Conferences & Events

Speech by Howard Davies, Chairman,
The Financial Services Authority
Federal Reserve Bank of Atlanta
Financial Markets Conference
27 February 1998

It is kind of you to invite me back this year, after my misleading performance in 1997. Twelve months ago I spoke as Deputy Governor of the Bank of England, and also as a non-executive director of the Securities and Investments Board. At that time, given what we knew about the attitude of the then Government and the then Labour Opposition, it seemed safe to assume that I would continue to need those two roles in order to give me a foot in banking and securities regulation.

But how things change in a year. The Securities and Investments Board, one leg of my activities, has been abolished. While, to compensate, the other leg has split in two: there are now two Deputy Governors. But neither of them has responsibility for financial supervision which has passed, lock, stock and barrel, to the new Financial Services Authority, built in the ashes of the SIB, and which I now chair.

I say 'has passed' but, in fact, the key operational date will be 1 June. At that stage we shall take on formal responsibility for all banking supervision in London and, at the same time, for all the regulatory activities of the current SROs — the SFA, IMRO, etc, which regulate securities, investments and fund management businesses in London. Their Boards will remain in being for another 18 months or so, but their staff will transfer to the FSA. So we will achieve managerial integration earlier, and supply services back to those Boards. For good measure, in eighteen months time, we shall also take in the division of the Treasury responsible for insurance regulation, the regulatory functions of Lloyd's of London, and a body which supervises building societies, friendly societies, and other small local financial institutions — our equivalent of the savings and loans industry.

This major regulatory restructuring is being implemented extremely quickly. We are working on the managerial side of it, at the moment, with the legislation catching up later. We have just offered new contracts to approaching 2,000 staff, telling them their new terms and conditions, and how they all fit into the new body. So it is a good time for me to be out of the country!

I have another reason, too, for being pleased to be here. It is good to see Doug Breeden again. Doug had the misfortune to teach me an investments course at Stanford Business School almost 20 years ago. Indeed it is the only formal education in investments I have ever had, and most of it turned out to be about matrix algebra. So you now know whom to blame for any future flaws in the British regulatory system.

I did not make much of an impact on Doug's class. I recall asking a naive question in the early weeks, to be greeted with the robust response, "is a form of market inefficiency being asserted here?". Since this was the worst crime to be conceived in the eyes of a man from Chicago, I realised it was wiser for me to keep quiet. But I looked back at my course papers — which I still have squirreled away in a loft — in preparation for this session. And I found an interesting example of misleading signals from the authorities. Looking through my mid-term blue book, I discovered that Doug had added up the marks wrongly, 20 years ago, and left me one light.

I have no idea whether it is possible to reinstate this mark today, and rewrite history, but I suspect not. And so it is with the decisions of the regulators. Even if they are wrong, they have market consequences which cannot easily be undone later. So it is crucial for them to consult as much as possible on the development of regulatory change, and to do as much work as they can to think through, in advance, the market consequences of changes they introduce.

These 'motherhood' observations are fine in principle, but rather more difficult to put into practice. And we face, in London now, a particularly acute example of the problem.

We are, as I have said, undertaking a root and branch institutional overhaul of our system of regulation.

It may be argued that the announcement of such a significant change in the environment could have such consequences for markets that it ought to be, itself, preceded by an extensive period of consultation. But that did not happen. The Government sprang the reform on an unsuspecting market — and indeed on an unsuspecting Chairman — one day last May. In spite of that, rather than hearing loud complaints about the lack of a lengthy consultation period, the market reaction was generally positive, and most participants argued that if there was to be regulatory change, at the institutional level it should be undertaken rapidly, to avoid any degradation of the regulatory environment which might be provoked by a lengthy period of planning blight.

But I do not think one could generalise from this and say that the market would, as a matter of principle, favour surprises. And we have encountered a lot of quite reasonable pressure to consult extensively on the details of the new system. We have therefore been giving a lot of thought to the question of how we should bring market participants into the process of regulation.

In legal form, the change we are introducing is a move away from self-regulation to a system based on statute. This will require us to establish new procedures for market consultation. The legal foundation of the regime we are about to replace was, for the most part, a contract between the regulated and the self-regulator organisation, albeit of course within an over-arching statutory framework. That structure created a set of trade association like conditions, with practitioners involved at every point, in rule setting, disciplinary procedures and in the governance of the regulator. There are prescribed balances between practitioners and public interest members on the Boards of all the self-regulators.

In a more statutory regime, this involvement could theoretically fall away and there was immediate market concern about the way in which regulations would be developed in the future. I hope that we have relieved some of those concerns by setting out in a consultation paper a framework for practitioner involvement in the decision-making within the FSA. The market reaction to that paper has been quite positive, and Gay Evans may say more about it today. We have a top Board with practitioners involved, indeed including the head of global risk management at JP Morgan, Steve Thieke: a sign of our commitment to London as an international market centre. But, more importantly, below that we have said that we will involve practitioners in all aspects of the system, in the future.

But what does this mean in practice? And how will such involvement be organised?

I think it is helpful to think of three elements of the regulatory framework. First, there is the new legislation itself. Second, there are the various codes of practice, guidance notes and rule books which will underpin the legislation. And third, there is the way in which those rules are interpreted from time to time, how those interpretations are communicated to the market, and the disciplinary consequences which flow. It is clear that, at all three points, environmental risk can be generated. So there is a need to expose options in each case, and to think through market consequences.

As far as the new statute is concerned, the Government have said that they will publish a draft bill for consultation in June or July. That, in the UK context, is a relatively unusual step to take. It is a sign of the Government's commitment to take account of market views: how useful it is in practice will depend very heavily on the ability of market participants to react rapidly and coherently to what is published. They will have, in all probability, about three or four months to do so. So no summer holidays this year for risk managers or compliance officers.

But we expect the legislation to be, in essence, a framework bill. In other words, and to simplify greatly, it will empower the Financial Services Authority to make rules and regulations in a number of areas, rather than specifying very precisely what those rules and regulations will be. That is the general intention which our Government has set out.

Of course it will not surprise an American audience to learn that there will be those in Parliament who may be resistant to the notion of giving a private sector organisation — which the FSA is — the ability to make rules without Parliament having an opportunity to see what they might be.

It is therefore our intention, as the legislation proceeds, to set out the basis on which we will interpret the law. In other words, we will publish a range of propositions, as we go along. In the first instance, and very shortly in fact, we shall set out what we see as the 'architecture' of our system in the future, proceeding from general principle, through source books which will pull together the information the market will need, down to codes of practice, guidance notes and rule books, depending on the area. We shall seek to ensure an-appropriate distinction between the approach we take to wholesale markets, on the one hand, and essentially retail markets on the other. Wherever possible we shall seek to build on existing codes of practice, rather than writing new rules from scratch.

We see this process as an essentially collaborative exercise between ourselves and the market. It is one where we shall need a high degree of input from firms. And we shall be keen to generate input from investors themselves — particularly important in the retail market, of course.

I think that this is a plausible general approach for a regulator to adopt. But there are two interesting questions which arise. First, are firms themselves equipped to assess the market consequences of new regulation? And, second, is there not a risk that a genuine consultation process creates more uncertainty and risk, than would a more closed process at the end of which the regulator launched his rule books on an unsuspecting world?

The first question is one we shall only be able to answer in the light of experience. But I would note in passing that it will be important for market participants themselves not to respond simply from their compliance departments. We do not want, in London, the British equivalent of the Japanese MoF; about whose activities we have recently learned. There are members of staff of financial institutions focused entirely on dealing with the regulator. If we are to get a good idea of the impact of our regulations on the marketplace, then firms will need to involve front-line trading and dealing staff as well as their risk management and compliance functions.

I might also observe, parenthetically, that the effects of regulatory change are by no means always predictable, either by regulators, or the industry. Big Bang in London in 1986 was predicted to lead to the emergence of UK investment banks to rival the Americans. The City's broking, market-making and investment banking skills, allied to commercial bank capital and freed from the old restrictive practices of the Stock Exchange would sweep all before them. It has not quite worked out that way. But Wimbledonisation was not on anyone's agenda 10 years ago.

As to the second question, I guess this is an issue for the market. There clearly could be a risk of generating uncertainty. But I think it is probably outweighed by the counter advantages.

The third level of involvement comes at the interpretation stage. Here again it is our intention to continue to involve market practitioners and we have suggested that they might also still be included in the disciplinary process. Experience in the SROs suggests that practitioners can be acceptably rigorous in policing the rules in their markets, indeed sometimes more rigorous than executive staff acting alone.

Let me conclude with one or two brief observations about some of the structural decisions we have made in building the FSA, which we hope will influence the development of policy in the future. Because the best solution to the problem we are discussing today is to build market-sensitivity into the process.

Firstly, we have made a decision to locate our policy units next to the front-line supervisors (and indeed to front-line authorisation and enforcement staff). We shall have a small central policy unit, but essentially as a co-ordinator, and also as a 'blue sky' unit, looking at new problems which may not yet be in the regulatory domain. We think that putting policy down with line regulation will help to ensure that policy is formulated and presented in a way which front-line regulators can understand, and will allow maximum possible input from those closest to the authorised firms themselves, within the regulatory framework.

Second, we are intending to use the flexibility we intend to be granted under the new legislation to shift the focus of regulation more towards the outputs of firms, and to the use of principles, guidance and codes, rather than detailed rules. That applies particularly, as I have suggested, to wholesale markets. This approach should make clearer the responsibilities of firms themselves to meet standards expected of them.

Third, we shall maintain a cost-benefit unit which should provide a coherent framework within which to assess the market impact of change — certainly the cost which would be imposed on the market by a regulatory initiative.

Lastly, just a word about the question of the indirect, or secondary effects of regulatory change.

In some cases, we deliberately want indirect and secondary effects to occur. For example, the shift towards giving firms incentives to manage themselves appropriately, should have a desirable secondary effect in raising standards more generally. The use of value at risk models to calculate market risk is one example. It is a case where we carefully considered, and continue to assess, the consequences of the use of these models for firms' risk appetites. This points to the importance of granting model approval on the basis not only of the quantitative features of the model itself, but also the supporting qualitative environment of a firm's internal risk management systems and controls.

I cannot help, in final conclusion, making just one provocative remark about one of the premises on which this session is based. The programme refers to environmental risk including "unusual interpretation of the law (e.g. Hammersmith and Fulham)".

I agreed with Ken Scott that we would not go into this case in detail. For two reasons. Firstly, I have a personal interest in that I am now a tax paying resident of Hammersmith and Fulham, and on the whole prefer that my Council Tax is not used as stake money in derivatives markets. And I was — as it happens, and in another manifestation — responsible for the prosecution in that case. I employed the District Auditor in question, and it was my legal team which serviced him. And I should say that we did not think the interpretation of the law, as far as local authorities were concerned, was at all unusual, though the transactions certainly were. This is a case where a bit more due diligence in the marketplace, consulting lawyers who knew about local government, rather than knew about derivatives, would have saved a lot of pain and anguish. But I said that would be a provocative remark, so I will leave it at that. There are still some painful scars out there in the market which I do not wish to irritate further.