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Speech by Sally Dewar, Managing Director, Wholesale, FSA
Securities House Compliance Officer Group conference
15 October 2008

Good morning and thank you for the opportunity to open this year's Securities House Compliance Officer Group conference.

I very much appreciate the opportunity to talk to you about some issues we are currently focused on. In particular, I would like to spend some time talking about the importance of robust and effective systems and controls and the importance of the role of compliance in achieving this.

In setting the scene for my opening remarks I can’t ignore the events of the last few weeks. For regulators, it has been extraordinarily challenging as we have had to deal with several events crystallising over a very short time. Events which by themselves would be momentous, but when taken together have been unprecedented. Just to give you a flavour of some of the issues the FSA has been dealing with just over the last month:

• The administration of the UK entity of Lehmans and the appointment of PWC as administrators. We have been very closely involved working through the many issues including those around client assets and clearing and settlement. 
• The acquisition of Merrill Lynch by Bank of America, and Morgan Stanley & Goldman Sachs becoming bank holding companies in the US and announcing new strategic investors.
• The introduction of our short-selling rules following a period of extreme volatility and market instability across the financial sector.
• The announcement of a merger between HBOS and Lloyds TSB.
• Over one weekend the nationalisation of Bradford & Bingley, the rescue of Dutch-Belgian group Fortis, the rescue takeover of US bank Wachovia by Citigroup and the liquidity lifeline provided to Germany's Hypo Real Estate.
• The US government's $700bn rescue package.
• The commitment from the Irish government to guarantee all retail deposits of the major Irish banks. A move followed last week in France.
• Seismic events in Iceland with trading suspended for several days and three of the countries top banks taken over by the Government. 
• Last weeks announcement of a £50bn Government backed scheme to help banks start lending to each other again.
• And as a follow-on from that, on Monday, Lloyds TSB, HBOS and RBS received huge capital injections by the government - an unprecedented move and one in which the FSA was deeply involved. Similar action occurred yesterday in the US.

And all that just in the last month.

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The events of the year will shape the financial industry for years to come and the compliance role is crucial in helping firms and regulators achieve necessary change in behaviours, standards and risk management.  As market events change, it is critically important that a firm's senior management engage with our regulatory objectives. Compliance will not be achieved by simply focusing on prescriptive rules.

So whilst there is an apparent appetite for greater regulation and more rules now in these troubled times, the FSA will continue to be a principles-based regulator. We believe additional regulation may be appropriate in some areas. We don't believe a knee-jerk approach to implementing regulation quickly and without due thought will necessarily help us in the longer term. So whilst some degree of change will be inevitable, it will still be principles that guide what we do.

The time for reflection of past events will come, but for now I would like to draw your attention to some of the comments made by my former Chairman, Sir Callum McCarthy, in his leaving speech to the Mansion House. He noted there needed to be greater realism within firms about their risk management capability. As we now know, the risk management of some of the most well known firms – banks, broker dealers, and insurance companies – was found to be wanting at the crucial moment. That is not to apportion blame but to note that that is something fundamentally incorrect in our industry and which is receiving urgent attention both nationally and internationally, through for example the International Institute of Finance, and the Committee of European Securities Regulators – CESR – on which I sit. In the interim, regulators will continue to rely, as a first port of call, on firms' senior management, to give us the best indication of the health of a firm. Senior management must always take accountability for the day to day running and governance structures that exist within their firm. To suggest otherwise would be to heed to the calls of some that say that the authorities should in fact be running the finance sector.

Importance of strong control environment

As you would expect in today's climate, a lot of our attention is focused on prudential issues within firms, particularly liquidity and capital – the building blocks of firms’ business models. With this shift in emphasis towards a more prudential focus, some may observe that we are going soft on Conduct of Business regulation and issues such as TCF. Let me clear any doubt – we will not - as you will have seen from some of our recent enforcement cases. 

Only in August, we fined Credit Suisse £5.6m for systems and controls failings. And of course last week, in the midst of the financial turmoil, we fined Alliance & Leicster £7 million for mis-selling Payment Protection insurance. Stronger internal governance could have gone some way to prevent such failings.

The challenge is to ensure that a firm not only meets its capital and liquidity requirements, but that it also maintains a strong systems and controls environment.

Trading Controls - MarketWatch 25

Perhaps one of the most dramatic recent examples of a breakdown in the systems and controls culture happened at Societe Generale in January. In this case, unauthorised open futures positions of about €50billion were discovered on three European stock market indices. Before the positions could be closed out, Soc Gen incurred net losses of €4.9billion. All of this is believed to have been the work of one single 'rogue-trader'. The fact that the trader seems to have conducted unauthorised trading for such a long time without being detected by the bank’s systems and controls underlines the importance of strong internal governance.

In MarketWatch 25, we set out 17 questions that we would expect a good internal governance structure to have satisfied themselves on.  This covered areas such as:

1. Front office culture and governance, in particular are traders encouraged to take two-week continuous holidays, and is there appropriate segregation of front office staff from middle and back office functions;
2. The use of suspense accounts;
3. The quality of management information, both routine and outside normal parameters; and
4. Elementary IT precautions, such as whether access to systems is password dependent.

Of course, no list of questions can ever be exhaustive and whilst the questions we have outlined can aid in maintaining a strong control environment, it is ultimately up to each firm to satisfy itself that internal governance procedures are strong enough.

Following the events at Soc Gen, FSA supervisors spoke informally to some 50 of the largest trading banks in London. We were pleased to hear that many of those we spoke to had already put in place reviews to identify and correct gaps that may have existed in their trading controls. I would also recommend MarketWatch 25 as it contains good practice points for handling inside information.  The misuse of such information can have serious repercussions.

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Market Abuse and recent Enforcement Cases

One such form of market abuse is insider dealing, something often seen as a victimless offence whereas it is in fact a serious economic crime. If some people are able to trade on the basis of inside information and are in a privileged position to make profits and avoid losses - that creates an imbalance between market participants.  Insider dealers will always have an advantage over others because they have more accurate information about what it is that they’re investing in.  This is not only unfair – it's cheating.  It’s not only unfair to individual investors - it has consequences for markets as a whole. 

Whether or not markets are clean fundamentally impacts on the competitiveness of financial markets.  Variable levels of market cleanliness between different markets means there isn’t a level playing field.  In the longer term market abuse and insider dealing can undermine the health of an economy as a whole. 

The FSA has a long term strategy, which involves using all the tools and resources available to us in a targeted way.  A big part of our strategy is credible deterrence, which means getting the right outcomes so that people sit up and pay attention.  It’s about making people realise that they will suffer meaningful consequences if they break the law and if they fail to improve standards of behaviour.

We’ve also asked the Government for additional powers because we want to make sure that we have the full toolkit to gather evidence and bring successful cases.  We want to be designated as a prosecutor with the power to offer statutory immunity to co-operating witnesses – to add to the common law power we already have to undertake not to prosecute.

This year we have put more emphasis on criminal prosecutions as well as prohibitions and higher penalties on civil cases. In September, Neil and Francis Uberoi were charged with 17 counts of insider dealing. Proceedings in that case will start next week. In the same month, we reached a settlement with Steven Harrison, a Hedge Fund Manager, who did not recognise inside information and subsequently misused it. On top of this we have an ongoing investigation after FSA staff, together with the City of London Police, arrested 8 individuals in connection with an insider dealing investigation. We also investigated the possibility of market abuse after HBOS shares took a sharp dip at the start of August, and of course we have recently introduced a temporary ban on the short-selling of certain financial stocks.  We have upped our game in tackling market abuse and this renewed focus is here to stay.

Financial Crime

In terms of financial crime generally, this remains a high priority for the FSA. In our Financial Risk Outlook, published earlier this year, we warned of the two-fold effects of turbulent market conditions: latent fraud will become increasingly detected and the incentives for people to commit fraud go up. In desperate times people resort to desperate measures and we all need to be alert to this. There can also be no excuses for instances of data security loss. Exposing sensitive customer information means enforcement action will be inevitable.

Criminals are dynamic and constantly look for new ways to launder money and avoid detection. By the time we've introduced new regulation the criminals have moved on and found the next weak link in the chain. This is why we believe the move to a more principles-based regime is the best way forward - it gives the flexibility to manage the risks to your business.

The key to tackling the problem is to work in partnership: between yourselves and with Government, law enforcement and regulators. Information-sharing is one of our key weapons against the fraudsters.

The creation of the National Fraud Strategic Authority (NFSA) and the implementation of the national fraud strategy are significant steps in improving co-ordination of our anti-fraud efforts.

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Conflicts of Interest

Moving on to conflicts of interest. In September this year we published Policy Statement 08/09 which sets out how we will extend the common platform – a set of high-level requirements on systems and controls and firms’ organisation – to firms not subject to the Capital Requirements Directive or MiFID other than insurers. 

Among other things, this will see the creation of a single set of high-level rules on conflicts of interest for these firms.  This is an important move, as it comes at a time when there is a heightened risk that firms or their staff could seek to exploit conflicts of interest to the detriment of their clients in order to maintain market share or in order to protect earnings.

The rules on conflicts in our Sourcebook require firms to take all reasonable steps to identify conflicts that impact on their clients, and to put in place effective arrangements to manage those conflicts of interest.  To satisfy these requirements, firms will need to have in place procedures to monitor and escalate conflicts of interest.  They will also need to keep the effectiveness of their controls under review to ensure that they are doing their job and preventing client detriment.

The effective management of conflicts of interest is an area that we will continue to focus on – for instance our July 2008 Capital Markets bulletin reported on our thematic review on the management of conflicts of interest within private equity firms, highlighting examples of good and bad practice.  Conflicts of interest management is also an area that we have been looking at as part of our ‘Supervisory Priorities’ review of MiFID implementation – with further feedback expected later this year.

How firms respond to the challenge of managing conflicts of interest is an important indicator of their governance framework more generally, and an important consideration in terms of our supervision of firms.

SEP

In all that has happened over the past year, the FSA has also had to learn the lessons and make changes. We have aimed to be open and transparent in what mistakes we have made and how we are learning the lessons. As we know from the last few weeks, long held assumptions can often prove incorrect and we all need to be adaptable to changing risks. 

We believe that a successful regulator has to seek constantly to learn, change and improve. With financial markets in a state of continual evolution and innovation, the concept of a fixed optimal approach to supervision is not credible. It is our view that the most effective regulatory regime is one which has the capacity to respond flexibly to changing risks. 

In May, we launched our Supervisory Enhancement Programme, which drew on lessons learnt from Northern Rock. The programme aims to upgrade the current supervisory competency framework for FSA staff and we have been recruiting extra supervisors for the past few months. But this is about more than simply having more supervisors. The way in which we look at risk has been improved and we are addressing the challenge of ensuring that supervisors have all the specialist support that they need in order that they can make good judgements about firms’ risk management.

We are giving greater priority to the task of supervising individual firms and high-impact firms are a key area of focus. You can also expect more senior management focus in the supervisory process. There are many other changes happening within the FSA which reflect the changed environment in which we operate.

Senior Management Accountability

Just as the FSA is adapting, it continues to be crucial that within firms, the boards and senior management actively manage delivery of firms’ regulatory responsibilities, and this requires that they demand relevant information and use that information to mitigate these risks. It should come as no surprise to you then that supervisors will be challenging senior management more intensely about the decisions made and holding them to account. It is crucial that senior management comply with our principles, that they review the consequences of their actions and that when they develop business options, that they give robust consideration to the risks and the impact of those risks if they were to crystallise.

Challenges ahead

So what lies ahead? As I mentioned earlier, ensuring that firms have robust funding and that they are sufficiently liquid is a priority for the FSA. Recent events have shown the importance of maintaining adequate liquidity, especially in times of stress. We are due to publish a consultation paper on liquidity and have set out our proposals to deliver a series of changes to our Handbook and to implement new supervisory processes under Individual Liquidity Adequacy Standards (ILAS). We have also set out our proposals for a new reporting framework which is intended both to monitor firms' compliance with the Handbook and to enable us to understand the liquidity position of a firm, and how it changes over time.

We are currently consulting on the detail of these proposals but it is worth saying that our primary focus on liquidity management should be on scenario planning and on stress testing.

What we can be sure of is that the events of the past year have highlighted that change is needed in how bank risk is managed: in the first place by banks themselves, but also by the authorities changing the framework where needed. We need to pursue vigorously a range of measures which we will do working with our stakeholders and with our Tripartite colleagues.

Remuneration

We have also been doing some work on remuneration. On Monday, we published a Dear CEO letter on this subject which you can find on our website. Back in September, the FSA held a number of high-level discussions with London-based firms on this subject and our intention is to communicate our findings regarding good practice in the early part of next year.  We will also publish about general findings about remuneration practices.  But as we say in the Dear CEO letter, having asymmetrical structures with traders receiving immediate reward and not bearing the consequences of these losses poses a risk to shareholders. It is important that remuneration structures focus on minimising this risk. There are various ways of achieving this goal.

Whilst the assessment of remuneration structures will become a greater part of our supervisory approach, the FSA is not going to start telling firms what to pay their staff. Remuneration will remain a matter for the firm but we hope that in future, firms will take our good practice into consideration.

Conclusion

2008 has been a very significant year for the finance industry - recent events have eclipsed anything that any of us have seen before. The role of compliance is fundamental in ensuring that risk governance within firms is appropriate and able to adapt to the changing risk environment. 

The FSA will still remain a principles based regulator and whilst we will be heavily focused on liquidity and capital issues, the importance of a strong systems and control environment is crucial to achieving our objective of financially sound and well managed firms. We have faced many challenges over the past year and I am sure we have many more to come. I am glad to have discussed some of these with you today.

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