Principles based regulation: the EU context
Speech by John Tiner, Chief Executive, FSA
APCIMS Annual Conference
Hotel Arts, Barcelona
13th October 2006
I understand that an APCIMS key point for regulatory change has been stated as: "Regulators and the industry need to agree a common understanding of how to establish and regulate a principles-based regime."
Today, I would like to take the opportunity to discuss our move towards more principles-based regulation - a topic that I regard as central to the future of the FSA and of UK financial markets. I believe that a significant tilting of the balance towards principles is essential. I will explain why, as well as outlining some of the challenges and opportunities that arise from the broader European context.
Why principles-based regulation?
Principles based regulation is not new. Our eleven high level principles for business have been in place since 2001 and have their roots in the former Financial Services Act regime. These set overarching requirements for financial services firms and have also formed the basis for successful enforcement action. We also supervise extensively on the basis of principles. Our supervisors have to make judgements about the adequacy of firms controls to mitigate the risk of breaking our regulatory requirements. This is difficult but a much more effective approach than ticking boxes to ensure that the firms are complying with patterns of behaviour that we have laid down for them. That is the essence of principles-based regulation.
The FSA Handbook, however, still contains thousands of rules setting out in detail the way in which firms are required to behave. And the number has increased considerably over the past few years. While there will always be a need for rules, I believe that the current regime is out of balance and that we need, over time, to effect a significant shift in favour of principles. Let me explain why.
Principles-based regulation is essentially about outcomes or ends while rules based regulation is about means. Principles-based regulation allows firms to decide how best to achieve required outcomes and, as such, it allows a much greater alignment of regulation with good business practice.
Firms should be able to operate a single set of controls which allows them simultaneously to meet their business objectives and our supervisory requirements rather than being forced to operate rafts of controls that have no purpose other than to satisfy the regulators. This emphasis on ends rather than means supports another precept to which attach great importance - that of senior management responsibility. Firms' managements - not their regulators - are responsible for identifying and controlling risks. A more principles-based approach allows them increased scope to choose how they go about this. In short, the use of principles is a more grown-up approach to regulation than one that relies on rules.
There are also practical reasons for shifting the balance towards principles-based regulation. Regulators could set themselves the task of creating a rule for every conceivable source of risk or detriment. But they would not succeed in this. The complexity of the financial system means that the number of ways in which firms can damage markets, investors or themselves is increasing exponentially. There are few remaining instances in which it is possible to say that behaviour X will always, uniquely lead to problem Y. Failure to manage conflicts of interest for example can result in clear detriment to investors and markets. Financial firms face many different types of conflict of interest and the number grows every day as business practices evolve. An army of regulators could be employed solely to codify these and write rules specifying how they should be managed. But it is much more efficient to make it clear to firms that they must manage all types of conflict capable of creating detriment and to explain to us and other interested parties how they do it.
Our Treating Customers Fairly programme is an illustration of how we are already applying principles-based regulation to firms. An asset management firm marketing a new fund directly to retail customers for example, needs to ask itself some searching questions. Do the staff devising the marketing and promotion of the new fund fully understand the new product? Are the selected marketing channels suitable in being able to convey a fair and adequate description of the product given the likely capabilities of the target market? Does the firm have the necessary arrangements for dealing with customer queries and complaints? We will look to firms to satisfy themselves and us that their approach to these matters is adequate.
What about benchmarks? Can you be sure, when you take funds under management that that the client understands what he is getting and the associated risk? We recently visited a firm where they used an Interest Rate Benchmark for an Equity Portfolio and were taking performance related fees from the performance over benchmark. This could be an example of customers not being treated fairly because when the equity markets are strong, it would appear to the customer that performance is better than it actually would be against an equity benchmark. To treat customers fairly, portfolio managers need to ensure their benchmarks are appropriate and easy to understand.
Of course it is possible to challenge the principles-based way of thinking. Both regulators and firms can find a sense of safety and security in detailed rules as they define the scope of their legal exposure. But giving way to this legalistic approach, risks imposing unjustifiable costs and limiting innovation and competition. The regulator and regulated must be bold enough to accept some uncertainty and ambiguity and to manage any consequent legal risks for the good of markets and hence of society as a whole. A preference for rules by the way is not universal and views may differ within the same firm. Senior management often get the point that principles-based regulation is good for business. I would encourage them to try harder to spread this message among those in their organisations who may take a narrower view and look for certainty at all times.
Supervisors have also in practice applied a principles based approach in areas that are not prescriptive and where judgement is needed. For example, many firms have been through risk assessments of their governance arrangements, and we are clear that one size does not fit all. Not all of you are big enough to justify a clutch of NEDs or an Internal Audit function. But our risk assessment will look at whether you have a level of governance and high level controls which is fit for your firm, is effective and is scaleable should you have growth aspirations. These discussions are grown up discussions which are not codified in rules but are about good practice in good firms.
But we need to be clear that a move to a more principles-based approach also poses challenges for supervisors. The task that we are asking our supervisors to undertake is much more complex than that of a few years ago. This needs to be reflected in our recruitment, training and remuneration. We recognise that and are committed to taking the necessary steps to ensure that our people are equipped to meet the challenge. Firms also need to recognise that greater freedom implied by a more principles-based approach also entails responsibilities. Where senior managements fail to exercise effective control we will have strong enforcement tools available to us.
I am convinced that a much greater emphasis on principles based regulation is the right - in fact the only feasible - way forward. Our Conduct of Business Simplification exercise provides an opportunity to start moving in that direction. This is a flagship project in the FSA which does not involve tinkering with or amending the existing COB sourcebook but providing completely new text. We will use the new COB sourcebook to implement the conduct of business requirements in MiFID - about which I will say more later. In drafting the new sourcebook we are applying a general presumption against retaining or creating new detailed rules. We will only do so where these are required to implement EU legislative requirements or where a rigorous case can be made to demonstrate that this is the only practicable way of achieving a specific regulatory outcome.
Some in the industry tell us that, while they welcome a move to more principles-based regulation, they wonder whether this may lead to some divergence from the Financial Ombudsman Service who may interpret high level rules differently. The anxiety is that firms which believe they are complying with FSA requirements may nevertheless find that complainants are able to win their cases at the FOS.
I understand why this worries you, but in fact I think your fears maybe misplaced. As I shall show in a moment, the FOS makes very few decisions that turn on the interpretation of FSA rules. We are, in fact, separate organisations with distinct but complimentary functions. The FSA supervises firms, focusing our resources on risks that matter most, accepting that there will be times when things will go wrong. One reason we can take this approach is because the FOS provides a complaints service for consumers, resolving individual disputes as an informal alternative to the courts.
In deciding individual cases - two-thirds of which go in favour of the firm - the FOS takes into account the law, regulations, regulators' rules and guidance and standards, relevant codes of practice and industry good practice, prevailing at the time. Most FOS cases turn on their individual facts or general legal principles, which apply to all businesses. The FOS estimate that few decisions turn on the interpretation of FSA conduct of business rules; fewer than 5% in investment cases and even fewer in other sectors. Many more investment cases turn on questions how to apply concepts such as 'suitability' in the circumstances of a particular case.
Sometimes an individual FOS decision may have broader application to other cases. Where that is the case we have established the 'wider implications' process to coordinate the work of the FOS and FSA. We have successfully used this mechanism a number of times to enable the FSA to undertake a wider policy dialogue on issues raised by specific cases. Much of this work has focused on packaged products and whilst the detail may be of limited interest to APCIMS members, I think the process is not. To give one example. The FOS received a number of complaints about contracts for long term care insurance in late 2004. After considering the issues, we and the FOS concluded that the cases raised wider implications about the way these products had been designed, priced, marketed, and administered, particularly through the periodic reviews of insurance charges and funding where there was a risk that the reviews had been carried out in a way that moved the goal posts for customers.
We undertook a programme of thematic work looking at the fairness of operation of review clauses. The FOS decided that it should continue to consider complaints referred to it except in those cases where the FSA was taking action involving a specific firm. The FSA and the FOS continue to liaise over the number and nature of complaints received about long term care insurance contracts.
Even where the FSA decides not to become involved, the wider implications process allows FSA to offer material to the FOS for their consideration and the FOS to obtain input from industry and consumer experts.
The process of simplifying the Handbook may result in the FSA removing rules on which the FOS has previously relied. We have been working closely with the FOS on the changes we will be proposing to the Handbook. As a result of this work, we and the FOS do not envisage that NEWCOB is likely to result in any significant change to the outcome of cases nor is it likely to create areas where FOS would need to develop a new approach to replace a rule that has been removed.
I can understand why some in the industry may feel defensive about the FOS; but an opportunity would surely be lost if firms did not see what they could learn from its findings. I wonder if everyone here is alert to what can be learnt from FOS decisions in your favour and how it might be applied to ensure customers feel fairly treated. For example, is there a pattern to the complaints made which suggests that more could be done to manage your customers expectations up front, particularly on performance for example.
I touched earlier on MiFID and this audience needs no reminding that much of our regulation originates in Europe. Let me now turn to that broader European context and what it means for our push towards a more principles based approach. The European context.
I am well aware that financial firms continue to face a heavy burden in terms of the implementation of European directives, especially MiFID. This may well colour attitudes to European regulation. But the sometimes painful adjustments required under MiFID should not be allowed to obscure the real changes for the better that we have seen in more recent European thinking about regulation.
There is now an acceptance in the highest levels of the European Commission that regulation imposes costs on business and therefore needs to be rigorously justified. This view has been held by the FSA since its inception but evidence of this thinking was conspicuously absent from much past European policy making. The Commission has undertaken to consult widely and openly on new measures, to undertake and publish impact assessments and we wholeheartedly welcome these commitments.
There is still some way to go on the practical application of these ideas. It is not clear for example that the commitment to better regulation disciplines has permeated all levels of the Commission or that the necessary tests and hurdles have been hard-wired into policy making processes. The impact assessments relating to mortgages and clearing and settlement - may be familiar to some of you. These left something to be desired in terms of detail and specificity. They represented a welcome start but were too broad brush. Assertions of the kind that improving market X will raise EU wide GDP by Y basis points over a five year period may or may not be correct but they do not provide a sufficiently detailed foundation for informed decisions about policy making. I welcome the commitment to undertake ex post evaluation of new legislative measures including those included in the Financial Services Action Plan. I would hope that in time we could go even further than that and remove any EU measures - whether or not they originated in the FSAP - that are not serving a useful purpose. A willingness to remove redundant measures is every bit as important as imposing proper disciplines on the introduction of new ones.
It is easy to level criticisms at the Commission in the light of its past regulatory record. But we should not lose sight of the fact that there has been a sea change in thinking about regulation in Europe which portends a more thoughtful and measured approach in future.
The FSA has traditionally been very active in seeking to influence the European agenda and we fully intend to continue with this role. We have been in the vanguard of pressing for the adoption of rigorous empirical disciplines around policy making, both in the Lamfalussy committees and in our direct engagement with the Commission. We have also, through early and extensive engagement with the Commission and others, sought to help shape individual measures to ensure that they effectively address risk and do not make it harder for us to achieve our statutory objectives. The FSA for example has pressed within the CESR expert group on UCITS for eligibility of specific instruments to be judged on a principles basis. This will increase flexibility and the scope for UCITS managers to innovate. And when implementing European measures, we have a commitment to make maximum use of 'intelligent copy out'. That is, we will copy out the text of a directive where it makes sense to do so, adding interpretative guidance where that avoids placing unintended additional obligations on firms. And, of course, we will not introduce additional requirements unless there is a demonstrable cost/benefit case for doing so. PBR and Europe
Notwithstanding a much improved climate for regulation in Europe, we are unlikely to see principles-based regulation embraced wholeheartedly in the near future. There are certainly some signs of things moving in the right direction. MiFID is a huge measure with a broad scope. It contains a wealth of detailed provisions that it would be hard to characterise as fully principles-based. But its provisions in some areas, such as risk warnings are pitched at a significantly higher level than those contained in the current COB sourcebook. Less prescription means more scope for firms to exercise senior management responsibility and for regulators and firms to have a mature dialogue.
But before getting too carried away here, it is as well to recall that some features of MiFID as well as other recent measures, such as the Insurance Mediation Directive and the Consumer Protection and Co-operation Regulation still contain high levels of prescription. These measures set requirements in the fields of monitoring and enforcement, which limit supervisors’ room for exercising risk-based judgement.
There are several reasons why it may be some time before we see a decisive shift to more principles-based regulation in Europe. Commission staff, like those in many firms and regulators, understand rules and are comfortable with them. Cultural and legal traditions vary widely among member states and in some cases there are legal impediments to adopting principles- or judgement based approach. It is evident that this is a factor in the implementation of Pillar II of Basel in some countries, along with the fact that many regulators have no experience of principles-based approaches and their staffs lack the necessary skills to apply them.
We need also to bear in mind that the Commission's main objective, supported and endorsed by HM government, is to create a single market in financial services. There is a beguiling argument which says that an effective means of achieving this is to introduce large quantities of uniform regulations on a maximum harmonising basis. I believe this logic to be flawed. There are deep rooted and legitimate differences in the financial systems of Member States, particularly at the retail level. Attempting to shoe-horn these into a completely uniform regulatory system would be inefficient and would create extra risks rather than mitigating them at an EU wide level. The prospects for principles based regulation in Europe
So is this a counsel of despair? Do these constraints mean that our desire to see a shift towards more principles-based regulation in Europe is doomed from the outset? My answer to that is 'emphatically not'. Realistically we must expect to see new rules continuing to emerge from the EU for some time to come. That in itself need not concern us over much. Our intention is not to abolish rules but to achieve a better balance between these and high level principles. We will of course continue to be scrupulous in carrying out our legal obligation to implement whatever measures emerge from Europe. This makes it all the more important that we - and HMT as the principal negotiators of EU measures - do everything we can to ensure that rules originating in the EU help us in achieving our statutory objectives rather than the opposite. We will pay particular attention for example to measures designed to promote single market objectives which do nothing to reduce risk or even increase it. We will also resist any tendency for European regulation to fetter our legitimate discretion of action, particularly in the areas of monitoring and enforcement. And we will be particularly sensitive to any measures which might compromise our ability to pursue risk-based supervision - a keystone of our regulatory system. Early engagement in the European policy making process is the key here and we will continue to be active in this regard.
Meanwhile, we will make the case for more principles-based regulation in Europe just as we are doing at home. It will take time to establish an enduring consensus in this area but that is no reason not to start. I am confident that others will come to see the inevitability of a shift towards a more principles-based approach as the only feasible way forward. Adoption of more rigorous disciplines around policy-making in Europe will improve the quality of regulation, ensuring that it is more evidence based, proportionate and attuned to market failure. Where we believe that that principles would be the appropriate outcome we will press for these.
In conclusion, I believe that a shift of emphasis towards more principles-based regulation is not only desirable but inevitable. Attitudes towards regulation in Europe have moved a long way in the past two years - a fact for which we in the FSA take some credit. Notwithstanding that and some examples of a higher level approach in some recent measures, it will take time for a consensus on a substantially more principles based approach to emerge. We will continue to take a lead in improving standards of regulation in Europe more broadly and to argue for what we think is necessary to get the regulatory job done in the most cost-efficient way for firms – including a more principles-based approach. We will prosecute all of our objectives in Europe with all the vigour you have come to expect of us.