Principles-based regulation - what does it mean for the industry?
Speech by Callum McCarthy, Chairman, FSA
Financial Services Skills Council 2nd Annual Conference
31 October 2006
I am grateful to you for the invitation to speak on "Principles-based regulation – what does it mean for the industry?". Let me start by choosing a (slightly) different title, namely "More principles-based regulation – what does it mean for the industry (and for the consumer and the FSA)?". Now, my change of title reflects more than the wish of any examinee to change the exam question he or she has been asked. Instead, it acknowledges two important realities.
The first is that, attractive though it would be to some (but not all) practitioners, there is no prospect of the FSA moving to a regime based exclusively on principles. We will always have a mixture of specific rules and general principles. The policy question is the balance between the two, and in particular the extent we can rebalance between the present very large (8500 pages and growing) rule book on the one hand and principles on the other (the FSA's eleven core principles can be fitted onto a 5" by 3 ¼" card. It contains 194 words). This rebalancing will not be easy. There is a constant flow of new rules from the EU (some, but not all, substitutes for existing rules); firms and their trade associations, in theory committed to principles rather than rules, often in practice show a surprising attachment to any rule which it is proposed to abolish; and within firms there is very often a contrast between the expressed wish of chairmen and chief executives to embrace principles and the concerns of their lawyers and compliance officers who prefer the certainty provided by rules. So the rebalancing will not be easy. Although it will not be easy, we are determined to achieve it.
My second point in rephrasing the exam question you have set me is that a move to more principles-based regulation has implications not only for the firms, but also for both consumers and the FSA. Sometimes our determination to move to the rebalancing we seek is discussed as if its principal objective is to lighten the regulatory costs borne by firms. This, although clearly one benefit, is not the principal objective. We are making the rebalancing between principles and rules because we believe this will enable the FSA better to discharge the duties Parliament has given us – that is, it will enable us better to meet our statutory objectives, particularly prudential supervision, appropriate consumer protection, combating financial crime (I don't think it will much affect our financial capability objective). And, just as the objective we are seeking in our rebalancing is wide, so are the implications of this rebalancing, in that it will affect firms, consumers and the FSA – in some ways quite profoundly.
So much by way of introduction. Let me now turn to the changes I expect to see, starting with the impact on firms. The first impact of a move towards more principles-based regulation will be a continuing and intensified reliance on the senior management of the firms we regulate. We will expect them to think hard about the principles we are attempting to promote, in terms not of mechanisms which have to be adopted but rather in terms of the outcomes which we are seeking. The FSA's work on treating customers fairly is a microcosm of what more principles-based regulation will require: not detailed rules setting out limitations on the form of advertising, or the scale and use of commissions, or governing any other particular parameter, but rather a concentration on the outcome of customers who – by means chosen by the senior management of the firm, not mandated by the FSA – have been treated fairly. This places a heavy responsibility on the senior management of a firm: to consider, for every part of its business and for every part of the product life cycle within a particular business, whether its processes actually promote that end – are products designed to meet consumer needs? Is advertising not only true, fair and not misleading but aimed at appropriate audiences? Do sales incentives incentivise appropriate sales, or simply maximise sales? Are complaints properly handled?
Treating customers fairly illustrates what firms should expect from a more principles-based approach: more attention to outcomes, less prescription as to the method of getting to those outcomes; greater responsibility given to senior management and – rephrasing that – greater opportunity given to senior management; more freedom for firms to innovate, since the emphasis will be on outcomes, with flexibility as to how those outcomes are reached.
Let me explore some of the implications of this change in the model of the relationship between regulator and regulated firm, and also look at some of the areas where we should expect significant changes, at least some of which will not be easy to make happen, and will require work from both the FSA and regulated firms.
I think that the contact between FSA and regulated firms will change, both in terms of the level of contact and the content of that contact. The level will change towards greater contact between FSA and senior management of the firm, reflecting the increased focus on the responsibilities of senior management, away from FSA: specialist compliance function contact. And the content of those discussions will also change, away from investigation of whether evidence exists to demonstrate compliance with specific rules to discussion of broader issues and of desired outcomes: in short a move away from what is normally characterised as "box ticking" – the comfort zone for both regulator and compliance functions.
The basis for enforcement action will also change, in that there will be more instances of enforcement based on breach of principles, and fewer based on failure to comply with detailed rules. Again, this change will be a matter of degree, not an absolute change.
The FSA already pursues enforcement cases on the basis of breach of principle rather than breach of detailed rules. Some of the largest fines imposed by the FSA have been for breach of principles. The enforcement action against Citigroup in relation to the MTS trade in August 2004, which resulted in a fine of £13.9 million, and the recent enforcement action against Deutsche Bank for trading in shares whilst carrying out a book building exercise, which resulted in a fine of £6.3 million, were both for breach of principles. So there is nothing new in the concept of more principles-based enforcement action. It would also be entirely compatible with the emphasis more principles-based regulation places on the responsibilities of senior management to find enforcement action is directed not only at the firm but also, where the circumstances of the case justify it, at individual senior managers as well. I have no illusions that successful prosecution of these cases will be easy.
I am also conscious that firms and their senior managers will be concerned that enforcement action based on breach of principle rather than of rule exposes them to dangers: that enforcement action might be based on an interpretation made some time or long after the event which imposes a standard of behaviour which was not current at the time of the event which has triggered the enforcement action. Again, this fear of retrospective imposition of standards is not a new issue. It is a complaint which is raised today both in respect of the FSA's interpretation of rules and – even more – in respect of the Financial Ombudsman Service. But it is a concern which we need to respect. We need to enable firms to know, at the time when they take an action, whether that action should expose them to the prospect of enforcement action because it is a breach of either principles or rules: in short, we need to establish a condition of predictability. When that condition of predictability has been established, it will be entirely legitimate for a breach of principles to entail consequences, including enforcement action, for the firm or individual committing the breach, even when no specific rule has been broken.
Again, I do not underestimate the difficulties which we can expect to encounter as we move further in this direction. It will require those who advise the senior management in any firm to embrace a new skill set. Rather than advising on specific rules, and the precedents which have been established around those rules, they will be required to take a wider and more judgemental set of decisions as to whether particular practices within a firm are reconcilable with desirable outcomes and general principles. I have no doubt that it will make the responsibilities of compliance departments both more interesting and also more difficult. Equally, I expect that they will make life more demanding for the FSA, in that they will properly want to discuss the application of principles with the FSA, and will raise questions of interpretation which will require an informed and thoughtful response: straight questions deserve straight answers. I hope that both sides will rise to the new challenges, and that the content of the contact between regulator and regulated which I referred to earlier will be substantially more based on real issues rather than on narrower discussion of rules – in enforcement as elsewhere in the regulatory relationship.
The present relationship which the FSA has with the firms we regulate differs markedly according to our assessment of the impact a firm may have on our statutory objective, and of the likelihood of this impact occurring. On this basis, we assign firms to different categories, ranging at one end from the relatively small number of firms of sufficient importance for us to have a close and continuous relationship with them to at the other end the very large number of firms which in the normal course of business we neither plan to visit nor to have over them a traditional supervisory oversight, but instead to rely on thematic studies and general statistical knowledge of the population. Less than one per cent of all the firms we regulate fall in the first category. More than 90 per cent of the 29,000 firms we regulate fall in the second category. For the latter category, the principal communication with the FSA, other than statistical returns, is via the FSA's contact centre. We recognise that one – of many – necessary conditions for a successful move towards more principles-based regulation is substantial change to the operations and scope of our contact centre. As well as the many detailed questions which are at present answered – many of which derive from the need to complete statistical forms, or obtain changes in authorisation, neither of which will be avoided by a rebalancing in favour of more principles – there will be more general questions: is a particular commission structure compatible with treating customers fairly? How should promotions be phrased? Although in very many instances the FSA will be able to – indeed should – do no more than expose the implications of a decision which must lie with the firm, there will be a need for a system within the FSA which allows us to give sensible, consistent and timely judgments for small firms who approach the FSA through the contact centre as much as for those large and important firms with which we maintain close and continuous contact. I regard this as a major task for the FSA.
Another area which will be affected by the FSA's move towards more principles-based regulation is that of training and competence. We have already undertaken to remove detailed training and competence rules (including those specifying examination requirements) in the wholesale market, which will happen in November 2007, to coincide with the implementation of MiFID. I have no doubt about the correctness of this decision, even though it was a prime example of institutions which in general support the abolition of rules objecting strongly to the application of this to a particular set of issues. But it should be the responsibility of those who manage wholesale firms to employ and train staff competent to do the job; and for them to decide on the appropriate tests, exams and qualifications they find most useful to deliver than outcome. I accept – though I confess to reservations – the concerns which are expressed about applying this principle in the retail market; and I am conscious both that – for better or worse – MiFID imposes a high-level competence standard, and that in future under MiFID we cannot impose any of our training and competence standards on firms which are passported into the UK from elsewhere in the EEA. So there is a complex of arguments, not all pointing in the same direction, which require us to reconsider our training and competence rules. We intend to publish a review of this in February 2007. I am grateful to all those, including many in the audience this afternoon and the FSSC, who are helping us sort through these difficult issues by contributing to the working group we have set up.
I think the FSSC's existing contribution to exams is an interesting model for the future interaction between regulator and other institutions. Since 2004, when the FSA stopped prescribing exam requirements in the FSA Handbook – an early move towards principles – we have relied on you to set the exam standards, maintain the list of exams which meet those standards and to review them. More recently, you have extended your remit by defining standards for generic advice, for home reversion and also looking at developing wholesale standards. I think in the future we will see much more of this model: the regulator establishing a principle in terms of a desired outcome – in this case firms who employ staff with the expertise and competence required for them to discharge their duties properly – and other bodies – giving the guidance or setting a specific standard which helps individual firms meet that principle.
At the outset of this talk, I said that the driver for our rebalancing in favour of more principles-based regulation is our conviction that this will enable us to meet our statutory objectives more effectively: that the principle of treating customers fairly, rather than detailed rules, is the most effective way of ensuring a fair deal for the retail customer; or that the principle that firms must manage the conflicts which they have is a more effective way of dealing with conflicts which are both endemic and unavoidable and occur in ever novel forms than would be the Sisyphean task of drawing up rules to cover each specific conflict. That said, there is undoubtedly a regulatory dividend for firms from the FSA's move to more principles-based regulation. The first element of this – though not necessarily the most important – is a reduction in the administrative costs which regulation imposes on firms: the costs firms incur in reporting to the regulator. We estimate, based on work done by Real Assurance, that the total administrative cost of FSA regulation runs at £600 million annually – a very large sum, but about ½ per cent of the associated industry turnover. Changes already made to our regulation, notably the move from 57 to 2 pages of rules covering anti-money laundering, have already removed requirements associated with annual reporting costs of £250 million – roughly a 40 per cent reduction. The FSA has a programme to review other parts of our rules which will result in our having reviewed by the end of 2008 activities which together account for more than 80 per cent of the administrative costs we impose. I am confident that this review will identify other opportunities for us to move further in the direction of principles, as the most effective means of meeting our statutory duties. And I am also confident that, by so doing, we will find further means of lightening the costs borne by firms.
Our review will be serious and thorough. That I can promise. What I cannot promise is to reach any particular target for reduction in administrative costs. There are two fundamental reasons for this, both firmly based on the Act of Parliament which gives the FSA its powers and duties. The first is our overriding duty to meet our statutory objectives, and our concern to do this. It would be quite wrong to commit to a particular reduction in administrative costs if achieving that were to make it impossible to deliver on our statutory duties: prudential, consumer protection, countering financial crime or improving financial capability. I would add that it would also be perverse to concentrate on a target defined exclusively in terms of administrative costs alone. One reason that the FSA is able to run a very light supervisory regime for more than 90 per cent of the firms we regulate is because we have some (relatively simple) reporting requirements on which we rely – and which impose administrative costs. It would be possible – but perverse – to reduce those administrative costs but then have to achieve our statutory objectives at greater expense (for both firms and the FSA) by imposing a more intrusive and expensive supervisory regime. As you would expect of any intelligent regulatory organisation, the FSA is much aware of the law of unintended consequences. The second reason is that we are committed to consulting on any changes and consultation means not only receiving, but also considering seriously, the comments and arguments of those who respond to our consultations. This is a process which we cannot pre-empt. So, for both those reasons, I cannot forecast the outcome of our reviews, though I can indicate that we have already reduced administrative costs by 40 per cent; and expect to do more.
I would add that I believe that regulatory dividend of the FSA's move towards more principles-based regulation will go far beyond administrative costs. The changes to our anti-money laundering regime, for example, will encourage firms to adopt a more risk-based and practical approach, not merely allow them to avoid bureaucratic requirements. And our proposals for a more risk-based approach towards the capital of life companies should result in their being able to reduce their capital requirements by some £4 billion.
Let me conclude. I have attempted to indicate what more principles-based regulation will mean not only for firms, but also for consumers and for the FSA. I have described some effects we expect for senior managers, and for those who advise them, and dwell on some particular issues of compliance, enforcement and regulatory dividend. I will be interested in your responses.