The Treasury Committee: Memorandum By The UK’s Financial Services Authority

A. Introduction

This memorandum is submitted in advance of the FSA’s appearance before the Committee on 8 November. We look forward to elaborating on it in oral evidence.
The memorandum:
- provides background information on the FSA, including on its scope and approach to regulation; and
- summarises the FSA’s work during the past year
.

B. Background information on the FSA
Our starting point is the powers and duties given to the FSA by the Financial Services and Markets Act 2000 (FSMA). Central to this are the four objectives set by the legislation (to maintain market confidence; to provide the appropriate degree of consumer protection; to promote public understanding of the financial system; and to reduce financial crime), and our obligation to meet those objectives in ways consistent with the principles of good regulation prescribed by FSMA (these include proportionality, economy in the use of our resources, facilitating innovation in financial services, taking into account the international competitiveness of the UK and the responsibility of firms' senior management). Our continuing concern is to discharge these duties effectively.
We have translated our four statutory objectives into three strategic aims, which guide our day-to-day work and which reflect our organisational structure:
- helping retail consumers achieve a fair deal;
- promoting efficient, orderly and fair markets; and
- improving our business capability and effectiveness
.

The FSA's scope
We regulate an industry that contributes 5% of UK GDP and employs almost 1 million people, providing products and services to millions of consumers. We regulate some 25,000 firms, ranging from major global financial groups to small financial advisers, and around 165,000 individuals.
Our scope is decided by Government. FSMA gives Treasury Ministers power to amend our scope through secondary legislation. There have been several increases in our scope since we gained our powers under the FSMA on 1 December 2001. In particular, during the past year we have taken on regulation of mortgage business and general insurance intermediation, which increased the number of firms by over 14,000. As a result of this extension of our duties, over 90% of the firms we now regulate are, in our terms, small (in that they do not have a dedicated supervisor).

The FSA's approach to regulation
We want to promote effective working of markets to deliver benefits for firms and consumers. We therefore operate a risk-based approach, which enables us to focus our resources and activities on the most significant risks. This approach accepts that some failure neither can nor should be avoided.
We aim to work with the grain of the market, introducing new rules, where we have discretion, only where this is justified by market failure and cost-benefit analysis – in other words, where we judge that market forces will not rectify the problem, and where it is likely that the benefits of that intervention would outweigh the costs.
While enforcement is an important part of our regulatory apparatus, our day-to-day supervision of firms and thematic work (where we seek to identify risks arising across different types of firms and market sectors) play a vital role in enabling us to achieve our statutory objectives, including consumer protection. Where we identify emerging risks, we set standards and work with the industry to mitigate them.

C. Overview of the FSA's work during 2004/05
We published our Annual Report for 2004/05 on 29 June, giving a detailed account of our work during the year. The Report was discussed at our Annual Public Meeting on 21 July.

Helping retail consumers achieve a fair deal
Our retail work is designed to make a real difference to firms and retail consumers. We focus our activities on four main aims: capable and confident consumers; clear, simple and understandable information available for, and used by, consumers; soundly-managed and well-capitalised firms which treat their customers fairly; and risk-based regulation, through firm-specific and thematic supervision, and appropriate standards set out in our Handbook.

Financial capability
It is widely acknowledged that levels of financial capability in the UK are unacceptably low. In pursuit of our statutory objective to promote consumer understanding, we have taken the lead in coordinating the work of a wide range of partners in establishing a national strategy for financial capability. Our own expenditure on financial capability has doubled in each of the last two financial years, and now stands at £8 million. We established seven working groups for: schools, young adults, the workplace, families, planning for retirement, borrowing and generic advice. Achievements to date include: the development of a web-based financial health check, now launched in partnership with the BBC; developing a good practice guide, with case studies, for improving the financial capability of young adults; and working with various partner organisations to support students in higher education.
The Financial Capability Steering Group, which we chair, has agreed seven projects for substantial upscaling from pilots already undertaken. The priorities are schools, higher education, the workplace, maternity leavers, debt and financial healthchecks, generic advice and the campaigns to promote the FSA's services to consumers. Business cases are now being developed to articulate the public policy and commercial benefits of the individual projects. We expect to complete these by February next year. Subject to persuasive business cases being developed and sustainable funding being available, these seven projects will be implemented nationwide. We are also analysing the findings of our comprehensive baseline survey, which seeks to establish the level of financial literacy among the population; its findings will be published in February 2006. This will form the basis for setting objectives for the implementation of the national strategy.

Consumer information
Good disclosure by firms to consumers is critical to empowering consumers and enabling them to make informed financial decisions.
As part of our new mortgage and general insurance regime, we require intermediaries and lenders to give their customers 'Key Facts' documents. These provide simple and focused information about a product, including risk warnings, enabling consumers to access the key information easily. We have worked hard to promote the Key Facts brand – through, for example, advertising in the national press and through promoting our Key Facts leaflets through libraries and Citizens Advice Bureaux – to ensure that consumers are aware of, and look for, Key Facts when considering buying products. Our research shows that consumers value information which the regulator has required firms to provide.
Following the abolition of polarisation, from the beginning of June this year we have required financial advisers to give their customers a 'Menu', explaining the cost of investment advice. The Menu provides details of the different payment options on offer (commission or fee), gives an indication of what the costs will be, and provides information on how the cost of commission for each product compares to the market average. We regard this as an important step forward in making the cost of advice more transparent to consumers.
In the light of the Committee’s interest in developing shorter, clearer information for consumers about investment products, we have also published proposals for a short 'quick guide' summary sheet for investment products, which highlights the most important issues consumers should consider before purchase. This forms part of a package of measures we are developing to help consumers better understand the risks and rewards of packaged products such as investment bonds and personal pensions. We plan to publish our proposals for consultation in March 2006.
An important resource is our consumer website which, among other things, provides tools, such as comparative tables and calculators, to help consumers make decisions. In October, we launched a new jargon-free website for consumers to promote our resources on mortgages. This site, designed as a first step and not an alternative to advice, aims to promote awareness of our range of tools and information for mortgage buyers. We also produce, at any given time, over 30 publications on a wide range of topics, including pensions, mortgages, basic bank accounts and financial advice. We monitor developments in the market closely and where we see trends that are a potential concern, we alert firms and consumers to the risks and the actions they may need to take.

Fair treatment of customers
A key element of our retail agenda is our Treating Customers Fairly (TCF) initiative. Based on principles rather than detailed prescription, our approach is to challenge the senior management of firms to work out what TCF means in the context of their business. We want TCF to be embedded within the culture of a firm and within each stage of a product's life-cycle – from product design right through to complaints-handling. To support this, we have produced a number of real world illustrations of good and bad practice as found by us in firms, and case studies to show some of the considerations senior management should take into account. We reported in July the progress that many firms have made over the last year or so in undertaking a gap analysis – to identify areas where they are not treating customers fairly – and in moving forward into identifying and introducing any changes arising from this. We have mainly focused on larger firms up to this point, and on the retail savings market. We are now including more medium and smaller firms, and we will also be reviewing TCF issues in the mortgage and general insurance sector.

Our risk-based approach to the retail sector
We identify risks by monitoring information from a number of sources, including market data, financial promotions and our discussions with firms. For example, having observed a rise in the number of so called 'phoenix firms' – where the directors of one limited company move with the assets to a new company, leaving the liabilities behind and avoiding claims from consumers – we thwarted twelve attempts to 'phoenix' in the last year. We have also undertaken work to maintain standards among smaller financial firms, which has resulted in a number of firms making changes to the way they operate, in order to address serious failings, and has led to several losing their authorisation to do business.
Through our risk-based approach we have reformed regulation of the insurance sector, requiring all firms to hold a level of capital that is sufficient to support the risks they face. We have also worked with life insurers to bring about improvements in the disclosure of with-profits products, to the benefit of policyholders, and have taken steps to ensure that acquirers of closed funds provide the appropriate level of service and information to policyholders, and are fit and proper to manage policyholders' interests.
As the Committee is aware, mortgage endowments continues to be a priority area for us. Following our intervention, firms have reviewed numerous sales in response to complaints from consumers and have assessed whether compensation should be paid; this has benefited tens of thousands of consumers. By the end of 2004, major firms had paid around £1.1 billion in redress to policyholders. We have worked with the industry to ensure that consumers have clear and timely information on the position of their endowment and assistance in considering what action they may need to take in response. Consumer research we carried out earlier this year showed that 69% of the 2.2 million households with an endowment-linked mortgage had already taken action to address their shortfall. We are now focussing our efforts on those few firms that have not yet established appropriate complaint-handling standards. We will require them to rectify the situation, and where necessary, we will continue to use the full range of sanctions available to us.

Mortgage and general insurance regulation
We began regulating mortgages and long-term care insurance, following the Treasury's decision to extend our remit, on 31 October 2004. In January 2005, the scope of our regulation was extended further to include general insurance business, as a result of the UK's obligation to implement the Insurance Mediation Directive. In addition to brokers, other intermediaries and the insurance mediation activities of product providers, it brought within our remit the many firms which advise on and arrange general insurance business as a secondary activity, for example, motor dealers and property managing agents.
This was a major challenge – as well as authorising over 14,000 new firms, we extended the permissions of over 4,500 firms already regulated by us. Under both regimes, consumers now have access to the Financial Ombudsman Service and Financial Services Compensation Scheme.
Subsequently, we have been taking steps to ensure that firms are aware of their new obligations. Where firms give advice, they must recommend suitable products that meet consumers' needs and, in the case of mortgages, consider the affordability of any product they identify for individual consumers. In the case of general insurance policies, consumers must be given clear information on significant and unusual exclusions from their policy before they buy, and on premiums and any fees payable. Insurance intermediaries are also required to ensure that client money is properly segregated and protected.
In the first year of these regimes our supervision has focused on a number of areas, for example, policing the perimeter (to identify firms that continue to conduct regulated activities without authorisation to do so), adequacy of disclosure (documents that should be handed to consumers before they decide to buy a product), complaints-handling and sales of higher risk products, such as Payment Protection Insurance and lifetime mortgages.
We commissioned a mystery shopping exercise to test whether firms in the mortgage market were issuing the Key Facts documents as required by our rules. The results were disappointing. We will continue to monitor this area closely through further supervision work, and if necessary, we will take enforcement action. Our supervision of this sector has identified a number of areas where we will need to continue to work with the industry to ensure that consumers are protected appropriately, as we envisaged when the regime was set up.

Payment Protection Insurance (PPI)
Before we began regulating general insurance business, we identified PPI as a priority for thematic work because of a relatively high potential risk of consumer detriment compared to other insurance products. We have recently completed a review of how firms have implemented our new rules. This involved visits to 45 firms selling PPI with mortgages and secured loans (prime and sub-prime), unsecured loans and revolving credit (credit and store cards, and catalogues), and also mystery shopping across 19 firms. We will publish our findings on 4 November and will ensure that the Committee receives a copy.

Lifetime mortgages
In establishing the new regulatory regime for mortgages, in order to reflect the risks associated with lifetime mortgages, we introduced additional requirements relating to advice and selling standards and disclosure for these products. We also identified lifetime mortgages as an early priority for supervisory attention, given the higher risk nature of the product which offers complicated terms to potentially vulnerable consumers.
We commissioned a mystery shopping exercise at the end of 2004, to find out how the product was being explained and sold to consumers. We found that advisers frequently failed to get an understanding of customers' personal and financial circumstances sufficient to enable them to make suitable recommendations. Advisers often did not take proper account of situations where taking a lifetime mortgage might affect a consumer's entitlement to benefits or where they might be able to obtain grants and other help, for example, from local authorities. We also identified significant concerns in selling practices in seven firms we visited. We will be undertaking further work in the first half of 2006 to test whether firms have improved their standards in relation to the key areas of concern identified in the previous exercise. Although our general approach in the early stages of mortgage and general insurance regulation is to give firms an opportunity to raise standards of compliance across the sectors, we will take enforcement action in the most serious cases.

Promoting efficient, orderly and fair markets
We seek to promote a well-regulated wholesale market which is efficient, orderly and fair, and which is internationally attractive and sustainable. The UK is the most international capital market centre in the world: for example, the most recent survey of the OTC derivatives market puts London's share of daily global turnover at 38%, well ahead of any other financial centre; the UK is the largest foreign exchange centre in the world; and it is the largest centre of fund management in Europe.
In the past year, we have concentrated on ensuring that firms identify conflicts of interest which threaten the proper working of the wholesale market and that they make information available to the market in a timely and relevant way. We have modernised and reinforced prudential rules and practices and have acted firmly against behaviour that falls materially below the standards we require.
We believe strongly that firms' adherence to our Principles supports efficient, orderly and fair markets. In a number of recent cases we have taken regulatory action where firms have failed to conduct their business with due care, skill and diligence and failed to control their business effectively. We have also used our powers to bring criminal prosecutions against individuals for market misconduct. We believe the outcomes of such cases have sent strong messages to the market about the importance of proper market behaviour.
An equally important issue in this context is our work on market abuse. Our strategy involves tackling the systematic abusers as well as the opportunistic ones; targeting institutional abuse and insider dealing rings; and taking effective action against cross-border abuse. Our emphasis is on deterring abuse rather than merely taking action after the event. We have various initiatives in train here such as reviewing the anti-market abuse measures which authorised firms have in place to ensure they are effective. Our efforts to combat cross-border abuse are strengthened by our close working relationships with overseas regulators. We have increased the resources devoted to our general anti-abuse work, enhancing both our market knowledge and intelligence capacity. We are also upgrading the technology we use for monitoring and analysing market transactions.
In recognition of the increasing influence of EU legislation on our work, we are taking proactive steps to influence the content of EU measures at the earliest possible stage. We are also conscious of the need to influence issues at a global level. Two areas on which we have taken the lead in this way are hedge funds and bond transparency. On the former, we published two Discussion Papers earlier this year setting out our view on a range of issues including the role these firms play in the market, the risks they pose and the extent to which retail investors should have access to such funds. We have also recently established a dedicated area of supervisory resource to monitor the activities of the major hedge funds. In relation to bond transparency, we published a Discussion Paper this year designed to stimulate debate among market participants and allow us to develop an appropriate policy in this area. The timing of the work was particularly important as the European Commission will begin to consider this issue next year.
In addition, we have worked with firms and their trade associations to bring about industry-led solutions to market failures. For example, in relation to soft commissions and bundled brokerage arrangements, with our encouragement the IMA, LIBA and NAPF created a credible solution to the transparency and accountability issues we had raised. In addition, following our concerns over the uncertainty in some aspects of insurance contracts, particularly the delay between the inception of insurance policy cover and finalisation of policy wording, we have challenged the industry to develop a solution, as an alternative to regulatory intervention.

Europe
The Financial Services Action Plan (FSAP), endorsed by the Lisbon European Council in March 2000, was designed to create an integrated EU financial services market by 2005. The FSAP and other European directives shape the regulatory environment in which we operate. A considerable amount of our policy work is driven by the need to influence, help negotiate and then implement European directives. Our Handbook is the main vehicle through which directives affecting financial services are implemented in the UK. We work very closely with the relevant Government departments in the various EU fora.
Senior FSA management are actively engaged in influencing the European agenda, including seeking to ensure that the same disciplines that are applied to UK policy development are applied in the EU. In particular, we dedicate a significant amount of time to the 'Lamfalussy' Committees, which provide the Commission with specialist advice in preparing the technical implementing measures for directives. Working to prepare for timely and proportionate implementation of the Financial Groups Directive, the Market Abuse Directive, Prospectus Directive, Transparency Directive, Markets in Financial Instruments Directive and Third Money Laundering Directive has been a key priority for us. At the same time, we have continued to play an active role in negotiating the Capital Requirements Directive, which implements Basel 2 prudential standards for banks, other credit institutions and investment firms within the European Economic Area.
In implementing EU legislation in the UK, our approach is not to impose obligations beyond what is required by directives (so-called 'super-equivalence') unless this is necessary to achieve our statutory objectives and can be justified by cost-benefit analysis. However, there has not been an adequate EU equivalent to our own approach to policy development, including cost-benefit analysis and the requirement for proportionality. We therefore wholeheartedly support Commissioner McCreevy's recent emphasis on the need to undertake impact analysis from the earliest stage for future directives. We encourage the UK financial services industry and its representatives to take early opportunities to contribute to policy thinking in the European Commission.

Financial stability
We work closely with the Treasury and the Bank of England to test and develop the ability of the financial authorities to respond effectively to a financial crisis. In December 2004, the Tripartite Standing Committee launched a resilience benchmarking project to assess the robustness of critical components of the UK financial services sector in the event of major operational disruption (MOD). Its findings will be reported in December of this year. On other, non-MOD sources of problems, we are active participants in the periodic testing by the Tripartite authorities of the financial crisis management arrangements; the latest such test was held at the end of October. We have also worked on financial stability issues in international fora, and have continued to contribute to initiatives within the European Union to pursue the financial stability implications of the increased integration of financial markets, including the arrangements for managing crises with cross-border significance.
Recent events have highlighted the potential for terrorist activity to disrupt financial markets in the UK. The City stood up well to the events of 7 July: information flowed smoothly between institutions, the FSA, the Bank of England and the Treasury; back-up arrangements, when they had to be used, worked; markets operated without interruption, and accommodated high levels of trading. It is important, however, that we learn lessons from 7 July so that we are able to deal robustly with circumstances that might in future threaten the financial system more directly.
One of the Tripartite Authorities' key roles is to work with the financial sector and other relevant bodies to try to ensure that all are well prepared for any such crisis. As one part of this, we hold an annual exercise to practise co-ordination between key participants in the financial sector in their responses to sector-wide disruption, to enhance market understanding of and confidence in the role of the financial authorities in the event of a major operational disruption and to identify areas for improvement in existing procedures. This year's exercise, which will take place on 28 November, will be the largest business continuity exercise of its type ever undertaken. It will involve some 80 firms across the UK, in addition to the Bank of England, the Treasury and the FSA. In a further contribution to improving the sector's robustness, we are encouraging the larger firms to enhance stress-testing of their capacity to cope with adverse scenarios.
In the current environment, we are also actively reviewing with the Treasury and the Bank the possible implications for the financial sector of any serious developments on Avian flu.

Financial crime
Much of our work on financial crime is aimed at monitoring standards of systems and controls in the firms we regulate to ensure they have in place the defences they need to combat money laundering and fraud, while avoiding unnecessary burdens on customers and firms; identifying financial crime risks within the sector; and working in partnership with stakeholders to this end.
Our work in this area has included:
- leading work with stakeholders to improve identification procedures designed to prevent money laundering – moving to a regime which is proportionate, commands industry and consumer support and delivers value to law enforcement;
- working closely with the Treasury to ensure that EU initiatives relating to financial crime are risk-based, effective and proportionate;
- developing our fraud policy which is founded on a partnership approach, working with the grain of the market wherever we can and intervening only where we can make a real difference. This has resulted in a more proactive role being taken by trade associations in developing best practice and sharing data on fraud trends; and
- developing intelligence and working with law enforcement agencies on the criminal money flows presenting the greatest risk to the UK.
Improving our business capability and effectiveness
We are committed to making it easier for firms, consumers and other stakeholders to do business with us; in particular, we have sought to reduce the time and effort which firms – especially small firms – and consumers need to spend dealing with us. As part of this commitment, in April this year, in conjunction with an independent research agency, we began a programme of work to measure levels of customer satisfaction for eight of the regulatory processes we operate, including applications for corporate authorisations and approvals of individuals. The research indicates that overall customer satisfaction on these processes is currently 73%. We now plan to extend our customer satisfaction research to other services we provide, including the Firm Contact Centre, which handles firms' queries on regulatory matters.
We have recently published an account of our performance against all published service standards for the period April - September 2005. On 72 of the 74 published standards we have achieved at least 90% of the targets we set ourselves. This represents a significant improvement on results in previous reporting periods, despite increased volumes of business arising from the extension of our responsibilities to include mortgage and general insurance. However, there is room for improvement in some areas and we are working on this.
We have listened hard to justified criticism of our processes and performance and have worked to make improvements. In particular, we have been reviewing two aspects of our performance: first, the costs we impose on those we regulate and whether, and how, these can properly be reduced (see below); and second, the effectiveness and fairness of our enforcement processes. In July, we published the recommendations of our review of our enforcement process. The changes we have now made, following criticism from the Financial Services and Markets Tribunal, are designed to introduce improved checks and controls during the investigation phase, increase transparency, and bring greater clarity by more fully separating those who investigate a case from those who decide.

Small firms
We have paid particular attention to making it easier for small businesses to deal with us, introducing a number of innovations, including:
- Tailored handbooks for small firms – in June we launched 14 sector-specific tailored handbooks for small firms. These new publications are 90 per cent smaller than the full Handbook and provide the most relevant information for each industry segment.
- Short-form application packs - for firms applying for mortgage and general insurance regulation and, more recently, for new applications to the securities and futures sector. These have reduced the burden on firms and have led to faster processing times.
- A consolidated single fee invoice for firms, replacing the three separate invoices previously issued for FSA fees, and the Financial Ombudsman Service (FOS) and Financial Services Compensation Scheme (FSCS) levies.
- Payment by instalment – working closely with the Smaller Businesses Practitioner Panel and the FSCS, we have facilitated the provision of a market solution to enable firms to pay their single invoice for 2005/06 by instalment.
Regulation of large numbers of small firms represents a considerable challenge for them and us. We believe we have made progress, but there is more to do.

Better regulation
Our better regulation work aims to deliver regulation that meets our statutory objectives in a way that is as risk-based and cost-sensitive as possible. We support the Government's better regulation agenda, which accords with our pre-existing commitments and the work we have been doing for some time in this area.
In areas where have reviewed our regime, we have sought to both liberalise markets and move to a principles-based approach. Examples of this in practice are our 'Listing principles', where we have introduced a set of six principles for listed companies (which has resulted in a 40% reduction in the size of the rulebook for listed firms), and our 'treating customers fairly' initiative which encourages firms to develop their own approach rather than complying with detailed rules. There will be times, however, when we continue to use detailed rules. We will need to do so, for example, in order to implement the detailed requirements of EU directives.
We continue to seek to achieve targeted reductions in our rules. As part of this, in July this year, we set out proposals for change in three areas: money-laundering, our approved persons regime, and training and competence arrangements.
We are also carrying out, in partnership with the Financial Services Practitioner Panel, a study to establish robust estimates of the costs of financial services regulation on firms in the UK. This study is analysing the impact of regulation on firms' operating costs and what firms would in any event incur as part of their day-to-day operations. The study, being undertaken by independent consultants, covers three sectors: retail advice, investment banking and institutional fund management.

D. Concluding remarks
In the course of the next three months we will publish our International Regulatory Outlook, Financial Risk Outlook and Business Plan. These documents will set out our future plans, and our view of the main challenges facing us. We will provide the Committee with copies.