Principles-Based Regulation - Lessons from the Sub-Prime Crisis
Speech by Hector Sants, Chief Executive, FSA
Securities and Investments Institute Annual Conference
15 May 2008
Good morning. I am very pleased to be here today at the Annual Conference of the Securities and Investments Institute. We very much appreciate the Institute’s work to foster professionalism in the financial services industry, for example, its extensive involvement in our Retail Distribution Review. We look forward to the Institute’s ongoing contribution to this vital work.
Today, I am here to talk to you about the recent market events and what we as regulators have learned from it. At this point, the story of the credit crunch has been well-rehearsed, so I will confine myself to a very brief summary of market events. This time last year we were still enjoying a period of substantial credit growth and leverage in the financial system, where benign economic and financial conditions had led borrowers, banks and investors to take on increased risk. This growing appetite for risk led to a wave of innovations that expanded the financial system's capacity to generate credit assets and leverage but, crucially, outpaced the system's capacity to adequately manage the increase in associated risks. Then, when problems in the US sub prime market emerged, inter-bank liquidity contracted severely.
As liquidity began to disappear in the asset backed securities markets, counterparties became increasingly risk averse, making funding extremely difficult to obtain and creating uncertainties about valuation and creditworthiness that persist to this day.
These developments have had a powerful impact on the financial services sector and many believe they have exacerbated deterioration in the real economy. So far, most of these effects have been confined to the United States and the European Union, but it is clear that, if these developments continue, the impact is likely to reach the broader global economy and financial system.
Today, I will focus on how we are responding to these market events, and what they have meant for our supervisory regime. I will then explain the lessons we have learned from the case of Northern Rock and our plans going forward, including our Supervisory Enhancement Programme.
More Principles-Based Regulation
Many have asked whether the events of the last year have changed our views on the viability of more principles and outcomes based regulation as a viable regulatory philosophy. I, for one, have not changed my mind. Indeed, in my view, recent events have demonstrated both the value of a more principles-based approach to supervision and the risks of deviating from it.
More fundamental questions will never be fully answered for all time by detailed rules. In regulation, as in life more generally, in times of uncertainty, it is our principles that guide us through. And I would also observe that, in my view, firms who have kept their focus on the high level outcomes that our principles demand for their particular business are coming through this period rather better than firms who have not.
In particular, market events over the last year drive home the critical importance of ensuring that a firm's senior managers engage with our regulatory objectives, adjusting approaches to delivery as circumstances change, rather than just focusing mechanically on compliance with prescriptive rules. More principles-based, outcome-focused regulation is an essential tool both for informing senior management about our objectives and for making them accountable for delivery. So, even as our supervisory priorities change, we will continue on the path of more principles-based regulation.
More principles-based regulation has implications for our supervisors as well as for your business. It requires that we work together to be alive to particular business models and the implications these models have for the firm's risk profile and, consequently, for risk management. Each of us must continue to develop our own view of emerging risk and this informs our approach to delivering regulatory outcomes, and in particular, our priorities.
We remain convinced that one of our main priorities must be ensuring that boards and senior management focus clearly on a variety of, stress scenarios that could develop and properly satisfy themselves that they can deal with those scenarios. A good, simple test is for Board to ensure they understand the circumstance under which their firm would fail and that they are comfortable that the risk is acceptable.
A practical lesson we can take from Northern Rock, for example, is that firms' boards and senior management must actively manage delivery of the firm's regulatory responsibilities, and this requires that they demand relevant information and use it to mitigate these risks. It is not enough for this risk information to remain in the hands of the specialists.
So, over the coming year, you can expect our supervisors to challenge your senior management and boards more intensively including:
- how they are ensuring continued compliance with our principles, especially as market conditions change.
- the judgements they are making.
- whether they review the consequences of their decisions.
- when developing and selecting among business options, whether they give robust consideration to the risks and the impact those risks could have if they were to crystallise, and
- whether they consider the potential for new risks going forward.
Supervisors will also put more emphasis on assessing the competence of firms' senior management. You can expect to be challenged and held accountable for outcomes.
We will not, however, prescribe the detail of how you make decisions. We recognise that firms can achieve regulatory outcomes in different ways, perhaps considering methods that align well with their business models, and this is acceptable provided the required outcomes are met. In trying to communicate our message in a way that firms and, critically, of course, the management of firms can understand, I myself find it quite helpful to focus on the word “outcome”. The simple point is that you must give proper consideration to the consequences of your actions. And if our regulatory outcomes are not apparent, senior management, not the regulator, must consider how their actions need to change to get the right result.
Compensation culture
A word at this point on a topical subject: compensation structures. As I have said before, it is important for Boards to recognise that having asymmetrical structures where traders receive immediate reward and do not bear the consequences of losses is a risk to shareholders. I do therefore believe that firms should focus on minimising this risk by ensuring, as far as possible, the structures ensure employees and shareholders both share in the risk in the upside and the downside. There are various ways of achieving this goal, such as deferred compensation with claw back and the increased use of share options. None, however, is perfect and I do believe the regulators need to consider the risk of such structures when judging the overall risk of an institution. The assessment of remuneration structures is part of our supervisory approach and we will emphasise this more in the future. I do not, however, believe regulators should have a view on the quantum of remuneration, this is for the marketplace.
Market Turbulence and its Consequences
This period of market turbulence has brought with it pressing risks that urgently require our attention. The tighter financial conditions many firms are facing have meant that market participants and consumers have lost some confidence in financial institutions and in the authorities' ability to safeguard the system.
We have stepped up our supervisory efforts in response. Firms should continue to expect increased supervisory attention to their funding and liquidity arrangements and the adequacy of their stress testing. But even as firms work to ensure they can deal with uncertain market conditions, they must also maintain sufficient focus on other important business as usual controls and regulatory priorities. We expect all firms to meet this challenge.
We have set out in our business plan a number of supervisory priorities for the coming year. I will briefly outline three key areas: capital, liquidity, and financial crime.
Adequate Capital
Our major supervisory focus for the coming year continues to be on ensuring that all firms continue to maintain adequate financial resources. The market conditions of the last nine months have highlighted how crucial it is for firms to look closely at the vulnerabilities inherent in their business models and test for extreme events.
We are continuing to work with firms to ensure they maintain robust funding, have adequate contingency plans and undertake proper stress testing. We are also continuing to monitor markets carefully and are liaising with key market participants to ensure that we and they are fully informed of market events and their implications.
Adequate Liquidity
Related to capital adequacy is the issue of whether firms' capital is sufficiently liquid. The key principle on liquidity has always been that firms must have credible and sustainable funding models. Recent events have confirmed the importance of firms’ maintaining adequate liquidity, especially in times of stress. We are continuing to focus on liquidity to ensure that firms take a suitably prudent approach.
We have said that we expect firms to take a comprehensive view of all the possible demands on liquidity that could arise from various sources, on balance sheet or off, and develop plans to meet those demands, even in times of stress.
So the primary focus, in our view, with regard to liquidity management should be on scenario planning and on stress testing.
As a further safeguard, we have said that firms should maintain a supply of cash, or assets that can immediately be turned into cash. We explored this topic more fully in the Discussion Paper we published in December 2007 and plan to publish the Feedback Statement later this month, with a view of consulting on more concrete proposals in September.
We are also taking a closer look at the increase in firms’ funding risk. To this end, we have been collecting additional information on your liquidity arrangements and funding plans. I do, by the way, recognise that such an increased information flow is a demand on your time and resources and we are grateful for the understanding and support you have shown in this area.
Financial Crime Risk
A third area of focus is financial crime. Market abuse remains a key risk to efficient, orderly and fair markets. In times of market uncertainty, the scope for market manipulation expands as does the economic damage it causes. So we are stepping up our efforts both to help prevent market abuse and to detect and act where abuse has taken place. We are strengthening the capacity of our Market Monitoring department to detect and pursue market abuse. We are also continuing to develop our new SABRE II market monitoring system.
Transparency
Alongside our work on supervisory priorities, we are also considering wider questions about how we operate. In particular, we are reviewing our overall transparency strategy to see whether further increases in disclosure will improve our ability to meet regulatory outcomes. This review occurs 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. This debate is about what to disclose, to whom and for what purpose. We are seeking to develop overarching principles we can apply to any particular set of circumstances that will help us decide whether to use transparency as a regulatory tool.
Credible Deterrence
Our transparency agenda forms part of our overall philosophy of credible deterrence.
In the supervision context, this philosophy is reflected in increasingly more directive supervision where we find that a firm is not addressing its regulatory responsibilities effectively. In the enforcement sphere, the critical goal is to convince market participants that those who deliberately seek to evade their regulatory responsibilities have a real risk of being caught and a significant penalty when they are.
As a risk-based and proportionate regulator, we describe our use of enforcement as "strategic" because we do not attempt to enforce against every single violation we find. Sometimes the right result can be achieved through a supervisory remediation programme.
Our strategy is to focus on enforcement cases where we think we can make a real difference to consumers and markets, using enforcement action strategically as a tool to change behaviour in the industry. We need to be visible in the market place, sending tough messages about wrongful behaviour and imposing sanctions (which doesn't just mean fines) that are severe enough to have a deterrent effect.
Recent events in the market have only served to demonstrate the importance of our work in this area. In this context we welcome the Chancellor’s recent announcement of his plan to give us the statutory power to enter into immunity agreements. This power is available to the CPS and to the Serious Fraud Office and will be a valuable addition to our existing powers. We are determined to achieve our goal of credible deterrence and a resulting improvement in the quality of markets in the UK.
FSA’s Supervisory Enhancement Programme
I have set out some significant challenges for us and for you. We will all need to be robust in our approach if we are to achieve the right outcomes.
You will no doubt be aware that, in part due to lessons we have learned from our supervision of Northern Rock, we have published proposals committing to moving forward and improving our supervisory practices.
This Supervisory Enhancement Programme will pick up the work we had already begun as part of our transition to more principles-based regulation. I said then and I still believe now that we can only deliver as an effective regulator if we have the right people making the right judgments, operating in an effective environment. Last year, we highlighted the considerable investment we are making to secure this goal. We have, I believe, made good progress in this area and I am proud of the work of the FSA in the last nine months. I believe this demonstrates the quality of the people we now employ, but, of course, more remains to be done.
Accordingly, the Supervisory Enhancement Programme aims to upgrade the current supervisory competence framework for FSA staff. And to ensure that supervisors have all the specialist support they need, we will also be increasing resource in the sector teams and expanding our prudential risk capabilities.
We will do more to ensure that FSA supervisors effectively use the risk information our central teams develop. Supervisors need an independent view of firms' risks, if they are to make good judgements about firms' risk management.
We will also improve our processes for allocating supervisory resource. We are developing more dynamic, risk-based information about what our supervisors are doing so that we can reallocate resource tactically and flexibly, as situations emerge and change.
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.