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Industry in depth
The Story So Far
14 July 2007
Andrew Strange looks at the origin and development of the FSA’s principles-based regulatory objectives
Back in July 2005, a consultation paper was issued by Financial Services Authority (FSA). Entitled ‘Reviewing the FSA Handbook’, it covered a number of subjects including reviewing the Conduct of Business rules. Peppered throughout the document was a four-word phrase that perhaps, with hindsight, to which we should have paid far more attention. Much as ‘prudence’ became the word of choice for our now Prime Minister back in his days at Number 11 Downing Street, and we all learned the seriousness and implicit connotations when used, ‘Principles of Good Regulation’ was about to become the foundations of a stock phrase for Messrs McCarthy, Tiner et al with just as serious connotations.
Of course it wasn’t until December of 2005 at his speech on FSA’s road map to better regulation introducing the ‘Better Regulation Action Plan’ that John Tiner, chairman of the FSA, changed the phrase slightly and the well-worn phrase ‘principles-based regulation’ was born as we all know it. The rest is history, culminating in ‘More Principles-Based Regulation’ which Tiner presented at the FSA’s conference on the subject in April of this year.
Principle basics
However, principles didn’t just start in 2005; they go back much further than that. Fundamentally the whole FSA is founded on principles. The FSA has four statutory objectives empowered to it by the Financial Services and Markets Act, and these in turn are supported by six principles relating to efficiency and economy, role of management, proportionality, innovation, international character and competition – collectively known as its Principles for Better Regulation.
Firms have their own principles too – known as Principles for Businesses, of which there are no less than 11. As someone recently commented, that’s one more principle than God required Commandments, which is telling.
The eleven Principles for Businesses are: integrity, skill, care and diligence, management and control, financial prudence, market conduct, customers interests, communications with customers, conflicts of interest, customers: relationships of trust, customers’ assets and relations with regulators. So it’s fair to say that principles really are at the heart of our regulator’s approach – they are in its blood.
Looking at the theory behind principles-based regulation is quite simple: fundamentally, the FSA can’t regulate every minute detail of the financial services industry; it simply doesn’t have the resources. If it wanted sufficient resources, it would require huge amounts of money, and in order to raise that much money it would have to charge such high fees that it would put us all out of business. I suppose that’s one approach to regulation, but perhaps not one that proliferates a durable market.
LPrioritising
Logically, therefore, the FSA has to prioritise and select areas of the market where it feels regulation and enforcement is most needed. In choosing how to tackle this, the FSA decided to address the areas that potentially could have the biggest and worst affects on consumers – a risk-based approach based on consumer outcomes.
Having decided on taking a risk based approach, FSA had two options. It could both develop and enforce a set of rules, or it could work to principles. Given that rules would be developed by the regulator and then enforced by the regulator, if the outcomes failed to meet the desired results, whose fault would that be? Advisers would have done as they were told, the results would be unsatisfactory and there would surely have been a regulatory failure? Conversely, it could assess outcomes against principles, and expect firms to find their own way there. Obviously, it is far easier to use principles to assess the results. If a firm then loses it’s way and doesn’t pass muster then that is a failure of the firm, not of the rules and certainly not of the FSA.
A sensible move?
It must be said, in some respects the move to principles-based regulation is actually quite sensible. AMI has long campaigned for ‘proportionate’ regulation and to an extent principles-based regulation allows for this.
The best firms should benefit from the ability to run their businesses as they see fit; to not be bound by prescriptive rules, and be able to service their clients as they deem appropriate. They should benefit from ‘regulatory dividends’ for their compliance, with lighter touch regulation and less time-consuming and expensive compliance procedures. Conversely, firms that do not pay due regard to their clients will still fall foul of the regulator, and can easily be disciplined for lack of adherence to the principles. The obvious example of this is the use of ‘failure to treat customers fairly’ as a reason for enforcement. If you read the FSA website, almost all fines or management or firm actions relate in some way to the failure in ‘Treating Customers Fairly’ (TCF).
It is also true that principles-based regulation succeeds in embedding compliance in the boardroom. It makes it absolutely clear where responsibility lies and forces management take compliance seriously, and install TCF in all areas of their businesses.
Problems
So that’s all fine then; principles work. Well, not quite. There are one or two problems related to principles-based regulation.
Firstly, smaller firms do struggle. AMI has highlighted this to the FSA, and continues to be of the opinion that the regulator doesn’t offer small firms enough help. For years we’ve lived on rules and while on occasions prescriptive rules can be awkward and tiresome, at least you knew where right and wrong lay. You could sit there and know that your file was water-tight, that if the FSA came knocking at the door everything was in order.
But in a world based on principles, there are so many shades of grey. While it can hold an opportunity for larger firms, who have the time and budgets to understand the theory, for the smaller firm it can be quite unsettling to have the rulebook pulled from under you.
We think the FSA should be doing more, and aiming more resource at helping smaller firms understand. Evidence suggests that smaller firms want to comply but ‘don’t get it’. When they are offered guidance, the proverbial light bulb switches on and they’re away, but the regulator should do more to help smaller firms with this.
Secondly comes the hanging yourself and ample rope analogy. There must be acknowledgement that principles could create a situation where the FSA gives a firm just enough rope to hang themselves. While for some firms adapting to principles is easy, some firms just haven’t understood it. While we have no sympathy for firms that flout rules, we do for those that genuinely struggle. Compliance departments rely on rules – without them compliance could become a subjective opinion which will never create a consistent and TCF approach.
AMI also has a serious concern about costs. The move to principles-based regulation is set to cost £50 million. Where is the cost-benefit analysis of this? Where are the regulatory dividends for firms that adopt this concept? And most worryingly, what are the long-term implications? Is this a huge cost that will only be overtaken by European regulation in years to come?
The Europe effect
Therefore the final overriding issue has to be Europe. Does principles-based regulation fit within Europe?
Historically, Europe has focused on product regulation – the complete opposite to principles based regulation. This is regulation-by-rule at the deepest level – within products.
However, on a regulator-to-regulator basis, Europe may well be starting to operate on a principles-based agenda. The irony with this is that the FSA itself has struggled on occasions to accept European principles. As recently demonstrated with the UK’s ‘strategic withdrawal’ of the Article Four exemption request for the Menu and Initial Disclosure Documents. So, sometimes the FSA find adhering to Europe’s principles difficult, preferring to interpret them as rules for our firms. Given that the Markets in Financial Instruments Directive is a maximum harmonisation directive, it is unlikely that this is the last we will see of such conflicts.
Looking to current issues, principles-based regulation is being tested given the FSA’s view that sometimes specific rules are needed. Reading the latest ICOB review, there are actually more rules for certain products – such as payment protection insurance. It is also noteworthy that in parts the FSA has used ‘copy-out’ of European directives in NewICOB – a nod to the power of the European regulator?
The Retail Distribution Review also poses questions of principles-based regulation. When considering ‘Primary Advice’, it is clear that ‘simple products’ could well come to mean ‘product regulation’. Of course, the industry could fill in the gaps between principles and practice without the regulator needing to introduce new rules. The meat in this sandwich is ‘industry guidance’ – where the industry provides its own ‘rules’ to operate within.
We are living in a complex world of rules and principles for quite some time yet and AMI will be helping its members steer between the icebergs.
BY: Stephen Atkins, Group Compliance Director, Freedom Finance
If there is one message that intermediaries should have taken on board from the FSA, it’s that future regulation of the mortgage market is going to be based on a set of principles rather than a set of rules.
In April this year John Tiner, chief executive of the FSA, said: "To be effective, regulators must be able to adapt their regimes to keep pace with market changes. We believe principles which focus on an outcome are more enduring while at the same time better foster innovation and competition.
"More principles based regulation is the natural next step in the evolution of our regulatory system. It will give firms more choice over how they meet our requirements bringing for many a closer fit with their business processes and more clearly placing the responsibility for key regulatory decisions at more senior levels in firms.”
The key message from the FSA is that they intend focusing on outcomes - it is the result rather than the process which really matters. It is also worth noting that they clearly see the regulatory buck stopping with senior management – regulation is not an issue which can be passed down the line to junior and middle management.
During the same conference, John Tiner went on to say: “We are also aware there are external issues that need to be addressed. The current preference of the EU Commission to adopt specific rules, the inevitable and proper establishment of precedent by the Financial Ombudsman Service and the role of consumers of financial services in a more principles based environment. All of theses issues need to be examined carefully and will not be ignored as we plan and pursue our course."
In short, the EU has the potential to put a spanner in the works, because it prefers rules! The truth is that the FSA is unlikely to develop its principles based regime further until the EU Mortgage and Credit white papers are published in November. It is also likely that any changes to MCOB will not be considered until 2008 and, even then, the focus is likely to be on making preparations for Europe rather than wholesale changes to MCOB.
However, despite the preference of brokers, lenders and the EU for rules, because they are easier to implement and monitor, the FSA is determined to press ahead with its drive towards principles based regulation. Brokers therefore need to ensure they understand what those high level principles are and they need to ensure they can prove they have been integrated into their daily working practices.
Nick Battersby, Compliance Director of RAMP
The question that is taxing many commentators is not what changes are likely in the rules surrounding financial promotions but whether the existing rules have actually had the desired effect to date. As far as RAMP is concerned, we have been particularly disappointed with the enforcement of existing financial promotions rules and the concern we have is that the general move away from prescriptive rules to a focus by firms on deciding how best to comply and then monitoring the outcome is not going to lead to greater compliance unless it is backed by more rigorous enforcement.
In fact to move to a more general position where individual firms have more discretion on how to interpret what and what are not, in the words of the regulator, ‘fair, clear and not misleading’ promotions, without improving the oversight by the regulator is going to make it even more difficult for the majority of firms who are abiding by the rules to see justice done. Firms which already break the rules by accident or design will see the new rules as a relaxation of oversight rather than a tightening up.
The problem lies not in the concept of being principles based but rather in how the new system will be policed. Moving from prescription to interpretation is the right way for the wider regulatory framework, but in the case of financial promotions, either a particular promotion is ‘fair, clear and not misleading’ or it is not. To allow interpretation in such a vital area, particularly with those who have chosen to ignore the existing rules for the past two years is an invitation for wider spread abuse.
RAMP has continued to lobby the FSA on issues of non compliant promotions which create an unfair playing field for those firms who make every effort to ensure their promotions are fair, clear and not misleading. Although for the most part, RAMP members and associate members issue promotions which are B2B, we nevertheless expect our firms to comply with the high standards in respect of the quality of the promotions.
A recent speech by Nausicca Delfas, Head of TCF Strategy, Financial Promotions and Unfair Terms at the FSA confirmed that the move to principles based regulation will mean that simply complying with financial promotions rules will no longer be enough. Firms will have to justify all promotions based on outcomes. Apart from being fair, clear and not misleading, promotions must explain the nature of the product, be clear that they are targeted at the right audience and raise accurate expectations in the client.
Tellingly, Ms Delfas went on to say that the FSA was not interested in how the right outcome was reached but only that it was right. However, if a promotion was wrong then she claimed that her department would definitely do something about it. However, only time will tell whether the FSA will now back up its changes with real enforcement. If it does not, firms that operate correctly will be further disadvantaged against those firms which persist in failing to comply.