Introduction
Ladies and Gentlemen, I am honoured to have been invited to give a keynote speech at the BBA's tenth annual supervision conference, especially in such distinguished company.
I am flattered to have been asked to speak on the subject of 'the UK's leading role in the adoption of international initiatives'. I will concentrate on the FSA's role, though recognising how important it is that we work in partnership with HM Treasury, the industry and consumer representatives.
Of course, in front of Commissioner McCreevy with a live Bloomberg stream, I can hardly maintain that we are less than fully committed European partners, indeed I know that some industry members would rather we were less thorough in meeting our European duties, especially when it comes to implementation!
But today, I want to go beyond pure implementation issues – even though I know that they are currently at the forefront of many of your minds – and expand on the sub-text of this title, namely the FSA's role in ensuring that our adoption of international initiatives is 'fit for purpose', and properly implemented. I will try to 'self-assess' how effective our approach has been in influencing and driving forward international initiatives, with the caveat that we are not in complete control of the process. I will then touch on some live implementation issues – notably MiFID and CRD - and finally conclude with a preview of some of the new international policy work that is coming round the corner.
Better Regulation, Principles-Based Regulation and the Cost of Regulation
But first let me provide some context. The FSA operates and is assessed against four statutory objectives, namely to: maintain confidence in the financial system; secure the appropriate degree of protection for consumers; reduce the extent to which it is possible for a business to be used for a purpose connected with financial crime and to promote public understanding of the financial system.
In carrying out our functions, we must also have regard to 'seven principles of good regulation', I will touch on three of them today, proportionality; paying due regard to the international character of firms and the role of a firm’s senior management in ensuring that its business complies with regulatory requirements.
The legislation that gives us our powers - FSMA - requires us to consult publicly on proposed new policies or requirements and to justify them on the basis that the benefits to the FSA's four statutory objectives outweigh the costs they will impose on firms and their customers. This discipline helps ensures that the UK's regulatory structure is 'fit for purpose'.
A number of studies have shown that global financial services businesses regard the UK brand of regulation, especially our lighter-touch regime for wholesale business, as a definite plus, which combined with its openness to newcomers, its energy, its depth of markets and its diversity of workforce, puts the UK ahead of other international financial centres.
But we can not afford to be complacent - to maintain, or even improve on this position, we need to ensure the regulatory environment remains appropriate to business, cost effective and supports competition and innovation. This is why we place such emphasis on principles-based regulation, to increase firms' flexibility by removing the 'one-size-fits-all' mentality of detailed rules and why we continue to work hard to implement European Directives in a market-sensitive way.
We have a long standing commitment to 'better regulation', and as our June Better Regulation Action Plan pointed out, this means not only challenging new policy proposals, but also reviewing the stock of existing rules. However, for us, 'better regulation' is not the same thing as cost reduction. Whilst we are serious about delivering, where justified, significant reductions in costs incurred by firms complying with our regulations, we will not do this where it undermines the effectiveness of regulation to secure market confidence, consumer protection and a reduction in financial crime. This is what we have to do, and is in the long-term interest of us all.
But there are immediate areas where there are 'win win' situations, where by focusing on higher level principles and outcomes, so better aligning good 'regulatory' practice with good 'business' practice, we can deliver the same or even better outcomes for customers at a lower cost to the firm. Our recent changes in respect of anti money laundering, where we have replaced 57 pages of detailed rules in our Handbook with two pages of high level rules is one such example, and of course this move has been made easier by the existence of the JMLSG guidance notes – I would like to thank the BBA for their significant involvement in issuing the revised notes earlier this year. These changes have also led to a more sensible and proportionate regime for customer identification, which under the former rules-based system significantly inconvenienced people going about their legitimate financial business.
We continue to look for such opportunities. For example, the publication later this month of our proposed new Conduct of Business sourcebook will mark a significant milestone in delivering more principles-based requirements. Today I am pleased to announce that by the end of 2008 we will have reviewed a wide range of our activities which in total account for more than 80% of the administrative costs which we impose on firms and we will have removed rules that are no longer effective or proportionate. What I can also promise, is that we will listen to your views on our proposals. As the Deloitte study on the cost of regulation (which we published at the end of June) demonstrated, regulatory change of all kinds costs money – even when that change reduces regulatory requirements! If we find that those transitional costs are perceived as too onerous, and can not be justified by the outcome, we will not continue down the path.
The last thing I would like to mention in relation to principles-based regulation, is that I am aware the industry has raised concerns that as we move towards a more principles-based approach, away from the 'safe-harbour'/certainty of detailed rules, firms may be left without any useful guidance to assist them in meeting their obligations. It is not our intention to strip the Handbook of necessary and valuable Guidance, and in some areas detailed Rules and Guidance will continue to have a role to play where they are necessary to achieve our regulatory objectives.
We do however, acknowledge that the industry may wish to create their own guidance for those firms who wish further clarity on our principles and high-level rules.
Following some research and analysis I commissioned earlier in the year, we will be publishing a discussion paper at the start of November outlining our approach on how we will work with the industry when it wants to develop its own guidance and how we can give a sufficient and meaningful level of acknowledgement to it.
'Shaping' international regulation
The international character of our firms/FSA Senior Management time
We apply the same cost benefit disciplines to assessing international initiatives. Here we are less in control of the final outcome, but as I will explain, we do our best to provide 'thought-leadership'; embed/spread 'better regulation' principles to our peers and shape the agenda. This is all the more important, given the international character of firms that operate in the UK market place:
- there are over 250 foreign banks operating in the UK (as the representation today amply demonstrates), accounting for 54% of UK banking sector assets;
- significant business is channelled through London. For example one third of Citigroup's investment banking revenue comes from London, but 80 per cent of that business originates abroad from more than 50 countries and flows through London;
- UK banks are increasingly global in nature – for the first time this year, more than half of Barclays' profits now come from its overseas operations; and
- many UK banks are also financial conglomerates, and the single regulator model is still not widely adopted abroad.
Banks complain, understandably, about the regulatory burden imposed on them by multiple regulators and the costs of complying with multiple rulebooks. To some extent, that will always be a reality that firms have to manage as part of their international ambitions. But to minimise this burden, we need to co-operate with overseas regulators, both to monitor global firms and markets effectively and to agree international standards where appropriate.
Reflecting this, a significant amount of FSA senior managements' time is dedicated to international work.
Within Europe the Lamfalussy committees are a key part of the architecture in making EU co-operation work better. I myself sit on CEIOPS, Callum sits on CESR and Thomas Huertas on CEBS. The FSA also sits on and actively chairs a myriad of sub-committees. One of our priorities is to ensure that CESR, CEBS and CEIOPS pursue consistent approaches to issues that are common across sectors. An example of this in practice relates to outsourcing, where CESR and CEBS have been encouraged to collaborate to deliver proposals that are compatible. For an integrated regulator and for industry alike, divergent approaches to the same risks across sectors makes no sense.
Outside Europe we also play an active part in the Basel Committee, the Joint Forum, IOSCO and the Financial Stability Forum, FATF, to name but a few.
So how is our influence working?
CBA/Maximum Harmonisation
As I have already mentioned, all domestic policy proposals have to go through a rigorous cost benefit analysis in order to identify the most appropriate form of market intervention. In our view, intervention is only justified in cases where there is a clear market or regulatory failure and where the benefits of proposed solutions offer a realistic prospect of being greater than the costs. Moreover, we are alive to the possibility of competition policy or an industry-based solution providing a more effective form of intervention than additional rulemaking by the regulator. Where regulation is the answer, we are now looking to make it more principles-based.
Within Europe, one area where we can claim some success, is in pushing for the adoption of Better Regulation disciplines – we welcome the impact assessments, consideration of alternative tools, open and timely consultation and the commitment to ex-post evaluation of regulations, set out in the Commission's December 2005 White Paper – for which I know that Commissioner McCreevy was a key architect. This should help manage the future flow and economic rigour of EU/international regulation, even though, as I will explain later, the need to reach consensus can still undermine/compromise the quality of the final outcome.
However it is worth noting that there will be times when the Commission's impact assessments argue for a proposal, but this position is not supported by the FSA's UK-focused cost-benefit analysis. This is especially the case if domestic rules already offer adequate protection, or the argument is more one of single market integration than risk-mitigation. In these cases, it is for HM Treasury – advised by ourselves and industry - to weigh up the costs and benefits of the directive and support or oppose it.
Whenever a directive emerges, we adopt a pragmatic approach. We look to minimise the costs to industry/consumers through active consultation on the detail of the directives, shaping the outcome, even if we fail to see the wider rationale for the proposal.
However it is not clear to me that the Commission's focus on 'maximum harmonisation' is the only way to deliver coherence in the Single Market. A high-level, principles-based, directive should achieve sufficient convergence, whilst allowing room for manoeuvre in implementation to address country-specific risks. I have not yet won that debate, but will continue to make my case with the Commission and other member states.
Ensuring regulation works with the grain of good management/business practice
Domestically we place a high reliance on senior management and seek to ensure rules mesh with firm's own internal operations rather than adding an artificial layer of reporting purely to meet regulatory standards. I am pleased to see that international initiatives are becoming increasingly aligned to this view. With Basel II/CRD, greater convergence between economic and regulatory capital should give banks' senior management greater freedom in deciding how best to allocate their financial resources. With Solvency II, I very much hope that when the draft Directive emerges next year, it will provide for the use of market consistent valuations. That will provide for more efficient allocation of capital within insurance. Allowing (and perhaps incentivising) firms to use their own models to determine capital, clearly plays to this core principle that it is management's responsibility to maintain sufficient financial resources, not the regulators.
Global engagement
The global reach of firms means that it is often not efficient or effective to act even solely at EU level.
Co-operation extends beyond the EU borders. For example, the trilateral arrangements in place between the FSA, the Swiss regulator (EBK) and the New York Fed in respect of the global Swiss banks.
Going forward we will be sharing more information and workstreams with our international counterparts. There is for example a well established trilateral process with the New York Fed and the SEC that already shares ideas and findings (such as stress testing, collateral management, counterparty risk management etc) and this will certainly generate more collaborative work going forward.
Operational risks highlighted by the credit derivative confirmations backlog is a good example of global co-operation which delivered both a proportionate response and played due regard to alternative tools. Having identified a serious operational issue that needed to be addressed back in 2004, but one we could not solve alone, regulators in the UK, US, Switzerland and Germany worked together and with the industry to come up with a co-operative solution. It was also a problem that firms could not solve individually but which needed collective action to resolve. Now substantial progress has been made, although this now needs to be built in as the 'steady state', and the focus is now shifting towards other markets, notably equity derivatives, where a significant confirmations backlog has emerged.
Engaging with industry
Continuing and constructive engagement with industry is also key to delivering market-relevant outcomes. On new directives, with HM Treasury we engage early on in an intensive dialogue with industry via dedicated liaison groups. And we are seeing the benefits of that at every stage, be it early dialogue and co-operation on the shape of Solvency II, detailed discussion of the Level 2 provisions of MiFID, or – now – patient work on implementing the CRD and MiFID requirements in a sensible cost-effective manner. We try and do this in as transparent a manner as is possible. For example the minutes of our high-level Basel Implementation Advisory Group have been posted on our website. So, too, are the proceedings of PRECLC (the MiFID pre-consultation liaison committee).
This combination of proactive early consultation and a more principles-based approach, can ensure that, where regulation is the answer, it rectifies the problem at hand, with minimum impact on the efficiency and competitiveness of the industry.
Implementation of directives – properly but intelligently
I know I said that I wouldn't focus on implementation issues, but one issue I do want to highlight is our overall approach to implementation of EU directives, transposed via FSA rules, where we are seeking to adopt an intelligent copy-out approach.
Take MiFID – given our duty to put Level 1 and Level 2 requirements into full legal effect, we do have to copy-out the detailed provisions. But, make no mistake it will be copy-out – rather than gold-plated elaboration - which is forming the basis of UK implementation. Save for some strictly-defined exceptions in the field covered by the Directive we shall be striking down more detailed requirements in our Handbook and rest instead on the minima set by the Directive.
The timetable has been tight, we have tried to ease the way with – starting in the autumn of last year – a number of publications to help industry understand our road map to transposition and prepare for implementation. We shall publish shortly an update on progress with the overall implementation programme with a revised programme of the remaining consultations.
The process has been intense, but with the excellent and continued close co-operation of the industry and HM Treasury I am confident that the UK will succeed in meeting the transposition date of 31 January 2007. The work however does not stop there; we will continue to work with industry bodies and other stakeholders on practical solutions – including those that might be encouraged through industry guidance rather than FSA guidance. The next 12 months will be a challenge for all parties. But I have no doubt that the resilience and the professionalism of the UK markets will show through, enabling us, to meet the implementation deadline of 1 November 2007.
Level 3 of the Lamfalussy process is to facilitate convergence of regulatory practice by supervisors. CESR has moved swiftly onto the Level 3 stage in respect of MiFID and we are playing a full part. The main immediate focus is on operational issues for the supervisors, the 'nuts and bolts' that the Directive itself does not address. The CESR Level 3 expert group established to deal with these questions, has set up sub-groups on intermediary and markets issues. We welcome their emphasis on the targeting of pragmatic solutions to the priority issues ahead of implementation. Matters such as the division of regulatory responsibility for branches as between home and host states are high on the list. Practical protocols for data consolidation are another aspect of the supervisory practices that will be taken forward by CESR. Transparency is crucial to investors in this growing global economy, but it is only of added value if the data is consolidated and not fragmented, maintaining the quality of data available to investors. This would avoid a potential downturn in confidence in the market place and business suffering as a consequence.
On all these issues CESR will be looking for practical inputs from market participants on what will work and what will not. It is good news that some leading players in the London market have accepted nomination to CESR’s Consultative Working Group on MiFID Level 3, which met for the first time in Paris on 3 October.
As I have said we have been working very hard and in close collaboration with the industry on bringing MiFID into the UK marketplace in a sensible and measured way and we remain committed to doing this with regards to best execution. Regulators and industry have both identified this as a priority topic and in particular two specific areas: demonstrating best execution in OTC markets and clarifying the scope of best execution.
In the UK, we are quite advanced in our thinking on this. Some time ago, firms approached us saying that they wished to offer best execution to their clients in OTC markets but were unsure how to approach the MiFID requirements. In response, our May discussion paper on best execution floated the idea that firms that execute client orders by dealing on own account could comply with the best execution requirements by relating their prices to robust external benchmarks. We floated this idea as one possible option for complying with the new requirements, while acknowledging its limitations in less liquid markets.
Overall, industry response to our benchmarking idea was quite negative although many conceded that benchmarks are already used to price instruments in some OTC markets. In any event, this feedback has convinced us that any guidance on benchmarks would be unhelpful so we will not be proposing any -- although, we continue to think benchmarking is a valid approach in some circumstances. Going forward however, we will step back from this debate and leave it to industry to devise approaches to complying with the MiFID requirements, whether through industry guidance or otherwise. Of course, we are ready to discuss practical questions of implementation with trade associations on the basis that we will be setting out in our discussion paper on industry guidance.
The second issue concerns the scope of activities to which best execution applies. Given the scale and complexity of the UK's wholesale market we were anxious to air some views early in the process and to engage in a discussion with the industry, about how the various best execution provisions could best be transposed into the UK markets. It is important to recognise and, if possible, build on the characteristics which have made London a successful international financial marketplace: freedom to operate a range of different business models; the competitive quote driven system operated in some markets; the essence of effective price formation in both traded and OTC markets; and, the deep pools of liquidity characterising many of our markets. I am aware that a number of market participants and trade associations have considered our initial views on the scope of best execution to be super equivalent to the requirements of the directive, and potentially damaging to some of these strengths.
This is in my view the wrong characterisation of the issue. It has been a complex task to marry the directive requirements with the nature of London's markets - where incidentally we have not found market failure. As is often the case, we have found our discussions with the industry very productive in moving towards a practical solution. I am now satisfied that we have found an approach to implementing the best execution provisions of MiFID which will maintain the positive aspects of the UK's trading markets. In particular, we are clear that dealers giving quotes will remain free to do so on the basis of their own books and internal models and that it will remain possible in dealer markets for fund managers to obtain best execution by shopping around themselves, if they wish and forming their own judgements about who to deal with, without that lucky dealer then being subject to a duty to provide best execution. It will of course be the case that fund managers will continue to be expected to obtain best execution for their funds and that if a fund manager wants a dealer to provide him with best execution, the dealer must do so or decline to trade. It is important to recognise that while these proposals will, we believe, enable current market practices to continue, it is possible that the Directive requirements for greater clarity around best execution may lead to the industry itself developing new business models. We will be setting out the detail of our implementation proposals in our Consultation Paper later this month and I hope you will be able to welcome these as a compliant, pragmatic and deliverable package of solutions to a tricky issue.
Turning to something slightly less controversial but no less important – implementation of the CRD – I am pleased to say that in two weeks time, the FSA Board will be invited to make the bulk of the final rules that give effect to the longest and most technically complex pieces of financial legislation to emanate from Brussels.
Despite its length and complexity, I would like to think – and I hope you do too - that we have made a good fist of implementing the CRD in a proportionate and pragmatic way. Within CEBS, a considerable body of work has been completed with active FSA involvement (CEBS has issued important papers on Pillar 2, Pillar 1 model validation and Home/Host cooperation), which are considered, internationally, as important bodies of guidance. This process has provoked a step-change in how the main trade associations seek to influence us and others involved in the negotiation and implementation of directives. The joint industry responses submitted by the BBA and the other main trade associations to our various CPs on CRD has meant that we have been able to identify the real crunch issues faced by industry and find sensible solutions to them.
Which is why I remain a firm believer that we should not seek to use Pillar 2 in such a way that renders the capital benefits that firms may get under Pillar 1 negatory.
I appreciate that there still remains uncertainty about Pillar 2, ranging from what the internal capital process should contain, to how the supervisory review process will work in practice, and to how this will be brought together and translated into individual capital guidance. This is not the time to go into such further details, though it is my intention before not too long to address some of these uncertainties in terms of setting out some key tenets of our approach. But what I can say now is that we want to take the opportunity of Pillar 2 to build on the "supervisory dialogue" so that we get a better understanding of how senior management is improving the links between enterprise wide risk and capital management. We intend this to be more of a top-down than bottom-up process and, using a risk-based approach, do not intend to second-guess firms where they can demonstrate sound and robust internal mechanisms/methodologies.
Implementation of Basel 2 in the United States continues to rank high up on the list of issues concerning banks' senior management. We are all familiar with the potential difficulties that arise out of the decision to delay Basel 2 implementation in the US by two years. I am unable to provide a cast-iron guarantee that everything will be plain sailing but we are committed to working closely with banks and our regulatory colleagues in the US to overcome these temporal differences.
It has taken a long time to reach where we are today – thanks in no small part to the time and effort of many of you here today. But we cannot rest on our laurels. As you know, the essence of Basel 2 is to establish a capital framework which reflects the risk profile of the bank and their risk mitigation and to incentivise good risk management. But there have been suggestions that a US-style leverage ratio be incorporated into the Basel 2 framework, in effect creating a capital floor for banks which is not risk based and this idea worries me for that reason. I believe that the new capital framework must be given time to bed down before we start tinkering about under the bonnet again.
Looking forward: driving the direction of policy/influencing the debate
Finally, what can I say about what the future holds in terms of international initiatives? I know you would like me to say regulatory pause, and we would like this to be the case, but at the same time you have told us there is additional work to be done. I would just like to touch briefly on two key areas, namely liquidity and the definition of capital ('own funds' in Europe speak). Both are issues where firms complain about outdated rules. And both qualify as 'too big for the UK to act alone'.
With liquidity, we have known for some time that our domestic rules were outdated. In 2003 we produced DP24 that set out a proposal to address the industry's concerns. But we took on board the feedback from firms that a UK-specific solution would not address the issue, and with hindsight the proposal was excessively detailed, too divergent from firms' own practices and the costs associated with complying with country-specific liquidity rules, when global firms manage liquidity on a cross-border basis, remained.
As for the definition of capital, it is also clear that the old rules need to be updated. Not only is there a need to take account of the significant pace of market developments, but also, in light of the Basel II framework, to re-focus on the reasons why capital is needed.
In both these areas it is clear that the UK cannot act alone, but we look forward to close cooperation with our colleagues in Basel and Europe and to the constructive contributions from industry which will enhance the outcome of this important work.
Conclusion
To conclude, it is difficult to know how successful (or not) the FSA has been in securing good outcomes in EU and international policy discussions. I would like to think that we and you have played an important role in improving many of the earlier proposals that passed our desks. What is clear is that well-founded evidence-based arguments are essential and I very much hope that the industry will continue to find time to engage actively with us, the Lamfalussy Committees, the Commission and other international standard-setters.
