The challenges of regulating wholesale markets in Europe
Speech by Hector Sants, Managing Director, Wholesale & Institutional Markets, FSA
Fifth Annual Institute on Securities Regulation in Europe
6 December 2005
Good morning and thank you to the Practising Law Institute and Sullivan & Cromwell for inviting me to speak to you today.
I would like to use this opportunity to expand on Mr Reynier's thoughtful comments by taking you through some of the challenges a pan-European system of regulation can pose for national regulators such as the FSA. There are many benefits to a European system of financial market regulation, but there can also be some tricky judgments required, particularly with regard to balancing national perspectives with the European agenda, and in reconciling different regulatory and legal systems. Today I would like to discuss some of these challenges as they relate to the wholesale market place - both in a broad sense and with respect to a number of current wholesale initiatives.
Before I begin, it is important for me to briefly define what I mean by wholesale markets. By this, I am referring to financial transactions between professional counterparties, and I therefore include in this category securities and derivatives firms, wholesale banks, insurers, and asset managers, as well as market infrastructure providers. In passing, may I remind you that the FSA is organised to recognise the differences in the market places we regulate by having separate wholesale and retail business units. Clearly the dividing line between the two is not a hard and fast one and we remain an integrated, single regulator. But we are sensitive to the fact that one size of regulation obviously does not fit all financial institutions, and believe our structure allows an appropriate degree of customisation.
Balancing FSA objectives with the FSAP agenda
I will turn now to the substance of my presentation - the challenges of regulating wholesale markets in Europe. It is important to recognise that most new financial services regulation in the UK originates in Europe. We estimate that up to three quarters of the flow of new regulation now comes from Brussels. It certainly feels like that, particularly now that we have reached a peak in the implementation of Financial Services Action Plan (FSAP) measures as well as facing the roll-out of some major post FSAP legislation. This naturally raises questions about how regulation devised at the EU level – seeking to promote pan European aims – interacts with national law, market practice and consumer preferences. It is not my purpose this morning to look at the wider constitutional debate, but rather to consider this from the practical viewpoint of a national regulatory authority.
If you were to position yourselves at the start of the decade and consider a Europe that would shortly include 25 Member States and upwards of 70 national regulators, one conclusion could be, and was, drawn: the status quo is not an option. Europe needs a properly joined up system of regulation (not, please note, necessarily a single regulator). What it needs is a system of regulation that is focused and flexible, which can identify and mitigate risk in an efficient and cost effective manner, a system which combines high standards with international competitiveness, a system in which good practice is shared and collaborative working developed.
In recent years a good deal of thought has been directed towards devising regulatory structures capable of delivering pan European regulation that is sufficiently focused and flexible. A particularly important part of this debate from our perspective is ensuring that new rules take account of the experience and expertise of national regulators. Those of us engaged in the practical application of regulation are aware that new rules may have unintended consequences, impose costs on practitioners (which may be passed on to consumers), are subject to regulatory arbitrage and can be overtaken by financial innovation or, indeed, stifle such innovation. We are also aware that there can be more than one means of achieving a given objective. At the same time, national regulators have to be aware of, and respect, the wider political and social context in which regulatory objectives are determined.
At an EU level, the participation of national authorities in the rulemaking process has been formalised recently through the so-called Lamfalussy structures. The details of these can be relatively arcane. But the big ideas behind the creation of these structures are clear enough. At an institutional level, this has resulted in the creation of three sector committees of regulators: CESR, CEBS and CEIOPS covering capital markets, banking and insurance respectively. Each committee provides a forum in which national regulators can discuss issues of common concern and assess potential solutions, with the intention that this will facilitate supervisory convergence. At a legislative level, the committees provide detailed, professional advice to the European Commission on the technical provisions or secondary legislation (known as Level 2) needed to flesh out Directives which are the Level 1 primary legislation.
The committees are at different stages of development and it is too early to expect any of them to be functioning perfectly. The FSA nevertheless strongly supports them, and is an active participant in all three. We believe that they offer the best prospect for achieving relevant and proportionate regulation along with meaningful convergence of regulatory practices.
I will return to the Lamfalussy framework later. But first I would like to take a step back and examine the way in which objectives and priorities may vary between different authorities – national and EU – charged with delivering and/or implementing regulation. It is significant in this respect that while much policy development occurs in Brussels, the tasks of advising on new regulation, implementing it and supervising firms and markets on a day-to-day basis still falls primarily to national regulators. This inevitably creates scope for tensions in the formulation of regulation at an EU-wide level.
Tensions might clearly arise where national regulators disagree as to the need for regulatory measures in the first place. Different market structures and consumer behaviour can give rise to different types of risk. Regulatory actions that are appropriate for one market may be inappropriate for others. Direct investment in corporate and sovereign bonds, for example, is a more important feature of the Italian than the UK retail savings market. Hence if new EU rules directed at protecting individual retail bond investors were introduced, this would likely have only a very limited impact on the protection offered to UK consumers, for whom such investments are atypical. On the other hand, such rules might have material implications for counterparties in the London market if all purchasers were to be treated equally.
Tensions can also arise where EU regulation aims to harmonise mutually incompatible national arrangements that have developed in support of local market structures to which national authorities are attached. One feature of negotiations over the Markets in Financial Instruments Directive (MiFID) has been the need to come to a common view about the extent to which equity market liquidity should be supported through concentration rules directing trades towards exchanges (as has been the practice of EU members) or whether a more flexible approach, allowing greater competition between different types of trading platform, should be adopted. In the event, the EU has opted for the latter.
In the UK context, there is a particular potential tension that I would like to explore in some more detail. This arises from the fact that the FSA and the European Commission approach their tasks with different objectives, which overlap in many areas but clearly are not identical.
The Financial Services and Markets Act sets out four statutory objectives for the FSA: maintaining market confidence, protecting consumers, increasing consumer awareness and reducing financial crime. These are supplemented by principles of good regulation which require us, in the pursuit of our statutory objectives, to take into account the full range of consequences that our regulatory actions have for our stakeholders and the wider economy. In particular, Parliament has said that we should aim to be proportionate in our actions, be supportive of competition and the UK's international role and take account of financial market innovation.
The existence of these clearly-articulated objectives and principles has proved of great value to the FSA in providing us with a sense of direction and purpose. They point us in the direction that is market-focused and risk-based and they have acted as a 'lodestone', providing guidance on where we should devote our attention and resources. This is not just a theoretical statement but informs our core supervisory processes. The Arrow framework, for example, focuses heavily on calibrating the extent to which firms or issues pose risks to our objectives and on devising a proportionate strategy towards risk mitigation. It should only be a slight exaggeration to say that if you come across an FSA staff member during working hours, he or she should be solely preoccupied either with the extent to which firm or market-wide developments pose risks to the FSA's objectives or how best to mitigate such risks!
The Commission has the somewhat different objective of promoting an internal market in financial services. The development of an internal market in its widest sense is, of course, embedded in the treaties on which the EU is founded. More specifically, promoting an internal market for financial services has been a particular focus for the past seven years, following the Commission's 1998 Communication: Financial services: building a framework for action. This is a laudable objective to which the UK government subscribes. A single market would increase consumer choice and provide opportunities for economies of scale and scope – all of which offers the prospect of real increases in economic welfare.
The problem is that these different sets of objectives – equally valid in their way - may not always prove compatible:
Examples of where the FSA's risk-reduction objectives and the European Commission's single market-deepening ones come together reasonably well are the CRD and Solvency 2. And in negotiation of the CRD, as an example, there was a good accommodation of UK concerns that the prudential requirements for limited licence investment firms – which we have in healthy profusion – should be proportionate. Generally, the introduction of properly calibrated risk based capital regimes for banking and insurance will increase safety and soundness of financial firms across Europe. And to the extent that such regimes create level playing fields and increase confidence in financial systems in the EU, they will tend to broaden and deepen the single market also.
But it will not always be possible to achieve such a congruence of objectives. The FSA might be asked, for example, to administer new regulations whose purpose is not to reduce risk but to achieve some other aim such as increasing access to parts of the European financial infrastructure. Such measures could prove to be risk-increasing if they were to divert resources away from the FSA's core task of risk mitigation.
It is largely to allow us to identify and address such tensions that the FSA strongly supports the introduction in Europe of the kind of disciplines that we apply in our own policy formation. We need constantly to remember that regulation imposes costs on firms – and ultimately on consumers of financial services. There are two tests which the FSA applies to any proposals for new regulation. Is there an identifiable market failure (relating to our objectives) which gives rise to a material risk? And if there is such a market failure, can we plausibly demonstrate that the costs of regulation designed to address it are outweighed by the benefits? Nobody pretends that this kind of cost benefit analysis is easy. But the quality of regulation can only benefit if we establish a mindset which requires promoters of new regulation to demonstrate what it is for; how it is supposed to work; and that the broad costs and benefits bear a sensible relationship to each other.
We therefore welcome the commitment made by the European Commission to subject all new proposals for legislation in the EU to impact assessments. These of course will not be identical to the FSA's cba but they will impart a degree of discipline to the policy making process that has, up to now, been lacking. The FSA strongly supports the idea of undertaking impact assessments in support of all proposals for new policy. In fact we would go further and say that this type of approach should permeate the whole life cycle of the policy making process. We also welcome the Commission's decision to review existing measures to see whether there are redundant rules.
Impact assessment, if undertaken properly, should help us to choose among policy options. And it is very important always to bear in mind that one of these options may be to do nothing – if the expected costs of regulation outweigh the benefits. Alternatively, it may guide us to a decision to use tools other than introducing new regulation, such as changes in supervisory practice or the development of principles or codes of conduct.
Impact assessments are of great value in increasing the transparency and rigour of the policy-making process. But they are only a means of helping us achieve better policy, not ends in themselves. Even the most disciplined processes will leave us with dilemmas – albeit ones which can be more clearly identified. Let me outline two:
- How should we respond to an impact assessment undertaken by the Commission which makes a convincing case for introducing a measure on the grounds that it would deepen the single market and hence impart real gains in economic welfare but at the cost of increasing risk (when measured in terms of our regulatory objectives)? In principle this introduces a trade-off for policy-makers – though not, as I will explain in a moment, for regulators.
- Similarly, cost benefit analysis conducted at an EU-wide level could support a convincing case for introducing a regulatory measure even though it would not pass a cba test at a national level. The FSA has already drawn attention to the possibility that MiFID could come into this category – although, given that MiFID has not been subject to a comprehensive cba it is difficult to assess the balance of costs and benefits even on a pan EU basis. Or take mortgages. In July, the Commission published a Green Paper on mortgage credit in the EU. The Commission's concern is that national markets are not integrated and the full range of mortgage products is not available in all member states, reducing consumer choice. The Green Paper is supported by a study produced by London Economics. This identifies that any benefits from integration would not be evenly shared across the EU. The UK would be least likely to benefit as changes would be directed at bringing others up to UK standards of market completeness.
These are important dilemmas. But the FSA's response to them is clear. First of all, we continue to be obliged to subject all new policy measures, including those contained in European directives to cba based on the costs and benefits of regulation in the UK. Second, we continue to interpret our statutory objectives – as the Financial Services and Markets Act requires us to do - primarily with regard to UK incorporated firms, the UK operation of foreign firms and their customers. This means that while a proposed measure may hold out the possibility of increasing economic welfare at an EU-wide level, we will highlight situations where such measures may pose risks to our statutory objectives.
What does all this mean at a practical level?
We will continue to work hard within the European policy making structures to achieve regulation that is proportionate and addresses clear market failures. While it will not always be possible to align UK and wider EU interests, we have a powerful incentive to achieve this to the maximum extent possible and will strive to do so in our work on new policy formulation – for example in our work on the Level 2 advice provided by the Lamfalussy committees of regulators. Our ongoing work on MiFID is an example of this.
We will also engage with the Commission in respect of its commitment to produce impact assessments supporting new measures. And we will subject those assessments to careful scrutiny. We would encourage the industry to do likewise. While, as I have explained, such assessments do not in themselves remove policy dilemmas, if undertaken properly they will at least highlight these and assist us in having a rational dialogue with the Commission and with other Member States.
In this regard I am encouraged by the Commission's White Paper which was published yesterday and which gave strong endorsement to the better regulation agenda. If the Commission's objectives are achieved the EU will be better placed to create not just a single market in financial services, but one which can remain internationally competitive. Wholesale markets will not thrive in Europe if they are strangled by poor quality regulation. We shall be suggesting to the Commission how their goal for better quality rule making might be attained.
Stakeholders
As well as looking at instances where the FSA's statutory objectives are not aligned with EU policy initiatives, we also need to look at how our stakeholders assess our performance in meeting our FSMA objectives and how this aligns with our own success criteria. In trying to craft regulatory solutions, we are more likely to achieve outcomes that will last if these are widely seen as fair, considered, and take account of market realities. We are most likely to achieve fair, considered and market sensitive solutions when we adopt an open and transparent approach to policy-making which takes account of stakeholder views. This takes various forms but the more important include:
• our commitment to consulting stakeholders on proposals for new rules and guidance and for providing cost-benefit analysis that is open to challenge;
• the requirement to engage with three independent panels - Consumer Panel, Practitioner Panel and Smaller Businesses Practitioner Panel - over new policy proposals;
• an FSA Board in which non executives comprise the majority of our directors; and
• appearances by senior FSA executives before the Treasury Select Committee.
In addition to these more formal mechanisms, there are less formal channels such as the continuous dialogue between FSA staff and firms, consumer groups, trade associations, professional bodies, other UK policy-makers and overseas regulators. Given the diversity that exists among financial consumers and within the regulated community for which we are responsible, it would be cavalier to avoid making good use of the wealth of informed opinion that is available to us. The same consideration leads us to welcome the better regulation agenda being advanced by Commissioner McCreevy [although clearly the institutional and process disciplines at the EU level will not mirror those in any single member state].
But while good policy disciplines help us to avoid making bad choices, they do not eliminate the need to make choices. Proportionate regulation requires the exercise of professional judgment. Hence FSMA avoids imposing a simplistic formula, such as requiring us to eliminate all risks to our objectives, or to users of financial services, without constraint. This is illustrated by our consumer protection objective. FSMA says that we should aim at 'securing the appropriate degree of protection for consumers' rather than providing blanket protection.
As regards EU-related initiatives, it may also be the case that the costs and benefits of regulation do not accrue evenly - either over time or between classes of stakeholder. In particular, firms may perceive the direct, short-term implementation costs associated with new directives as high while the long-term benefits (e.g. gains from trade) to the wider UK and EU economy from promoting the single market will emerge over a long period and will not be so readily observable, say as the spend required on new compliance officers or IT. Where firms benefit in the long-run, these gains are unlikely to be assigned to the same cost centres that carried the original costs.
While it would be impossible to reconcile all tensions between stakeholders, our best hope for managing these (and encouraging creative solutions) is to continue our commitment to openness and to articulate clearly the reasons for our actions.
The complex regulatory environment: different regulatory and legal systems
So, what do these reflections on European policy-making, and its relationship with the obligations of the FSA as one national regulator amongst many, imply for the future of the Lamfalussy structure? The key objectives of that structure - to streamline the process for introducing (and amending) financial services legislation and achieve convergence of regulatory practices throughout Europe – are clear and have been widely welcomed.
The Lamfalussy committees are composed of national regulators, which have different – and sometimes inconsistent – remits, structures, objectives and powers. This is sometimes apparent when the committees are asked to provide the Commission with advice on new measures. And it can be all too obvious when directives come to be implemented at the national level. Critics sometimes suggest that such a heterogeneous groupings will never be able to deliver regulatory convergence and that regulation in Europe will remain fragmented and costly for firms unless some more radical change – in the direction of more unified structures - is introduced.
The FSA strongly supports the idea that regulation should be proportionate and cost effective. This principle certainly extends to the regulation of internationally active firms which all too often can be duplicative and inefficient. However we do not agree that this can only be achieved with radical structural change.
We have yet to see a proposal for radical change in European regulatory structures that is workable – in the sense of addressing the many practical, legal and jurisdictional issues raised – or which does not require quite fundamental changes in European legislation.
Equally important, we believe that the Lamfalussy structures, if implemented to their full potential, are capable of providing real regulatory convergence. Levels 1 and 2 of the process create a common set of legislative requirements which have to be transposed by Member States. Supervisory convergence - or Level 3 – is an opportunity to achieve useful regulatory convergence through sharing of experience by regulators and agreed guidelines on interpretation and practice.
This is not to say however that we do not need to do significantly better in European regulation.
The Lamfalussy structures are at different stages of development and continue to evolve. They are certainly capable of delivering better European regulation but only if all involved demonstrate the will to deliver real convergence. This will involve for example being serious about questioning and challenging the way that particular directives have been implemented in particular Member States. The committees also need to demonstrate a real willingness to work for convergence.
One area in which regulators are rightly under close scrutiny is that of home and host relationships. I firmly believe that there is scope within existing legal frameworks for regulators to collaborate more closely in ways which will carry out our regulatory task more effectively while also posing demonstrably less duplication and cost on firms. The FSA has been in the lead in pioneering college arrangements and shared working with other regulators of European groups. We will continue to press hard on this front and strongly encourage others to do likewise.
Again I warmly welcome the Commission's White Paper commitment to enhancing the Lamfalussy arrangements. But again a note of caution is needed. We have learnt that harmonisation cannot be pursued at any cost, and it is critically important that as we set out on the road of supervisory convergence it leads to a reduction in duplication not to an imposition of an extra layer of supervisory oversight. The same principles of proportionality must therefore guide the way we approach this work.
Has the FSAP delivered value?
So, those are my thoughts on priorities for the Lamfalussy committees, against the background of my opening commentary on how the perspectives of national regulators and of European standard-setting relate to each other.
Let me close with some remarks – perhaps teasing rather than satisfying – about the potential impact of the FSAP. Many of its components are of course the product of the pre Lamfalussy world.
The long debate over MiFID Level 2 is set to come to a conclusion next spring, and other FSAP measures like the Prospectus Directive and Market Abuse Directive are already agreed and implemented. So, it is tempting to start drawing up a balance sheet for the impact of FSAP as a whole. Tempting, but tricky as there are some complex interactions to think about between the individual measures. There is certainly insufficient data at this point to draw clear conclusions about observed impacts. And attempting an ex ante analysis at a pan European level – while it would have been a useful discipline to have applied before the FSAP commitment was made in 2000 – is not really the province of the FSA or any individual Member State.
The Commission published in November 2002 an analysis by London Economics of potential upside for EU GDP if the FSAP as a whole were to unlock a reduction in the European cost of equity capital of, on average, around 50 basis points. I think it is fair to say that that study, whilst not unreasonably pointing to the efficiency and liquidity of US capital markets, did not seek to articulate a close cause and effect case, tied back to the individual elements of the FSAP. In some areas, the various measures may have opposing effects, the balance of which needs to be carefully assessed. So, for example, whilst transparency in markets is clearly a good thing in general there can be circumstances where, if overdone, it can actually harm liquidity.
Given the absence of cba thinking in the negotiation of individual FSAP measures and of analysis of the different markets across the EU, we very much welcome the announcement made by the Commission on 7 November about plans for a thorough going ex post evaluation of the economic impact of FSAP, to be carried out in the period to 2009. It will be essential to feed back the results into long-term thinking about European regulation.
In the UK, we and HM Treasury have published cba assessments, from a UK perspective, of the individual FSAP measures implemented so far and, we plan to do the same next year for MiFID. Our analyses of the individual measures implemented so far suggest that costs and benefits have been reasonably proportionate. Nevertheless, in some areas, such as the Market Abuse Directive, it has been easier to see the costs of changes to the existing UK regime than the benefits which may eventually flow.
In all of this it is important not to forget that there can be a real distinction between the cost and benefits of any regulatory measure and its commercial impact on financial services firms. For example, to the extent that enhanced transparency does reduce the cost of capital, that may partly be at the expense of the profitability of intermediaries and advisers including brokers and investment banks. Such firms, do I think well recognise such potential downsides for their operations and they also are properly aware of the systems costs that can arise from MiFID and other FSAP measures. Equally however, the more thoughtful firms at least are I think seeing the potential upsides for them from, for example, MiFID's opening-up of continental equities markets as concentration rules are abolished.
Another point that I have already alluded to is the possibility that both for commercial impacts and costs and benefits in economic terms, the net impact of a European measure can be very different for a single country than for Europe as a whole. With European capital markets partly concentrated in London and the scope of UK regulation currently wider than in some other Member States, the balance of costs and benefits in the UK context could well differ from that at the level of Europe as a whole.
So much for thinking out loud. I do not propose today to try to draw a conclusion about the net costs and benefits of the FSAP or indeed of its impact on the business prospects for particular sectors in London. As I have already mentioned, we will be publishing next year our assessment of MiFID costs and benefits from a UK perspective. And we would encourage all players with views about key analytical challenges involved in assessing the economic effects of FSAP at a European level to be ready to share those with the Commission. Much has moved on since 2000, not least views on the notion that hard wired regulation is always the best means to promote clean, efficient and fair capital markets. A clear assessment of the overall effects of the FSAP can only be helpful to the longer-term debate about the direction of European regulation.
Better Regulation
I have now outlined a number of the challenges posed by a pan-European system of regulation, as well as some examples of how we, as a national regulator, are trying to respond to some of these tricky issues. I have also shared with you my initial thoughts on evaluating FSAP, a very worthwhile, if challenging, area of investigation. Before I end my presentation I would like to make some brief observations on the better regulation agenda – as you know this is currently a very topical area of discussion.
In recent times both the British government and the Commission have been emphasising the importance of focussing on ensuring that regulators and the regulations they produce deliver what society requires from them. Broadly, that is focussed and proactive regulation addressing genuine market failures. And the costs of that regulation, for firms and consumers, should be proportionate to its benefits. This has come to be termed as the "better regulation" initiative. Much of the better regulation agenda as developed following the Hampton and Arculus reports in the UK, maps directly onto the approach the FSA has already adopted. An example is the importance of ensuring effective cba. Another is a risk-based approach. It is many years since UK supervisors stuck to a rigid timetable in visiting firms, regardless of their size or their risk profile. Instead, all of our supervision is driven by the amount of risk that we believe firms or issues pose to our objectives.
A challenge, however, can arise for regulation of wholesale markets in respect of an often implicit, and sometimes explicit, belief that better regulation should always equate to less regulation. Of course, in wholesale markets – where informed clients are dealing with firms on a much more level footing than is the case in retail product markets – we would expect regulation to be much lighter touch. And it generally is, reflecting the requirements of FSMA, that, for example, we take due account of the differing degrees of expertise of different kinds of client. So where rules are needed as a backdrop or framework – to discourage poor behaviour which undermines market confidence and to ensure appropriate protection that even sophisticated clients deserve – they can often be lightly drawn.
Whilst this is true as a generalisation, it is also interesting to note that in some respects the success of the London capital markets – the biggest concentration of capital markets in Europe – has to a degree been based on having higher standards than markets in some competing locations. These higher standards are ones which have been supported, and in many cases proposed, by the industry itself. An example of this can be found in our approach to the standards for listing. In our recent review, taking account of the Prospectus Directive the institutional listing community and institutional investors were strong supporters of retaining key established elements of the UK system such as sponsors and a 3-year track record. The proposed rules with respect to the use of commissions in institutional equities is arguably another example
There is a clear challenge here for the FSA and the authorities in general to ensure that as the better regulation agenda is taken forward, that its overall thrust does not inadvertently remove the ability of industry to work effectively with the authorities. This is an important point, as we need to ensure that we have the right level of standards to encourage international business to be transacted in Europe, and not migrate elsewhere
As you can see the challenges of regulating wholesale markets in Europe can be difficult, and there are a variety of tricky influences involved. Given that to date the UK continues to develop and expand its wholesale markets, I believe I can make the following reasonable conclusion. Although the challenges are complex, working carefully with industry and other relevant authorities at large, appears to be producing a reasonably successful system of financial regulation for the wholesale market.
Thank you for your attention today. I hope you have found this presentation interesting and that you enjoy the rest of the conference. I am now happy to take any questions you might have.