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Introduction
Good morning ladies and gentlemen. I am delighted to be present once again at the FSA’s Annual Public Meeting, having had a forced absence last year. By and large the year ending March 2006 was a strong one for financial markets. Equity markets continued their recovery with the FTSE100 rising by 21.87%. Interest rates edged upwards as consumer spending and borrowing showed little sign of abatement. Bond markets remained generally benign. Credit markets remained extraordinarily benign with spreads on both investment grade and high yield bonds narrowing sharply. House prices rose by an average of 4.6% in 2005 and commercial property saw capital growth of 12.8%. And commodities surged in value with the Dow Jones AIG Commodity Index rising by 5.6%. So all asset classes strengthened and this enabled banks to build significant capital strength, life insurers to rebuild their solvency following three years of decline at the beginning of this decade and traditional investment funds to post strong growth. But not all was rosy and the general insurance industry experienced a severe stress test of its resilience, with the $50 billion-plus losses of Hurricane Katrina being absorbed by insurers and their reinsurers, just four years after another catastrophic event, nine-eleven.
These market conditions presented both opportunities and threats for participants in the financial services sector, including the FSA. The substantial levels of liquidity in the market have enabled firms to look at a wide range of investment opportunities, perhaps to an extent that risk premia have been squeezed sharply, raising important questions about asset price vulnerability. I would also raise a cautionary note that the historical problems we have had to deal with in bear markets – splits, precipice bonds, endowment mortgages – have their genesis in strong markets. We have been alert in particular to products, especially complex products, where the downside risks which may crystallise in weakened market or economic conditions may not have been made clear to customers. For example, on the investment side we have been active in alerting consumers to the risks of Venture Capital Trusts and on the insurance side to the risk that costly Payment Protection Insurance may contain exclusions which cause the cover not to perform if the consumer falls on hard times. We have worked with the industry to improve the standards of disclosure related to these products.
The initiatives we have undertaken during the benign period covered by the Annual Report fall into four broad categories: improving FSA processes, addressing new risks in the wholesale market, making the retail market work more effectively and better regulation.
Improving FSA processes
The Board and senior management of the FSA felt disappointed that it took the Tribunal judgement in the Legal and General case to stimulate a thorough review of our enforcement process to ensure it was both fair and efficient. We could and should have addressed these issues earlier. The review carried out by David Strachan made forty four recommendations. These have made the process more transparent, given the firm or individual equal access with the FSA enforcement division to the decision making body, the Regulatory Decisions Committee, and established clear blue water between the role of the executive in settlement discussions and the RDC in hearing a contested case. Firms and their advisers have told us that they are satisfied with how these new processes are working and it is interesting to note the acceleration in settlements, a trend I expect to continue.
Addressing new risks in the wholesale market
Turning to our work with the wholesale markets, a well recorded trend of recent years has been the growing significance both in terms of funds under management and market liquidity of Alternative Investment Management entities. Following extensive consultation we concluded that hedge funds were increasingly a core component of the financial markets and also important to market stability, efficiency and innovation. We also recognised that London had emerged as the main location of choice for hedge fund managers outside the US. Overly heavy-handed regulation could send these businesses offshore while the underlying market activity remained on the London markets. But we did identify some significant potential risks in this sector and so designed a carefully tailored regulatory approach which we believe is proportionate to these risks and which appears to have been welcomed by the both hedge fund managers themselves and the investors in their funds.
Making the retail market work more effectively
In the retail market (as in the wholesale market) our principal objective is to facilitate the working of a more effective and efficient market. There are particular problems in the retail market that make it difficult for consumers to secure a fair deal and so all the more important that we make the market work. During the year we have seen good progress in our main demand- and supply-led initiatives: financial capability and treating customers fairly, respectively.
During the last two to three years the FSA has led the development and testing of a strategy to realise a step-change in the financial capability of the citizens of the United Kingdom and I believe that 2005/6 was a breakthrough year in putting the ideas into practice. We completed the largest ever survey of the financial capability of the British population and the results enable us and our partners to carefully target resources at where they are both most needed and can make the biggest difference. We also set out a programme of action, which is currently being implemented, to improve the financial capability of teenagers still at school, students in further and higher education, adults in the workplace and those who find themselves excluded from the financial system altogether. We have engaged the enthusiastic commitment of organisations across the private, public and voluntary sectors and I am delighted to see this month the Government coming forward with a 10 year strategy for financial capability, including looking at extending the teaching in schools beyond the functional maths curriculum. The FSA has increased its expenditure on financial capability from £2m three years ago to £11m in the current year. With the programme in full operation by the end of this year, I anticipate our annual expenditure for each of the next three years reaching £15m to £20m.
On the supply side our work centres around the Treating Customers Fairly principle. We have noticed increasingly strong engagement by the senior management of retail firms in both the principle and its components and many firms see its effective application as common ground between delivering value to shareholders and a fair deal to customers. But we need to see this engagement converted into action throughout the product supply chain.
Last year also saw the bedding in of the regulation of mortgage and general insurance mediation. The introduction of these sectors into FSA regulation was a significant change to both the nature and extent of FSA's work, increasing the number of firms we regulate by over 14,000 to 29,000, many of those being small firms which had never previously operated under statutory regulation. I am delighted to say that, thanks to close working with the industry and its representative bodies, there was smooth transition for the industry into the world of regulation.
Better Regulation
The concept of better regulation has been rising up the public agenda in the last year or so but for the FSA this marks heightened public interest in an area that has always been at the core of our business. Finding the balance between discharging our duties and avoiding unjustified costs to firms and, ultimately, consumers has, since the FSA's formation, been an integral part of our regulatory process. In December we published a Better Regulation Action Plan that included some of the deregulatory initiatives we have taken in recent years. And at the end of last month we published a suite of studies that moved us closer than ever before to understanding where our regulation imposes costs on firms. We also, in June, issued an updated Action Plan that listed our more recent actions on this front – for example streamlining our anti money laundering requirements (a commitment I made at our Annual Public Meeting two years ago) and removing detailed rules on training and competence for firms that only deal with wholesale or non private customers. We will continue to be in the forefront of this kind of thinking in the year ahead, and beyond.
International
I also want to say a few words about our work at the international level, as we spend a good deal of senior management time exercising influence through a variety of international bodies and fora. The Committee of European Banking Supervisors has been a particular priority for us given the significance of its work on the Capital Requirements Directive, including on Home/Host issues, on Pillar 2 and on advanced model validation. Elsewhere, working in close partnership with Committee of European Securities Regulators and the Treasury we have influenced the form and substance of the implementing measures applying to the Markets in Financial Instruments Directive, which comes into force in 2007. Through my own membership of the Committee of European Insurance and Occupational Pensions Supervisors managing board and the FSA's extensive involvement in the specialist working groups we have also been at the heart of the international risk based solvency agenda that has arisen from the Solvency 2 Directive for insurance firms. And our work extends beyond this to highly active representation in the International Organisation of Securities Commissioners, the Basel Committee and the International Association of Insurance Supervisors and we work hard to build and enhance our relationships at every level with other regulators. In particular we have succeeded this year in broadening and deepening our working relationship with the SEC at the highest level of both organisations as well as at the working level.
The risk outlook
All of the work I have outlined has, as I said at the beginning, taken place against a background of benign economic and market conditions, although this does not mean we have been able to reduce our vigilance. Looking forward, there are signs that the environment for regulated firms may become more challenging in the short and medium term. The data remain mixed but there is evidence, for example, to suggest an increased risk of sharp, and possibly coincident, corrections in a number of asset classes and areas. We are urging firms not only to ensure they are stress testing their planning scenarios appropriately but in particular to consider their exposure in the light of possible correlations between shifts in different markets.
Added to this are the risks arising from unprecedented levels of consumer borrowing not just at home but in the US and elsewhere. The secured lending market in the UK continues to remain sound but heightened concerns are emerging in the unsecured market, especially among younger people who generally cannot look to the rising housing market to cushion their risk. This, coupled with the evidence from our financial capability baseline survey earlier this year that just over half the population aged over eighteen are not prepared to meet unexpected challenges like a drop in income, as well as the need to provide for their retirement, makes for a worrying picture that could quickly become a reality if, for example, the labour market was to deteriorate significantly.
The FSA's mandate is substantial and my time this morning has allowed me to mention just a few of our activities during the year. In closing, I would like to recognise the commitment of all of my colleagues at the FSA to doing a difficult job well and thank them, together with the many people outside the FSA who help, support and criticise us, for their hard work during the past year.
