Implementing principles based regulation
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7 December 2006
Speech by Dan Waters, Director Retail Policy, FSA
at the ABI Conference, London
Introduction
Good morning ladies and gentlemen. I am delighted to join you today. As you know, on 31 October the FSA published a draft new Conduct of Business sourcebook (NEWCOB) for consultation. It was a major piece of work, and one that I think it is fair to say has been well received by the industry as a whole. Indeed, at a recent event an ABI spokesman was kind enough to say that the FSA had done "a really good job".
So you may be surprised to hear that I don't want to talk about NEWCOB in my speech today, except insofar as it is part of the FSA's much wider programme of change. You have asked me to talk about implementing principles-based regulation. But implementation is about much more than simply making rules.
The FSA is now embarking on a wide ranging programme of work to make a real difference -- in the way that we run ourselves, and through that, to the way we interact with firms, consumers and other stakeholders. The move towards more principles-based regulation (MPBR) is a key element of this, and cuts across a wide range of FSA activity.
MPBR
What do we mean when we talk of moving towards more principles-based regulation? I would sum this up by saying it is a shift of emphasis by the FSA away from looking at the processes carried out by firms, towards the outcomes we seek to achieve, for consumers, firms and markets.
There are three points I want to emphasise about this.
First of all principles-based regulation of financial services is not new. So it is not, or should not, be something which firms see as alien, or unfamiliar. The FSA's Principles for Businesses have been in place since N2 (December 2001), and they have their origins further back in the rules of the former regulators. And there are also high level rules in the current COB sourcebook that you will all be familiar with. The requirement that advice on investments must be suitable for a client is a clear example of this. "Suitable" is not defined within the rule. What is required to ensure suitability is something that firms need to decide in each case, in the light of circumstances of the particular client and of the products being advised upon.
The second point is that more principles-based regulation is not just about new rules. Rules are a key part of this – and in this respect NEWCOB might be the beginning but it will not be the end of the changes we will be making to our Handbook. But the changes we are planning to make to our rules should be seen as a part of the broader process of change within the FSA. This work is already underway, and has several different elements. These include our work on Treating Customers Fairly (TCF), and the changes to the way we carry on supervision and enforcement.
The third point is that these changes are not just a matter for the FSA. The move towards more principles-based regulation will give firms more flexibility to innovate as to how they achieve the outcomes we are seeking. There may be more than one way to achieve these outcomes. The primary responsibility for achieving this remains - where it has always belonged - with each firm's senior management.
This is not to say that we are simply leaving firms to decide for themselves, without assistance, what is acceptable or unacceptable behaviour. Just because a rule is high-level should not mean that it cannot be clearly drafted and easy to understand. However, it is certainly true that high-level regulation is, and should be, incompatible with an unthinking or automatic approach to compliance. We want to discourage any kind of purely box ticking approach to regulation, wherever this may have existed, both in firms and indeed in the FSA itself.
We also intend to make continued use of Handbook guidance, where this is appropriate, and of other material, such as case studies. And we recognise that the FSA itself is not necessarily the only source of good ideas about how firms can comply with our rules. This is what lies behind our recent discussion paper DP06/5, on FSA Confirmation of Industry Guidance.
Treating Customers Fairly (TCF)
I would now like to say more about a number of the different pieces of work that I have mentioned above – the building blocks, if you like, of more principles-based regulation. Our TCF initiative is intended to bring about a step-change in the behaviour of the financial services sector and therefore to deliver six key outcomes for retail consumers.
These outcomes are:
Outcome 1: Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture
Outcome 2: Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly
Outcome 3: Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale
Outcome 4: Where consumers receive advice, the advice is suitable and takes account of their circumstances
Outcome 5: Consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and also as they have been led to expect
Outcome 6: Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint
We do not see these outcomes as requiring us to make new rules. They are implicit in our existing Principles for Businesses, and in particular in Principle 6, which states that ' a firm must pay due regard to the interests of its customers and treat them fairly'. Other Principles are also relevant when taking a rounded view of what fair treatment might mean.
In taking forward TCF we have used a range of approaches – for example the publication of case studies and of statements of good and poor practice – to help firms to interpret for themselves the meaning of relevant principles and to challenge firms to review their practices and to facilitate change.
We recognise that some firms may prefer that the FSA focused solely on detailed rules. We have been asked “What are the minimum standards which firms are required to comply?’ Surely the answer is blindingly obvious: the requirements in the Handbook. But in a way the question risks missing the point of more principles-based regulation and indeed the TCF initiative, which is to encourage a thoughtful and individual engagement by senior management and firms with the core of what regulation is trying to achieve. TCF is about developing understanding of how the Principles and high level rules apply in practice, in the real world, in the circumstances of particular firms. It is not about a mindset that implies once I’ve met the minimum I can forget about regulation. Life changes, firms and their business models change, the implications of the principles and high level rules in the day to day life of firms changes too. TCF is about thoughtful, challenging engagement, firm by firm with fundamental regulatory questions. There is no handbook, however large, that could contain the answers to these questions.
It has also been suggested that the TCF initiative has resulted in a significant increase in the rules that firms need to comply with. Again, this is not the case. All the initiative has asked senior management to do is put in place a review (proportionate to business size and complexity) of the degree to which they currently meet the existing FSA Principles and high level rules, and to remedy the position where they find they are adrift. There are no new requirements here.
We are pleased by the very constructive way in which senior management in many firms have recognised that they were less compliant with the Principles than they at first supposed, and have sought to address the issue – often increasingly recognising the commercial benefits of doing so. In order to maintain momentum we have set a target – we expect all firms to have reached at least the implementing stage of their TCF work by the end of March 2007.
In addition, it has been said that the material we have published on TCF is equivalent in its impact to the rules and guidance in our Handbook, but that because it is not formally defined as such, it is not subject to the same process disciplines of consultation and cost-benefit analysis. For our part, I would re-iterate that we are clear that TCF is not a new regulatory requirement. Nor is it something which we have developed without consultation. We have had very valuable assistance from the TCF Consultative Group, which meets regularly and provides advice and input on our strategy and overall approach.
But more worrying to me is the apparent mindset that lies behind these process-based criticisms. They seem to rest upon the assumption that the FSA cannot, working with the industry, find flexible and creative ways for individual firms to interpret and apply principles and high-level rules in their own particular circumstances. Instead, we must proceed by formal consultation and rule-based approaches that dictate solutions across the board. We need not look too far to find the sort of regime that a defensive, legalistic approach will lead to. How many years would it take before we had our very own Enron experience? For my part, I would rather take the path, which no doubt has risks, of seeking a proportionate regulatory regime that tries to build upon trust between the regulator and the regulated, rather than one that relies upon the illusory certitude of detailed rules – which in reality is more likely to lead to escalating cycles of legalistic gamesmanship to evade them.
Supervision and ARROW 2
20. But TCF is by no means the only area in which we have been seeking to advance our more principles-based approach. In 2007, we will be beginning a comprehensive programme of training for FSA supervision and enforcement staff on NEWCOB. And this is not the beginning of the work we have done to move our supervision towards a principles-based focus. We have already achieved much through the ARROW 2 project. Between March and September this year we have undertaken 5 days offsite training for 750 supervisory staff. The focus has been on practical application, with extensive involvement of industry practitioners. And the emphasis has been on behavioural aspects, not about systems and IT. What we will be focusing on in future is the extent to which compliance is embedded in the culture of firms.
More principles based enforcement
The move towards principles-based regulation is also relevant to our enforcement work. As we expect firms not to breach our detailed rules, so we expect them to comply with the Principles for Businesses. If they do not, they run the risk of enforcement action. It is true that enforcement of Principles may require a different approach than the enforcement of detailed rules. There may need to be a very close examination of all the circumstances surrounding the case, a focus on how the rule should be interpreted, and a greater use of expert evidence. And, of course, we need to ensure that what we are enforcing was the standard as it applied at the time.
Knowledge management
Knowledge Management (KM) has also been identified by us as a key delivery component in achieving the shift to principles-based regulation. Many of the 'making a real difference' deliverables are dependant on KM to support or facilitate the changes. So we have begun a major project to ensure this will happen.
The implementation of effective Knowledge Management will mean that:
- Our staff will have one interface to systems, giving easy access to the information required to make reliable and informed decisions, greater confidence that information is stored securely and knowledge that the information is up to date. This should mean that we will only need to ask a firm for information once.
- For firms and consumers the FSA will be seen as easier to do business with by providing clear and consistent guidance and information, faster response times to enquiries, and a convenient browser interface designed to support consumer decision making.
- We will look to capture guidance given by supervisors to firms to help us to ensure that firms that are similarly placed are being required to deliver similar outcomes. We take seriously the responsibility to ensure that in focusing on regulatory outcomes rather that processes, we are able to demonstrate that firms are being treated in an equitable manner.
Industry Guidance
We are also hard at work in the area of industry guidance and our relationship with it. At the start of November, we published our discussion paper on Industry Guidance and how we can give formal recognition to it, which we have referred to as FSA confirmation.
There are a few key points that I would like to highlight. Firstly, Industry Guidance and FSA confirmation is not something new. Indeed, there are a number of examples of work developed by the ABI that highlight this, including recent good practice guidance on unit linked funds and individual capital assessments.
We intend Industry Guidance to be a tool to facilitate the move towards a more principles-based approach to regulation, to help firms make the adjustments necessary and provide additional detail in areas where we consider FSA guidance is not necessary.
There are some key things that we are not looking to achieve with Industry Guidance. We are not requiring trade associations to take on the role of issuing guidance if that is not the role that they and their membership wish to undertake. Nor do we plan to require trade associations or other bodies that do develop guidance to monitor firms' compliance with it or move towards having trade associations acting as second tier regulators.
Furthermore, we are not looking to use Industry Guidance to outsource regulation. Where necessary and appropriate, we will still have detailed rules or guidance in the FSA Handbook. Where we do not, the use of Industry Guidance and FSA confirmation should give the industry other options to obtaining useful guidance that they can place reliance on.
MPBR and the FOS
Concerns have been voiced about the implications for more principles-based regulation arising from the role of the FOS. Some firms are concerned that the move towards principles-based regulation will create greater uncertainty as to what their obligations are to consumers, and to what extent they may be held accountable for these by the FOS. We appreciate this, but for the reasons I set out below do not think this should be a serious cause for concern.
In fact, the FOS makes very few decisions that turn on the interpretation of FSA detailed rules. It takes into account the law, regulators' rules and guidance, codes of practice and industry good practice, prevailing at the time. Fewer than 5% of investment cases and even fewer in other sectors turn on the interpretation of detailed FSA Conduct of Business rules. Most FOS cases turn on their individual facts or general legal principles, which apply to all businesses. Where an individual FOS decision may have broader application to other cases, we have established the "wider implications" process to co-ordinate the work of the FOS and the FSA. Should ambiguity or uncertainty arise in respect of significant FOS decisions as a result of our move to more principles based regulation, we would be prepared to place increased reliance upon this process going forward.
The ICOB review
As I mentioned earlier, the move towards a more principles-based Handbook will not end with NEWCOB. Over time, we intend to extend this to other sourcebooks. One piece of work that will be of particular interest here is the review of our general insurance rules in the ICOB sourcebook. We expect to go out to consultation on this in the middle of next year.
As we made clear in June, we are following a differentiated approach in this review. In those general insurance markets where the risks of consumers losing out from unsuitable purchases are relatively limited, we are looking to rely to a greater extent on the principles for good business, always subject to the substantial Directive constraints on removing detailed rules.
In markets where the risks to consumers are greater, we will consult on any additional obligations we think are needed to achieve the standards set out in our Principles, whilst still simplifying our Handbook wherever possible.
This approach will, we believe, deliver a more risk-based and proportionate set of conduct of business rules for general insurance, and one which is based firmly on principles.
Disclosure/projections
I said at the beginning of this talk that I was not going to say much about NEWCOB. But I would like to touch briefly on our regulation of firms’ use of projections within information for consumers, because the development of our proposals offers a good example of both evidence-led policy making and our focus on principles-based regulation.
We currently have very detailed and prescriptive conduct of business rules governing product disclosure and projections. We kicked off a wholesale review of these rules in 2004, looking at whether there were better ways of informing consumers about product features and benefits along with investment risks and rewards. Projections are a particularly good example here; perhaps improvements in technology would make sophisticated tools and approaches feasible which had previously been impractical.
But we also probed extensively the practical benefits and costs of changes to our requirements. We wanted to know if consumers would actually use new ways of presenting information. And what would the costs and impact of changes be? To answer these questions we carried out an extensive cost survey looking at a range of options along with a robust programme of testing alternatives with consumers.
Our results showed there wasn’t a strong case for introducing changes to projection requirements, as the changes would be very costly, but it was difficult to demonstrate benefits for consumers over the current calculation and presentation. So we decided in March that significant changes to our requirements could not be justified.
As noted in the current CP we found similar results for our proposed Quick Guide – so decided to retain the Key Features Document with tweaks such as adding the Key Facts logo.
We still continued to ask ourselves, however, whether retaining the detailed rules was in all areas the best way forward, and we found significant opportunities to simplify our general disclosure requirements.
For projections, the MiFID implementing directive brought this question into far greater relief. Instead of containing prescriptive detail, it took a higher-level approach, and simply obligated firms doing MiFID business to always base any projections on reasonable assumptions supported by objective data.
This looked like a good starting point for a more principles-based approach to projections. At the same time, we found that it would be difficult for us to make a case to the European Commission for keeping our own standard in this area for business covered by MiFID. And our analysis also suggested that applying the new standard to MiFID business would not raise significant cost and benefit issues, and that projections were not widely used for MiFID products.
So we chose to apply the new standard for MiFID products. It is important to say that although this might be seen as a deregulatory step, we do not think it should be interpreted as a lowering of standards. Firms will have to think hard about how customers use the information they provide, and they also will have to consider how they will demonstrate that reasonable assumptions have been made which are based on objective data. And this also raises challenges for the FSA, to help firms and trade bodies to better understand the responsibilities placed on them by a more principles-based approach.
We noted in the CP that we thought life and pensions products raised different considerations. For instance they are often particularly complicated products, which are tailored to individual customers and their needs or targets. Also, our earlier work showed that the costs of any changes would be very high. Yet we wanted to consider the wider impact of our decision for MiFID business. On balance we have decided that we will keep the basis of our current approach for life and pensions business. It is worth stressing, however, that we will still be looking for any opportunities to simplify the rules further, and will consult on our proposals in the second quarter of next year.
In the meantime we are keen to see how firms respond to challenges of the MiFID approach for MiFID business, and we will continue to focus first and foremost on practical outcomes.
Conclusion
In closing, let me say how important it is for each of you to engage proactively with the more principles-based agenda. The first level of engagement is obviously with the NEWCOB Consultation Papers themselves – especially the draft rules. There is a great deal in it, some of it new, which warrants your attention. Your comments directly or through the ABI will be valuable. I know that many of you have already responded on those aspects for which there was a very tight, MiFID-driven deadline. Thank you very much indeed for pulling out all the stops on that.
Second, and just as important, is your engagement with the topic of this speech today, namely the implementation of a principles-based regulatory regime. That is a challenge for each one of you; it is just as big a challenge for us at the FSA as well. We are looking for an approach to delivery of regulatory outcomes that is dynamic and sensitive to the complexity and variety of financial services businesses in the United Kingdom. In this country, perhaps more than in any other in Europe, there is a plethora of business models, and a profusion of creativity and innovation that we do not want to inhibit through lacklustre regulation.
We firmly believe that, properly and sensibly implemented by firms and by the regulator, a principles-based approach to regulation will set the trend for future regulatory development globally, just as our work on risk-based regulation did at the beginning of this century. But, let us be very clear that delivery of this vision is a joint enterprise between the industry and the regulator; it cannot be achieved in any other way.
Thank you for your kind attention.