Are we heading towards over regulation?
Speech by John Tiner, Chief Executive, FSA
Rendez Vous de Septembre, Monte Carlo
12 September 2006
I am honoured to be here in Monte Carlo making my debut at the Rendez Vous de Septembre. A number of my colleagues have attended the Rendez Vous during the past years and reported back on how intensive, interesting and exhausting it is. I am sure each of these is true but I wonder whether the exhaustion really comes from just the intensity of debate!
May I say I am particularly pleased to be participating in a discussion under the title "Are we heading towards over regulation?", since this is an issue I have been concerned about since becoming head of the UK FSA three years ago. My simple answer is yes. You maybe surprised to hear that from someone who makes his living out of regulation and so let me explain. I believe strongly that markets are the lifeblood of successful economies and societies and that only carefully judged regulatory intervention can add to rather than detract from the positive impacts of market forces. It seems likely to be the case that the stock of rules and regulations across countries, across society and across the industrialised spectrum already contains much material in the latter category.
But I would not like to spoil the debate by being the one who having been set up to speak against the motion, switches sides on the Platform, even before hearing the counter arguments. I will therefore go on to make the case for wise and cost-effective regulation of the financial services industry, including insurance, where over the next few years I believe we have a great opportunity to get it right. I will come back to this later in my remarks.
First a few basics. In his opening remarks, Piotr focussed on seeking rational grounds for regulation in life more generally. Regulation is all around us…whether we are travelling to Monte Carlo, working in our businesses or sitting at home…I recently had three contractors visit my house over a 3 week period to run a wire to the roof – the first two looked at the job and departed. Only the last had the necessary authority to climb a ladder above a certain height and complete the job. Now I appreciate the importance of health and safety but I wonder how much wasted time, productivity and cost were involved in this simple assignment, not to mention the inconvenience of the being woken at 8.00 a.m. on a Sunday morning to let the first contractor into my house.
Rule number one must be that if there are no rational grounds for regulation there should not be regulation. I am moved to wonder whether legislators, regulators and other policy makers derive their job satisfaction and meet their objectives by adding new regulations with insufficient incentives to remove unnecessary regulation. I do not know the genesis of the Insurance Mediation Directive but I wonder whether the legislators in Brussels at the time properly thought through the market issues it was seeking to address, the costs it would impose on business and consumers and its broader market impact. Some provisions I applaud; others I wonder about. I think there are a few pre requisites before society should accept the need for new regulations.
First, is there a failure in the particular market which needs to be addressed? If there is no market failure there is no need for regulation as the market, including the business and consumer participants, can take care of itself.
Second, if empirical analysis shows there to be a market failure then is regulatory intervention the most efficient and cost-effective form of correction? Market failures can also be addressed using other mechanisms such as competition policy and it is policy makers' responsibility to consider what is the most effective tool to address a particular situation, taking into account the need to secure specific outcomes and recognising the increase in costs to business and their customers. But even here, the blunt instrument of regulation does not have to be the regulator's only option, even if there is both a market failure and the benefits have been shown to outweigh the cost of regulatory intervention. At the FSA, we appreciate that we have a position of stature, authority and, I hope, respect in the market, which enables us to use our influence with market participants and their trade representatives to change firms' policies, processes and behaviours without reaching for the heavy handed tool of the Regulator's Rulebook. Again, I will come back to this in a moment.
Thirdly, regulators must be very wary of the damaging effects they can have on creativity, innovation and competition. The FSA is an advocate for principle-based regulation – that is where the focus is on the outcomes rather than the prescription of detailed processes. Targeting outcomes such as customers of financial firms being treated fairly, or firms holding financial resources sufficient for the risks they run, enables companies to focus on the substance of what is good for their business, their customers and for society around them. But I am the first to acknowledge that an approach along these lines is not easy. Both regulators and firms find a sense of safety and security in detailed rules as they define the scope of their legal exposure. However, I am worried that a legalistic approach can impose unjustifiable costs and limit innovation (through one-size-fits-all requirements) and competition (by creating barriers to entry). The regulator and the regulated must be bold enough to accept some uncertainty and ambiguity and to manage any consequent legal risks for the good of markets and society as a whole. My preferred approach requires there to be a good degree of trust between the regulator and the regulated and for the regulator to have the experience, market insight and intuition to make good judgements. These are the qualities I want the FSA to develop more deeply. This approach also creates a converging force between good business practice and good regulatory practice and so reinforces another key principle that it is management who are responsible for running a companies business and not the regulator. In practice, we find that a combination of principles and detailed rules is necessary in the content of a regulatory rule book. Strong enforcement, however, is a fundamental counterweight to the freedom that comes with a principles-based regulatory system.
So why are we heading towards over regulation? I have heard it said that too much regulation is a knee jerk response to a crisis where legislators, regulators and other policy makers need to be seen to be doing something to prevent the same kind of crisis occurring again. This is perfectly understandable given the real politik which engulfs a regulator when a major market problem arises. But we must guard against working hard to close one stable door while the doors down the yard are edging open. We must also ensure that regulatory actions address the real causes of failure and not simply the symptoms. That is not to say that there have not been serious problems which need to be addressed or that regulators should ignore the lessons of past problems. On the contrary. The UK financial services industry paid out over £11 billion due to pensions being missold. Something had to be done to restore confidence and protect consumers. I believe the global banking system is safer thanks to the advent of consolidated supervision introduced following the collapse of BCCI in the late 1980s. In the UK, the strengthening of the life insurance industry has been due, in part, to the major overhaul of insurance regulation following the problems of Equitable Life. This seems to me a benefit of good regulation which I think is often not recognised. Sensible, proportionate and fit-for-purpose regulation can be a force for improving not just standards within a sector, but also efficiency and competitiveness. Many of you will know, that in December 2004, I challenged the UK insurance market to satisfy contract certainty on the vast majority of its policies within a period of two years. Progress has been good and momentum has been maintained. We now need to see the market push for the finishing line, so my commitment not to intervene can be delivered. While my particular concern was the operational risk being run by brokers, carriers and insurers, a very important by product of this initiative should be to raise the level of investment in technology, people and process improvement and so, reducing transaction costs within the London Market whilst improving the quality of service to customers. Surely these must be good for competition.
Interestingly, the market seems to be having more difficulty resolving the issue of commission transparency. Perhaps this is due to there being divergent commercial interests among participants and the fact which continues to surprise me, that buyers are not more demanding of their brokers about price transparency. We will be assessing this issue later this year and, for our part, regulatory intervention remains an option.
My challenge today was to discuss where the limits of wise regulation should be set. As I have wandered along my random walk of regulatory philosophy during the last few minutes I have mentioned where I think some of those limits should be established. But the limits I have discussed need to be set in terms of objectives and outcomes which capture what the regulator is trying to achieve recognising its limitations. Regulation should not seek to eliminate risk for the users of the financial system. This would destroy the essence of the financial services market, which has risk transfer at its heart, and in any case would be impossible for any regulator to deliver at a cost which society would be willing to bear. So in a free market which is well regulated, failure and losses will occur and should occur.
There are three rather obvious objectives for financial regulators. First, since the financial system sits at the heart of all free market economies, it is central to the effective working of the economy that all citizens, businesses and other organisations have confidence in the operation of the financial system. This extends beyond national borders to regional markets and the global economy. Secondly, users should be entitled to think that when they enter a market they will be treated fairly. This means different things in the wholesale markets and retail customer markets. Wholesale markets operate among professionals and while the regulator must be concerned about the integrity and cleanliness of those markets it would not be proportionate to impose costs which seek to protect wholesale participants from making a bad or unwise decision. On the other hand most retail financial service markets are characterised by information asymmetry between the company and its clients and it is, therefore, reasonable that the regulator should seek to protect clients in their dealings with the company. I think one of the dangers that regulators face in the retail market is the belief that customers' interests can be protected by comprehensive and detailed disclosures to them about the products and services they are considering acquiring. To my mind this is not the Holy Grail. Customers can find such literature boring or completely unintelligible. In fact, such kinds of disclosure regimes can confuse the customer and slow down the sales process to such an extent that they switch off, failing to take out a product they need. This is perhaps the most difficult and complex area to establish where the limits of wise regulation should be set and in the UK we are working hard to simplify the relationship between the customer and the company at the point of sale on the basis that less is more.
The third objective is the need for regulators to reduce the use of the financial system by criminals and terrorists. While the total of financial activity by criminals and terrorists may be relatively modest in the context of the financial system as a whole, the cost to society of acts of criminality and terrorism is a significant multiple of that number and so the fight against financial crime must appear increasingly high on any financial regulator's list of priorities.
In the UK, we have a fourth objective which is not common among regulators. That is to promote public understanding of the financial system, including improving the financial capability of the people of the United Kingdom. For us this is a very important role working with Government, educationalists, the voluntary sector and businesses to develop a more competent, capable and informed customer of financial services. These are the demand-side initiatives geared at making the retail financial services market work more effectively.
I would like to close by saying a few words about future developments in the supervision of an insurance company's solvency. Policy holders, from householders protecting their home against burglary to major multi national corporations protecting their businesses against catastrophic events, want to be confident that the insurance company or reinsurance company that has assumed their risk will be able to satisfy their obligations should those risks crystallise. Of course the problem of accounting is that the size and timing of claims can be highly uncertain, leading regulators to take a highly prudent approach to the assets in which a company is allowed to invest, the technical provisions it establishes to cover future claims and, to a lesser extent, the capital it needs to hold if provisions prove inadequate. When I joined the FSA just over five years ago, I noticed that unlike other financial industries I had worked in before, the insurance industry produced one set of financial information by which they managed the business, another set of accounts for its shareholders and a third different set of accounts for its regulators. Investors, customers and market commentators have found this all very confusing.
In Europe a new directive, Solvency 2, will determine how solvency is to be measured and reported in the future. This offers us and the industry a unique opportunity to forge convergence between the financial and operating risks identified and managed by an insurance business with the basis on which regulators judge the financial solvency of an insurer. More generally, it provides an opportunity for insurance to drag itself into the twenty first century, utilising modern and sophisticated risk management techniques to determine required levels of liabilities and capital. These will become sensitive (up or down) as the risks of the insurance company change. In line with this, I hope very much that market consistent valuations will prevail when the draft Directive emerges next year. This approach will provide for more efficient allocation of capital within insurance groups and across the insurance industry. Allowing (and perhaps incentivising) firms to use their own models to determine capital, clearly plays to one of my core principles: it is management responsibility to maintaining sufficient financial resources, not the regulators.
So I believe Solvency 2 offers us all who work in the insurance industry a great opportunity to design wise, sensible, market orientated regulation and I feel optimistic that we will not forego this opportunity.