues into the risk mitigation programmes developed for a number of market participants. More recently we requested that significant market participants complete a short quantitative and qualitative questionnaire. We wanted this to enable us to assess the impact that individual firm and industry-wide initiatives have had upon these backlogs. Such initiatives include the recent establishment of a protocol for trade novations and assignments by the International Swaps and Derivatives Association. The findings of this survey will be used to guide any additional regulatory action that may be required.
As part of this process, we have also been working closely with the Federal Reserve Bank of New York to take this issue forward. This has involved getting the major banks and investment banks to agree the actions they will take to reduce and then eliminate the volume of confirmation delays, and to establish an acceptable methodology for assignments. It was encouraging to see the reply, received last month, from 14 banks that attended the 15 September meeting in New York. The firms are best placed to understand the structure of the markets in which they operate and craft solutions that reduce risk without unduly inhibiting trading activity and credit diversification. 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. But hopefully, this will prove to be a case where the market is be able to assess and resolve the risks identified without the need for prescriptive regulation.
I have now outlined the rationale for our collaboration with overseas regulators, and some of the key challenges and current initiatives in this area. International regulatory cooperation is a complex issue, and before I end my presentation I would like to make some final observations on the FSA's overall stance. Our view is that we need to recognise that different regulators have different philosophies, and at times to seek to solve problems from first principles will not lead to constructive solutions to the benefit of industry. At the end of the day, the best approaches are those that enable firms to come up with a consistent global approach with respect to their procedures, even if regulators may have somewhat different rules which lie behind these procedures. If firms are able to act in a consistently global way, then in my view the regulators can claim success with respect to their collective engagement.
Thank you for your attention today. I hope you have found this interesting and that you enjoy the rest of the conference. I am happy to take any questions you might have.