Professional and financial regulation ¿ conflict or convergence?

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Speech by Andrew Whittaker, Director, General Counsel Division, FSA
Fountain Court Chambers Conference on Better Regulation
31 January 2006

Introduction

Thank you for that kind welcome. I am very pleased to take part in this conference on "Professional and Financial Regulation – Conflict or Convergence?" As both a member of the legal profession, and a financial regulator, the subject of whether there is conflict or convergence between regulation of the professions, and regulation of the financial services industry, is one in which I take great interest. But the main focus of my presentation today will not be this general issue. Rather, speaking as the FSA director responsible for better regulation, I will be focussing on our work on better regulation, and in particular, on our strategy of developing into a more principle-based regulator. I hope that this will show that there are at least some common themes, and common approaches, between regulation of the professions and regulation of the financial services industry. I will also take the opportunity to challenge those who suggest that there is some inherent conflict between the rule of law, or the principles of the ECHR, and more principle-based regulation. I will address this topic under four headings:

the FSA's commitment to better regulation;
the need for principle-based regulation;
principles vs rules – which work best? and
fairness in principle-based regulation.

The FSA's Commitment to Better Regulation

I should start by reinforcing the FSA's commitment to better regulation, and setting out why we are committed to it.

The fundamental reason for our commitment to better regulation stems from our commitment to securing the objectives of regulation themselves. In our case, these are set for us by statute. We are required to maintain confidence in the financial system, promote public understanding of it, secure the appropriate degree of protection for consumers, and reduce the extent to which it is possible for financial services businesses to be used for a purpose connected with financial crime. So better regulation is about finding better ways to secure these objectives, rather than simply a polite codeword for deregulation.
We have set out our wider better regulation agenda in our Better Regulation Action Plan, published in December. Our better regulation work will be fully integrated into our plan and budget when it is published tomorrow.
We give effect to better regulation through three basic approaches:

being risk-based in our approach to regulation;
being sensitive to the costs of regulation; and
being more principle-based, reflecting the importance we attach to the responsibilities of senior management.

In addition, we are undertaking some targeted deregulation. For example, we announced on Friday the first set of decisions following consultation on our Handbook Review project. That announcement confirmed that we will press ahead with streamlining our anti-money laundering requirements as part of a drive to simplify our Handbook and remove rules and guidance that are no longer needed. There was overwhelming support from the industry and other respondents for these proposals. We have removed our former detailed rules on account opening in their entirety, which previously overlapped with, and duplicated, both Government anti-money-laundering regulations, and industry guidance from the Joint Money Laundering Steering Group. Instead, we have introduced high-level requirements for firms to have their own risk-based controls on money laundering. This reflects our wish to provide firms with greater flexibility in the fight against money laundering, and an increased focus on senior management responsibility for doing so. Our aim is to encourage firms to target resources on activities which are most likely to result in deterring and detecting money laundering – a reflection of our more principle-based approach.

But what do we mean by being "more principle-based?", and why is that part of our wider better regulation strategy?

The need for more principles-based regulation

In some ways, the FSA is already a principle-based regulator. To start with, we have a set of 11 principles for firms, set at a high level of generality, which set out clearly, at a level of principle, the essence of what we expect from firms. Based on a set of 10 principles operated by one of our predecessor regulators since the early 1990s, according to these principles:

"A firm must conduct its business with integrity.
A firm must conduct its business with due skill, care and diligence.
A firm must take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems.
A firm must maintain adequate financial resources.
A firm must observe proper standards of market conduct.
A firm must pay due regard to the interests of its customers and treat them fairly.
A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading.
A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and a client.
A firm must take reasonable care to ensure the suitability of its advice and of discretionary decisions for any customer who is entitled to rely on its judgement.
A firm must arrange adequate protection for its client's assets when it is responsible for them.
A firm must deal with its regulators in an open and co-operative way, and must disclose to the FSA appropriately anything relating to the firm of which the FSA would reasonably expect notice."

We have regularly taken enforcement action for breach of these principles, as well as for breach of more detailed rules. We have stood back from making detailed rules in areas which are not well suited to them, for example corporate finance. We have developed a project in the retail financial services sector on "Treating Customers Fairly", which aims to encourage firms to enhance the fair treatment of their customers, without new rules. We have supplemented detailed rules with industry guidance. And we regularly give guidance ourselves, sometimes in real time, for example on market conduct issues.

This more principled-based approach can be contrasted with that of some other financial regulators outside the UK, which can often be more rule-based. It can also be seen in the context of a wider UK market differentiation, involving the "true and fair view" override for audit, and the "comply or explain" approach to corporate governance.
If we are already taking this approach, is our current commitment to more principle- based regulation anything new? And surely it is, anyway, only part of the story, with the other part being a massive and detailed rulebook, often applied, or said to be applied, without regard to underlying principle or objective? My view is that our commitment to being a more principle-based regulator is both new and important. But it is not a complete change of direction. Rather, it is about changing the balance between principles and more detailed rules.

Why is this rebalancing needed?

First, prescriptive standards have shown themselves inadequate alone to prevent misconduct, not least through the experience of pension misselling. For those of you who may not remember the background, through the late 80s and 90s, there was massive misselling of personal pensions, causing loss to consumers totalling over £11 billion. This took place not withstanding the existence of detailed rules.

Second, the current volume and complexity of our standards makes them not only a barrier to entry, but also a barrier to compliance. This is true both of our Handbook itself, and also of the increasing volume of other normative material, setting standards for firms but outside the Handbook.

Third, prescriptive rules divert industry attention towards complying with the letter, rather than the purpose, of the standard, making it less, rather than more, likely that it will achieve its goal. Compliance can then become a displacement activity – a substitute for achieving the objectives the rules are designed to secure.

Fourthly, many issues are not adequately dealt with through prescriptive standards, or can be dealt with in that way only at the cost of making the system overly complex.

Finally, maintaining a set of standards of the current sophistication and complexity is liable to become an increasing consumer of our own resources, let alone those of people in the outside world, at a time of renewed sensitivity about costs.

What then is our strategy for developing more principle based regulation? The key elements are that:

we will rely on existing principles, rather than introducing more rules, unless there are strong reasons for more rules;
we will integrate these principles more directly into our supervisory work, finding ways to operationalise their importance without losing their character by building processes round them;
when we decide to use rules, rather than rely on existing principles, we will make them high level and outcome focussed, unless there are strong reasons for more detail;
as part of this, when we implement EU directives, we will not gold-plate them, but will add additional requirements only where these can be justified in their own right;
finally, we will develop our staff to ensure that they are better able to operate in a principles-based system, understanding firms and the industries in which they operate, making outcome-focussed judgements rather than simply applying rules, and giving straight answers to straight questions.

This does not mean that we will be moving in short order to a situation where there are only the 11 principles. We will continue to use detailed rules where there are strong reasons to do so. For example, we may need to do so in order to implement detailed directive requirements, or because we want to give customers clearly enforceable rights. We may need to set standardised approaches to allow comparability, for example on calculation of APRs. We may aim to allow implementation through electronic systems or on another basis standardised across a wide group. Sometimes, we may be able to cut costs by requiring a standard form of disclosure, rather than a bespoke one. Our objective though is that progressively we will move to a more principle-based approach, of the kind I have outlined.

Fairness in more principle-based regulation

The public response to what we have said about a more principle-based approach has been mixed. Some have welcomed it. Others, particularly in the compliance community and in US investment banks, say that they favour detailed rules. Others like general principles, but want them to be supplemented by guidance. Yet others see them as an unnecessary and an unfair imposition on top of detailed rules.

In this part of this presentation, I want to focus on the fairness of using general principles. This has arisen in the context of the FSA's own approach, for example in taking supervisory or disciplinary action. And it has also been raised in the context of decisions by the Financial Ombudsman Service, which can award compensation to customers on the basis of its own opinion as to what would be fair and reasonable in the circumstances. The suggestion there is that, without guidance from detailed FSA rules, the Ombudsman will make awards in circumstances which could not have been predicted at the time of the action which gave rise to the complaint.

Is there something inherently unfair about principle-based regulation? In my view, the answer is clearly "No". A fundamental requirement for the application of a principle is predictability. In order for consequences legitimately to be attached to the breach of a principle, it must be possible to predict, at the time of the action concerned, whether or not it would be in breach of the principle. But, where this requirement for predictability is met, it is legitimate for consequences to follow, even if the principle is expressed in general terms. So the use of principles is clearly fair, if the way they work is predictable.

Predictability can of course be improved by guidance. We recognise that more principle-based regulation may require a greater readiness to issue guidance. This may take the form of formal guidance, which is designed to help interpret a principle. Or it may take the form of an informal case study designed more to help people to identify and address issues than to expand on the principle itself. Our Treating Customers Fairly initiative has made wide use of case studies of this kind. So both in terms of decisions by the FSA, and by the Financial Ombudsman Service, we would expect predictability to be helped not only by looking at the terms of the principle itself, but also by the availability of guidance, case studies and industry codes. Of course, that does not mean that the guidance, case study or industry code itself becomes mandatory, without going through the 'due process' needed for new rules. Any formal action will still depend on the terms of the principle itself. But it does mean that an application of the principle which may not be immediately apparent can be clearly illuminated. And we also recognise, and indeed intend, that where we move to more principle-based regulation, this will allow more discretion to firms than if detailed rules were used. The intention is not the same degree of prescription, but achieved through guidance and case studies rather than rules. The intention is less prescription.

Conclusion

I hope that, in this presentation, I will have given you a clearer idea of why FSA claims, and is determined, to be a more principle based regulator. My focus has been mainly on what this will mean in terms of our Handbook of rules and guidance, but we recognise that it will also require important changes of approach and behaviours, both in ourselves, and in others who apply principles and rules. For our own part, we do not underestimate the size of the task ahead in achieving the change we wish to bring about. My own conviction is that, in the interests of comprehensibility, flexibility and effectiveness of our rules, and the effective securing of our objectives, it is vital that we do so.