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Speech by Clive Briault, Managing Director, Retail Markets, FSA
International Federation of Financial Ombudsmen Conference
28 September 2007

Good morning and thank you for your kind invitation to speak to you today.

I would like to extend my own welcome and that of the Financial Services Authority to all the delegates from 32 countries who have travelled to London for this conference, which has been so well organised by the UK Financial Ombudsman Service. The objectives of the conference include sharing ideas and good practice between different jurisdictions, so I welcome this opportunity to provide a UK perspective on how the FSA views the importance of an Ombudsman in supporting the delivery of our regulatory objectives; and to explain why an effective Ombudsman for financial services is such a critical part of the system of consumer protection in the UK.

In that context, I will talk this morning about:

• the current market turbulence;
• the role of the FSA and our statutory objectives, and the distinct roles of regulator, ombudsman and compensation scheme in the financial services markets;
• how we and the Ombudsman work together in practice; and
• our move towards a more principles-based approach to regulation and the essential role of the Ombudsman in this context.

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Markets: The current turbulence

Since many of you may be interested, I begin by outlining briefly some of the causes and consequences of the recent market turbulence.

Current market problems have their origins in the US sub-prime mortgage market. Lax lending standards in the US sub-prime market led to increased homeowner default rates and consequently concern about the quality of securities based on sub-prime mortgages. This has led in turn to:

• a game of "hunt the loss" as the diversification of credit risk has resulted in the direct losses from sub-prime mortgages being spread across institutions, and across countries;
• a marked shift in investor preferences and a fundamental reappraisal of risk, resulting in an unwillingness to purchase asset-backed paper, not confined to mortgage-backed paper, accentuated by a lack of transparency and by difficulties in the valuation of complicated financial products, irrespective of whether they are connected to the US sub prime market;
• a general drying-up of liquidity, except at very short maturities; and
• banks that have securitised mortgages (or other assets) into so called "conduits", which also need liquidity, have had further funding demands placed on them. Some banks have provided liquidity to these vehicles, while others have taken the assets back onto their balance sheets.

Because of these uncertainties the funding of a number of financial institutions has come under strain. Banks and other financial institutions have been preserving liquidity by shortening the average maturity of, or even reducing the amount of, the funding they are prepared to provide to other institutions.

The three-month inter-bank rate has, as a result, moved out of line from the overnight base rate set by central banks, at times to a percentage point or more above base rate. A combination of the limited availability and high price of wholesale market funding has placed a particular strain on banks that are particularly reliant on securitisations and on wholesale funding to finance their assets.

As a regulator, we have addressed these difficult conditions in a number of ways. There is a Memorandum of Understanding between us, the Bank of England and HM Treasury. This has enabled us to work closely with our partners at the Treasury and the Bank of England to pool our understanding of market conditions, to coordinate our actions, and to engage in contingency planning for various possible scenarios.

One result of these difficult conditions was acute liquidity pressure on Northern Rock, a medium-sized bank that relied heavily on securitisation and wholesale funding to finance a rapidly growing mortgage lending book.

We have been monitoring the position of Northern Rock closely throughout. In response to its liquidity difficulties, the Chancellor of the Exchequer authorised the Bank of England to provide liquidity support to Northern Rock. This was a "classic" lender of last resort action to provide liquidity to an institution that we believed to be solvent.

Unfortunately, however, the announcement of this support resulted in a lack of confidence among some of the firm’s retail depositors, who withdrew funds, resulting in long queues at branches and an overloaded internet capacity.

In reaction to this loss of consumer confidence, and the risk of contagion to other firms, the Government announced on 17 September that it would, if necessary, put in place arrangements that would guarantee all existing deposits in Northern Rock during the current instability in the financial markets. The initial impact of this intervention was a restoration in consumer confidence and the disappearance of queues at the bank's branches.

More generally, it should be recognised that the UK banking industry has entered this period of severe market turbulence after several years of very strong market conditions which have helped the industry to build up healthy balance sheets and strong capital positions.

We remain confident about the industry's ability to withstand current market pressures. We are in constant dialogue with firms to ensure that they are vigilant with regard to potential risks and we continue to monitor developments closely.

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Regulation: the role of the Financial Services Authority

For the benefit of our overseas visitors, I will outline briefly the role of the FSA more generally.

We are the main statutory regulator for the UK financial services industry. We regulate some 29,000 firms – ranging from major retail firms and global investment banks to very small businesses, and around 165,000 individuals. This industry contributes nearly 7% of UK GDP and employs 1.1 million people, providing products and services to millions of consumers.

We have four statutory objectives. These are: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and fighting financial crime.

In our day-to-day operations, we aim to promote efficient, orderly and fair markets, to help retail consumers achieve a fair deal, and to improve our own business capability and effectiveness. In practice, this means that we want to make markets work effectively to deliver benefits to firms and consumers. In the retail market we believe there are four elements to this.

First, capable and confident consumers. We are working to achieve this through our Financial Capability programme, to help UK consumers manage their money better.

Second, firms and ourselves providing simple and understandable information for, and used by, consumers.

Third, well-managed and adequately capitalised firms that treat their customers fairly.

And fourth, risk-based, principles-based and proportionate regulation.

Alongside but independent of the FSA there are two other organisations that provide the foundations of the system of consumer protection in the UK - the Financial Ombudsman Service and the Financial Services Compensation Scheme.

The Ombudsman delivers informal dispute resolution - as an alternative to the courts - where consumers remain dissatisfied over the way in which a financial services firm has handled their complaint against the firm. The legislation demands that complaints are considered by reference to what is, in the opinion of the Ombudsman, fair and reasonable in all the circumstances of the case. Where the complaint is upheld in favour of the consumer - which happens in about a third of the cases considered - the Ombudsman generally aims to put people back into the position they would have been in if things had not gone wrong. The Ombudsman's decisions are binding on the firm, but not the consumer who can proceed to the courts if not satisfied. Until recently, the Ombudsman dealt almost exclusively with complaints about firms authorised by the FSA. However from April this year its jurisdiction was widened to cover complaints about firms licensed by the Office of Fair Trading to carry on unsecured consumer credit business.

To complete the picture, the Compensation Scheme provides a scheme by which it can pay limited compensation to the customers of firms regulated by the FSA which have, for some reason, failed. Given today's audience, I will not dwell on this element of the system.

The FSA, the Ombudsman and the Financial Services Compensation Scheme are operationally independent of each other and each occupies its own clearly defined territory as set out by legislation.

The FSA sets down, or approves, most of the rules under which the Ombudsman and the Compensation Scheme operate and we appoint both the Chairmen and the other members of the Boards of these organisations. But, as mentioned, each organisation is operationally independent of one another. For example, the FSA cannot, even if we ever wanted to, influence or change decisions made by the Ombudsman in individual cases. This is an entirely deliberate consequence of the way in which the UK system of financial regulation has been constructed.

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Working effectively with the Ombudsman

So how do we ensure that we work together effectively? The operational independence of the Ombudsman makes it absolutely vital that we have systems in place to do so and that consumers and firms are clear about how this operates.

There is a daily flow of communication between our respective organisations; regular bilateral meetings between our dedicated liaison teams; and regular strategic discussions which take place at Board level. In addition to this, there are two main mechanisms in place:

• First, we have published a Memorandum of Understanding between the FSA and the Ombudsman which provides an explanation of our respective legal responsibilities and ways of sharing information. This is a short document which gives a high-level explanation of our respective roles and how we work together.
• Second, we have a 'Wider Implications' process which covers how we handle issues where complaints may have wider regulatory implications for firms and consumers. The essence of this process is that the FSA and the Ombudsman can consider whether regulatory action would be appropriate when the resolution of individual complaints might have significant wider consequences for the way that firms operate. For example, the FSA may take supervisory or enforcement action, or offer the Ombudsman and the firm an interpretation of existing rules, thereby ensuring that any wider consequences are in line with desired regulatory outcomes. Or the FSA may decide that regulatory action would not be appropriate. In addition, the process allows for the FSA and the Ombudsman to consult industry and consumer representatives.

Recent examples of the Wider Implications process have included:

• Mortgage exit administration fees, where earlier this year an industry-based solution was established to deal with unfair variations in such fees, with the Ombudsman remaining available to deal with any complaints from consumers who were not treated consistently with that solution; and
• A case involving a specific advisory firm, where consumers were recommended investments issued by a bank or building society but the financial adviser paid the consumers' money into his own account. We raised the issue with the relevant industry bodies: the British Bankers' Association and the Building Societies Association, following which the acceptance of cheques made out simply to a bank or building society and paid into the account of a third party was phased out, thus reducing the scope for fraud. Again, the Ombudsman remained available to deal with complaints from individual consumers.

Given the Ombudsman's new complaint handling responsibilities for consumer credit, similar wider implications arrangements have been agreed between the Ombudsman and the Office of Fair Trading (OFT). This extension of the wider implications process also fits in well with the strengthening of our relationship with the OFT.

The current topical issue in the UK concerning unauthorised overdraft default charges on current accounts is a good example of how the three organisations already work closely together on matters of mutual interest.

An unauthorised overdraft charge is typically charged when a bank or building society current account holder exceeds the agreed overdraft limit on his or her account. The FSA, the OFT and the Ombudsman discussed the issues raised by complaints by consumers against such charges and agreed that they have wider implications: the issues are new, they involve a large number of banks and building societies, and they affect a large number of consumers.

In July 2007 the OFT announced that it was starting proceedings in the High Court of England and Wales for a declaration on the application of the law in respect of unauthorised overdraft charges. This is a test case with a view to securing a clear and orderly resolution on the fairness or otherwise of these charges.

At the same time, in order to facilitate a fair outcome for all consumers, we announced that we would permit banks and building societies not to handle complaints relating to unauthorised overdraft charges within the time limits set out in our rules. This is subject to various conditions to ensure that customers are not materially disadvantaged during the test case.

Consistent with this, the Ombudsman announced that in view of these developments, it will not progress complaints about unauthorised overdraft charges until the resolution of the test case.

At the same time as extending the process to the OFT, we and the Ombudsman have recently reviewed how the wider implications process has operated in practice since it was formalised as a process over two years ago. The record is a good one. There have been considerable successes in helping to deal with some of the more difficult issues that I have mentioned, but we also found some lack of understanding about the process among firms and consumers and a resultant unwillingness to refer issues that they were concerned about for consideration.

Accordingly we have recently re-launched the wider implications process, including to industry and consumer bodies involved with consumer credit. We have increased the flexibility in how the process may be applied, and we have strengthened the involvement of industry and consumer representatives to allow them to be brought in at an earlier stage when considering an issue with wider implications.

So there are very clear ways in which we collaborate and communicate to ensure that the regulatory system as a whole addresses issues in the most appropriate way.

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Principles-based regulation

Principles-based regulation is not new but we are changing the balance of our approach towards a greater reliance on principles and high-level rules. We already have eleven high-level Principles for Businesses for firms that have been in place in their current form since 2001 and have their origins further back in the rules of former regulators. These Principles provide the backbone of our regulatory regime. They cover such things as integrity, skill, care and diligence, management and control, financial prudence, and treating customers fairly.

These Principles express the outcomes that firms should be trying to achieve in broad terms rather than detailed rules. They focus on where we want to be rather than how we get there. By setting out what outcomes and behaviours we expect, firms can decide how best to achieve them.

Accordingly there are two main reasons for the move to more principles-based regulation.

First, we want a stronger focus on the outcomes that really matter – better outcomes for consumers, for investors and for markets; and therefore better outcomes against our four statutory objectives. It is important to stress here that we are not changing our Principles and other high level requirements – the move to a more principles-based approach is absolutely not about any lowering of the standards we are seeking to achieve.

Second, a more principles-based approach should deliver these outcomes more effectively, in particular by emphasising the responsibility of the senior management of firms to engage with the Principles and to ensure that their firms deliver outcomes that meet these high level requirements. So we want the senior management of firms 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.

Detailed rules clearly have 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.

We welcome market-led solutions where we use our influence rather than our formal powers to encourage the industry to change. For example, following our challenge to the insurance sector on contract certainty in December 2004, the market has achieved considerable success in tackling the practice of 'deal now, detail later'. This was achieved without the need for any additional rules and guidance from us. Our Retail Distribution Review is looking for market-led solutions to address issues surrounding the availability of advice, sustainability, professionalism and incentives in the distribution of retail investment products.

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The role of the Ombudsman under principles-based regulation

I want to comment specifically on the role of the Ombudsman under principles-based regulation because that role is an essential enabler of our move towards more principles-based regulation.

A principles-based approach is not about any passing of standard-setting to the industry or to the Ombudsman. The very existence of the Ombudsman helps to facilitate the FSA taking a risk-based, principles-based and increasingly outcome-focused approach. The vast majority of cases considered by the Ombudsman turn on questions of fact or the application of general legal principles rather than on the application of detailed FSA rules. And ultimately, 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 Ombudsman upholding cases against them on a regular basis.

Some firms are concerned that the move towards principles-based regulation will create greater uncertainty about what their obligations are to consumers, and that they may be held accountable for these by the Ombudsman rather than by us. There is some concern that the Ombudsman may interpret high-level rules and principles differently from us. This could limit the potential benefits from our move to more principles-based regulation.

But, again, it is important to bear in mind that most cases considered by the Ombudsman turn on disputes of fact or the application of general legal principles. This is unlikely to change as a result of our move to more principles-based regulation. So we believe that it will not change the Ombudsman's role and its interaction with the overall regime. And the wider implications process I mentioned earlier will continue to capture those issues with the potential for broader application across the industry.

We are firmly of the view that the Ombudsman is key to allowing us to concentrate on the wider issues that are likely to cause consumer detriment. Without an Ombudsman service we would not be able to pursue our risk-based and principles-based strategy and consumers would need to resort to an already over-worked court system to resolve individual disputes. And the highly respected system of financial regulation in the UK would be much less effective for that.

Conclusion

Thank you for the opportunity to discuss these issues with you. I hope I have furthered your understanding of the FSA's role in the current market turbulence; our role as regulator; how we work with the Ombudsman; and how principles-based regulation works in practice.

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