Documents: 18/07/2002 - FSA ANNUAL MEETING, Howard Davies' address 18 JULY 2002 - FSA ANNUAL
MEETING, CABOT HALL
Howard Davies
Chairman, Financial Services Authority
I speak at a time of great nervousness in financial markets, both here
in London and around the world. There have recently been significant swings
in the foreign exchange market, as the dollar has fallen significantly against
the euro. But it is the equity market which has been particularly weak and more
than usually volatile. As of yesterday, the FTSE 100 was down 40% from its peak
two and half years ago, and the last two weeks have seen some of the sharpest
daily moves in the markets' history. In fact, the UK market has fallen less
far than those in France, Germany, Italy and The Netherlands. But that is little
consolation to those who operate in the markets from day to day, and to those
investors whose financial circumstances have significantly deteriorated in recent
months.
It is hard to interpret the recent moves and impossible to forecast where we
go from here. If I were able to do so reliably, I would be working elsewhere.
But it would seem that the soft economic background is a factor, as is uncertainty
about the strength and durability of the recovery in the US and Europe.
But the most recent sharp falls, which seem to have been triggered by the earnings
restatements at WorldCom, appear to have more to do with investor confidence
and trust, than with the economic fundamentals. Many investors have been shocked
by a series of unpalatable revelations from US companies, in particular. Some
of the previous comfortable certainties about corporate earnings, and the integrity
of company accounts, have been thrown into question. There has been uncertainty,
too, about the nature of the regulatory response in the US, with continued debates
surrounding a number of different proposals for reform.
How far is it appropriate for these fears to be shared by investors in the UK?
I have said before that we cannot afford to be complacent, even though our accounting
standards are different from those in the US, and the approach taken by accountants
here is in a number of respects to be preferred. We also have a greater degree
of independence already built into our regime for accounting and audit oversight.
Nonetheless, the prudent assumption is that it could happen here. If, that is,
by "it" one means a fraudulent attempt to inflate earnings for personal gain.
So it is right for us to look hard at our regulatory regime, to see whether
improvements are required. A paper on options for reform produced by a group
convened by the Treasury and the DTI, to which we are contributing, will be
published shortly.
But while "it" could happen here, so far it hasn't. So investor fears in this
market look to be overdone. We do appear to be being buffeted by winds from
across the Atlantic, rather than by any domestically generated bad weather.
This makes it slightly odd that the fall of the FTSE 100 has been greater than
either the Dow Jones index in the US, which has fallen by only 27% from its
peak, compared to our 40%. And valuations in UK markets, as measured by price/earnings
ratios, remain lower than in the US. The p/e ratio of the FTSE is currently
17, compared with 24 for the Dow Jones.
Now of course, as the health warnings would have it, we can expect share prices
to go down as well as up. And a weak stock market does not, in itself, necessarily
justify any regulatory response. Indeed, in some respects, the fall we have
had from the dizzy heights of early 2000 has been a healthy correction to what
can now be seen to have been an unsustainable bubble. But the speed and scale
of the price falls can be expected to have some consequences for financial markets
and, perhaps, to generate some collateral damage.
In fact, overall, financial institutions have behaved prudently and sensibly
through this turbulent period. Very few financial firms were excessively leveraged
as we hit the difficult patch. That is particularly the case in relation to
the banks, who remain strongly capitalised and profitable, performing a reassuring
role as a sound anchor in our financial system. But there are some areas where
problems have been created, or perhaps revealed.
The losses sustained by investors in some split capital investment trusts, where
those trusts were highly leveraged and invested in each other, are the most
striking example. This is an unhappy episode, where exaggerated and in some
cases absurd claims about the security of particular investments, misleading
some investors into believing that they were putting their funds into relatively
safe vehicles. We have disciplinary investigations under way, and the Ombudsman
is actively considering the circumstances of a range of individual investors.
The falling stock market has also put pressure on the life insurance sector
and indeed - though responsibilities for these lie elsewhere - on occupational
pension schemes.
Equitable Life remains a particularly difficult case, due to the finely balanced
financial position the society has been in ever since the House of Lords judgement
in the middle of 2000.
On 28 June this year we issued revised guidance to the life insurance industry
on the stress testing of their portfolios, generally referred to as the resilience
test. The resilience test is an important element in the prudential framework
which is designed to protect policyholders, as it helps to determine the appropriate
mix in risk assets to the term, size and nature of policyholder liabilities.
We had been considering possible changes to the test for some time, in anticipation
of the new prudential rules that will come into effect in 2004. In the light
of market conditions we considered it appropriate to make a change at an earlier
stage, to head off potential market distortions.
The change to the test on 28 June was not made with any immediate pressure to
sell in mind. The suspension of the test on 24 September last year was under
very different circumstances and we have seen no need to further suspend the
test in recent market conditions.
Since we revised the resilience test on 28 June, the equity market has fallen
a further 9%. We continue to monitor closely the impact of market movements
on the life industry as a whole and on individual firms. We continue to be satisfied
that the insurance industry is meeting the minimum solvency requirements. Of
course it is bound to be the case that the weak equity markets will affect firms
with a large proportion of shares in their asset base. We are working with firms
to ensure that all their actions are taken in the best interests of policyholders.
It is also useful to remember that, whilst changes in asset prices on a day
to day basis must be monitored closely, the liabilities of insurance firms arise
over the longer term.
Regulators cannot, of course, prevent markets falling. Nor, as we have often
said, do we aim for a zero failure regime. But that does not mean we are powerless.
We can, through our prudential controls, help to build a financial structure
which can withstand pressures and strains. And, through our behind-the-scenes
work with individual institutions, we can head-off particular problems, and
resolve others, as (or even before) they arise.
This kind of tactical work inevitably occupies a lot of our time in circumstances
such as those we are experiencing today. But it is important, even now, to keep
in mind the strategic aims of the regulator. They are set out in the Plan and
Budget we published in January. And in our Annual Report, which is the basis
of today's Annual Public Meeting, we reported for the first time on the achievement
of our statutory objectives.
Our four strategic aims for 2002/3 are that, as a result of our work:
- consumers are better
able to make informed choices and achieve fair deals for themselves. Our consumer
education work is largely oriented towards achieving that objective.
- regulated firms and
their senior management understand and meet their regulatory obligations.
Our legislation explicitly requires us to regulate in a way which emphasises
senior management responsibilities. Management are best able to motivate their
employees to deal fairly with their customers.
- consumers and other
participants have confidence that markets are efficient, orderly and clean.
That objective incorporates both our code of market conduct and also our financial
crime initiatives, and
- we establish an appropriate,
proportionate and effective regulatory regime in which consumers, firms and
others have confidence. Unlike most other regulators internationally we are
statutorily required to consult both market practitioners and consumers in
developing our regime, and we are required to prepare cost-benefit analysis
on the vast majority of the requirements we set.
This year, for the first time, we have attempted to organise our report around
the Authority's major aims. There is not time this morning to review all of them
- you will be pleased to hear. So I will limit myself to drawing attention to
just a few points which were of particular significance during the year.
Our new regime was introduced on 1 December last year. For a while, as the Parliamentary
process inched forward, it seemed that N2 was retreating as we approached it.
But, in the event, the lengthy preparatory period paid off, and we were able to
bring in the new regime with a minimum of disruption to firms and their customers.
That we were able to do so is a tribute in particular to the work of firms themselves
and their trade associations, who helped greatly throughout the process. It was
a genuinely collaborative effort, and one in which our three Panels of practitioners,
consumers and small business representatives, played a particularly important
part.
More recently, we have introduced a new credit union regime which brings a large
number of small voluntary organisations into a regulatory regime for the first
time. A second theme of the year, which I would hardly describe as a highlight,
was the effects of the terrorist attack on New York on 11 September.
In the immediate aftermath our focus was on disaster recovery. A considerable
volume of business previously transacted in New York was routed through London,
which required a collaborative effort between firms and regulators on both sides
of the Atlantic. While that process passed off remarkably smoothly, in the circumstances
- which is a tribute to the spirit of collaboration demonstrated - the experience
taught us a lot about the stresses generated for financial systems by a terrorist
attack. We also paid close attention to the strains caused by the knock-on effects
on a wide variety of firms and markets. Since then, in collaboration with the
Treasury and the Bank of England, we have overhauled our own contingency plans,
moved our back-up sites and re-trained key staff. We hope this effort will turn
out to have been wasted.
Since 11 September we have also devoted considerable effort to enhancing the anti-money
laundering regime in London. Inevitably, this causes some inconvenience to individual
consumers, and to financial institutions. I am pleased to say that, with very
few exceptions, we have had good co-operation from institutions, and understanding
from individuals that the inconveniences they suffer are worthwhile, and inevitable
if we are to make life difficult and uncomfortable for terrorists and drug dealers,
in particular.
The third important theme of the year was the continuing clean-up of the problems
inherited from the past. There, I believe, we can claim some credit for the progress
made. At the end of last month we explained that 98% of the pensions review mis-selling
cases had been satisfactorily resolved by the target date we set three years ago.
At the time, many thought this was an unrealistic deadline but, faced with the
need to meet it, firms stepped up their efforts and, as a result, hundreds of
thousands of investors who previously faced uncertainty and anxiety now know their
position. While the final figures for redress will not be known for a little while,
we expect that around 11.5 billion will have been paid to some 1.1 million investors,
in what is almost certainly the largest consumer compensation exercise undertaken
anywhere in the world.
We do not wish to go down that road again, which is in the interests of neither
consumers nor the life insurance industry. That is why we are engaged in a substantial
programme of reform of retail regulation. That reform programme has been boosted,
recently, by Ron Sandler's report on the long-term savings and investments market.
I recognise that many investors, and even some of the firms most closely involved,
are confused by the number of and scope of initiatives under way. That is, to
some degree, understandable. But now that Ron Sandler has reported, it is possible
to sketch out, somewhat more clearly than before, the way ahead.
There are four main strands of work, covering:
- the regulation of distribution;
- the governance and structure
of with-profits funds;
- the design and regulation
of simpler products targeted at the mass market, and
- consumer education.
The first strand of work is well under way. We consulted earlier this year on
some radical proposals to reform the polarisation regime. We have received much
support for those proposals, and in particular for the removal of the basic polarisation
rule, which we believe to be anti-competitive and constrained the market unhelpfully.
The Office of Fair Trading take the same view. Ron Sandler's report supports our
propositions in that area. Given the depth and scale of his analysis for the sector,
I believe that support is highly significant.
But both Ron Sandler, and a number of representatives of the IFA sector, argued
that our proposal to require independent financial advisers to be remunerated
on a defined payment basis is too restrictive. A number of alternatives, designed
to achieve a similar objective, have been put to us, and we are looking positively
at those suggestions. Our aim is to reach a final view on the way ahead in the
autumn and to move quickly to the necessary rule changes thereafter.
The second strand of work, reforming with-profits funds, is also well under way.
There, also, Ron Sandler has supported the broad lines of our proposed approach.
In some respects, however, he has argued that we should go further, and that funds
should be reconstructed on a "charges less expenses" basis. That would be a radical
change, which requires careful thought and analysis, in particular to look at
the implications of a transition from where we are now to where Sandler would
like us to be. That will require a satisfactory method of handling issues about
the ownership of estates within life funds.
We aim to pull these ideas together with our recent proposals on governance of
funds in a comprehensive paper around the end of the year.
The third area is not solely a matter for the FSA. The Treasury will need to take
the lead in designing the simplified suite of products for which Ron Sandler calls.
Alongside that, we shall need to look at the way in which the sale of such products
would be regulated in the future. In our consultation paper on the polarisation
reforms we put forward a proposition for a different type of financial adviser,
with lower qualifications. Ron Sandler's ideas go rather further, and are clearly
conditional on product features which are not typically available in today's market.
I hope that, through the autumn, we and the Treasury will be able to move forward
in this area. But there is some difficult work still to be done on product features,
to ensure that it is possible to free up the conduct of business regulations without
the risk of widespread mis-selling. We already know that the Consumer Panel has
strong views on this issue.
The fourth and last area concerns consumer education. Up to now, we have built
up our consumer education work on a modest scale, in effect by making savings
elsewhere, so allowing us to keep regulatory costs to the industry broadly flat.
Even within that constraint we have been able to develop curricular materials
in both primary and secondary schools. And we have prepared a wide range of documentation
for adults to help them think through the kind of financial decisions they need
to make. If, however, as Ron Sandler recommends, we are to step up a gear then
there would undoubtedly be a need for additional funding from the financial services
industry.
So our plan in this area is to put forward some preliminary proposals early in
the autumn for augmenting our consumer education effort in the next financial
year. Then we will consult early in 2003 about the long-term strategy we should
follow. That will cover major issues such as whether we should work primarily
alone, or in partnership with financial firms. It will cover the governance arrangements,
and the distribution mechanism we should be aiming to develop.
In this whole complex area, we need to balance two potentially conflicting pressures.
First, the need to keep the period of uncertainty to a minimum. There is undoubtedly
a risk of planning blight over the long-term savings sector. So we must get as
much clarity into the future product and regulatory environment as we can, as
soon as possible. On the other hand, we must get it right. And there are many
plausible propositions around for reform which, on reflection, may not deliver
what is claimed for them. Sadly, the history of the last 15 years is littered
with examples of that latter phenomenon, and the law of unintended consequences
is a powerful force in this industry.
I conclude with a few thoughts on the FSA's progress as an organisation. Those
of you who have been through corporate mergers will be well aware of the challenges
involved. With our own 9-way merger and N2 firmly behind us we are now more in
control of our own destiny and are embarked on implementing our risk-based approach
in everything we do. This is making a difference to the decisions we take on where
to focus our attention and on how to tackle particular issues. Some high and medium-impact
firms have now been through a risk assessment new-style and are experiencing our
new approach at first hand. We plan to roll out assessments for most of the remaining
firms over the rest of this year.
I do not underestimate the challenges facing my management team and staff in implementing
the new regime fully, while continuing to bear down on costs. I have recorded
in my Statement in our Annual Report my appreciation for the hard work which our
staff have put in, but I repeat it here, along with my thanks to all the others,
in regulated firms, and the practitioners and consumers on our statutory panels,
from whom we shall now hear.
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