NEWCOB: The practical implications
Speech by Andrew Sykes, Head of Retail Investment Policy
City & Financial Conference
19 June 2007
Good morning ladies and gentlemen. I am very pleased to have been invited to speak here today about the structure and content of our new Conduct of Business sourcebook. I shall do so within the broader context of principles-based regulation and the practical implications of this for firms.
Much has been said about principles-based regulation over the past few years, so there is little doubt in my mind that the industry – and consumer groups – now understand much more about the FSA's general principles-based direction towards financial services regulation. Nevertheless, as you might expect, principles-based regulation remains the key theme of my talk today.
Principles-based regulation
You will no doubt be aware of the paper we published in April called Principles-based regulation – focusing on the outcomes that matter. That document explained the evolution of our approach to regulation in the UK, and set the tone and direction for the future.
It is an important paper, which sets out a succinct statement of the FSA's principles-based regulatory philosophy. It explains 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 regulatory approach, alongside our statutory objectives and principles of good regulation. It also indicates the challenges that firms and the FSA need to get to grips with in order to adapt to this changing regulatory environment.
In essence, principles-based regulation is about focusing on the regulatory outcomes that we want firms to deliver, rather than on specific rules or the prescription of particular, detailed processes to be performed by them. It relies on our 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 the strategic direction that we are convinced is necessary in order to deliver our statutory responsibilities, while at the same time keeping pace with the dynamics of the financial services market and fostering the innovation and competition that make markets successful.
The FSA is committing itself to this principles-based approach, primarily because we believe it puts us in a position to improve the way we discharge our statutory duties. The more effective we are in pursuing our objectives, the more successful we will be in achieving orderly and efficient markets, alongside balanced and proportionate consumer protection. We expect this principles-based approach to enable firms to better understand required regulatory outcomes in relation to their business, thereby delivering more proportionate regulatory costs.
For many years the UK regulatory regime has embodied a core set of eleven principles (the FSA Principles for Businesses) governing financial services firms – all of which can be set out on a single sheet of paper. In spite of this, as you know, the FSA has a very large rule book.
This has developed over 20 years but it goes without saying that it has not always prevented major shocks or consumer detriment – examples of which include: pensions mis-selling (which cost £11bn), mortgage endowments (which cost £2.5bn), spilt capital trusts (causing severe reputational damage to the sector and compensation of £200m) and mis-selling of structured capital at risk products. These instances also illustrate how detailed rule-based regulation often simply plays catch-up (sometimes with significant delay) in financial markets that are dynamic and innovative. That is because detailed rules are often specific to the product or circumstances they seek to regulate – and hence can usually only be introduced after a specific detriment has occurred and, as seen in the examples I have given, cannot pre-empt misconduct.
Principles which express outcomes (and have the status of rules in law) are more enduring and appropriate within fast changing markets.
It is also our experience, not just at the FSA but in its predecessor organisations, that a mass of detailed rules can distract firms from the purpose of regulation and encourage a legalistic and tactical attitude to compliance. And of course it makes it harder for firms' senior management, and for smaller firms without extensive legal and compliance departments, to get their heads and hands around our requirements. In fact, given the significance of senior management responsibility in our regime, a principle-based approach provides senior management with more room to make the decisions they need to take for their businesses and customers.
Reflecting the emphasis which the Financial Services and Markets Act places on the responsibility of firms' senior management, our view has consistently been that the onus is on them to manage their business with integrity and with due skill, care and diligence. The Boards and senior management of companies must explicitly recognise their responsibilities for making the decisions which affect their business, investors, and customers. It should not, and cannot, be the regulator's job to tell them what precisely they should do in all situations. Principles provide the latitude to do this within their own particular circumstances and business models. And this for us, we will be monitoring 'what' is being delivered as opposed to 'how' a firm is complying with specific rules.
Furthermore, principles should help nuture a common interest between customers, shareholders and management. For example, making money through treating customers fairly seems a sound long-term business proposition. Making money from systematically preying on customer ignorance or inertia will either be removed by new business models and entrants or forced out through public policy making.
The regulatory regime will of course never be one of principles alone, nor have we ever claimed as much. The FSA has, and will always have, a mixture of principles and high-level rules as well as more detailed rules. We are committed, however, to rebalancing this mixture, with greater reliance on principles and high-level rules and less reliance on detailed rules, other than in areas where – for cost-benefit or other reasons – these are the only practicable way of achieving a given regulatory outcome. A good example is the RU64 rule, which we have retained because of continuing concerns over the general quality of investment advice and the key importance of pensions savings.
Rebalancing the overall mix of our rules is not (and has not been) easy. For instance, there is a constant flow of new European Union directives, some of which replace existing UK rules. Sometimes European requirements operate at a high-level of generality – the much-maligned MiFID, for instance, has many principles-based provisions, especially in the conduct of business area. However, very often European directives contain many detailed rules, which we have to copy-out into our Handbook to avoid imposing any unintended additional obligations.
Firms and trade associations, moreover, even when they are committed in theory to principles rather than detailed rules - and not all are - sometimes in practice show a stubborn attachment to particular rules that the FSA seeks to remove. 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.
NEWCOB
If principles-based regulation is the direction of regulation in the UK, you will be aware that it now has a face too – our new Conduct of Business sourcebook (NEWCOB) which will be replacing COB on 1 November.
NEWCOB is a significant regulatory milestone because it demonstrates what we mean by principles-based regulation. It will be the first major part of the Handbook to come into force that we have revised in line with principles-based regulation. It is shorter and simpler than COB, with a much clearer structure. This is broadly chronological, reflecting the successive stages of firms' relationships with their clients, starting with marketing, moving on to the point at which contact is first made with an individual client, and so on. In some areas, specialist material has been brought together to make it easier to use for reference purposes. A couple of examples of where we have done this are distance marketing and with-profits.
But, in line with principles-based regulation, the key change is that NEWCOB focuses on the outcomes that really matter for consumers, rather than on procedure or process. It does this by placing greater reliance on principles and higher-level rules. As many of you will know, we have combined the move towards a more principles based regulatory framework in NEWCOB with the implementation of MIFID. A Herculean task, but one which was unavoidable if we were not to create confusion and even greater costs of change for firms (and indeed consumers).
We have of course been helped here by the high-level nature of many of MiFID's conduct of business provisions. Not only did we apply a copy-out approach to its highly harmonising implementing provisions but in a number of areas our cost benefit analysis indicated that there would be net benefits in also extending some MiFID provisions to non-MiFID firms and business. This was particularly the case in the retail sector where there are many substitutable products and services and leaving difficult or marginally different regimes would have caused confusion.
Unnecessary guidance has also been reduced, and its use confined as far as possible to material that is genuinely useful for firms, for example in explaining a rule, indicating a possible means of compliance or aiding navigation.
As a result of all these factors, significant simplification has been achieved in many areas, including financial promotion, prescribed content for risk warnings, client agreements, dealing, managing and client reporting. Elsewhere, we have achieved significant improvements in clarity and presentation without changing underlying policy.
NEWCOB's focus on outcomes shifts more of the onus onto firms to consider the purpose of the provisions and to apply them to their particular circumstances. It places 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.
Principles-based regulation in practice
And what principles-based regulation actually means in practice is becoming more and more clear.
Over the past few years, you will have seen through our work on Treating Customers Fairly, that we have asked firms to focus on delivering six consumer outcomes in order to meet the spirit of Principle 6. The challenge we have set for the management of each firm is to work out the shape and content of the expected regulatory outcomes within their individual business models. Our regulatory work in this regard has focused on getting firms to make the mind-shift that is necessary to deliver these core outcomes. 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. So firms need to show that they have allocated appropriate resources and responsibilities, developed plans and processes, and created capability to meet the Treating Customers Fairly principle.
In the NEWCOB context, more specifically, let me use the financial promotion rules to demonstrate what we mean by being outcome-focused. Despite a small change to the COB wording to reflect MiFID, the key outcome for financial promotions is unchanged. They must be 'fair, clear and not misleading'. This is a high-level rule which restates Principle 7. We require this outcome in order to deliver the objective of the financial promotion regime, which is to address information asymetry in the buying process. Consumers should get what they need to make informed investment decisions, in a comprehensible form, and at the right time.
If consumers get 'fair, clear and not misleading' information about financial products and services, they will be less vunerable to buying - or being sold - unsuitable or poor value products or services. Detailed financial promotion rules have not always resulted in these objectives being achieved as fully as possible.
Many aspects of the new financial promotion regime will be familiar, but some are new. Firms cannot assume that if they comply with the current rules they will automatically comply with the new ones. A tick-box approach, which some may have seen as embedded in the old COB Chapter 3 rules, is unlikely to achieve the desired outcomes. More flexibility within the rules will allow firms to be more innovative and imaginative in designing promotions that more effectively reflect the products they sell and the needs of their customers. Obviously this will require similar flexibility in firms' own compliance checking.
So, without the security of detailed rules to guide them, firms - and more specifically their senior managements - must in future take more responsibility for the content of their financial promotions. They will have to determine what is appropriate for their products and customers, and must put themselves in the shoes of their customers. Since different consumers respond to advertising in different ways – to seek more information or to buy - firms should focus on the key outcomes when designing their financial promotions and consider who they are promoting to, and what response they expect to their promotions.
The benefits are not just for consumers (in the form of higher standards) but also for firms. The new high-level rules will allow more flexibility within promotions, allowing them to be more tailored to the client, products and services, and for more innovation.
However, whilst the removal of detailed rules creates opportunities for firms it also presents challenges, many of which are the challenges of principles-based regulation generally. I cannot overstate the need for senior management to engage. In particular, firms' systems and processes must be capable of delivering a financial promotions regime that reflects the outcome based approach to regulation that the regime reflects. Management information will be vital and can be effectively used for financial promotions. Research will also be a valuable tool to explain the rationale behind advertising campaigns – in particular, relating to the identity of target markets and their levels of financial understanding, which might help justify the choice of media or, for example, the use of risk warnings.
Implications for firms
Firms will need to work out how they will respond to our principles-based regulatory approach. And we know that many have already made significant steps in this direction.
Being regulated and regulating in a principles-based regulatory environment is not an easy option either for firms or the regulator. It is challenging and, as well as opening up greater flexibity and choice, can potentially expose both sets of parties to more risk. Greater manoeuvrability for firms in deciding how to comply will mean key decisions move further up the organisational hierarchy, with the Board and senior management having the key role. But because the high-level rules are designed to deliver outcomes which most - if not all - good companies would want to achieve for their businesses, the discussions will be better integrated into everyday business issues. We understand that this more overt responsibility will represent for some Boards a new and difficult challenge as they will need experience and insight to make sound judgement calls and be willing to accept the responsibility.
For compliance, internal audit and legal departments there will also be change as they adapt to support their senior management and Directors. There will be less reference to the FSA rule book and more judgement about what processes are fit-for-purpose for their business and their customers. Many will see this as a dilution of the legal certainties they feel they enjoy today.
We have given a good deal of thought to how, in a more principles-based world, we can increase flexibility, while not exposing firms to risks they may find they cannot bear and so withdraw supply. We will be making more guidance material available, not always or even primarily as formal guidance in our Handbook but more often in case studies, Dear CEO letters and industry guidance that we confirm as reliable for compliance. Of course materials such as these do not create obligations on firms; but where firms choose to apply them to a relevant business process, they will be able to rely on them in deciding how to satisfy their regulatory obligations.
The implications and challenge for firms is to make a cultural change from looking for a safe harbour within the rules, to a mind-set where they are comfortable with disclosing to the regulator how they have chosen to apply a principle. As part of this shift, they will need to consider whether they are getting the type of management information they will need in a princples-based world, and if necessary to make systems changes.
In asking firms to make these changes, we as regulators must also make changes of our own. Specifically, we believe that it is important that we become more effective and open in our exercise of judgement and be more willing to explain how we arrived at our decisions. This will require us to attract, retain and develop the right people, and improve our knowledge management systems and technologies. We will also need to work with industry bodies who will want to identify areas in which industry guidance can supplement the principles – in place of rules.
I realise that firms will want to be able to find quickly and easily information that is relevant to them, irrespective of whether it is included in our Handbook or in other material we have published; and we are investing heavily in technology to facilitate that. We are also investing in the skills of our people so that they can have a helpful dialogue with firms about our expectations, not simply direct them to the relevant rule. We aim to deliver the resources, information, cooperation and guidance to the industry and are committed to working better overall with the industry to achieve the benefits of principles-based regulation. We expect there to be more dialogue between the industry and us to agree on standards of behaviour. Without this dialogue, the right path to choose in demonstrating compliance may be unnecessarily difficult to determine.
Conclusion
In conclusion, the changing nature of regulation in the UK is undisputed. And the move towards a more principles-based and outcome-focused regulatory regime is, in our opinion, an absolute 'must' in order to address the current realities of the market and 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 new Conduct of Business regime. This will have a significant effect on the way in which retail markets operate in the UK.
But principles-based regulation should be seen as providing the industry with a huge opportunity as well. Those regulated firms that invest in risk management functions, design good value and effective products and develop their client facing functions to deliver the services that customers expect, will achieve market advantage over time. The new world of regulation is mature regulation and mature risk-based compliance. Successfully implemented, it will further build on and enhance the success of the UK financial services industry.
Thank you.