Principles-based regulation in the retail market
Speech by Clive Briault, Managing Director, Retail Markets, FSA
FSA conference on principles-based regulation
23 April 2007
It is good to see so many of you here for this session on the retail aspects of our move to more principles-based and more outcome-focused regulation.
I want to offer some brief remarks to set the scene – for my fellow panellists, and for what I am sure will be an interesting question and answer session with you all.
So here are eight propositions to set the ball rolling.
First, what is this really all about?
Our desired outcome is to improve the behaviour of firms and of consumers.
From firms we want to see a stronger focus on the outcomes that really matter for consumers. A more principles-based and outcome-focused approach should encourage senior management to focus more on the Principles and the outcomes we want them to deliver; and should enable these outcomes to be delivered more effectively.
We want senior management to develop a greater understanding of how the Principles and our other high-level requirements should apply in practice; to drive and embed change throughout their firms; and to measure that this is delivering the right outcomes. A more principles-based approach also provides senior management with greater flexibility in how they run their busimess while meeting our requirements, and greater scope to compete and innovate while doing so; or indeed to compete by exceeding our minimum requirements.
For consumers we are working, in partnership with many others, to improve levels of financial capability. We want consumers to be capable and confident in dealing with the financial services industry. And we are looking for ways to encourage consumers to engage more actively when dealing with financial products and services, since it is in their own best interests to do so.
Second, this is absolutely not about any lowering of our standards. We are not changing our Principles and other high level requirements. Our Principles are themselves rules. They articulate the outcomes we require firms to deliver. Examples include that firms must conduct their affairs with integrity, that firms must pay due regard to the interests of their customers and treat them fairly, and that firms must maintain adequate financial resources. And this does not mean that we will confine ourselves entirely to high-level conversations with the senior management of firms in order to establish that these standards are being met. There remains a role for more detailed testing, not least to determine whether the aspirations and intentions of senior management are indeed being translated into putting in place appropriate procedures and into delivering the right outcomes in the customer-facing operations of their firm, especially if firms are not testing this adequately themselves.
Third, although detailed rules have their uses, and are often forced upon us by EU Directives, they have considerable limitations. They have not always delivered the outcomes they were supposed to achieve. Some firms do not follow all of these detailed rules. Detailed rules cannot cover all circumstances and eventualities. We cannot hope to devise a set of detailed rules to cover all types of business and all types of firm; and we cannot expect detailed rules to be responsive to market innovations and structural changes. Detailed rules tend to address processes, not outcomes. This can encourage a narrow approach to compliance. Regulators are too often drawn into tackling problems by shutting the stable door after the horse has bolted – writing yet more detailed rules to address yesterday's problems. And detailed rules can inhibit innovation and competition.
Detailed rules have not been successful in preventing major mis-selling episodes in the UK such as personal pensions, mortgage endowments, split capital investment trusts and ‘precipice bonds’. We have consistently seen examples of firms giving poor quality advice; selling complex, opaque products to consumers without fully identifying or explaining the associated risks; and providing unclear product information.
Fourth, we want to make this shift to a more principles-based and more outcome-focused approach not only in terms of changing our rulebook, but also – and more importantly – in the way that both we and firms behave. For us, we recognise the challenges that this poses in terms of the ability of our people to explain and illustrate the outcomes we are seeking to achieve; to give straight answers to straight questions; to take more outcome-focused judgements; to influence and persuade the senior management of firms to change; and when necessary to take tough action on the basis of our Principles and other high level requirements.
Fifth, is a more principles-based approach more appropriate to the wholesale markets than to retail markets? No. The imbalances of power and information between consumers and producers/advisers is much greater in retail markets. So there is a case for more intensive regulation and supervision in retail markets than in wholesale. But this tells us about the volume of regulation, not the type of regulation. So on the retail side we have been taking forward a more principles-based and outcome-focused approach through the Treating Customers Fairly initiative; through halving the length of our Conduct of Business rules for investment business and planning to do the same on general insurance; and through seeking industry-led solutions from our Retail Distribution Review to the structural difficulties in the retail investment market.
Sixth, is a more principles-based and outcome-focused approach more suitable for large firms than for small firms? No. We recognise, of course, that in small firms much of the regulatory interaction will fall directly on the management of the firm, which can generate a considerable burden on a firm's management. Equally, however, the management of a small firm is very much in the front line and engaging directly with its customers. So if the management of a small firm engages actively with and understands the outcomes we are seeking to achieve then it ought to be more straightforward for them to run their businesses accordingly. The "just tell me what to do" response remains alive and well in some small firms, but this is very much at odds with what we hear from small firms who want to know the key outcomes we are seeking to achieve, and where to find some helpful illustrations of ways in which this can be done. This is why we are enhancing the role of our Firms Contact Centre and why we have published today some fresh material on our website, aimed specifically at smaller firms. I am pleased that both these initiatives have been strongly endorsed by the Smaller Businesses Practitioner Panel.
Seventh, is the Financial Ombudsman Service a significant issue here, in terms of being a replacement source of detailed rules? And is there a risk that the FOS will judge firms on a different basis to the FSA, or judge firms retrospectively? These risks are exaggerated. The very existence of the FOS as an individual complaints resolution service helps to facilitate the FSA taking a risk-based, principles-based and increasingly outcome-focused approach. The vast majority of cases considered by the FOS turn on questions of fact or the application of general legal principles rather than on the application of detailed FSA rules. And at the end of the day, firms that put in place a culture and a set of operating procedures that deliver the outcomes we are seeking are unlikely to find the FOS upholding cases against them on a regular basis. As one firm told me recently "having looked at every FOS judgement against us they were all absolutely correct and reflected failures on our part to meet the standards of customer care that we had set ourselves".
Finally, enforcement. We can take enforcement action on the basis of our principles, which are rules. And we have done so, including twenty actions against retail firms in the last year where our findings were based on a breach of our Principles (either primarily or in conjunction with breaches of more detailed rules). We expect in future there will be more instances of enforcement based on breach of Principles, and fewer based on failure to comply with detailed rules.
Firms have expressed concerns that enforcement action based on breach of a Principle exposes them to dangers: first, that a more principles-based approach will lead to more enforcement against minor failures to meet our Principles; and second, that enforcement action might be based on an interpretation made long after an event which imposes a standard of behaviour that did not apply at the time of the event.
On the first of these concerns, we are not looking to take more enforcement actions for their own sake, and we are not looking to catch firms out by finding some aspect of their behaviour that falls slightly short of meeting our requirements. Where we find that a firm is failing to meet a Principle we will consider the most suitable course of action. In many cases, we will agree with the firm a means of addressing any shortfall. We do not expect to take enforcement action if we see that firms have made a genuine attempt to deliver on what our Principles mean for them and there has not been significant risk or actual detriment against our statutory objectives. But the more that a firm has not responded to indications of a problem, has failed to identify shortcomings and to develop a strategy to remedy them, and has committed a serious breach of a Principle, then the more likely we will be to take enforcement action.
On the second concern, the fear of retrospective imposition of standards is not a new issue. We recognise that firms need to be able to know, at the time when they take an action, whether that action could expose them to the prospect of enforcement action because it is a breach of our rules: in short, we need to establish a condition of predictability. Adherence to our own or appropriate industry materials can provide a 'sturdy breakwater' for firms' protection. But when that condition of predictability has been established, it will be entirely legitimate for a breach of a Principle to entail consequences, including enforcement action, for the firm or individual committing the breach.
To conclude, we believe that we will deliver better outcomes for consumers if the senior management of firms focus on the Principles and our other high level requirements, and if they ensure that these are met throughout their businesses.