Reflections of a soon to be former regulator
Speech by John Tiner, Chief Executive Officer, FSA
High Level City Group
2 July 2007
Ladies and Gentlemen I am most grateful to the Chancellor’s High Level City Group and to John Varley in particular for organising this opportunity for me to address a few reflections on financial regulation over the last several years and to offer some thoughts for the future.
It has been a privilege to lead the FSA these past few years and to serve the customers and firms of the British financial services market. I am conscious that on occasions such as these, there can be a tendency for the speaker to talk about all the things he felt constrained from saying during his period in office and so make life difficult for his successor. Having led the FSA for 4 years that would be neither responsible nor consistent with how I have tried to act - where openness and honesty have always been my by-words. But having had a unique view of both the UK and international financial services industry as its referee, I hope that I can provide some personal perspectives which will stimulate discussion on the one hand but will not upset my Board or my successor on the other. I have learned that the art of good regulation is achieving the right balance between fostering the forces of the market and protecting customers, and I very much hope that my experience at the FSA will enable me to pull off the necessary balancing act in my remarks today.
Perhaps then I could start by looking back at what has happened over my time at the FSA – two years as Managing Director and four as Chief Executive, which by coincidence, and I assure you it is coincidence, almost exactly matches the fall and rise of the equity market.
As the good old football proverb goes, my time at the FSA has been a game of two halves, with quite a bit of extra time played in the second half. Let me explain.
I joined the FSA on 1 June 2001. The FTSE 100 stood at 5800. On 17 June, the firm which the market had rated as the emerging tiger of British insurance and had been voted insurance company of the year over a number of years, Independent Insurance, went bust with the many brokers and analysts who had, for the most part, lauded the new business model of extraordinary growth (but sadly no cash), claiming that they knew all along the business was in trouble.
On 23 July, Equitable Life announced a bombshell to its already worried policyholders of a cut in policy values of 15%. Over the following months, as the FTSE continued to slide, severe problems which had been building up in the Split Capital Investment Trust Market for several years were surfacing and many pensioners who had put their money into High Interest Bonds saw the capital value of their hard earned savings fall off a precipice and in some cases disappear altogether.
Of course on 11 September 2001, the world was shocked, disgusted and numbed by the events in New York. In the distance beyond the human tragedy was a severe test of the resilience of the general insurance market and, because of its prominent position in global markets, of Lloyd’s and the London market. And life insurance companies, with well over half of their assets invested in equities, were running out of solvency. With bonuses in the £400 billion with-profits industry falling steadily there were real problems for savers and mortgage endowment policyholders. There were also deeper concerns about the stability of the market as a whole.
By March 2003, the FTSE 100 had fallen to 3287 and hedge funds were laughing all the way to the Cote d’Azur as many had shorted the market in anticipation of the life insurers’ sell-off. In the midst of all this, just before Christmas 2001, as the FSA was grappling with all of these and other issues, we were, as you can imagine, delighted to hear Ruth Kelly the then Economic Secretary, announce in the House of Commons that the FSA would be asked to regulate all general insurance and mortgage intermediaries – increasing our coverage from some 9,000 to 25,000 firms. And the FSA had only become operational under the Financial Services and Markets Act on 1 December 2001.
Hence this was a period of extraordinarily intense activity dealing with what we call in regulatory jargon “crystallised risk”. At the same time, however, we urgently needed to reform our regulation of the insurance markets by introducing modern techniques of financial economics and risk management into the opaque world of life insurance in particular and prepare for the influx of firms to the world of regulation as diverse as vets which promote pet insurance, to the largest insurance brokers in the world.
Having spent 25 years in the private sector prior to my arrival at the FSA, I was conscious that as a regulator one should not and cannot set out to please everyone all the time (occasional unpopularity is a prominent part of the job description). But it is probably fair to say that I had not anticipated the weight of conflicting opinions on so many issues, so early on. Our job is to think about the arguments in the context of the best outcomes consistent with our Statutory Objectives – and during these first years of the FSA’s life, balancing the maintenance of market confidence with the appropriate protection of consumers was constantly in the forefront of our thinking. And an additional problem is that often we are not able to fully explain decisions we take. I believe the outcomes from the challenges we faced in those early years have been satisfactory, including:
- The life insurance industry was stabilized and the heat was taken off the falling FTSE, by what at the time seemed a brave decision by the FSA’s to assess a companies balance sheet with reference to realistic values rather than some opaque historical method;
- Mortgage Endowment policyholders have been compensated to the tune of some £2 billion; and
- Investors in Zero Dividend Preference Shares, the worst affected by the problems in the Split Cap market, have received almost £200 million from the largest fund ever created on a voluntary basis in the UK financial services industry. Due to a multitude of legal complexities, the payouts to investors were certainly years earlier and quite possibly of a larger sum than would have been paid out as compensation had we concluded successful enforcement cases in the Tribunal.
Like watching the first 45 minutes of my beloved Leeds United, the first half of the FSA’s life was one of attrition, but with the scoreline still intact. And yet commentators who follow the FSA continue to place its progress as a regulator since its formation in 2001, in the context of benign markets – perhaps this is illustrative of the short memory which inflicts some in the financial services market and which may spell some dangers for the future as markets become much tougher. It is true that the credit markets have been benign for many years but, as I have tried to illustrate, the investment markets have been anything but.
The last 4 years have witnessed sustained growth in all major asset classes and the correlations between them have been rising. Of course these market conditions and correlations have been great news for investors across the board, but wearing the mantle of a (rightly) sceptical regulator, one obvious question I worry about is what will happen when conditions become tough. As they have moved up together, will they go down together – personally, I doubt it as tighter liquidity will create different price developments in different markets and correlations will break apart - but how and with what impact? And if we face really difficult conditions in the credit market, will there be enough wise and experienced heads from the last severe downturn to take control of the situation? There are an awful lot of brilliant young people in the credit market who have not faced such times before.
The lessons of earlier periods tell us that problems which surface in falling markets are created by exuberance in strong markets and so we have been particularly vigilant these past 4 years to identify products and trends which when faced with stressed market conditions will not perform as consumers had been led to expect. However, the broadly based benign market conditions have given us the breathing space to develop our strategy and our capability for delivering this strategy. This was the essence of the half time talk in September 2003, between the new club chairman, Callum McCarthy and the recently elevated manager, John Tiner.
In taking the field for the second half we were both clear in our belief that the core of our regulatory strategy should be to harness the forces of the market to deliver the results set for us by Parliament – and to utilise the yellow and red cards when the players committed serious fouls. But we wanted to let the game flow. By its very nature regulation is the grist in the mill of a free market place. With rare exceptions it is markets which are the fuel of economic growth, competitive activity and product, distribution and service innovation. If regulation is to contribute positively to the outcomes free markets produce, its application must be very carefully and cautiously considered with all other avenues explored and rejected first. If strict disciplines are not followed by regulators, unjustified costs will be loaded not just on the firms or entities which are directly subject to regulation but on consumers and society more broadly.
Markets thrive on competition and in its regulation the FSA has a responsibility to have regard to competition. I must confess that I would favour the FSA having a fifth statutory objective to promote competition. This would be entirely consistent with our strategy of working with the grain of the market and delivering fair outcomes for consumers. It might simplify the regulatory structure for many firms as the FSA would have a different kind of relationship with the OFT and it would join-up responsibilities for unfair contracts. For the avoidance of doubt, I would see this as a responsibility to create better, cleaner, fairer markets and not to promote the attractiveness of London as a financial centre. We will do our bit for that agenda if we regulate sensibly and effectively and we should leave others to do the marketing.
Earlier this year we published an important paper outlining our More Principles Based Approach to Regulation. I passionately believe that this is the right approach – building a regulatory regime which facilitates the ability of markets in the first instance to deal with problems and which incentivises firms to do the right thing in a way which fits their own business model.
As I have said before, I believe a business proposition which pursues a confluence of interest between owners, customers and managers will be successful for the long term and will ultimately reduce the need for regulation. The application of this approach should then be in a risk-based and proportionate way and relevant to the characteristics of the marketplace. This is why, shortly after I became CEO I reorganised the FSA to help us focus a distinct approach on each of the wholesale and retail markets. I believe the various surveys which highlight the growing strength of the London markets bear testament to the benefits that a principles based approach to regulation and a disclosure and eligibility approach to listing can bring. As significantly, I feel the focus on retail has helped us zero in on products and issues which have caused real problems for consumers, such as PPI and Mortgage Exit Fees and we are now tackling the highest of hurdle of all in the retail investment market.
To support this strategy, we have been building an organisation which is relevant to the markets it supervises. We have been improving our internal organisation and infrastructure to enable our staff to focus more on the issues that matter and the real world outcomes of what we do. Although the output of our work cannot be measured in earnings per share as for the firms we regulate, I believe strongly that we should run ourselves like a business – delegated decision making, action orientated, risk taking, investing in people and technology, optimising efficiency.
So the second half has been more fluent. The FSA has enjoyed good ratings by both international and domestic commentators, but I am all too conscious of how things can turn - after all it was only 6 years ago I saw Leeds play in the semi-final of the Champions league and now they’re in what I still think of as the 3rd Division. I can assure you the FSA is neither over-confident nor complacent – it is absolutely committed to seeing through the strategy of a More Principles Based Approach to regulation and is investing heavily to achieve that.
Now to look to the future. I leave on my desk a large in-tray of outstanding work for my successor. It will be for him or her, together with the Board, to decide how to bring the outstanding matters to a close; although some of the items will be well above their pay grade: at the Government and European level. I would like to say a word or two about five of the dossiers – to borrow a term from our continental colleagues: (1) regulation of the largest EU financial institutions; (2) the shape of the retail market for investment products and services; (3) financial capability; (4) banking regulation; and, (5) market abuse. These are all complex and evolving issues and I do not claim to have the answers – if it were that easy I would have dealt with them by now – but I hope that raising them today will contribute to the debate - as I think they are vitally important matters for our economy, society and financial markets.
Firstly, how should the major financial institutions of Europe be regulated? In my view, policymakers and regulators at the EU level should challenge themselves to pull-off the three card trick of:
- facilitating the largest financial institutions to become stronger European institutions and more competitive globally;
- enabling smaller firms to compete fairly alongside these major players in domestic markets and so increase diversity and choice; and
- maintaining financial stability and protection of European consumers.
I want to focus particularly on the first of these. In my mind the regulatory structure in Europe is overly complex and burdensome for major firms – the Champions League equivalents, if you like - who operate across the European Union and who compete in global markets.
The current picture is mixed. A firm which branches across Europe will have a single prudential regulator in its home country and the conduct of business responsibilities will vary depending on the sector in which the firm operates (i.e. conduct of business may be country-specific). On the other hand, groups which operate through subsidiaries will have to maintain adequate capital in each and every legal entity and comply with the particular prudential and conduct of business requirements in each country of operation.
The political ambition outlined in the Lisbon agenda, was to make European markets more competitive which in turn would stimulate economic growth and a wider choice for consumers. It must be wrong that in a single market decisions on corporate structure, location of capital and modus operandi (that’s the only piece of Latin in this speech) should turn more on regulatory considerations than on business needs. Yet we have a situation today where large groups change their structure and domicile often not to better serve their customers or their shareholders but to get a regulatory outcome they want. Of course, there will always be some kind of regulatory or other arbitrage between jurisdictions on a global basis – and this is not a bad thing if its effect is to bring regulatory standards towards an equilibrium - but it should not exist within a single market. Coupled with duplication of demands from regulators across the EU, this hampers European firms from competing in the global markets.
I have heard that the idea of a single EU regulator for the largest firms is gaining currency among both the major firms themselves and the political establishment. I should say very clearly that I do not think this is the answer. Apart from questions of cost, location, regulatory style and so on, there will be intractable negotiations about whether there should be an integrated regulator like the FSA or sector based regulators as they have in France, Spain, Italy and some other member states. There is no agreement on whether that approach should be risk-based; or whether the regulatory organisations should combine prudential and COB responsibilities. I believe that Europe must be pragmatic in promoting the growth of the single market and fostering the competitiveness of our major companies and should not become distracted by theoretical, bureaucratic and perhaps partisan discussions about the institutional framework.
To me the answer lies in the intelligent – not simplistic – adoption of the so called “Hard Lead Regulator” approach. In December last year the Treasury and the FSA (in a joint discussion paper on group supervision for the purposes of Solvency 2) proposed that prudential supervision of a group should be the responsibility of the home supervisor. So, for example, risk-based capital would be considered only at a consolidated level, with only minimum levels of capital required to be held in subsidiaries. Legally enforceable mechanisms would need to be put into place requiring parent companies to maintain the minimum capital in subsidiaries. I think of a parallel in the world of auditing, where group auditors send instructions to their offices to do specific work at a local level on material branches and subsidiaries. The home supervisor could similarly instruct host supervisors to assist for example with Pillar 1 capital assessments and the judgements required under Pillar 2. Ultimately, the home supervisor would take responsibility.
I could see this concept applying to European financial conglomerates, insurance groups, banking groups and securities groups. Of course such a system would require regulators to work closer together at an operational level and for the legal system to be robust.
Alongside this approach the Lamfalussy Committees would continue, but their priorities would shift from providing technical advice to the Commission on new laws (which I hope very much will be significantly curtailed in the future), to aligning regulatory approaches and practices at a day to day level. I think the benefits would include more efficient allocation and therefore lower costs of capital for business, less regulatory duplication and so lower costs, more competition and ultimately a better environment for maintaining financial stability and protecting consumers.
The approach we have introduced of holding regulatory colleges to discuss large groups is already helping to co-ordinate regulation and is the kind of platform that the EU should build on.
Every proposal to address this important issue has its challenges and I see three which would need to be overcome. First, there would need to be consideration of special powers being granted to countries where institutions which are systemically important to that particular country but are not material to the group whose parent is located in another member state. Second, compensation systems in the event of failures would need to be better aligned. Third, provisions would need to be introduced for host supervisors to be able to deal with liquidity crises in their domestic banking sector
As a final point on Europe, I would urge the Commission to step back from the patchwork quilt of conduct of business regulations and the mess over home/host responsibilities and seek a coherent solution which firms and, most importantly consumers, will be able to understand.
Moving from the international to the domestic arena, last week the FSA published a discussion paper on the retail market for investment products and services. This sets out the ideas of the industry/consumer/FSA working groups to address the problems of the retail investment market which were so clearly diagnosed by Callum McCarthy last year and which seem to have resonated with many stakeholders. I don’t want to repeat the comments of my colleagues who have been talking about this paper during the last few days, but would like to emphasise two points of my own:
- Whilst I do not believe in theory that advisers or intermediaries who are remunerated by commission based on volume of sales are necessarily biased in their recommendations, the practical effect of the incentive structures in the supply chain has all too often been to operate against the interests of the customer. I very much hope the FSA will have the fortitude to follow through the proposition that the cost of the product and the cost of the service should be clearly separated and negotiated and that the term “Independent Financial Adviser” should only be used by those who select from the whole of market and are remunerated by fee. On reflection, I wish we had stuck to our guns in 2002, when we made a similar proposal in the infamous CP121 on depolarisation.
- To my mind the biggest prize from the review will come from a successful debate about how to improve supply to and access by the mass market. There are some big questions here, the answers to which will require all parties to be bold and take some risks:
- Firstly, is there an economic equation which will bring the major financial brand names to increase supply substantially? This will need to involve lower regulatory and other cost of sales, much lower ongoing regulatory risk, a competitive market for charging levels and sufficient average levels of investment to generate adequate returns on capital employed. It will remain a feature of investment markets for sometime that products are sold and not bought, and stimulating supply is the critical element in unlocking the mass market.
- Secondly, can the above be achieved in a more principles based regulatory environment because firms have operationalised the principle of Treating Customers Fairly? Or, in order to lower regulatory costs and regulatory risks, is it necessary for there to be tightly defined product specifications and risk parameters which would fly in the face of the FSA’s market-orientated, principles-based approach?
- Will consumers flock to the market in response to increased accessibility, marketing, advertising, etc based on higher levels of financial capability or will they remain on the sidelines until there has been a simplification of the tax and benefits system?
I, like many of our stakeholders, feel that the climate into which the Retail Distribution Review is being launched offers as good an opportunity as any time in the last 20 years to realise a market which will work for both firms and consumers. Government, regulators, ombudsmen, firms and consumers must step up to the plate if this is to be successful.
My third point has been one of the main areas of focus for the FSA over the last four years. Since I launched the FSA’s national strategy for financial capability in 2004, I have been extremely pleased with the progress made in schools, the workplace, colleges of further education, universities and in many voluntary and community organisations across the country to help people become more financially able and confident.
I am delighted that the FSA board has backed a programme to spend £60 million over the next three years. Financial Capability is now firmly on the public policy agenda and under the leadership of Ed Balls in his last position as Economic Secretary, the Government has put cross-departmental weight behind financial capability.
To create a more self standing society in the future, young people will need basic levels of financial competence as they make key money decisions earlier in their lives and I would hope that Ed, in his new role as Secretary of State for Children, Schools and Families, will be able to ask his new colleagues to find room for financial education on the mandatory core curriculum at the earliest opportunity.
Otto Thoresen of Aegon is currently leading a study for the government of generic advice. I feel generic money advice is a key missing component in helping people become financially included and making the right choices about their money. It remains to be seen whether Otto will be able to construct a persuasive business case for the private sector to fund a generic money advice service, perhaps in partnership with Government. Others have been through this loop and have been unable to unlock the business case.
I do not think the FSA should be given the specific responsibility to build and operate a generic advice service funded through its annual levy. This could certainly put the FSA into a compromised position and in any case it is not set up to run or oversee a national operation of that kind. Generic advice needs to leverage off what has already been done through the FSA’s National Strategy, existing and trusted routes to target consumers should be harnessed and a new superstructure should be avoided at all costs. But even with highly devolved delivery channels, there will be a need for centralised governance, oversight, support and content management. This will provide the Government with an opportunity to plan for the next stage in growing the financial capability of the British population.
The FSA will have a key long term role to play as its brand is respected by intermediary organisations, trusted by consumers for being independent and raising the financial capability is central to its strategy towards the retail market. I would encourage the Government to look creatively at this issue. I think there is good sense in consolidating the financial capability agenda with generic advice, perhaps under a new body dedicated to this work and which somehow sits within the auspices of the FSA.
Of course I realise that I throw this idea out having not heard Otto’s conclusions and with many unanswered questions related to funding, accountability, etc. But there is a real chance to make a difference and to scale-up this critical work for society and I just urge all decision makers not to pass up the opportunity.
As I mentioned earlier, the scope of activities the FSA regulates has increased markedly during my 6 years. Only last week we [I shall have to stop saying that very soon] were handed responsibility for travel insurance sold by travel agencies, which may bring up to a further 3200 firms into the FSA net.
I strongly agree with the sentiment of Callum’s statements in successive annual reports, business plans and speeches, that the FSA should not be a skip for all things regulatory which touch on financial services because it risks diluting our focus and damaging our operational capability.
I think it would be helpful if a model were to be defined setting out the public policy rationale for what the FSA is required to do. I can see, for example that it makes eminent sense, as Mervyn King outlined at the Mansion House, for the major payment systems to be regulated by the FSA – a proposal which we have supported.
Earlier this year I told the House of Lords Committee on Regulation in March that I thought further consideration should be given to consolidating regulation of the banking industry and I would offer a couple of specific ideas in this area.
I understand that in the run up to the introduction of FSMA, following consultation, the FSA decided not to "switch on" its principles or exercise powers to make rules relating to the conduct of deposit taking business. Perhaps surprisingly to the outside world, therefore, retail banks do not have a regulatory obligation to treat their customers fairly, other than in respect of complaints. The FSA said in its submission to the review of the Banking Code that a fairness provision should in future be included in the code. I wonder, on reflection, whether in fact the conduct of banks should be brought solely under the umbrella of the FSA so falling into its principles and risk-based approach and with enforcement powers to utilise when warranted. This way, the regulatory gaps I have referred to would be eliminated, the regulatory landscape would be simplified with one less regulator and the FSA as the UK’s integrated regulator for financial services would have a much better overall picture of the UK banking market.
Perhaps more controversially, I wonder whether the regulation of the consumer credit activities of the banks, building societies and other firms already authorised by the FSA would not be better located in the FSA.
The growth in consumer credit is well documented and risks related to credit have jumped up the household agenda, with concerns about opaque charges, over-borrowing and affordability. Yet the regulatory framework is disjointed – with first charge mortgages coming under FSA's risk-based regime but other types of credit subject to more of a licensing approach. I am certainly not saying that credit should be subject to the full rigours of FSMA, nor am I advocating all 126,000 companies with a consumer credit licence be regulated by the FSA. For the many other very small firms, it might be worth reviewing the benefits of regulation at all. But there are risks to consumers which I believe could be better dealt with through a more coherent and risk-based regulatory framework, which would also make more sense for the main lenders to only have to deal with one regulator and one set of regulations.
There is not time today to develop all the arguments or to analyse in detail the pitfalls and problems and I recognise there are real complexities about the potential legal framework and maintaining a level playing field.
The final area I would like to touch on is market conduct. During the last several years London has strengthened its position in the world’s capital markets. The UK now has leading positions in international equity and bond offerings, derivative markets and structured products such as securitisations. Market participants have become more diverse and active – as hedge funds and private equity houses have joined longer term institutional investors and private investors as owners of businesses.
As a by product of all this increased activity, corporate announcements which impact on share prices have risen. There are more advisers, longer lists of firms and individuals who have knowledge of impending announcements (so-called insider lists) – we have seen one with a list of 1,500 people. Then we have the old grey area of what is a genuine market rumour and what is a planted story designed to move a share price. And international participation in our markets has continued to strengthen. The heightened level of activity has fuelled the growth of the City and the contribution of financial services to the British economy. This all sounds pretty positive and indeed is for the most part. Of course my concern centres on questions of market abuse and insider trading in particular.
We have been the first regulator in a major capital market to research and publish the pattern of share price movements ahead of announcements and to note that over a four year period around a quarter of announcements on the London Stock Exchange had observable material movements in advance. Research by The New York Times suggests the comparable figure in New York is 41%. A similar study carried out by the same firm indicated that last year unusual trading preceded 33 out of 52 larger Canadian takeovers. But there is little or no data in other European or Asian markets. So there can be no suggestion that London is any worse than other markets and may well be better.
These statistics help to put the position in the UK into perspective but in aiming to promote efficient, orderly and fair markets, our concern is to understand what is behind these numbers. Of course some of the movements will be the result of the normal functioning of the market, as investors and speculators take their positions. But it seems likely that inherent in these numbers is the unacceptable practice of trading on inside information.
Over the past few years we have increased the resources dedicated to identifying, investigating and prosecuting market abuse and we have had some important successes. We have committed to our largest investment ever in technology to help us identify patterns of trades between markets and which suggest suspicious behaviour. This will be ready next year. We have focussed increasingly on conflicts of interest between investment banks and their clients, which we will continue to prioritise in our work.
But successfully prosecuting market abuse is not straightforward. The perpetrators may be in a ring designed to disguise the identity of both the intermediaries and the beneficiaries and some may operate from abroad. Market abuse can be a very sophisticated activity where complex derivative transactions which are not easily visible to the market or us may be used. And the standards of evidence to prosecute successfully market abuse are high and reliance on circumstantial evidence can seriously weaken a case. Last year I said that reducing the incidence of market abuse was one of the FSA’s three most important priorities. In this area the deterrent effect of enforcement can be considerable and we need all the tools at our disposal to be successful. To help the FSA build a strong case we would like to be granted formal powers to offer immunity in exchange for hard evidence and I would urge the government to accede to this request.
I am sorry I have reflected for rather too long this afternoon. Perhaps this itself reflects the huge breadth and depth of our responsibilities. Can I close by thanking all of you for being professional, challenging and for the most part courteous counterparts during the last several years. For someone who cares passionately about the financial services industry and its contribution to the economy and society, I cannot imagine a better job than being CEO of the FSA. And so it just leaves me to wish my successor (whoever that may be) every success and good fortune for the future. Thank you.