Judgements on judgements - Retail firms and principles-based regulation
Speech by Hector Sants, Chief Executive, FSA
FSA Retail Firms Conference
27 February 2008
I am pleased to have the opportunity to talk this morning to such a wide range of firms operating in a variety of sectors. A lot has changed since our first Retail Firms Conference a year ago. Financial market conditions have been transformed from benign to difficult, creating challenges for the industry, firms and the regulator. Against this background, I would like to share with you today my thoughts on how the broad issues surrounding recent events impact on our work as the UK's financial services regulator; how we intend to deal with the concerns that these events have given rise to; and conclude with an overview of our business plan to set today's conference in context.
Market conditions
It is now more than six months since the market turmoil began and both market participants and regulators are learning from what has happened and applying those lessons. Northern Rock is clearly the most visible manifestation in this country of the extraordinary market conditions that developed last year. It is worth noting, however, that there have been similar upheavals across banking and other sectors elsewhere. The US, most notably, has had to contend with the sub-prime crisis which began the current instability. This, in turn, has damaged confidence in a wide variety of global asset classes. And regulators in various countries are having to manage a number of problematic situations.
Market induced problems, however, are not an excuse for any inadequacy in our regulation of firms and I would thus like to make some comments on the events surrounding Northern Rock. Having reviewed our supervisory engagement with Northern Rock prior to July 2007, I have already acknowledged that it was not of sufficient intensity and rigour, particularly with regard to challenging the company's board and executive in respect of their risk management practices and their understanding of the risks posed by their business model. Furthermore, given the importance I attach to learning lessons quickly, I commissioned an internal review of our supervision of Northern Rock in the period up to July last year. We have committed to publishing the conclusions next month. I can now say it will show that the supervision of the company did not meet the standards I would expect of the FSA, although I should also say that it is not necessarily the case that more active supervision on our part would have prevented what later occurred.
That said, being prepared to examine ourselves and learn from our mistakes, in my view, is a crucial characteristic of a successful organisation. Successful organisations have a learning culture and an institution which expresses infallibility is not one to trust. I would thus like to think that our efforts to be open and proactive should be seen as being to our credit and help give confidence to industry and consumers. To that end, I want to assure you that we will act decisively to address the shortcomings that emerge from the review.
However, I should also remind you that the fact remains we are not intending to operate a no fail regulatory regime. Firm failures can happen for a variety of reasons. They are certainly not always a result of market or regulatory failure. The regulatory framework is not designed with the intention of ensuring that any given institution cannot fail. This would involve a degree of regulatory caution, and regulatory intervention, which would severely restrict innovation, to the cost of us all. The freedom to innovate allows firms to take risks which, in turn, means that some may fail. In the case of Northern Rock, the government guarantee has secured the position of depositors. I strongly believe that a moral hazard argument should apply to shareholders and management, but not to retail depositors.
This point is now addressed by the Consultation Paper published by the UK Authorities in the wake of the events at Northern Rock. This sets out the changes proposed to strengthen the current framework for financial stability and aims to give greater clarity in terms of the depositor guarantee scheme. The consultation document contains proposals for improving the resilience of the financial system, providing effective compensation arrangements in which consumers have confidence, ensuring coordinated actions by authorities and reducing the likelihood of individual banks facing difficulties. It also contains proposals for a new 'special resolutions regime', that would make available a range of tools to the authorities that would apply if a bank was to get into difficulties.
The FSA has also increased the pace of our liquidity work and published, last December, a Discussion Paper on requirements for banks and building societies. This has drawn lessons from how banks and building societies coped with the recent market turbulence and sets out preliminary ideas for reforming our regulation of liquidity. We will, in any event, be conducting more rigorous supervisory reviews of firms to ensure our qualitative requirements are applied appropriately and have strengthened our specialist teams within the FSA who support our supervisors. We are also developing new reporting requirements to support our work in monitoring liquidity.
With that in mind, my final comment on the changes we are planning as a result of the lessons we have learned is to make clear that we are all too aware of the risks of rushing into decisions as a result of these events and forcing through radical amendments to our regime. History has shown the dangers of rapid regulatory response and few will argue that what the UK now needs is to introduce ill-judged policy responses. I feel strongly that any overreaction on the part of legislators could damage longer term competition and we will seek to resist any imprudent recommendations that are made.
Regulatory philosphy
Having commented on the specifics of the lessons learned from Northern Rock, I would now like to move on to explain our overall regulatory philosophy. First, I would like to make absolutely clear that our stated move toward a more principles- and outcome- based regime has not changed. Although some external commentators have doubted whether now is the appropriate time to drive forward an approach based on fewer, less prescriptive rules, we believe that these times of more turbulent markets demonstrate the need for both the regulator, and the industry, to focus on the outcomes and consequences of actions, including consideration of risks.
So, the FSA will continue to move towards reliance on principles rather than detailed rules, and will move to a regime focused on achieving the outcomes to support our aims.
We are an evidence-based regulator. We seek only to intervene, and intervene in a cost-effective way, where there is evidence of market failure and where the market itself cannot provide the necessary solutions. We will not apply hindsight when judging firms' actions in an enforcement context, as it must be possible for you to predict at the time of an action whether it may constitute a breach. Accessibility of supporting material is therefore key to this approach. Provided we get this right, firms should have the confidence to take up the greater flexibility and innovation afforded by our approach.
We are and remain a risk-based and evidence-based regulator. We will consider how individual firms and particular risks across sectors could impact our ability to fulfil our statutory objectives, and how likely this is to happen. These impact and probability measures combined will enable our supervisors to decide on the appropriate tools to use and help my senior management team decide where our finite resource would best be applied.
Risks
This focus on risks is particularly necessary now, when market conditions have deteriorated considerably and investors have reassessed the risks in their portfolios. As a result of this, we believe markets could be more vulnerable to external shock and the impact of shocks on firms could be more significant than in previous years. We recognise that the operating environment remains difficult, both for you and for us, and it is likely that these pressures will persist, particularly as investor confidence in some markets remains low.
You should be preparing for this changed environment and you, and your customers, will need to recognise that there are both short- and long-term risks, and think about the implications. We will work with you on this and, last month, published our Financial Risk Outlook to help you consider the potential economic scenarios and correspondent risks that could emerge. The document identifies five priority risks which you should be considering in relation to your firm. I will not repeat these today but would recommend, if you have not yet done so, that you take a look at this Outlook and consider how these risks may affect your firm over the coming year.
Despite this, I need to be clear that you should not seek to divert your attention away from focusing on conduct of business requirements and our high level principles. In particular, you will need to continue your focus on treating your customers fairly and to tackling the areas of financial crime that can occur in your sector.
Our priorities
So, while the prevailing market conditions dictate much of the direction of our risk priorities, we continue to work towards achieving our desired outcomes in the other key aspects of our regime. We have thus set ourselves a challenging programme of work for the coming year which includes improving our overall effectiveness, continuing policy developments, and further enhancing our supervision and enforcement strategy.
I strongly believe we can only deliver as an effective regulator if we have the right people making the right judgements, operating in an effective environment. It is to that end that we are continuing the considerable investment plan to increase the quality of our people and improve our technical infrastructure. This is a multi-year programme, which we remain convinced will provide widespread benefits to our stakeholders.
We will continue to focus on key retail themes, which include a number of long standing, deep-seated risks to our objectives. The area of greatest structural concern for us remains the retail market and I should highlight here our ongoing commitment to the Treating Customers Fairly programme, the Retail Distribution Review and the Financial Capability programme. We will continue to deepen our understanding of the economic context and drivers in the market place. We want to explain clearly to you how these initiatives are positioned within an overall retail strategy, something that Clive will be talking you through during his session. This contextual work will also need to take account of the outcomes of the Thoresen Review of Generic Financial Advice. The decision as to who takes forward Thoresen's proposed agenda will undoubtedly significantly affect both the industry structure and the way the FSA operates.
Our view remains that an outcome-focused regime is still the most appropriate way to meet the challenges we face. I do not underestimate the difficult adjustment that such an approach brings, not just for the industry, but also for our own people, who need to be able to make good judgements on the judgements you are making about your businesses.
Our supervisors need to understand enough about your business to make timely, confident and proportionate decisions. There will be uncertain or ambiguous conditions where they may not have all the information. But provided their decisions and your own judgements lead to broad consistency of outcomes, we expect some variation in how individual firms are going to get there.
Of course, this supposes that firms' senior management engage to a greater extent to ensure that firms are making the right judgements in delivering the outcomes we want to achieve. Thus, effective compliance may mean some changes in the overall structure and inter-relationships the compliance function has within your business and the capabilities required to operate the function effectively.
With this strategy in mind, we will continue to prioritise achieving 'credible deterrence' in our enforcement strategy. We will focus on those cases where pursuance will make a real difference to consumers and markets, using enforcement strategically as a tool to change behaviour in the industry. In line with the move towards more principles-based regulation, it is likely there will be more enforcement cases where principles, rather than specific rules, have been breached. It is critical, however, to achieve a belief among market practitioners that those who deliberately seek to evade their responsibilities have a strong likelihood of being caught. To achieve credible deterrence, wrongdoers must not only realise that they face a real and tangible risk of being held to account, they must also expect a significant penalty.
Where there is evidence standards are not improving, despite clear messages to the industry, we will move to increase penalties. There are a range of disciplinary sanctions available and we will use our powers to prosecute matters as criminal offences and to restrain the proceeds of crime in appropriate cases. You may be aware that we have had some important developments recently in enforcement. In January, two men appeared at the City of London Magistrates' Court on a charge of insider dealing and are currently on bail awaiting committal proceedings. Earlier this month, an unauthorised stockbroker was sentenced to 15 months' imprisonment for offences of dishonesty including theft and a man was sentenced in Glasgow for offences under the Financial Services Act and FSMA. We have also banned a former broker and fined him £21,000 for selling high risk shares to customers without their consent and deliberately misleading customers by not explaining the risks involved with such shares.
We have a range of disciplinary sanctions available to us and we will continue to use our powers of enforcement in appropriate cases. However, it is important to note that enforcement is an important component, not the sole element of a credible deterrence policy. An effective supervisory regime, including proportionate risk mitigation programmes, has a key role to play.
In addition to highlighting these key regulatory initiatives I would like to end by commenting on a particular programme, that of further improving our transparency. We have started a review of our overall transparency strategy to see whether further increases in disclosure will increase our effectiveness. This is within the context of greater public expectations, in part reflected by the government's Better Regulation initiative and obligations under the Freedom of Information Act. This review will culminate in a Discussion Paper, to be published mid year, which will ask for your views on how we should proceed. We do not see this as a debate about whether we should have regulatory transparency. We already publish a great deal of information across a wide spectrum. But it is about what to disclose, to who and for what purpose. We are seeking to develop overarching principles which we are able to adopt and adhere to in deciding whether to use transparency as a regulatory tool in any particular set of circumstances.
I believe that this work is an example of the type of organisation we are aiming to be. I also hope that our approach towards learning lessons from the recent market events demonstrates that we are committed to being open and transparent in the way we operate. To be effective, we have to have high quality people who are able to make judgements on the judgements you are making about your business. To be trusted, we must show our ability to learn and adapt to an ever changing environment. I want to assure you that we not only expect you in the industry to adhere our principles, we will also be exacting in applying rigorous standards to ourselves. I hope you have found these remarks useful as a backdrop to today's conference.