Delivering intensive supervision and credible deterrence
Speech by Hector Sants, Chief Executive, FSA
The Reuters Newsmakers event
12 March 2009
Good morning ladies and gentlemen.
When regulators speak at the moment the expectation is they will give an explanation of how our financial system has come to the state it is now in and what should be done about it. This analysis normally tends to be primarily economic and policy orientated.
Today I intend to do something slightly different. I would like to restrict myself to a brief résumé of the causes of the crisis and focus primarily on the response of supervisors and market participants.
Before my brief résumé, I might say that my Chairman, Adair Turner, has set out the origins of the crisis in a cogent and thoughtful way in his Economist lecture, which I think is generally being seen as a definitive account of what has happened. As he makes clear, the principal causes of the crisis are fairly self-evident, albeit with hindsight.
I think I would characterise the main drivers of the crisis as follows. Firstly, there were a set of macroeconomic and macro-prudential issues; the principal of which were the existence of global imbalances caused by the response of the Asian countries to the last crisis; a period of historically very low interest rates and in general globally, particularly in the US, a drive by the wider authorities – governments, finance ministries and central bankers - to encourage a significant credit boom particularly for the benefit of consumers who wished to purchase housing. In addition to that macro-prudential backdrop, there were a set of cultural drivers particularly around the view that credit was good for votes and that somehow or other it would be possible for the authorities to avoid a boom/bust culture.
These wider social and economic drivers were indeed then facilitated by the regulatory framework. The weaknesses in the regulatory framework, were both in respect of the rules, particularly in the way the prudential and accounting regime works in a procyclical way, but also in terms of the fragmentation of the regulatory architecture both in many national locations and globally.
Here in the UK, of course, the principal gap in the regulatory architecture was in what now carries the common tag of ‘macro-prudential’, with the local supervisors of the FSA primarily focusing on individual companies and the central bank on interest rates.
There was also, here in the UK, an inadequate depositor protection regime and bank resolution mechanism.
Other countries, it could be argued, had even more fundamental gaps in their regulatory architecture or significant and massive fragmentation, such as in the US which led to a lack of oversight of a number of major institutions – of which AIG is the best example. There was also, notably in the US, a lack of oversight of ‘bank-like institutions’, otherwise known as 'shadow banks'.
So, we had a set of economic drivers; a set of social and cultural drivers; a set of regulatory drivers but also a set of market participant drivers – notably a failure of market discipline: markets did not self-correct. This was underpinned by the willingness of investors and indeed those who sell products not to follow the golden rule of 'don't buy things you don't understand'. And, in this of course, they were significantly facilitated by credit rating agencies. Investors and banks were all too willing to accept their analysis as relevant to a whole set of risks which were not actually addressed by the research of the agencies.
This set of structural failures was then magnified by a series of governance failures and poor business judgements by the financial institutions themselves.
I think these factors which I have just characterised are now generally recognised as the causes of the financial crisis. It is also recognised that the financial crisis has gone through a series of phases and now indeed has become a general crisis for the real economy.
The key question then is where do we go from here and how do we seek to minimise the likelihood of this sequence of events or a similar crisis happening again recognising, of course one of the truisms of financial markets 'namely a belief we can fully abolish cycles' is an illusory goal?
In passing, in seeking to learn lessons - which we shall - we do need to be very careful that we are not sowing the seeds for the next crisis.
In terms of what we do next, the FSA's view on the wider structural regulatory architecture will be laid out in our Discussion Paper due to be published on 18 March, accompanied by Lord Turner's overview of the wider set of causes and potential responses that the authorities in aggregate can make.
As I said in my opening remarks, my intention today is therefore not to anticipate this extremely wide brief but rather to focus in on the supervisory response and the changes I think that are required from market participants.
I do that because I believe that these changes need to be made now. Indeed, in respect of the supervisory response the FSA has already embarked on a programme of change and is well down the track to completing it.
The key feature of this programme is greater supervisory resource of a higher quality. We are on course to hire, by the end of 2009, 280 extra specialist and supervisory staff which will represent a 30% increase in our supervisory capacity. To ensure these individuals are properly equipped to do this job we have introduced a new Training & Competence scheme which involves a regulatory testing regime for existing supervisors. We have also ensured that we have the right mix between professional regulators and market practitioners.
The principal reason for focusing on supervision is that this is the core of the FSA’s activities. As a regulator we of course have two roles – to formulate policy and to deliver it through supervision but we do not, as you know, have full control over policy formulation. This has been for a long time, rightly so, primarily a global and a European preserve. We, of course, are a major participant in that policy formulation process and it is important that we focus on that and seek to implement the outcomes to the best of our ability – working in partnership with the Bank of England and the Treasury – but it is as a supervisor that we should be primarily judged because that is where we can be held accountable and that is where we are accountable.
We have already made absolutely clear that there are lessons to be learned and we are learning those lessons. So what is our new vision of supervision; what is the supervisory revolution that we have talked about. I think it is useful in considering this question to do so under two headings: 'our philosophy' and our ‘operating model’.
On our philosophy we have significantly modified and adjusted our historical approach. We have not jettisoned it, but we have adapted it.
Historically, the FSA characterised its approach as evidence-based, risk-based and principles-based. We remain, and must remain, evidence- and risk-based but the phrase 'principles-based' has, I think, been misunderstood. To suggest that we can operate on principles alone is illusory particularly because the policy-making framework does not allow it. Europe, in particular, has a particular penchant for rules and in any case in a number of key areas such as prudential they are indeed necessary.
Furthermore, the limitations of a pure principles-based regime have to be recognised. I continue to believe the majority of market participants are decent people; however, a principles-based approach does not work with individuals who have no principles.
What principles-based regulation does mean and should mean, is moving away from prescriptive rules to a higher level articulation of what the FSA expects firms to do. In other words, it helps emphasise that what really matters is not that any particular box has been ticked but rather that when making decisions, executives know they will be judged on the consequences - the results of those actions.
Similarly, the FSA, when it supervises, needs to supervise to a philosophy that says 'It will judge firms on the outcomes and consequences of their actions not on the compliance with any given individual rule'. Given this philosophy, a better strapline is 'outcomes-focused regulation'.
So if we are an 'outcomes-focused' regulator two questions then arise. Firstly, what do we mean by that? Secondly, how do we deliver it or what is our operating model?
Explaining what we mean is best achieved by contrasting it with the past. The historical philosophy was that supervision was focused on ensuring that the appropriate systems and controls were in place and relied on management to make the right judgements. Regulatory interventions would thus only occur to force changes in systems and controls or to sanction transgressions based on observable facts.
It was not seen as a function of the regulator to question the overall business strategy of the institution or more generally the possibility of risk crystallising in the future.
In the future we will seek to make judgements on the judgements of senior management and take actions if in our view those actions will lead to risks to our statutory objectives. This is a fundamental change. It is moving from regulation based only on observable facts to regulation based on judgements about the future.
This will of course carry significant risk and our judgements will necessarily not always be correct with hindsight. Furthermore, too aggressive intervention will stifle innovation and arguably reduce risk to a level that inhibits economic prosperity. However, I believe the revealed preference of society says that this is, and possibly will always be, what society as a whole expects regulators to be doing. Indeed, it was what they thought we were doing.
This more 'intrusive' and 'direct' style of supervision we call 'the intensive Supervisory Model'. To see the full picture it is important to ally this with our more proactive approach to enforcement – 'our credible deterrence philosophy.' Since we set out this philosophy, last year, we have demonstrated by our actions that we will use all our powers including criminal prosecutions to deliver our mandate and we are not ducking that responsibility. This week the first of our insider dealing criminal prosecutions has come to trial and we have several more in the pipeline.
There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA.
It is also very important to be clear what our mandate is and what it is not. There has been some media commentary of late criticising the financial crime and fraud enforcement architecture in the UK and the effectiveness of the FSA has been included in this criticism.
This set of observations demonstrates a lack of understanding of the FSA's role. The FSA focuses on delivering credible deterrence in respect of its Financial Services & Markets Act (FSMA) mandate. We focus in particular on market-related offences and issues relating to unauthorised activities such as boiler rooms. We are not and do not seek to be the responsible agency for prosecuting financial fraud in its ‘conventional’ or wider sense. It may well be that responsibility is shared elsewhere and it may well be that historically this was not taken seriously enough but we are clear about our responsibilities and are delivering on them.
To split enforcement powers from supervision would in my view make both tasks immeasurably more difficult.
Returning to the delivery of supervision, after what, comes the how? In respect of the how I would like to focus on three points. Firstly: effective delivery requires a comprehensive understanding of risk in any given institution. A comprehensive understanding of risk requires both prudential and conduct oversight responsibilities. The idea that 'twin peaks' regulation would have helped mitigate the current crisis is, in my view, not supported by events at all.
Events such as the failure of AIG clearly demonstrate the value of integrated risk assessment delivered through a single supervisory authority. As the FSA has already acknowledged, there was an operational and managerial failure in our supervisory area which was responsible for large UK institutions but the response to that should be to address the operational failure not to change the operating philosophy and structure. The problem was not structural, it was cultural. Much has been made recently of the importance of understanding business models. The twin peaks approach creates structural barriers to a full risk assessment of an institution and would sow the seeds of the next crisis.
My second point, however, is to emphasise that effective risk assessment of a firm requires industry knowledge and for that assessment to be set in a macro-prudential context. This was not done in the past, but will be done in the future.
A consequence of this in my view incidentally, is that when the necessary macro-prudential oversight structures are put in place they should involve both central banks and supervisors. The process should be 'top down and bottom up'. It needs to be a balanced partnership.
My third point is that our intensive approach will mean a greater emphasis on outcomes testing relative to assessments of adequate systems & controls. In the past the principal focus was on ensuring that there was adequate management information and controls in a firm and then relying on management to address the issues. This is a slight caricature but broadly correct. In the future we will switch resources to outcomes testing. For example, on conduct issues I believe a better use of resources is 'mystery shopping' and 'branch visits' rather than detailed reviews of high-level management information. This switch to outcomes testing is also central to the delivery of 'credible deterrence'.
However, this switch causes risks. The switch to focus on outcomes testing, by definition, means that, due to finite resources, we cannot test all outcomes and failure will be missed. The opportunity will be given for ‘with hindsight’ criticism. It would be better if the systems limitations were recognised, upfront, by all. In essence, we recognise that changes are required but even now it is not realistic that we could deliver to perfection. I hope that when we emerge from the current media spotlight that this is recognised by all, including the media. If it is not it will prove difficult to recruit, motivate and retain staff.
My fourth and critical point is that the delivery of supervision has to be done in partnership with responsible firms, shareholders and auditors. The supervisors cannot operate alone. All involved in oversight must ensure the right business strategies and behaviours are being pursued. This will require greater engagement by all of us and in particular by shareholders and the non-executive community. The greater engagement of shareholders and non-executives will be central to this improved regulatory proposition. I talked yesterday at the NAPF conference about shareholders' responsibilities; a word today, albeit briefly, on non-executives responsibilities.
Non-executives will need to commit more time and raise their technical skills to exercise rigorous oversight. These changes will no doubt warrant more support and indeed compensation for these individuals. They will also however, need to be more willing to challenge executives. All of this suggests that non-executive directors, as others have already observed, will need to become more like full-time 'Independent Directors'. Sir David Walker’s report will no doubt be addressing these issues in more detail and the FSA looks forward to working closely with him.
However, even with all these changes to supervision and the wider oversight process, we cannot ignore that the principal responsibility for managing firms responsibly lies with the management themselves.
It also needs to be recognised that the ultimate responsibility for what has happened rests with firms’ senior management. In reviewing the recent litany of firm failures in many cases, albeit with hindsight, specific decisions and strategies can be seen to be at the root of those firms' demise.
What can be done to improve the quality of management decision making to minimise failure. Yes, regulators can intervene more decisively, and we will. Yes, in many cases I believe management could have greater technical skills, and we the regulator should seek to ensure that is the case through changes to our authorisation process which we are carrying out. We will in future be seeking to judge competence as well as probity. However, primarily I suspect the issue is behavioural. Markets have shown not to be rational; excesses have not been corrected by market discipline.
This is a central point for us all and management, in particular, to recognise. The managers of the future must acknowledge and fight against the ‘herd mentality’; ‘the collective wisdom’. To be helpful may I suggest a few simple rules which I am sure we all aware of but it is worth reminding ourselves of:
- 'Do not take risks you do not understand.'
- 'Ensure the focus is on the long run franchise and profitability of the institution not the short term.
- 'Ensure a healthy and ethical culture in your organisation!'
- 'Recognise the future is not predictable and ensure at all times you understand the circumstances under which your firm will fail and that you are happy with the degree of risk mitigation you have.'
- 'Ensure a healthy and thoughtful culture of challenge from the independent directors.'
These rules may seem simple but they are regularly ignored. The recognition that financial markets are not rational but rather they are a behavioural system built around personal aspirations is critical to us effectively changing this time round.
Before concluding, could I just observe that it is not as simple as delivering better regulation, supervision, oversight and management? If only it were that simple. We have to recognise that in this crisis the reaction of society as a whole has itself been a contributor to the severity of events. In particular, at times the public’s reaction has created a negative feedback loop. This continuous interaction between wider society and the financial sector has been a unique characteristic of this crisis. I believe that this aspect of these events require further consideration by us all.
For my conclusion could I return, however, to my central message? My central message is that when I took on the CEO role in the summer of 2007 my intention was to radically change the supervision practices of the FSA. I set out to ensure the FSA is seen as a regulator which delivers 'intensive supervision' and 'credible deterrence'. The programme to achieve that goal was commenced 18 months ago and we are well on track to achieve that goal by the end of this year. The FSA is already a radically different organisation. The FSA has been seared by recent events but it is tougher and better as a result. The FSA has grown up.
I hope you have found these remarks helpful and I look forward to taking questions.