The UK approach to regulation
Speech by Hector Sants, Chief Executive, FSA
Financial Services Seminar at the British Embassy in Tokyo
7 November 2007
Other speakers have described and will describe the many advantages of doing business in London and Scotland from the point of view of infrastructure and the skills base. We are fortunate to have representatives from many sectors of the financial services industry from both the UK and Japan from infrastructure providers to experts on the increasingly important area of Islamic finance I am delighted to have this opportunity to say a few words about the UK approach to regulation. This approach has been severely tested in the past few weeks. Many of you will have noted the effects of a recent loss of confidence in a UK mortgage bank resulting from a particularly extreme set of market conditions. That situation has now stabilised as a result of the intervention of the UK authorities and we are of course looking carefully at what happened to see what lessons we can learn. However, from the FSA perspective, I think that a 'lessons learned exercise' will mainly impact on our specific supervisory engagement with that institution and look at the specific set of our regulations around liquidity. I believe those events actually strengthened the case for our overall approach to regulation. Let me share with you a few broad observations about this approach and then return to the lessons learned:
- One fundamental aspect of our regime is that we apply our regulation in exactly the same way to UK and non-UK firms. We do not give special treatment to UK firms and we do not apply special requirements to non-UK ones. This is a long established principle which partly explains why the UK has always been a popular location for international firms. Provided firms and their management meet our requirements for authorisation, we are delighted to welcome them to London where they can compete on level terms with everyone else.
- The second broad point about our approach is that it is risk based. This is often misunderstood, leading some people to describe our approach as ‘light touch’. I can assure you that it is not light touch and I am confident that any of the firms against whom we have brought enforcement action would agree with me in that. A risk based approach means that we focus our effort and resources where they are really needed. A small firm which is well run and which, because of its size or the nature of its business, poses little risk to consumers or financial stability is likely to receive less attention from us than a firm which does pose significant risks; either because of the type of business it does or its size. In a world of scarce regulatory resources that makes sense, but it certainly does not amount to having a ‘light touch’ overall.
- As a general matter we also believe that we should, wherever possible, rely on markets to solve problems rather than rushing to regulate whenever we see a problem. By its nature, regulation interferes with the working of firms and markets and creates costs. That does not stop us from introducing regulation where it is needed but before doing so we ask ourselves searching questions about the nature of the problem, whether market solutions are possible and, if not, whether the cost of regulation can be justified.
The aspect of our regulation which has received most attention over the recent period, however, is our intention to move away from detailed rules further in the direction of high-level principles. This implies a focus on outcomes rather than on the detail processes of how firms comply. To take an example, everyone is familiar with the idea that many financial institutions face conflicts of interest. As a result of its M&A work an investment bank may be in possession of information which could be abused by its traders. It is not feasible to eliminate conflicts of interest but it is absolutely essential that firms manage such conflicts effectively to ensure that investors, consumers or clients do not suffer damage.
In practice, there are dozens of ways in which conflicts can arise in a large investment bank. One approach to this problem would be for the regulator to write a rule telling the firm how to deal with each and every one of these. That would be immensely time consuming and, given the complexity of modern business, ultimately futile. It is much more effective to set out clearly an expectation – or principle - that the firm will identify all conflicts and manage these in a way which prevents damage to consumers and investors. In that way the focus is shifted away from detailed process orientated rules to the achievement of the right outcome.
Let me give a further, very topical, example. I mentioned earlier the problems that we have recently seen in the UK banking system. One obvious lesson is that we will need to look harder at the role of stress testing in liquidity management. Firms need to subject their balance sheets to severe but plausible tests to ensure that they are robust in the face of market stresses. Supervisors, in turn, need to scrutinise this process to satisfy themselves that firms really are resilient. It is impossible to imagine any of this being governed by rules specifying the nature of the stresses, their severity, the frequency of the tests and the nature of the management response. This would make no sense in a world in which firms' balance sheets, business models and the markets in which they operate differ widely. A principles based approach is required here in which the firms exercise judgement in their stress tests and supervisors do likewise in assessing the adequacy of these. This is a very demanding task for all concerned but we all need to rise to the challenge.
Turning from the rationale for a principles based approach, let me take this opportunity to correct another misunderstanding about the FSA regime. Despite our enthusiasm for principles, we are not in fact a principles based regulator! We currently have a rule book which is 9000 pages long – partly a legacy from the several institutions that were merged to form the FSA. Neither do we expect to become a solely principles based regulator. That would not be feasible. There will always be a need for rules – for example where outcomes are hard to observe because the kind of detriment we are keen to avoid may not materialise for many years. It is also important to remember that much of our regulation in the UK derives from the European Union. If, as is often the case, rules are created there, we have no choice but to apply them.
We do however want to shift the balance of our regulation further in the direction of principles. Let me set out two main reasons for this:
- It is much more efficient for firms. When it comes to controlling risks, firms may well develop approaches that differ in detail but are equally effective in terms of their outcome. In that case, they should be allowed to use these approaches rather than one arbitrarily laid down by the regulator. The alternative is that they will feel obliged to maintain two sets of controls: the ones they think are effective and those they maintain simply because the regulator requires it. This is closely linked to the point I made earlier that industry and markets are often better at finding solutions than regulators and one implication of a more principles based approach is that we may well make much more use of industry guidance.
- A principles based approach is also likely to be more robust when markets and products are changing rapidly. In the example I gave earlier of managing conflicts of interest, business models and products are developing all the time in ways which create new sources of conflict. A general principle – that firms must manage conflicts and avoid detriment – will prove much more durable and robust than any attempt to keep pace through the creation of ever more detailed rules.
The aims of the FSA are to promote efficient, orderly and fair markets; to help retail consumers achieve a fair deal and to improve our own business capability and effectiveness. Promoting the UK as a financial centre is not one of our objectives, though we are required to think carefully about the impact of what we do on competitiveness and the ability of the financial industry to innovate. Our aim, quite simply, is to deliver good regulation and as I have explained, we believe that an approach which places maximum reliance on market solutions and which is risk- and principles- based and outcome-focused is instrumental in that.
In conclusion, I believe the recent market events have reinforced rather than contradicted this need to focus on the outcomes and consequences of management actions rather than just on the compliance of the actions with a set of rules. Principles are, in many ways, a more efficient and real-time means than rule-making, enabling us to meet our statutory objectives and assisting firms' management in dealing with the type of challenges they faced in the summer. We are not operating a 'no fail regulatory regime' and recognise that a successful financial market place requires innovation and competition. In turn that means there will be failures. But a principles based regime clearly, in our view, provides the best chance of achieving the requisite balance between the benefits and risks of innovation.