London's Financial Markets and the FSA's approach to financial regulation
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Speech by Verena Ross, Director, Strategy & Risk, FSA
Economist Conference
4th December 2007
Good afternoon ladies and gentlemen. Thank you very much for the invitation to speak at this economist conference on London's Financial Markets. I am very grateful for the opportunity to describe briefly to you today the FSA's approach to regulation and how we go about conducting it in practice. I am also going to briefly touch on recent market developments and what they mean for our regulatory approach.
Let me start by briefly talking about the FSA's statutory responsibilities that are outlined in the four objectives around which the Financial Services and Markets Act was built in 2000. The four objectives cover, not surprisingly, the fact that we should aim to maintain confidence in the UK financial system markets and that we should secure an appropriate degree of protection for consumers. Slightly more unusually compared to other financial regulators around the world, we also have an additional two statutory objectives; one dealing with the need to reduce the incident of financial crime being conducted through financial services firms; and secondly the need to promote public understanding of the financial system.
These four statutory objectives, however, have to be fulfilled in a way that also has regard to a number of, what are called, "principles of good regulation". These really often drive on a day-to-day basis how we go about our work, we need to make sure that when we fulfil our four objectives we do so in a way that provides an economic and efficient use of our resource. We also need to make sure that in the way we regulate we take account of balancing the burdens and restrictions on firms with the benefits of regulation. So we need to make sure that we conduct proper cost benefit analysis of new policy proposals but also think about burdens and benefits whenever we go about regulating on a day-to-day basis. In fulfilling our objectives we are required to facilitate innovation and competition and minimise any adverse impact on competition between firms. We also need to take into account the international character of financial services and markets and maintaining the UK's competitive position globally. It is important to note that this is a principle of good regulation and not a primary objective but clearly in whatever we do these "principles of good regulation" are an important consideration when determining how to best go about regulating in practice. There is one other point that I haven't mentioned which is the responsibilities of senior management in regulated firms. This means that we should place responsibility on senior management wherever possible rather than trying to intervene as regulators ourselves where that is not necessary. All of this goes back to making sure that we only regulate where regulatory intervention actually provides for a better outcome, and that is something that I will come back to later.
We have put all of these statutory requirements into three broadly defined strategic aims around which we now structure our work and also structure the public accountability, that we provide through outlining what we are planning to do in our Business Plan early in the year and then reporting back on last year and what we have done through the Annual Report. The strategic aims of the FSA are: to first of all, promote efficient orderly and fair markets in both retail and wholesale markets; secondly to help retail consumers achieve a fair deal; and finally (focussing on how we actually conduct ourselves) to improve our business capability and effectiveness. The statutory obligations that are placed on the FSA combined with how we have actually approached our regulatory work have led us to what I would describe as four key ways in which we actually go about our regulatory task. First, and probably the most well known and broadly approved approach to how we go about regulation, is that we are very firmly risk-based, we look at the impact that individual financial services firms or particular issues in the financial services sector have on how we might be able to fulfil the statutory objectives. And we then look at what the probability is of something going wrong. These impact and probability measures in combination lead us to decide how much of our limited resource we should spend on a particular issue and how intensively we should supervise or enforce against it.
We are also an evidence-based regulator making sure that we only regulate where there is evidence of market failure and where the market itself clearly cannot provide the solutions that are necessary. This also involves conducting a cost-benefit analysis for any regulatory rule or specific significant regulatory initiative.
Thirdly we are becoming increasingly principles-based in our approach. We have always had the eleven principles for business, ever since the inception of the FSA. However, we have recently become ever more publicly committed to moving towards a more principles-based approach to regulation. In April this year we published a short document outlining what we mean by principles-based regulation and try to outline what this approach means for the firms that we regulate and for the FSA itself.
Finally and very closely linked to the three above, is the fact that we are outcome focussed. We are trying, wherever we can, to be very clear about the outcomes that we want to achieve and try wherever possible to measure whether we are achieving those outcomes. All of this is being pulled together in our outcome performance report which is a senior management tool but also the means through which we will increasingly report publicly on how far we believe we have actually achieved our statutory objectives and regulatory aims.
It is important to note that we are not saying that by moving towards a more principles and outcomes focussed approach we will give up on actually having some detailed rules in areas where it appears necessary. What we want to do is make sure that where rules are necessary we are clear that they describe the outcomes rather than just the process. We try to make sure that we then supervise against those outcomes and wherever possible avoid very detailed prescriptive rules. We want to ensure that ultimately everyone we regulate aims to achieve the desired outcome. We want to avoid that people just focus on trying to meet the letter of the law, which in regulatory terms is often described as a "tick-box" approach. We do recognise that in certain areas rules remain necessary because either the outcomes are not easily observable or not observable over a short period of time. Another reason for detailed rules might be where comparability between sets of information are important. So for example, in the consumer area there might be a small number of areas where actually making sure that firms disclose information to consumers in exactly the same way is important to ensure that the consumer can compare the fact easily and so ultimately make the right choices.
Finally we are also conscious that regulation and legislation that is coming from Europe is not always yet written in a fully principles-based way and therefore this will sometimes mean that we need to take a more prescriptive approach than we would probably have decided on a purely domestic basis. But we are working actively in Europe to ensure that the Commission and other member states move increasingly towards more principles as well, and are seeing some progress in that direction.
It is probably worth at this point just dealing with some of the myths that are around about the FSA's regulatory approach. It is at various times being described as "light-touch" or "soft-touch". We are emphatically saying that it is not. Having a risk-based and a more principles-based approach to regulation does not mean that we have lowered our regulatory standards. It is purely about how we best achieve that regulatory standard overall. We are keen to make sure that we continue to regulate the areas that we have responsibility for in the most effective and efficient way. Achieving the right outcomes not only for firms but also for consumers and the markets as a whole.
We strongly believe that the more flexible approach to regulation that is described by more principles-based regulation is the right way forward in this regard. We recognise that we have limited regulatory resources and we firmly believe that we need to allocate those on the basis of where the greatest risks are. Therefore I would describe our approach as risk-based and proportionate, certainly not "light-touch".
The other point that I would just like to touch on at the end of this speech is the fact that we believe very strongly that the recent events surrounding the credit crunch, more properly called liquidity crunch I believe, and the Northern Rock episode, reinforces, rather than contradicts the need to focus on the outcomes and ultimate consequences of management action rather than just on the compliance of the action with a set of detailed rules. We are not operating a zero failure regime. We recognise that a successful financial market place requires innovation and competition and, as I explained earlier, that is recognised in the principles of good regulation that were given to us by Parliament. In turn that means, unfortunately, that there will occasionally be failures. But we believe very strongly that a more principles-based regime provides the best chance of achieving the requisite balance between benefits and risks of innovation. It is a much more flexible way of dealing with markets and products that are changing rapidly. If you look at areas such as conflicts of interest management or stress-testing, it is very clear to us that it will be very, very difficult to ever have very prescriptive rules in those areas. Ultimately the individual businesses and their circumstances are different and that difference needs to feed through into a flexible approach for looking at how best to achieve the ultimate outcomes of either managing conflicts or conducting proper stress-testing.