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Clive Briault

Speech by Clive Briault, Managing Director, Retail Markets, FSA
'State of the Nation' Seminar, Compliance Institute
23 November 2005

Thank you for the invitation to address your annual seminar.

It is a great pleasure to be here. The Compliance Institute plays a vital role in establishing and improving standards within the UK compliance profession. I am encouraged by your enthusiasm and commitment, and the constructive input you provide to the compliance debate.

When I spoke to you last year I focused mainly on the retail market. Today I will update you on progress with our retail priorities, but I will also talk about our regulatory approach generally, including our work on 'better regulation', and I will summarise our key workstreams on the wholesale side.

FSA approach to regulation

As you know, the Financial Services and Markets Act requires us to: maintain confidence in the UK financial system; promote public understanding of the financial system; secure the appropriate degree of protection for consumers; and help to reduce financial crime.

In working towards these objectives we are required by the Act to have regard to a number of factors that we refer to as the 'principles of good regulation':

the need to use our resources in the most economic and efficient way;
the responsibilities of senior management in regulated firms;
the need to balance the burdens and restrictions on firms with the benefits of regulation;
facilitating innovation;
facilitating competition between financial firms;
minimising any adverse impact on competition; and
the international character of financial services and markets and maintaining the UK’s competitive position.

To help us achieve our statutory objectives we structure our work around three strategic aims:

to promote efficient, orderly and fair markets, both retail and wholesale;
to help retail consumers to achieve a fair deal; and
to improve our business capability and effectiveness.

Better regulation

Becoming better at what we do is a priority for the FSA. This is not just a political objective or about making life easier for firms. I believe better regulation is about becoming ever more efficient and effective in meeting our objectives, and maximising the benefits of regulation.

I want to give you some examples of what we mean when we talk about better regulation and how we are attempting to put this into practice.

We have worked hard to deliver some practical improvements in the way we operate. For example, we have reduced the text of our listing rules by 40%; our new CIS rules are 50% shorter and more flexible; our authorisation application packs are shorter; we have the firms online system – a web-based tool for submitting secure applications and notifications to us; and we have significantly reduced the number of FSA consultations. I am sure that working in the compliance profession you will have appreciated having fewer lengthy FSA CPs to read. We have also implemented a range of initiatives to make it easier for small firms to do business with us, for example offering payment of fees in instalments; capping fee increases of 2% for most small firms; and providing 14 tailored Handbooks which are 90% shorter than the full Handbook and cover 70% of the FSA’s regulated community.

In assessing whether we are being efficient in meeting our objectives, it is important that we look at the costs we impose on the regulated community. There has been much comment on this subject, and a succession of industry surveys have reported ever increasing costs of complying with regulatory requirements.

We are keen to understand the true position, so this year we have commissioned a study by Deloittes on the costs of regulation. We are working closely with the Practitioner Panel on this important topic. The objective is to develop a deeper understanding of the impact of the costs of regulation on firms, especially smaller firms, and to ensure that these costs are justified by the benefits. The initial work covers three sectors: retail advice, investment banking, and institutional fund management. If the study highlights areas of regulation that are expensive but offer little benefit to firms, consumers or the markets, we will look for ways of easing the burden on firms.

As part of better regulation, we are also working to become more principles-based and encouraging firms to do likewise. A more principles-based regime emphasises the importance of a relatively small number of broad and enduring principles, rather than a vast number of detailed rules.

In achieving this, our aim is to work towards market solutions, not more intrusive regulation. Some examples of where we have applied this approach include delivering a market solution to softing and unbundling; a proportionate response to conflicts of interest issues; resisting pressure to regulate credit rating agencies; implementing lighter advice regimes for stakeholder pensions and now the Sandler suite of products; and our whole approach to treating customers fairly has been to work with the industry to deliver fair treatment of customers.

We recognise that, in part, more principles based regulation is about our Handbook of Rules and Guidance. After all, our Handbook is 8,000 pages long. Through our Handbook Review project we are working to tackle this by identifying areas where our requirements are more restrictive than needed to achieve our objectives; where they do not deliver benefits to justify their costs; or where they are not consistent with our focus on senior management responsibility.

Our Handbook Review Consultation Paper, published in July and which closed for comment at the end of October, suggested a number of target areas. For example, we proposed that detailed guidance on money laundering should be replaced by high-level principles; the approved persons’ regime should be streamlined; the training and competence requirements for wholesale firms reduced; and our retail conduct of business rules simplified.

Getting rid of rules sounds like it should be a popular choice. But we have not been overwhelmed with support for our proposals, and some (for example on training and competence) have provoked concern. This is not surprising. The senior management of many larger firms support a move to a more principles-based approach. But many smaller firms and some compliance staff in firms of all sizes are reluctant to move away from more detailed rules and guidance. So more principles-based regulation is not an easy option, and we are not there yet. But we continue to believe that it is the right approach.

We do recognise that the interpretation of high level principles can in practice be difficult, both for the regulators and the regulated. So in our treating customers fairly work, for example, we have made the training of our own staff a priority, to ensure that we adopt a consistent approach to monitoring firms' implementation of the treating customers fairly principle. In addition, we have issued statements of good (and indeed less good) practice, case studies and other information to aid firms' interpretation and implementation of the treating customers fairly principle.

I announced in September that we will be undertaking a review of the effectiveness of the general insurance regime. This review will begin in April 2006, and will focus in particular on our retail conduct of business requirements in this area, and on the effectiveness of the regime in meeting the intended outcomes for consumers. This review will be undertaken alongside the review of the effectiveness of the mortgage regime, which we have already announced and which will begin at the end of this year. This joined up approach will recognise the linkages between the mortgage and general insurance regimes, and the fact that many firms are active in both these markets. In addition, the review will take into account our determination to find ways in which we can improve the effectiveness of our regulation and can contribute to the better regulation agenda.

It is almost six months since the full implementation of depolarisation and, while it is clearly too early to make any formal assessment of the effects of the new regime, it is a topic that has generated some interest. As we have previously stated, we will be conducting a full post implementation review, in a number of stages, to assess the effects of depolarisation against its original objectives.

In particular, we have a piece of work in hand looking at use of the disclosure documents (the initial disclosure document and the menu) by consumers. Providing consumers with clear, understandable information about the status of their adviser and the cost of advice is key in the depolarised world and this work is important in helping to assess the impact of the new disclosures.
One change that we made at depolarisation was the removal of the so called "better than best rule". As a result, we have seen an increase in investment by product providers in distributor firms. We have no problem of principle with this, provided this is transparent. A potential danger is that significant payments could be made, outside normal channels, that would not be apparent on the initial disclosure document and the menu. If this happened, it would be unfair both to consumers, who would not see the full cost of the advice they were offered, and to other firms, who would appear less competitive than they really were. We have sought to prevent this by requiring that payments from product providers must generally be either in the form of commission, which will appear on the menu, or of loans or investments made on commercial terms. So long as these conditions are met, we have no difficulty about product providers and distributors working together to develop new and innovative financing arrangements.

Another major work stream this year has been our review of our enforcement process. The key priority was to ensure that our enforcement is fair, and seen to be fair, effective and efficient. The review considered the processes followed by supervisors and enforcement staff when considering possible regulatory breaches, and the communications between them; the role of senior FSA management; some options for making regulatory decisions based on fair procedure; and the accountability of decision makers to the FSA Board.

We have therefore introduced:

greater separation between those who prepare an enforcement case and those who make decisions on the case;
settlement decisions to be made by the FSA executive;
incentives for early settlement;
opportunities for those subject to enforcement processes to comment on the process afterwards; and
fuller publication of the enforcement record and processes.

Retail priorities

Within the overall FSA priorities, our retail agenda focuses on delivering an effective and efficient retail market for financial services and products. This requires:

Capable and confident consumers.
Clear, simple and understandable information available for, and used by, consumers.
Soundly managed and well capitalised firms who treat their customers fairly.
And risk based regulation.

We structure our work in the retail area around these four 'pillars'. Time is limited today, so I will not dwell on the first two pillars. I should just mention that we continue our leadership role in the National Strategy for Financial Capability which is designed to increase consumer understanding and awareness. And I hope that you have noticed the efforts we have been making to draw the attention of consumers to the excellent information that is available on our own website. We are also progressing a range of initiatives to support the second of the pillars, namely the need for consumers to have access to simple, clear and understandable information to help them make informed financial decisions and shop around. Some examples include the increased focus we have placed on financial promotions and our work on disclosure, including introducing the Menu and Key Facts documents. And we are working on the Key Facts Quick Guide and projection rates for investment products.

Treating Customers Fairly

Moving on to the third of our retail pillars, Treating Customers Fairly is rooted in our statutory objective and strategic aims. It is embedded in the sixth of our eleven principles for businesses, namely that "A firm must pay due regard to the interests of its customers and treat them fairly". So it already lies behind a number of rules in our Handbook, and is a principle which should inform how business operates. Nonetheless, the increased focus on Treating Customers Fairly as a priority should ensure that the principle assumes greater importance in the minds of both firms and supervisors. We expect firms to thoroughly consider their operations and processes and to tackle those practices that can potentially cause customer detriment.

Naturally firms are anxious to identify what we, the regulator, will be looking for as evidence that they are treating their customers fairly. I cannot emphasise enough that we are not trying to create new rules or obligations or checklists. Treating Customers Fairly is about the interpretation of existing requirements. It adds no new ones.

The more principles-based approach to regulation that we want to move to requires that we, as the regulator, avoid a prescriptive approach to telling firms how they should discharge their responsibilities. Additional rules will not necessarily get us to where we want to be. Such detail may have the benefit of providing certainty, but by definition a rigid approach lacks flexibility. The 26,000 firms that we regulate come in all shapes and sizes, occupy different positions in the distribution chain, and operate in different product markets. In such a dynamic marketplace firms can achieve the objective of Treating Customers Fairly in a variety of different ways. One size does not, and should not, fit all.

By pursuing a more principles-based approach we are giving firms the opportunity to determine for themselves how to meet the obligation to treat their customers fairly. The approach will be determined by the profile of the business and the culture which senior management wish to establish.

If I can offer a simple definition of Treating Customers Fairly, it is this – what we are trying to achieve is for senior managers to put themselves in the place of their customers and to consider very carefully whether they are being treated fairly by the firm. This offers a simple and effective test – a yardstick against which issues can be tested.

As I mentioned earlier, to help you with this we have produced a number of statements of good practice (and, indeed, some indications of less good practice) and case studies to illustrate some of the considerations that senior management should take into account. We published many of these in our July paper, and at the end of October we published further case studies on management information, remuneration, complaint-handling, and closing a with-profits fund.

A useful starting point is for senior management to think of treating customers fairly in terms of what we have called the product life cycle. So depending on the precise nature of a firm's business this could mean addressing the fair treatment of customers at any of the following stages: product design and governance; identifying target markets; marketing and promoting the product; sales and advice processes; the remuneration of sales forces and advisers; after sales information; and complaints handling.

From speaking to senior management it is clear that many firms have taken a fresh look at their businesses from a treating customers fairly perspective and in many cases have realised that they needed to make changes or improvements to satisfy themselves that they are really delivering fair treatment of customers.

So the right things clearly are happening out there and progress clearly can be, and is, being made. A thank you is appropriate at this stage as I am aware of the work that the Compliance Institute has done on promoting this issue through countrywide seminars. But there is further to go. Not all firms are "on message" about the need for them to undertake a "gap analysis" to identify any shortcomings in the fair treatment of their customers and then to address these shortcomings as necessary. And many large firms face a major challenge in embedding the fair treatment of customers in all parts and at all levels of their business.

We have now reached the stage where we are building treating customers fairly into Arrow, our core risk assessment and risk mitigation process. Supervisors will be looking at the approach that a firm has taken to treating its customers fairly, including both the initial "gap analysis" and subsequent actions to address any resulting issues.

Risk based supervision

The fourth of our retail priorities captures our risk-based supervision. This includes our supervision of individual firms, using the Arrow assessment and relationship management for so-called A-C firms. And for D firms we rely on thematic work, and alerts from a variety of sources.

We undertake a lot of thematic work in the retail markets, identifying important issues and investigating these across a sample of firms, then communicating the findings back to the industry. Some recent examples are our work on Venture Capital Trusts as well as a number of our initiatives within our mortgage and general insurance programmes.

Mortgage and general insurance regulation

It is now just over a year since we took on responsibility for mortgage regulation, and the anniversary for general insurance firms is in January.

We gave ourselves a clear, targeted set of priorities when regulation began:

policing the perimeter, to ensure that mortgage and general insurance intermediaries are correctly authorised and operating lawfully;
ensuring that disclosure documentation (including Key Facts) is provided at the right time, and is clear and accurate;
making sure that our financial promotions requirements are being met by mortgage firms;
reviewing systems and controls of general insurance networks to monitor sales by appointed representatives;
work to quantify the risks posed by specific products such as linked sales of Payment Protection Insurance, critical illness cover and equity release products;
thematic work on insurance claims handling; and
regulatory returns, to ensure that we receive accurate and timely data to enable us to focus our supervisory efforts in the right areas.

In our mortgage and general insurance work, as well as our thematic work more generally, we try to use a 'graduated approach'. Where our initial work identifies problems, we will work with the industry to tackle these issues. We only take enforcement action at this stage in the most serious cases. The next step will be follow up work to check that our messages have been received and acted upon. Where at this second stage we find problems that have still not been tackled, we will not hesitate to intervene, including taking enforcement action if necessary.

As we hoped, our perimeter work found the vast majority of both mortgage brokers and insurance firms were well informed about the need for them to be authorised by us for regulated activities. Where we did find issues, we worked with firms to regularise their position and took further action in some cases. This work is now drawing to a close, earlier than expected.

On financial promotions, we looked at a cross-section of firms across the mortgage market to check the quality of their financial promotions. The objective was to see how firms' management, systems and controls ensure that their promotions are clear, fair and not misleading. Overall, we found that standards are good.

On the quality of disclosure given to customers, we checked the quality of mortgage lenders' and intermediaries' Initial Disclosure Documents and Key Fact Illustrations. We also set up mystery shopping to see whether firms gave these documents to customers at the right time. We found that the quality of the documents varied. Many firms did not produce fully compliant Initial Disclosure Documents and Key Fact Illustrations. Some firms did not even provide these documents to consumers. We are taking forward follow-up supervisory and review work to check that improvements have been made in the quality and provision of these documents.

We also looked at general insurance disclosure, reviewing policy summaries and key facts, to check whether they are in the right format with the right content. The sample was deliberately risk based, with a bias to more complex policies. Overall we found that firms were frequently not producing policy summaries and key facts documents in line with our rules. For example, the presentation and style of the product disclosure documents did not meet an adequate standard, and significant and unusual exclusions were not always being brought to customers' attention in the product disclosure documents as required. This is not good news given that much of the emphasis of our new regime is on ensuring that firms provide clear and understandable information to consumers.

Our work on equity release (a combination of mystery shopping and visits to firms that give investment advice on the capital released through equity release scheme) identified significant concerns. In particular we found poor quality investment advice when consumers were advised to take out money from their properties to put into often risky investments. We are taking enforcement action in the most serious cases and working with specific firms to correct problems. A further round of visits and a second mystery shopping exercise will take place at the beginning of next year.

We have also taken forward work on the mortgage side on higher risk areas which have emerged from our day-to-day supervision work, including on self-certification mortgages, sub-prime lending and responsible lending.

On Payment Protection Insurance (PPI), we have completed a series of visits and mystery shops to look at selling practices. Our findings – which we published earlier this month - are variable. When properly structured, explained and sold, payment protection insurance can provide worthwhile cover for consumers against unexpected changes in their personal circumstances. We were therefore pleased to see that sales of regular premium PPI sold with prime mortgages are generally compliant. However, compliance standards in other areas of the market, notably single premium PPI business, are generally weak. Those firms where these problems exist must take urgent action to address them.

For example, of the 30 firms we visited found to be selling PPI with revolving credit, unsecured loans and secured loans, half the firms failed to take reasonable steps to ensure that customers did not buy policies on which they could not claim, or which provided very limited cover. In some of the firms we visited, the price the customer was paying for the PPI policy was not always clear in documentation and was sometimes only disclosed at the very last minute, after the customer had agreed in principle to make the purchase. We also found that there was an over reliance on product documentation given to the customer at the expense of explaining the policy to the customer orally; most firms selling by telephone did not give sufficient information on exclusions; and the quality of training provided to staff and appointed representatives, and therefore their competence to sell PPI products, was found to be variable.

We are determined to improve standards in this market, so when we published the results of our thematic work earlier this month we also provided examples of good and bad practice, so that firms know what we expect from them. We will also be following up problems with individual firms. However, such measures are unlikely to be sufficient in themselves to turn this into an effective and efficient market. I would prefer to see a market solution to PPI rather than us or the competition authorities being left to resolve the problems. We are therefore actively engaged in discussions with the industry on how both providers and lenders can improve their own standards and move decisively towards putting in place the elements of a considerably more competitive market.

Finally, I should mention the new Integrated Regulatory Reporting system which went live on 1 July to enable a range of firms, including mortgage firms and general insurers, to report electronically. We experienced some teething problems with the first Retail Mediation Activities Returns. Problems with new systems are not uncommon and we acted promptly to minimise the impact on industry by extending the deadline for submission. Whilst some system issues remain, we have been encouraged by the submission rates so far. The system to capture Product Sales Data has also now been rolled out. We will use the data provided by firms to identify and act on emerging trends and risks.

Wholesale priorities

Our main objective for the wholesale and institutional markets is to promote a well regulated market which is efficient, orderly and fair. We also aim to ensure that it is internationally attractive and sustainable.

The wholesale regulatory landscape has been dominated over the past year by a small number of high impact, large scale issues: the Markets in Financial Instruments Directive (MiFID), Basel 2 and the Capital Requirements Directive (CRD), Solvency 2, the Market Abuse regime, the Listing Review and the Prospectus Directive, Softing and Unbundling, and 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 market confidence, as well as issues of investor protection and growing retail exposure.

Last summer, we issued a Discussion Paper setting out our assessment of the risks arising in the sector and outlining current, planned and potential actions to mitigate those risks. In that paper 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.

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 contributed to the debate. It is important that in addressing risk issues of this type the industry remains engaged to ensure that risk mitigation does not unduly impede the action of markets.

Some of the key wholesale market issues have moved on significantly over the last year, so our involvement will start changing to focus on implementation. For example, in respect of the Listing Review, Prospectus Directive and Market Abuse Directives our attention is turning to working with the industry and other stakeholders to ensure good implementation.

Other issues have progressed in the past year but have not reached a conclusion and still require the active focus and engagement of the FSA, firms and their trade bodies. Clearly the most prominent of these are the Capital Requirements Directive, MiFID and Solvency 2.

The Capital Requirements Directive (CRD) translates Basel 2 into EU law. It extends the scope of the Basel 2 capital requirements to some investment firms, but allows alternative, simpler capital standards for some limited licence firms. The key aim of the CRD is to introduce a modern, risk-sensitive prudential framework for banks and investment firms across all Member States. Like Basel 2 – which will apply to internationally-active banks – the CRD is based on three pillars: quantification of the risks arising from financial firms' trading and credit businesses; a stronger, constructive dialogue between regulators and firms on the risks run by firms and the level of capital that should be held to support these risks; and a series of robust requirements on public disclosure by firms to allow market discipline to play a distinctive role in ensuring the efficient functioning and good health of the financial services sector.

There has been some notable progress with the CRD recently, which allows us to move ahead with our own implementation plans. Following the European Parliament's approval of the CRD in September and the subsequent endorsement of the European Parliament's amendments by EU finance ministers last month we plan to produce our second Consultative Paper on UK implementation in February next year. It will take account of discussions with stakeholders since we issued our initial Consultation Paper – Strengthening Capital Standards – in January this year, 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 of next year.

Our strategic objectives for the implementation of the CRD include establishing:

capital standards proportionate to risks;
risk disclosures that are relevant to market participants;
broad equivalence in standards in practice across the EU and internationally; and
early clarity on key policy and practice choices.

Firms wanting to move to the advanced approaches for the calculation of capital requirements for credit and operational risk will need to have in place strong risk management and corporate governance, and it is clear that standards for access to the advanced approaches are challenging even for firms that are today at the cutting edge of risk management. Large firms should not assume they will meet these standards simply because they are large. Small firms should not assume that being small bars them from access to the advanced approaches.

With only 17 months to go before CRD is due to go live, we are now open to receive applications for moving to the advanced approaches. We continue to work intensively with the industry and the Committee of European Banking Supervisors (CEBS) on Pillar 2. The Committee is currently undertaking consultation on Pillar 2, the aim of which is to enhance the link between an institution's risk profile, its risk management and risk mitigation systems and its capital. CEBS aim is to advise the European Commission on banking policy issues and to promote greater convergence of supervisory practices across the European Union.

We are also in the midst of work on implementation of the Markets in Financial Instruments Directive (MiFID). We are currently preparing our Consultation Paper and Handbook amendments with a view to publishing in March 2006. Our approach to domestic implementation has been to aim for "intelligent copy-out” of the Directive text; simplification and rationalisation of existing rules; introduction of new Handbook guidance when necessary; and continuing dialogue with the industry. You will continue to hear more from us on this subject.

On Solvency 2 – a prospective European Directive setting new prudential standards for insurance firms - our objectives are clear. We want a Solvency 2 regime which is proportionate, and more transparent, robust and risk-sensitive than the existing Solvency 1 Directives. We also want a regime which is implemented in a more consistent manner across the EU than currently. An appropriate market-based and more harmonised standard for the valuation of technical provisions is critical to the success of the project.

In our view, the current Solvency 1 Directives are outdated and unduly restrict firms' business models; they have not kept pace with market developments, risk management developments, or the ways in which firms organise their business. The EU business passport is not yet a reality. Broadly, rather than dictate a restricted business model, we need to let firms decide how to run their businesses, how they should respond to market demand, how they may best provide cost-effective products that address policyholders' needs. And we need a regulatory regime that encourages and rewards good risk management.

Conclusion

I hope that I have provided at least an overview of some of the key issues facing both you and us in the regulatory sphere today. Clearly we live in interesting times.

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