Challenges for the FSA
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Speech by David Kenmir, Managing Director of Regulatory Services, FSA
Compliance Institute Summit 2007
October 4th
The focus of my speech today will be on the challenges the FSA and the regulated community will face over the next couple of years, in particular the implementation of our principles-based regime and our retail strategy. However, it would seem odd not to first briefly discuss the recent events in the banking industry.
The 'credit crunch' in general and the Northern Rock saga in particular has dominated headlines over the last few weeks, and it is important not to underestimate the anxiety this has caused consumers. However, it is also important to remember that the UK banking industry has entered this period of market turbulence after several years of very strong market conditions which have helped it build up healthy balance sheets and strong capital positions (which are higher than regulation requires). Therefore banks are generally starting from a good position to withstand the global pressures arising from what is an issue of liquidity distribution.
Callum McCarthy pointed out in his Mansion House speech two weeks ago, that we should not necessarily see this change in market conditions as a change for the worse. The change in risk appetite over the last few months has meant that risk premiums have risen. He pointed out that 'an increase in risk premiums which investors require to take risk – is probably a healthy development on the whole, as these premiums have been exceptionally low for quite some time..and this pricing of risk could and should not be continued.' The fact that there is a liquidity problem is not a total surprise to us, we highlighted the possibility in our Financial Risk Outlook at the beginning of the year, however, what has been difficult to gauge is exactly when the problem would crystalise and in what form. Nobody predicted the exceptional circumstances experienced over the last few weeks.
In addition to addressing the legitimate concerns of consumers, the challenge now for the FSA is to look both at the root cause of this problem - how liquidity is spread within the the financial system – a challenge on a global scale; and at the lessons we can all learn from recent events.
I am sure that many of you will want to return to this subject in the Q&A session later.
More Principles-based regulation (MPBR)
I should start by saying that in many ways the key word here is MORE. Nobody at the FSA thinks that a 9000-page rule book is sustainable, equally nobody thinks that the 11 FSA Principles alone would suffice. We are moving along the spectrum between these two extremes. Rules will still have an important part to play, for instance where market failure analysis or EU Directives lead us to conclude that they are the right regulatory tool to deploy.
Given the events of the last few weeks, some may think that now is not the time to introduce a new regulatory framework which allows for greater freedom and flexibility for firms. However, we firmly believe that regulation based on high-level, outcome-focused rules is exactly what we need to support ever-evolving, complex, competitive, and sometimes turbulent markets.
Our introduction of high-level rules means that firms will have to look carefully at how they meet our outcomes, rather than simply comply with low level prescription without thinking any more deeply about it. In meeting the spirit of the rule, firms will now need to look for the right regulatory outcome: one which best aligns with their business practices and delivers the right outcome to their customers.
As our markets are fluid and ever-evolving, it is no longer desirable for us to introduce detailed rules every time a new product is introduced or the market experiences a hiccup. Principles and high-level rules work with the grain of the market. Our focus on outcomes should stand the test of time; for example, our requirement for firms to treat customers fairly is unlikely to change much, but firms will need to think regularly about what this means for them and act accordingly.
High-level rules are evident in a number of Handbook changes which have been introduced over the last year - our new sourcebooks on Training and Competence and New Conduct of Business, and the Decision Procedure and Penalties manual to name but a few are now at a higher level of generality overall. It is our intention, where possible, to make all changes to our Handbook more principles-based, simpler to understand and more accessible.
While Directive material may limit the scope of our discretion in some areas, we do not see the implementation of Directive material necessarily hindering this move to MPBR. As we have previously stated, we believe Community Law is not in itself incompatible with our more principles-based approach. Directives are quite often intentionally high-level and outcome-focused to allow for the national authority to transpose them. We intend to implement changes by using 'intelligent copy out' and in doing so will maximise the level of flexibility our firms can benefit from.
So, far I've explained the potential benefits of MPBR and the reasoning behind why we think principles-based regulation is the right direction to take, but what will be the challenges for firms?
We acknowledge that less prescription could increase uncertainty within firms about our requirements. Compliance departments will need to make the shift from designing, implementing and monitoring processes that embed detailed regulatory rules, to exercising more judgement about the best way to achieve the outcome the FSA requires. They will need to provide more support to their Board and senior management teams to satisfy them that the processes and controls they have in place will be suitable for their business and the regulatory outcome. On a day-to-day level, compliance teams may be more vigorously challenged by front office staff about if and when they can perform certain activities or execute certain transactions if there is no rule providing that degree of prescription.
In addressing these challenges firms may need to make both operational and cultural changes, and we are conscious that some firms may be better equipped to make the shift and reap the benefits than others. Firms should be thinking now about how what these changes will mean for them and how they wish to operate as a result.
Of course we will need to change too.
We recognise that the task we are asking our people to undertake in an outcome- and principles-based environment is much more demanding and complex than that of a few years ago. We are therefore taking steps to ensure that our people are equipped to meet this challenge. Key to this will be improved recruitment, training, management and reward practices. In each of these areas we have made significant progress in recent years, but have further to go.
We have started a comprehensive programme of training and development covering those working in areas ranging from policy to supervision and regulatory transactions, and our contact centres. Our Contact centres team have a particularly important role to play helping small firms operate in a more principles-based regime. We will also invest in Knowledge Management technology to enable our staff, consumers, and firms, to access the information they need.
Our Retail Strategy
A number of concerns have been raised in the past about whether more principles-based regulation sits well with our consumer protection obligations. Our view is that is does. History has shown that having detailed rules does not prevent problems from occurring or improve standards within the market. Retail investment markets have been regulated for almost twenty years, yet there is still plenty of room for improvement, which is why we have initiated a review of retail distribution and upped our efforts on financial capability.
Our aim is for customers to achieve a fair deal, so we want retail markets where:
- consumers are capable and confident;
- information for consumers is clear, simple and understandable;
- firms are soundly managed, adequately capitalised and treat customers fairly; and
- regulation is risk-based and principles-based.
Financial Capability and the Thoresen Review
Raising the financial capability of the UK population is central to our strategy towards the retail market. Through our leadership of the National Strategy for Financial Capability we are seeking to help people acquire the knowledge and skills which will enable them to make capable and confident financial decisions. And a more capable and confident consumer will, we believe, encourage the market to respond with more appropriate and better value products and services.
That is one reason why the provision of "generic" financial advice – that is, personalised but unregulated advice – has always been a component of the National Strategy. We have, for example, worked with the Financial Services Skills Council to create National Occupational Standards for generic advice. We have launched our 'moneymadeclear' website and made good progress in building relationships with a range of intermediaries – such as housing workers, youth workers and voluntary advisory services – to support the expansion of entry-level generic financial advice. But it is clear that these intermediaries cannot be expected to give more in-depth advice, for which specialist provision is required.
We are delighted that Otto Thoresen is undertaking a review for the Government looking at developing a national service for generic financial advice (or, as Otto prefers to call it, 'guidance'). There are many questions that Otto and his team are grappling with such as: How should the service be established? How should it be funded? What advice should be given and through which channels? Who should be the service target and how should demand be stimulated?
We think generic advice could usefully follow on from what has already been achieved through our National Strategy, building on the relationships we have established with a range of intermediaries and complementing existing providers of such advice, such as Citizens Advice Bureaux who already provide a good deal of face-to-face advice, albeit mostly helping people who are facing a debt crisis. We are also conscious that, for many consumers, the service will result not only in heightened awareness of their financial needs but will also lead them to seek a range of regulated advice services. This is something that we will very much have in our sights as part of the Retail Distribution Review.
Retail Distribution Review
The problems with the retail investment market are well-known: primarily complex charging structures, remuneration practices that lead to conflicts of interest, poor standards of advice, the circular problem of firms failing, mis-selling claims and compensation bills and so on. Added to the problems associated with a basic lack of consumer understanding and willingness to engage with the retail investment market, these problems have manifested themselves in poor treatment of customers.
So, alongside our important work to ensure that firms treat their customers fairly, and our efforts to improve consumers' understanding of financial matters, we are seeking to find ways to help the market remove some of these fundamental problems and work in a way that leads to better outcomes for all: firms, customers and the regulator. That is what we are seeking to do through our review of retail distribution.
We have acknowledged that, our regulation and supervision in the retail market has historically tended to focus on the problems that stem from these issues rather than looking at the root cause of them. Whilst we are clear that we have made improvements in some areas, we still haven’t progressed enough. Consequently, we have committed to driving up standards across the entire retail distribution market and helping the market remove or better manage some of the inherent conflicts that arise: this applies equally to banks, life companies, financial advisers and anyone else involved in the distribution of retail investment products. We accept that our approach may be part of the problem and so we are looking at that too.
We have sought to do this by engaging the industry and helping it identify solutions and better ways of operating, making it clear that our role is not to dictate market structures but rather to remove unnecessary barriers and provide regulatory incentives for higher standards where appropriate.
Our discussion paper published in June this year outlines the ideas that were put forward by groups of senior people from across the entire distribution chain, presented in a way that explains what this could mean for the future of retail distribution. Many of you will be familiar with the content of the DP, and my colleague Sharon Campbell is due to address you on Friday morning, so I don't propose to get into the detail now. I am keen simply to explain how the RDR fits within our overall strategy for the retail market and why it is one of our key priorities.
I also want to emphasise that our discussion paper is the end of the first stage of this review, the beginning of the debate and we want to get your views and thoughts on both the ideas set out in the paper as well as alternative ideas. So far, we have received over 140 responses to the paper which, alongside our own work to understand more about the practical implications of the ideas put forward, will enable us to decide how to proceed when we publish our feedback statement in the middle of next year. You still have over two months to respond so I would encourage those of you that haven't done so already to turn your attention to that now.
On their own, these two programmes of work will not deliver our commitment to consumers, we shall continue to press ahead with our treating customers fairly (TCF) agenda, and we are currently undertaking some work to determine what we can reasonably expect the consumer to be responsible for. This should lead to an elaboration of what 'caveat emptor' means in the financial services markets. These, coupled with our continued supervision of retail firms, should take us some way to where we want to be. However, we realise this will not be a quick win, or indeed easy to implement. It will require the FSA to be clear and proportionate about its expectations (introducing rules where necessary) and it will take commitment from firms and for some, significant changes to the way they do business.
Wholesale Strategy
So far I've mainly talked about our retail strategy and the challenges that may bring, but what is in store for wholesale firms?
Our wholesale business unit is about to embark on a new three year plan which will shape our approach to regulation in that market. However, our ultimate goal, and the one we continue to work towards is unchanged. That is to pursue efficient, orderly and fair markets. This forms one of the FSA's statutory objectives and our plan is couched in terms of this objective.
But what does this mean in practice?
To improve efficiency within the markets, we think it important that investors can make decisions on the basis of relevant information. This means we need a market where both buyers and sellers have the facts they need to reach an informed conclusion about how to use their assets. To achieve this we intend to look at the need for greater transparency and freer information flows within the market. A key benefit of a more principles-based regime is the ability for markets to flourish and innovate. Therefore it is imperative that the structure of the market is efficient enough to accommodate new instruments and products and in a manner which is consistent with the FSA's objectives.
In order to maintain an orderly market we shall ensure that firms are properly managed, not vulnerable to use as a vehicle for financial crime and remain well capitalised. This means we need to enhance our capacity for monitoring and managing intelligence to ensure we keep up with the ever–more complex techniques used for committing financial crime. And, as recent events have shown, we can’t prevent turbulence within the market place but we can seek to ensure that firms are able to meet their liabilities and obligations and are resilient to and well prepared for a crisis. That is why we have consistently emphasised the importance of 'stress testing' to firms in recent times.
To promote a market which is fair we intend to look closer into conflicts of interest and how firms handle client money. We will pay closer attention to both issues as part of our Arrow risk assessments, and we plan to review our client money rules to ensure that they remain appropriate and fair. We also intend to continue with our work under market abuse through a combination of stronger supervision, on the chance of detection through the implementation of improved transaction monitoring technology, strengthening prosecutions where we bring them and ensuring penalties are sufficiently robust.
Finally, there is still a big effort required, particularly over the coming months to ensure MiFID and CRD (which of course are not exclusively wholesale) are properly implemented. We will continue to dedicate significant effort, including at the most senior level, to influencing the international agenda. Of course much of our work is directed to the developments in the EU – where at the moment we continue to play an active role in shaping Solvency 2.
We look forward to engaging with the wholesale community in delivering these workstreams.
Regulatory Transparency
I thought I would finish off by talking about a particular piece of work that the FSA has initiated in which we would like the financial services industry, together with consumer representatives, to play an active part. On the one hand it is simply exploring an extension of the approach we have always taken. And on the other it has the potential to change quite significantly the nature of the relationship between regulated firms and the FSA.
What I am talking about is a piece of work looking at the extent to which we could better achieve our statutory objectives by disclosing more about what we know or think about individual firms.
Right from the beginnings of the FSA we committed ourselves to being open and transparent as a regulator. In line with this, several months ago we discussed with stakeholders whether we should introduce a public register identifying actual financial promotions which have been amended or withdrawn following FSA intervention. One of the questions we explored with stakeholders at the time was whether disclosing this information would improve overall knowledge in the industry about what we considered acceptable and what not, and so raise standards across the industry as a whole. Having started to explore some of the issues raised by this proposal we decided that a decision would be premature – we really needed to look again at our strategy in the round to see what part increased disclosure could play in improving regulatory outcomes across all our regulatory activities – from Authorisation, to Supervision, to Enforcement.
Inevitably we will encounter some difficult issues. We are highly constrained by a raft of legislation that governs both what we must disclose and what we cannot disclose, with some untested areas in between. In fact one of those untested areas very recently came to light when the Information Commissioner issued two important decision notices which directed the FSA not only to name individual firms that had been visited but in one case also to disclose our findings in relation to those firms. To date we have considered that the FSA was constrained from releasing information of this specific nature, but the Information Commissioner judged that the public interest weighed in favour of disclosure.
We disagree with the Commissioner’s judgments and think that there are important points of principle here which is why we have appealed against these decisions.
You should not find it surprising that both the Information Commissioner and we are exploring and testing the sensible limits of what we do and don't disclose. We are, after all, in a climate where parliamentary and regulatory bodies across the world are being urged to illuminate - and to explain – the basis for their decisions. But we do not underestimate the potential consequences for firms, and we will be active in engaging with the industry and consumer representatives in coming months, leading to the publication of a Discussion Paper looking at options in the first quarter of next year.
Ladies and gentlemen, thank you all for listening. I look forward to taking your questions in the Panel session after the coffee break.