The Future of UK Regulation
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Speech by Dan Waters, Director of Retail Policy
Securities & Investment Institute Annual Conference 2007
Wednesday 23 May 2007
Good morning Ladies and Gentlemen and thank you Mr (Scott) Dobbie (SII Chair), Mr (Tony) Watson (Conference Chair) and the SII for inviting me to speak here today. I have been asked to speak about the future of regulation in the UK, a subject that has a certain perennial ring to it, but which I believe is particularly timely now, given our recent publication on principles-based regulation. The key messages of that document bear repeating and I will do that very briefly. I also want to illustrate the approach in practice through a couple of examples that I hope you will find relevant and helpful in understanding what the FSA is seeking to achieve with this heightened emphasis on principles and high-level rules. I have in mind our work on Treating Customers Fairly, and our approach to reform of our Training and Competence regime.
I also thought I would share with you some observations on the early thinking emerging from our Retail Distribution Review on professionalism, a topic that I expect will be of keen interest to the SII and this audience. Obviously the remarks on the RDR must at this stage be preliminary – our Discussion Paper is set to be published at the end of June. But this audience will want to familiarise itself with the emerging ideas on the importance of enhanced professionalism in retail distribution, and we will certainly welcome your comments on our discussion paper when the time comes.
Principles-Based Regulation: Focusing on the Outcomes that Matter
By now you will no doubt be aware of the paper we published last month entitled "Principles-Based Regulation – Focusing on the Outcomes that Matter". This document explains this important evolutionary step in our approach to regulation in the UK. It sets the tone and direction for the future of UK regulation, and hence is the core subject of my remarks today. If you have not had the opportunity to read the paper, I commend it to you. It is short, and is as clear a statement as you will find of the FSA’s principles-based regulatory philosophy. That paper sets out what we mean by principles-based regulation and what we have been doing, are doing and propose to do to deliver it. It sets it in the context of our risk-based, proportionate regulatory approach and our statutory objectives and principles of good regulation. It also indicates the challenges that firms and the FSA need to get to grips with to adapt to this changing regulatory environment.
So what do we mean by principles-based regulation? If I had to sum up what principles-based regulation is about in one sentence it would be this: Principles-based regulation is about focusing on the regulatory outcomes that we want firms to deliver, rather than focusing on the prescription of particular, detailed processes to be performed by them. It relies on us being clear about the regulatory outcomes we want and then marshalling our supervision and enforcement efforts to ensure that those outcomes are being achieved. This is a direction of travel, not a project to be implemented by a specific 'go-live' date. It’s a strategic direction that we're convinced is necessary to deliver our statutory responsibilities, while at the same time keeping pace with the dynamism of the financial services market and fostering the innovation and competition that make markets successful.
It is possible to overstate the case. We don't mean that we are exclusively principles based as some have suggested. The UK regulatory regime has involved a core set of principles governing financial services firms for many years – going back - as this audience will know very well - to many of the organisations that were the predecessors of the FSA. There are eleven core FSA Principles for Businesses – short enough to be put on a single sheet of paper: only 194 words. But the FSA is also an organisation with a very large rule book (some 8,500 pages of rules and guidance), and could equally – or equally misleadingly – be described as a rule-bound regulator. The reality is that the FSA has, and will always have, a mixture of principles, high-level rules and particular, more detailed, rules.
We are committed, however, to striking a new balance between them, with greater reliance upon principles and high-level rules and less reliance on detailed rules. This is not easy to do. For instance, there is a constant flow of new EU rules, some of which replace existing UK rules. Sometimes EU requirements operate at a high-level of generality, but very often they do not. Firms and trade associations, moreover, even when they are committed in theory to principles rather than detailed rules - and not all are - in practice often show a stubborn attachment to particular rules that the FSA seeks to abolish. And within firms, we often find that increased reliance on principles is supported by chairmen and CEOs, but opposed by compliance officers and lawyers who prefer the supposed certainty of prescriptive rules.
Why Principles-Based Regulation?
Why then is the FSA committing itself to a more principles-based regime? The short answer is that we believe it will enable us better to discharge our statutory duties. There are a number of reasons but let me focus on four.
First, financial markets are constantly changing. Continuous innovation and new product development are important ways in which the financial services industry generates benefits for consumers and markets. It is important that regulation responds rapidly to the pace of change in markets and so allows them to continue to develop for the benefit of their users. We believe regulation that focuses on outcomes rather than prescription is more likely to support this development and innovation. Prescriptive rules will struggle to cope with changing market circumstances and practices and can delay and in some instances prevent innovation. In a quickly changing marketplace, principles are far more durable.
Secondly, past experience suggests to us that prescriptive standards have been unable to prevent misconduct. The ever-expanding rule books of our predecessor bodies and our consolidation of them into our Handbook were designed to prevent misdemeanours, but they have not stopped further misselling, market misconduct or other detriment. The more we write detailed rules to address the last scandal, the more one wonders whether we are treating symptoms rather than addressing the underlying causes of failure to deliver regulatory outcomes.
Thirdly, the complexity of a very prescriptive regime with thousands of detailed rules is also likely to make it inaccessible to many firms’ senior management. Senior management of larger firms faced with such complexity may simply disengage and delegate to compliance, without tackling the challenge of leading the firm from the top towards a more compliant culture. For smaller firms, who do not generally have access to deep compliance or legal expertise, the amount of detailed rules can be bewildering.
Finally, a large volume of detailed, prescriptive and highly complex rules can divert attention towards adhering to the letter rather than the purpose of our regulatory standards. It can encourage a legalistic and tactical attitude to compliance in firms rather than a meaningful attempt to find an alignment of the firm’s business objectives with the regulatory outcomes that we seek. These behaviours make it less likely that we achieve our regulatory goals.
Benefits of Principles-Based Regulation
Our belief is that our principles-based regulatory approach will achieve outcomes that produce significant benefits for consumers, both from more efficient markets and from firms better attuned to consumers’ needs. We firmly believe this is the right direction for our regime, that it will enhance our ability to meet our statutory objectives, and allow us to deliver better regulatory outcomes in a proportionate way that is more efficient and effective.
We believe that, in many circumstances, the economic and business interests of firms’ senior management and their Boards and shareholders can be aligned more effectively with our regulatory goals through a principles-based approach. In practice this means giving firms increased flexibility to decide more often for themselves what particular business processes and controls they should operate.
An increased focus on the outcomes of regulation and more reliance on principles and outcome-focused rules do not necessarily mean, however, that firms will find it cheaper to deal with the regulatory issues that they face. Rather, we believe that this regulatory approach will result in an industry that deals with regulatory issues in a more effective and efficient way. The aim is that regulation will not be seen as a side-line occupation that just imposes costs in addition and in parallel to business costs; it will be seen as an integral part of business decision-making and operations. This should lead to more effective regulation for firms and crucially, better outcomes for their customers.
Illustration of what Principles-Based Regulation means in practice: Treating Customers Fairly
So if that is the theory behind principles-based regulation, how is it actually playing out in practice? We have some experience here that is instructive. In the time allowed me today I intend to focus on two leading examples: our work on Treating Customers Fairly and on our Training & Competence regime.
You will be aware that Treating Customers Fairly has been a major priority for the FSA over the past few years. It will continue to be for the foreseeable future. The requirement that firms treat their customers fairly is contained in the 6th of our 11 Principles, which states that “A firm must pay due regard to the interests of its customers and treat them fairly.” The next step in our principles-based approach is to identify what the expected regulatory outcomes are. This we have done. In July of last year we issued a paper entitled "Treating customers fairly – towards fair outcomes for consumers" in which we stated that firms should be focusing on delivering the six TCF consumer outcomes:
- Consumers can be confident that they are dealing with firms where the fair treatement of customers is central to corporate culture;
- Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targetted accordingly;
- Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale;
- Where consumers receive advice, the advice is suitable and takes account of their circumstances;
- 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 as they have been led to expect; and
- Consumers do not face unreasonable post-sale barriers imposed to change product, switch provider, submit a claim or make a complaint.
These outcomes operate as a focal point for firms in understanding what Principle 6 means in their particular businesses. They will be relevant in different ways for different firms and business models. The challenge we lay down for management of each firm is to work out the shape and content of the expected regulatory outcomes in their individual business model.
So our regulatory work focuses on getting firms to make the mind shift that is necessary to deliver these core outcomes. How are we going about that? Through a carefully staged, thorough, on-going programme of work right across the entire regulated community, focusing for obvious reasons on the retail market, although some of these outcomes are relevant to certain wholesale businesses as well.
The basic challenge is to ensure that firms are in a position to demonstrate in a comprehensive and convincing manner that they are treating their customers fairly. The work we have undertaken thus far indicates that while some firms may be in fact treating their customers fairly, few are in a position to be certain of that, or to demonstrate convincingly to us that they do. And we know of course from the far too frequent scandals and problems that have arisen in our retail financial services markets that many firms are falling well short of the mark.
In July last year we set a deadline for all firms to be at least implementing Treating Customers Fairly initiatives in a substantial part of their business by the end of March 2007. To meet this test, firms needed to show they had allocated appropriate resources and responsibilities, developed plans and processes, and created capability to meet the Treating Customers Fairly principle. The aim was to stimulate action in firms that were slow to appreciate the significance of Treating Customers Fairly; to maintain momentum in those firms that were moving ahead with their Treating Customers Fairly initiatives; and to demonstrate how seriously we take Treating Customers Fairly within our more principles-based approach.
The results that we published earlier this month showed that many firms have made good progress with their Treating Customers Fairly work. The implementation deadline helped to focus firms' efforts on Treating Customers Fairly and generated momentum within the industry as a whole. The proportion of firms that met the deadline varied from 93% of major retail groups and 87% of medium-sized retail firms to 41% of a sample of small firms.
We are encouraged that senior management in many firms are showing a strong commitment to TCF and are rising to the challenge of a more principles-based and outcome-focused approach to regulation. However, more progress clearly needs to be made, and quickly. The key objective is achieving improved outcomes for consumers and this is why we've set further deadlines in our recent progress report on TCF. Meeting these deadlines will require sustained focus from senior management of all firms but particularly those of smaller firms. Small firms, however, ought to be able make relatively swift progress; we have provided many tools to help them to do so, including our self-assessment tool for Treating Customers Fairly; and we strongly encourage the management of these firms to move ahead on this.
To achieve our aims we are significantly increasing the focus and intensity of our supervision of firms that missed the end-March implementation deadline. We will take a targeted approach, depending on the reasons a firm failed to meet the deadline, and the scale of the task they face in filling the gap. Our follow-up work is likely to have significant cost implications for those firms that have fallen short of the mark thus far.
Let’s also be very clear about what meeting the implementation deadline means. It is does not mean, as some have asserted, that all those firms that have met the implementation deadline are now treating their customers fairly. Many of them will be. But even those that are already delivering TCF outcomes need to be able to demonstrate to us in a comprehensive and convincing manner that they are. Surprisingly, we have found that most firms are not in a position to do that.
So we have set a deadline of end of March 2008 for all firms to have appropriate management information or measures in place to test whether they are treating their customers fairly. And by the end of December 2008, all firms are expected to be able to demonstrate to themselves and to us that they are indeed consistently treating their customers fairly. These deadlines are being set to encourage firms to move from the implementation phase of TCF to the embedding phase; namely, firms need to start delivering on the outcomes we have deemed appropriate rather than explaining how they think or expect these may be occurring. The approach we have taken to date has created a momentum behind the TCF initiative, but we now want firms to deliver the goods: namely, better outcomes for consumers.
Training and Competence Reform
Let me turn now to my second example of principles-based regulation in practice: the reform of our Training & Competence regulatory regime. This example demonstrates a rather different phase of principles-based regulation: that is, the design phase, during which we scrutinise our existing regulatory requirements and reform them in accordance with our preference for a principles-based approach. By the way, our consultation period ends today, so if you have not commented, and you are planning to, you need to get your skates on!
In reforming our T&C regime, we have adopted a ‘clean sheet of paper’ approach, although of course making sure that it complies with the Markets in Financial Instruments Directive (MiFID). From the point of view of principles-based regulation, MiFID is helpful here, in that it contains a high-level, outcome-focused competence requirement, which we are obliged to apply to all MiFID firms and business.
Unsurprisingly perhaps the MiFID ‘competent employee’ requirement covers the same ground as the high-level provisions (known as the ‘Commitments’) which appear in Chapter 1 (TC1) of the current T&C Sourcebook. So we think it makes sense to apply the ‘competent employee’ requirement across the board - that is, to all UK authorised firms (including wholesale firms) for the sake of consistency and clarity.
As we've already decided to disapply our detailed T&C rules for wholesale business, the next obvious question for us was whether we should do the same for retail business and rely just on the competent employee requirement. In other words, if we don’t need a detailed T&C Sourcebook for the wholesale markets, why do we need one for retail?
There are clear and important differences between retail and wholesale markets that are directly relevant in answering this question. The retail financial services market in the UK is characterised by severe market failures, as is well known. These include a very significant imbalance or - as the economists prefer to call it - asymmetry of information between retail financial consumers and those who provide, sell and advise on financial products for them. This asymmetry is exacerbated by the now well-researched and understood weaknesses in financial capability of many UK consumers, and by the fact that the performance of many financial products cannot be known with confidence in the short term, so that learning from experience is difficult and getting it wrong costly. We also know from our recent work on Quality of Advice that many firms – far too many – do not operate proper systems and controls in respect of delivering proper financial advice to their client base, and that there is a strong correlation between failing to do that and having poor arrangements for ensuring the competence of sales and advice staff.
So we undertook our review of our T&C regime fully aware of the significantly different position of retail consumers as opposed to wholesale market participants, who are generally well able to look after their own commercial interests.
It was clear that whatever its virtues, the current T&C Sourcebook was due for an overhaul. It had become increasingly complex as its scope expanded and many of the more detailed provisions were piecemeal legacies from the rulebooks of previous regulatory bodies. But we were determined in seeking to simplify the Sourcebook that we would not lower the standard of behaviour expected of firms and individuals and that has been a key message throughout this exercise.
The proposed new regime
The proposed new regime, like the current one, will be proportionate and risk-based, but it will also be more flexible. It will place an even stronger emphasis on senior management responsibility as we believe that senior managers are best placed to decide how to achieve the outcomes we want.
In looking to simplify, a key question for us was whether we should remove the exam requirements on the retail side. You will probably not be surprised to hear that we think compulsory exam requirements continue to play an essential role in the retail sector. This is because, as I’ve already explained, the risks in the retail market are so different from the risks in the wholesale sector.
We recognise, of course, that exams can only ever provide a snapshot of the knowledge held at a particular point in time and that they are not the only way of assessing the level of knowledge held by an individual. But we believe they have clear benefits for retail consumers. In particular, they set a consistent and objective minimum 'baseline' standard for entry-level knowledge across the retail sector – a knowledge threshold, if you like. And we think that removal of the retail exam requirements could lead to greater inconsistency and lower standards and create consumer detriment (e.g. through mis-selling). As noted, our recent Quality of Advice work demonstrates that the link between incompetence and poor consumer outcomes is not just a theoretical one. And our cost-benefit analysis work, including work undertaken by an independent consultancy (Europe Economics), has demonstrated that firms believe that the average level of competence and consumer confidence would be lower without exam requirements.
So, we've concluded that we need to keep the retail exam requirements - and therefore the T&C Sourcebook - a view strongly supported by the industry working group who helped review our proposals. However, the new sourcebook will be much shorter, more focused and easier to understand. The rules in our new sourcebook are largely exam-related. This is an example of where we have decided that it is necessary to keep detailed rules in a principles-based world.
Of course, our examination requirements are concerned with achieving appropriate and consistent minimum standards. But we hope that firms will see merit in competing with each other above that minimum standard by making their staff take higher-level exams, thus driving up standards. There is evidence that firms with good T&C arrangements are already doing this – and we would encourage others to follow their example.
Retail Distribution Review
This brings me rather neatly to my final topic for today, namely the work on adviser professionalism that is emerging from our Retail Distribution Review. We are planning to publish our Discussion Paper on 27 June, so I am not able to go into any great detail at this stage, as decisions on precisely what the paper will contain have not been taken by our Board. But there is emerging thinking that is highly relevant to the question of delivering better outcomes to retail consumers through higher levels of competence and professionalism, matters that I know are of great interest to the SII and to this audience.
The RDR is supported by five industry working groups on Sustainability, Impact of Incentives, Consumer Access, Professionalism & Reputation and Regulatory Barriers and Enablers. These groups comprise senior industry representatives as well as Trade, Professional and Consumer bodies enabling the FSA to take on board a wide range of views right across the entire retail market for investment business. It is a rather daunting but extremely important project and one I am privileged to be directly involved in as chair of Regulatory Barriers and Enablers group. Despite the diversity of participants' backgrounds, an encouraging degree of consensus has emerged from all of the groups, but it is the developing thinking on the professionalism strand that I consider is most relevant to this audience today.
The starting point is the acknowledgement by the group that, in general, higher standards of behaviour and competence are needed. Furthermore – and this is a theme running through the whole review – there is a strong desire for the market to be segmented according to the nature of services supplied. And in line with the thinking of other industry group's, this group has suggested that a wider range of services may be more appropriate in today's world, with advisers differently skilled but suitably qualified according to the services supplied, starting with fully-fledged financial planners offering advice typically to the higher end of the market where complex portfolio advice is needed, to advisers operating at a more transactional level for consumers who have more focused and possibly less comprehensive portfolio requirements, through to those advising on simpler products through some kind of simplified advisory process. All of this would sit above a generic advice service that would be widely available, although the nature of that delivery mechanism has not yet been clarified and indeed is subject to a separate review commissioned by the Treasury in January and being led by Otto Thoresen (who coincidentally also chairs the RDR's Consumer Access industry group).
This segmentation of the advice model necessarily implies a higher minimum standard of professionalism particularly at the more affluent end of the market, and more rigorous continuing professional development for all advisers. And whilst there is a role for regulation in delivering this, the industry itself might develop and implement a more coherent, and broader-based, standards framework through its own professional bodies, such as the SII. A good measure of whether such a shift is successful might be the extent to which high quality, young graduates would be attracted to financial planning as a career, as they are for example in the United States. At present we seem a long way from that position.
Conclusion
In conclusion, the future of regulation in the UK is changing. The move towards a more principles-based and outcome-focused regulatory regime is, in our opinion, an absolute "must" both to address the current realities of the market and to provide the appropriate degree of protection required under our statutory objectives. We are clear that this will be a challenge not only for firms and individuals, but for the FSA too. But we are committed to seeing this change through. This commitment applies to the changes we are making under our Treating Customers Fairly initiative and our approach to the Training & Competence regime. I also encourage you to keep an eye open for the forthcoming Retail Distribution Review Discussion Paper as this will have a significant affect on the way in which retail markets operate in the UK. We welcome your comments on these initiatives, so I encourage you to respond to these important steps down our evolutionary path.
Thank you.