Annual Lubbock Lecture in Management Studies by Hector Sants, Chairman of the FSA, at Saïd Business School, University of Oxford

Friday, 12 March 2010 | Leadership in Finance

'UK Financial Regulation: After the Crisis'

Good evening ladies and gentlemen. It is a great pleasure to have been invited to speak here today.

It is now almost three years since the onset of the worst financial and economic crisis in modern times.

The UK economy and financial sector has stabilised but significant challenges remain. Notably, to ensure that the momentum to reform regulatory policies and practices is maintained.

The FSA has a pivotal role to play in this crucial endeavour.

The focus of my speech today is thus on two areas.

Firstly, what the FSA is doing differently following the crisis, and secondly, my personal perspective on what the critical unresolved issues are and where more needs to be done.

To put both of these in context, it is helpful first to recall the key causes of the crisis.

I do not intend to review these in detail as there is general agreement on the list and recognition that it is multi-faceted.

Within this list, however, there were clearly a number of drivers that the regulators must address.

The drivers relating to regulators broadly fall into two categories: firstly a poor set of prudential rules or policies, and secondly, elements relating to supervisory practices.

The changes to practices apply not just to more effective policing of prudential rules, but also to encouraging and overseeing management behaviour and culture.

In passing, may I note that the FSA's role in policy setting is essentially one of an influencer, not a decision-maker, as the bulk of the decisions are made in the international and European fora.

The FSA's effectiveness should thus primarily be judged on the effectiveness of our supervision and not the quality of the rules.

Some remarks on how we are progressing the global reform agenda relating to prudential rules.

A useful approach here is to distinguish between those issues that contributed to the onset of the crisis and those issues that have been exposed through the need to manage the consequences of the crisis.

In my view, in general, there has been good progress on the former but less good on the latter.

On the required changes to rule defects that contributed to the crisis, I would characterise that the best progress has been on the capital and liquidity regime, but there has been less progress on accounting and how the macro-prudential framework will operate (although the latter, of course, are not directly within the FSA's remit).

On capital and liquidity, the FSA's work, carried out under the auspices of The Turner Review, has been recognised as a vital contribution to the debate, and we have been at the forefront of developing the international agenda.

In the meantime, we have put in place a credible liquidity and ‘interim' capital regime. This is consistent with the direction of travel that the Basel Committee has set for the global banking community, as described in its December consultation paper.

The FSA is more than aware that we must not be out of alignment in the longer-term with any international framework.

So turning to those elements that contributed to the crisis which relate to supervision and, in consequence, what the FSA is now doing differently.

As I mentioned, the FSA has radically changed the way it operates. This is best described in two main respects: first, the changes we have made to our philosophy; and second, the resultant changes to our operating model.

Regarding the first, there were various ways to describe the FSA's philosophy historically. By politicians as ‘light-touch', by the FSA, as derivations of ‘principles-based' or ‘more principles-based'.

The new approach we have moved to is ‘outcomes-based' and this is delivered through intensive supervision. But why outcomes and how is this different?

The ‘old-style' FSA rarely intervened until there was clear evidence that something had gone wrong. It was a retrospective form of regulation. Intervention needed to be based on observable historical facts.

The old approach was never going to stop firms making mistakes, as that was not its intention. This was well supported by society and the city at the time.

The new outcomes-based approach, however, is centred on intervening in a proactive way, and judging the future decisions of firms based on business model and other analysis.

Moving into making judgements is undoubtedly more difficult. The FSA will now ‘take a view'. That may well be disputed by firms and require greater engagement.

In some cases we may prove to be wrong and accept that we are. But in others we will be right, and make real improvements.

I recognise that in order to do this we require more and better quality people and analysis - where we have already made real strides - as well as more sophisticated systems. However, it is only by doing this and being more proactive that we will achieve society's goal of minimising failure.

Turning to the second area of change: our operating model.

The old FSA's reactive philosophy focused on ensuring firms had the appropriate systems and controls. Judgements were rarely made on the consequences of management actions.

In the new intensive approach to supervision the FSA is taking a view on management action. This new approach, as I will explain, underpins how we now carry out both prudential and conduct regulation.

Due to the nature of the crisis our initial focus was necessarily in the way we carried out prudential supervision. For prudential supervision, the application of this new approach essentially requires firms to be far more proactive in the assessment of risks and of course monitoring adherence to the new tougher prudential regulatory framework.

It also requires us to improve our own monitoring capacity to reach independent views on risks.

A good example of this is our initiation and implementation of a forward-looking approach to capital for banks. We set a challenging stress test for banks based on a much more severe recession than the Bank of England's official forecast. Banks were required to have in place (or have credible plans to put in place) capital sufficient to maintain their core Tier 1 ratio above 4% of their risk-weighted assets over a three to five year horizon.

This proactive approach resulted in banks materially improving their capital positions and enabled them to better withstand the downturn. This involved us making judgements about the banks' business models, capital plans and proposed management actions.

In 2010/11 we will be further developing and embedding this new approach within our day-to-day supervision. In particular, conducting annual stress tests for all major financial institutions. These will involve detailed reviews of asset portfolios, income projections and funding strategies.

Now that the prudential reform agenda is well under way, we are turning our attention to reforming our approach to conduct.

Today, I would like to take this opportunity to formally launch our new approach to conduct regulation.

Historically, the FSA's approach to conduct was, as with prudential, essentially reactive. Too often, it focused on high-level systems and controls analysis merely reacting to crystallised risk and consumer detriment.

It also focused, as has been the approach across Europe, on disclosure, sales processes and suitability. Both elements thus avoiding product and price regulation.

There are significant limitations to this approach.

Critical among these was the inability to spot and prevent major risks from crystallising, resulting in damage to consumer and market confidence and ultimately consumer harm.

Even though in these situations we have delivered redress, firms have continued to make substantial profits from exploiting market failures. Fines and past business reviews are proven not to be a sufficient deterrent.

Essentially, our focus has been too late in the product lifecycle to ensure that we identify potential issues early enough to prevent consumer detriment.

Our Treating Customers Fairly (TCF) initiative, a key element of our retail agenda from 2004/05 onwards, did acknowledge that it is preferable to prevent substantial failures occurring.

However, its implementation essentially relied upon the ‘old-style' supervisory approach that focused on senior management equipping themselves with the right systems and controls. This therefore remained a reactive approach.

The TCF initiative has yielded some benefits, particularly with regard to raising management awareness of the outcomes the FSA seeks but it has not yet delivered substantial on-the-ground benefits to consumers.

Our new conduct model seeks to take a dramatically different approach.

We will now seek to proactively intervene earlier in the product chain to anticipate consumer detriment and choke it off before it occurs.

We will do this through using our integrated model of risk analysis and research to identify earlier sources of conduct risk; intervening further up the value chain and scrutinising products at the design stage.

We will also use sector-wide intervention where necessary, for example to change incentives in a market.

Our Mortgage Market Review is a recent example of this already in action.

This approach will be combined with a greater willingness to test outcomes through mystery shopping and on-site visits, which should increase the probability of identifying issues before they gain industry-wide momentum.

Finally, we will improve the framework and delivery of redress to consumers, including a review of the complaint-handling standards of all the major banking groups.

As I have explained, both of these models are built on the essential cornerstone of intensive supervision, namely integrated risk assessment at the firm level, a strong understanding of business models and a willingness to intervene earlier based on our own judgements.

This new operating model is underpinned by our credible deterrence approach to enforcement. I have been consistently clear that when firms do not adjust their behaviour, they can expect tough action from the FSA.

In summary, our new approach to conduct seeks to achieve three goals:

making the retail market work better for consumers;

avoiding the crystallisation of conduct risks that exceed our risk tolerance; and

delivering credible deterrence and prompt and effective redress for consumers.

The mechanism for achieving this has three key strands:

first, seeking to improve the long-term efficiency and fairness of the market;

second, delivering intensive supervision of firms. The new supervisory approach will ensure firms treat their customers fairly and will equip the FSA to intervene earlier in the development of retail products. Interventions of this nature, which necessarily involve us making a judgement on potential detriment, will need to be based on sound business-model analysis and integrated firm-risk assessment; and

third, in the event that failure has occurred, we will secure the appropriate level of redress and compensation (when justified), and achieve effective credible deterrence by taking tough action against firms and individuals who have transgressed.

A successful consumer protection strategy must restore consumer confidence in the financial market place.

A key element of restoring that confidence is that the consumer can trust the regulator. This strategy will restore trust in the regulator and will benefit everyone, including consumers and providers.

A regulator must be willing to place themselves between consumers and harm. We will only achieve this by taking a proactive stance.

So, having outlined what the FSA is doing differently in response to the crisis, I would now like to focus on those critical areas that remain unresolved and where, in my view, more needs to be done.

These fall within two main categories.

First, those principal areas still being debated; and second, areas that I believe are not being adequately debated and for which there is no obvious process for progressing the debate.

Of the first category, I would highlight five.

Firstly, society's expectations of what regulation can achieve.

There remains the perennial problem of a mis-match regarding what a regulator can do - and indeed what it is charged to do - and what society expects.

Events have shown that society never really accepted or understood a ‘non zero failure' regulatory regime. What is not grasped is that if society wants innovation and competition we will always have judgements that, with the benefit of hindsight, prove to be wrong.

We do need to remind ourselves that taking risk is required for a return and with risk there must be the possibility of loss. We therefore need greater alignment here.

This is a challenge for all of society, not just regulators.

The second area relates to the structural issues highlighted during the crisis that have yet to be satisfactorily addressed.

There is broad agreement on the drivers of the crisis - that is the easier part - the issue that remains is agreeing how to deal with its consequences. A specific example I would highlight here is the ‘too big to fail' debate.

The cost of the extensive and successful interventions by central banks and governments to rescue some of our largest financial institutions has engendered a sense of injustice within the community at large.

In addressing this issue we need to recognise that the basic operations of many of these institutions are integral to a well-functioning finance system and the broader economy.

Furthermore, we cannot try to remove risk-taking from the system entirely, nor would we want to. However, the FSA is firmly of the view that we must have a system that avoids the consequences of excessive risk-taking being borne by the tax payer.

We therefore need to reduce the risk of failure and ensure that if it does occur the cost is ultimately borne by those who fail.

Reducing the risk of failure leads us into the ‘Glass Steagall' argument and whether we should break up banks and/or restrict activities. The Obama administration, advised by Paul Volker, has been vocal in this area of late.

The FSA suggests that a similar effect can be achieved through the mechanism of increased capital to curtail trading activities as opposed to such structural changes.

In the FSA's view, the right approach would be a ‘cocktail of measures'.

Higher capital and liquidity will reduce the probability of failure, while living wills can improve the probability of recovery and ensure resolution can be achieved in an orderly fashion.

However, the avoidance of failure can never be assured, so we still need to address the question of how the cost can be recovered from the industry. Such recoveries can be either made ‘ex ante' or ‘ex post'.

The advantage of the former would be that authorities could raise funds, in a risk-based way, from financial institutions before they fail. This avoids the problem of those who fail avoiding paying, but accentuates the moral hazard issue.

Furthermore, I would question the feasibility of raising a sufficiently large fund to cover all eventualities.

The alternative is to raise a levy from the surviving firms after the event. Such a levy could either be in the form of general taxation or a specific recovery.

Pragmatic analysis thus suggests a combination of measures may be the way forward but further analysis is needed. It should also be noted that the debate about levies is inextricably linked with that of capital. They are all forms of taxation.

The third area currently being debated, and arguably the biggest failure in the UK and internationally, was a lack of a resolution mechanism and lack of oversight over the stability of the whole system, or as it is termed, ‘macro-prudential oversight'.

On the latter there remains a gap. Any interventions would need to be made through macro-prudential rules - for example, restricting the supply of credit, capping loan-to-values and so forth.

As a micro-prudential supervisor, this is not an area where the FSA can act alone. While we may have ideas to contribute to the debate, and as a supervisor may well become the transmission mechanism, this is not an issue that can be resolved without the Bank of England and the Treasury.

Fourth, there is the collective issue of the degree to which the system should ‘mark-to-market'.

This debate is ongoing; however, I believe this will need to continue to be a compromise. The banking book needs to be more clearly delineated and a clearer distinction is needed between the trading and banking books.

There is also the linked question of trust in and the effectiveness of auditors. This has been, in my view, an under-debated point. This needs to be addressed alongside the technicalities of the accountancy debate.

Fifth, we need to assess the economic impact of the entire package of reforms that is being proposed. We do not want to raise the cost to firms to a level which means they are unable to deliver a fair return to shareholders or extend an appropriate level of credit to the economy.

Making such an assessment is intrinsically difficult but we should do this before final decisions on the rules are reached.

The FSA is seeking to contribute to this work through the model we are building with the National Institute of Economic and Social Research. Our thoughts are set out in an Occasional Paper which was published in October 2009.

The second category of unresolved issues is those that I personally feel are not being adequately addressed or even debated.

I would highlight three: culture, investor responsibility and the level of return from banking activity.

Firstly, on the issue of culture and behaviour - dare I say it, ethics? Poor risk management was a key driver of the crisis.

We need to answer the question of whether a regulator has a legitimate focus to intervene on the question of culture.

This arguably requires both a view on the right culture and a mechanism for intervention. Answering yes to this question would undoubtedly significantly extend the FSA's engagement with industry.

My personal view is that if we really do wish to learn lessons from the past, we need to change not just the regulatory rules and supervisory approach, but also the culture and attitudes of both society as a whole, and the management of major financial firms.

This will not be easy.

A cultural trend can be very widespread and resilient - as has been seen by a return to a ‘business as usual' mentality.

Nevertheless, no culture is inevitable. But changing it is a task that cannot be achieved by policymakers alone - we need to collectively address these issues.

From the regulators' perspective it is probably the case that seeking to set ourselves up as a judge of ethics and culture would not be feasible or acceptable. More realistic would be to relate the consequences of culture to regulatory outcomes. However, developing this line of thinking requires much further debate which I would welcome.

We have already taken steps, both in the UK and internationally, to address remuneration structures, which provide a key influence on culture.

A further mechanism for driving this change would be our oversight of individuals.

Following the crisis we already judge technical competency as well as probity. But seeking to make a judgement on the ability of individuals to deliver the right culture in organisations they manage would be a further major step.

Secondly, which is linked to the first, is the question of investor/shareholder responsibility. Are they owners with owner's responsibilities or investors who merely trade the shares with their obligation being to their investors? I suspect they will insist on remaining the latter.

Thus while investors will resist taking on additional responsibility, they should recognise the value to them of challenging management to ensure their business plans are credible.

With regard to investors, the other important point is whether they fully understood the investments they were buying.

Adherence to the maxim ‘do not buy something that you do not understand' is critical. The crisis has undoubtedly been exacerbated by an intense search for yield, which encouraged the creation by banks of a multiple of opaque structured products. The subsequent opaqueness and illiquidity of these instruments was a major contributor to the crisis.

Finally, a word on the issue of society's judgement on an acceptable level of return from the banking industry.

Central to society's unease with banks is the current perceived high return they extract for their activities. This, in my view, is essentially a competition problem that, since the franchises are global, would need to be tackled at this level.

Before closing, I would like to make a few remarks on a ninth unresolved issue: the national regulatory structure in the UK.

My personal view is that the structure of regulation was not a major contributory factor in the crisis.

Yes, there were deficiencies in the Tripartite system.

But what matters here is that we have the right people making the right decisions, and the right policies and rules in place to support that process.

Furthermore, the extent to which any regulatory structure in the UK in practice will have any meaningful discretion looks to be highly problematic.

The new European regulatory structure will mean that in the future policy and rules will be determined in Europe, and the FSA, or any successor organisation, will be a locally-based supervisor delivering European rules.

I have skated over many issues this evening but I do hope that this will stimulate some interesting questions and discussion.

In closing, the FSA has changed, it is now doing its job - but globally and within society as a whole there still remains much to do.

At the heart of the challenge is the need to restore trust. In particular, society's trust in the regulatory authorities and financial market participants.

The FSA has a central role in restoring that trust.

I hope that I have outlined today how we are going about achieving that goal. Nevertheless, I am sure that you recognise that proactive regulation requires judgement and all judgements necessarily carry risk that with the benefit of hindsight, may prove to be incorrect.

Full restoration of trust will require society to recognise this fact.

I look forward to taking questions.

Annual Lubbock Lecture in Management Studies by Hector Sants, Chairman of the FSA, at Saïd Business School, University of Oxford

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