How we aim to make financial markets work
Speech by Callum McCarthy, Chairman, FSA
The Smith Institute Finance Lecture
29 november 2005
To speak at an institute which is concerned with issues which "flow from the changing relationship between social values and economic imperatives" is an intriguing challenge. To do so in the land of both John Smith and Adam Smith makes it particularly so, since the conjunction of names shows clearly how both social values and economic imperatives change over time.]
What I would like to do today is to discuss one set of responses to a particular relationship between social values and economic imperatives, namely how we at the FSA approach the various issues involved in establishing and maintaining effective markets for financial products and services. Please note that the approach we have is based on promoting markets, not on regulation per se. Markets require rules (it is the rules which define access to and conduct within a market), but the rules are a means to the end, not the end itself. The ends we seek are the objectives laid down for us by statute: confidence in the financial system, appropriate consumer protection, understanding of finance, and the combating of financial crime. Our preferred means of achieving these is via markets.
Before I describe our approach, a word about the importance of financial services to Scotland. The industry generates nearly 6 per cent of Scotland's GDP; it accounts for nearly 110,000 direct employees and a further 90,000 indirectly. It is one of Europe's leading financial centres. Its presence in banking, insurance and – particularly notable here in Edinburgh – asset management is clear. I hope it is taken as a mark of distinction, and not an impediment to the financial services sector in Scotland, that the only FSA office outside London is based here in Edinburgh – and is an office which we are growing, having increased our staff there from 18 to 39. We hope this will contribute to a close and productive relationship in Scotland between the FSA and Scottish financial services firms.
I have sympathy with those who find it difficult to see a pattern within the wide range of FSA activities, for they are indeed wide-ranging. They include international policies like the new definition of capital requirements for banks (and others) now painfully brought to conclusion by the Basel Committee – and about to be translated into the Capital Requirements Directive – an academic sounding exercise until you recognise that banking crises typically cost a country approaching 20 per cent of GDP; work within a European context on directives covering investment services, prospectus, market abuse, risk- based capital – I'll come back later to the implications of this; policies aimed at preventing financial crime; work to reform the accounting and regulation of insurance, where our package of reforms represents the most significant advance in at least 20 years, and probably longer; making the listing process easier; managing the new mortgage and general insurance responsibilities given to us, recently, which brought an extra 14,000 firms within our scope; and, critically for both you and us, work on financial capability.
So I am sympathetic to those who see the FSA as the source of a constant stream of activity, and find it hard to identify the connections between one event or action and another.
Today I want to set out the big picture. When I cut through all the individual initiatives, programmes and projects, there are three strands to our work. The first is to promote efficient, orderly and fair markets; the second is to help the retail customer get a fair deal; the third is to improve our business capability and effectiveness. Let me deal with each in turn.
Efficient, orderly and fair markets should be an objective on which everyone can agree. Efficiency is needed for the continuing competitiveness of the UK as the most international of all the world's capital market centres; it brings obvious advantages to the users of financial services, as well as to competitive producers and providers of financial services. And markets, to work, need to be orderly (since disjunctions and disruptions impose large costs) and to be fair and clean – free from insider trading, manipulation, or favouring of one class of dealer or customer over others.
Some of the most important pieces of work we have planned under this heading are:
- new rules for the capital adequacy of banks, and investment firms, building on the work of the Basel Committee, via a new directive;
- ongoing focus on the operational problems in the credit derivative markets including the backlog in trade confirmations and the non-notification of trade novations and assignments. We are doing this in close cooperation with other regulators, particularly the New York Federal Reserve;
- risk identification and response with respect to the hedge fund sector including establishing our hedge fund manager centre of expertise and producing a feedback statement on our June Discussion Paper;
- an examination of transparency standards in the secondary bond markets, about which we published a Discussion Paper in September;
- a raft of European directives, where the FSA is legally bound to implement what has been agreed in Brussels. In particular
- the Markets in Financial Instruments Directive which is scheduled for implementation in April 2007;
- the Transparency Obligations Directive, due for application in November 2007;
- a possible Directive on Clearing and Settlement.
- we will also be working hard to support business as usual under the newly implemented market abuse and prospectus directives.
- and finally as Scotland created the Investments Trust Industry I should mention a planned consultation paper on listed investment entities. As the asset management industry has moved on since the current rules were first introduced, this will ask whether we should open up the listing regime to trusts employing a broader range of structures and investment strategies than we currently do?
9. On top of these initiatives, we will continue our normal market monitoring and supervision. In our supervision work we also intend to adopt a thematic approach which will focus on five areas. These will be: conflicts of interest, corporate governance, business continuity, stress testing and market abuse. In addition to these supervisory themes, we will focus particularly on the challenge of taking on our new responsibilities in the insurance sector.
10. The second strand of our work is making sure the retail customer gets a fair deal. The retail market for financial products is a complicated market: the product is often inherently complex – certainly for long-term, equity-linked products; the customer is often ill-equipped to make the decisions increasingly being asked of them, as more and more decisions move from being taken by the state or by employers and must now be taken by individuals; and sales forces have too often been irresponsible. We want to make this work as an effective market – customers who get clear information and are held responsible for their decisions; providers of services who sell those services honestly. This involves a very large change from the present position, above all in establishing a greater degree of competence among customers – hence our emphasis on financial capability.
11. Financial capability is core to this, and we at the FSA have been much concerned to see how this can be improved. Of course, the principal responsibility for educating citizens to be literate and numerate lies with the government (and its £32 billion budget for primary and secondary education) not with the FSA (whose total budget for all our activities is some £260 million). But we have been much concerned to identify what can be done to improve a position which needs substantial improvement.
12. To that end, we have brought together the key players: and a number of priority subjects, groups and channels have been identified. Some of these are workplace-related, and some relate more to education. An example of this is the Young Scot MoneyLine Project which is being jointly funded by the FSA and the Scottish Executive Financial Exclusion Unit, and aims to reach young people aged 16 to 26 across Scotland. The project will create a 'one door' centre of excellence, with access to financial information and referral services that people can trust.
13. Another project is the Scottish Centre for Financial Education (SCFE) is championing financial education in schools across Scotland. SCFE is based at Learning and Teaching Scotland and funded jointly by the Scottish Executive and the wider Financial Services sector in Scotland. The Centre is playing a key role in implementing the Schools Project element of the Financial Capability strategy in Scotland. The good practice developed by SCFE is being closely watched by other devolved administrations who are interested in replicating the model.
14. Within our retail market objective, there are various particular projects, only some of which I'll mention:
- we are prioritising, and giving more resources to, work aimed at preventing misselling, through our work monitoring financial promotions;
- it is for companies to treat their customers fairly. They have a huge incentive to do so: it's their brand which is at stake. We are encouraging them to do so, both by acting fiercely when they fail, and by encouraging them to take this seriously, including at senior management level. We are much more interested in encouraging good behaviour than in fining miscreants after the event;
- following the implementation of Key Facts for mortgage and general insurance products, we aim to continue to implement them gradually for other products. We will also conduct checks to ensure that firms are providing the disclosures in the right format and at the right time to consumers;
- we faced a major expansion – the result of decisions in Brussels and by Government in the UK, not of any empire building on the part of the FSA – in our responsibilities when we became responsible for mortgage and general insurance regulation in the last year. This was a huge logistical, managerial and policy challenge as we taken on regulating over 14,000 new firms. It profoundly altered the demographics of the firms we regulate, over 90% of which are classed as "small" firms – ones which, on a risk-based approach, we expect never to visit in the normal course of business.
15. The third strand of our work is simply to make the FSA easier to do business with by improving our business capability and effectiveness. There are many components of this:
- we have substantially reduced the number of CPs, and made them shorter (well, most of them);
- we will continue to develop ways of dealing with firms which reflect their size and the issues that exist. This is especially important now that so many of the firms we regulate are small;
- review of the FSA rule book; and
- review (with the Practitioner Panel) of costs of regulation. This will look not only at the gross costs – ie not simply the administrative costs - of giving information in response to FSA demands, but also at the wider costs of implementing regulation. It will also look at the net costs – the marginal addition to costs that follow directly from FSA action. The distinction is important. It is clear that banks would hold capital even if there were no regulatory requirement to do so (indeed they hold more capital in fact than they are required to do by regulation). In a litigacious world, financial services companies would have compliance departments for their own protection irrespective of regulatory requirement.
We have in addition mounted a special and very thorough examination of how the FSA carries out its enforcement procedure. Enforcement is a small part of our relationship with the financial services sector. We use it sparingly and selectively, but it is important that when we use it, it is seen to be a fair process. In the light of criticisms, particularly from the tribunal in relation to the L&G case, we have revised our processes to ensure that they are not only fair but are seen to be fair.
Conclusion
The relationship between any regulator and those that it regulates gives rise to many questions. It is a prime case study for the "changing relationship between social values and economic imperatives" with which the Smith Institute is concerned. I hope that this account and how we tackle this relationship will at least give rise to questions and debate.