Examination of Witnesses (Questions 20-39)|
TUESDAY 16 OCTOBER 2001
20. What does that amount to? Abuse, obviously.
(Sir Howard Davies) I was trying to clarify. It is
reasonable to be confused because there has been some somewhat
confusing reporting, mainly from misunderstandings arising in
a private meeting. We have nothing against short selling as a
matter of principle, it provides liquidity to the market, it is
a perfectly normal market practice and we have no intention of
banning short selling or anything like that at all. It would be
a particularly odd thing to do in circumstances where market liquidity
is important. At the other end of the spectrum, however, we have
set out now in our code of market conduct a set of definitions
of what we see as good and bad market practice as the underpinning
for our market abuse regime, which comes into effect on 1 December.
We consulted on that code, we produced two or three versions of
it and we have now reached one with which we are happy and which
I should say has achieved a broad degree of consensus in the City.
That explains the particular circumstances in which we might consider
short selling to amount to abuse. Effectively we describe things
like abusive squeezes where perhaps a group of investors might
collude as a concert party to drive the price of a stock down
by taking aggressive short positions in the hope that they could
then go bottom fishing afterwards, pick it up cheaply. We have
defined the sort of practice we would think was abusive and inconsistent
with our code of market conduct and if we identify things like
that we shall take action. What I said when I characterised aggressive
practices was that we had been observing some rather aggressive
short selling practices by individual firms, individual funds,
which appeared to us to be close to the line, but where there
was no evidence of actual collusive practice or that this really
qualified under our code of market conduct. Investors had been
concerned about it, we had had some complaints raised with us
about it on occasion and I therefore made those remarks as a sign
to people that they should be a bit careful about which side of
the line they chose to be on and drawing their attention to the
fact that there were rules about short selling embedded in our
code of market conduct. That was in the nature of a warning shot.
21. Is there any abusive practice in respect
of short selling which applies uniquely to going short and not
to going long?
(Sir Howard Davies) I am not sure, though an abusive
squeeze is a little bit hard to conceive of in a long position.
You could do the mirror image of it of course. Yes, you could
push the price up and then quickly sell short as it fell. Yes,
I suppose you could reciprocate.
22. In which case I am not sure that there is
anything new to regulate in the area of short selling which is
not already something you should be considering in the field of
standard stock market.
(Sir Howard Davies) I was drawing people's attention
to the fact that there is a new code which covered certain elements
of the way in which people were using short positions. I think
you are right that that code will apply to short and long practices.
Yes, it will apply to abusive practices generally.
23. In his speech yesterday the Chancellor mentioned
that he will be funding within the National Criminal Intelligence
Service a new multi-agency terrorist finance unit. In particular
the focus of that will be to improve financial intelligence further
with a new task force which will bring to the anti-terrorism effort
the best of academic, financial and commercial expertise. What
role will you be playing in that? May I also ask about the Financial
Action Task Force which you mentioned? I have read press reports
in the past month or two which would indicate that in terms of
staffing and budget it is perhaps not up to the job internationally
of monitoring the new regimes against money laundering.
(Sir Howard Davies) As far as the Financial Action
Task Force is concerned, we are members of that task force. It
is staffed largely by the OECD in Paris. The new chairman of it,
Jochen Sanio, who is my German banking opposite number, who is
a very energetic character, has said that he wishes to strengthen
the resources of the FATF and I am sure he will get political
support for doing so. As for the domestic arrangements, we shall
play our full part in that, essentially to ensure that the financial
institutions are providing the raw material for that new intelligence
network to work on.
24. And the Chancellor's unit.
(Sir Howard Davies) Yes, I would hope that we would
play a full part in that.
25. We will now turn to the issues relating
to the with profits funds. Given the decline in stock markets
since 2000, how widespread is the problem of "smoothing account
deficits" among with profits funds where the policy values
exceed the asset share?
(Sir Howard Davies) What we have seen is that a number
of companies have felt the need to impose exit penalties, or what
are sometimes called market value adjusters. This came to public
attention particularly in the case of Equitable, but now a large
number of with profits funds have imposed such adjusters in order
to ensure that exiting policyholders do not take more than their
asset share out of the fund. The extent to which a company is
vulnerable to this depends to some extent on its bonus policy
as well as on the strength of its fund, in that at one extreme
in the Equitable case, the Equitable allocated bonuses as they
went along and pursued a full bonus allocation policy to individual
policyholders. Other companies allocate lower bonuses year by
year and a larger proportion of the return is a terminal bonus.
Therefore they can in the light of market conditions adjust the
terminal bonus and that has a bigger effect. Given the size of
the market fall we have seen in the last 18 months or so, most
firmsI would say most nowhave felt it necessary
to impose some exit penalties to ensure that people did not take
away more than their asset share.
(Mr Tiner) Yes, that is right. A number of companies
have introduced market value adjusters to create fairness between
policyholders who stay in a fund and policyholders who leave early.
It is interesting to note that over the last ten years payouts
as a percentage of asset share, in every year except one, exceeded
100 per cent; it dipped in 1993. It will be quite interesting
to see therefore what that sort of background has done to create
policyholders' reasonable expectations in the event that bonuses
need to come down and policy values are reduced. Our feeling is
that life offices are taking a careful look at what they can do
to make sure that the asset share ratios are preserved. That is
why we have seen some reduction in bonuses, it is why we have
seen some increases in market value adjusters and for those who
have not had them at all, that has been introduced. I think that,
going forward, they are getting their liabilities properly matched
to their assets. I do not think there is a widespread problem
at the moment with this.
26. Is not the essence of smoothing that at
times some individuals get more than their precise asset share
and some get less?
(Mr Tiner) That is the exact purpose of smoothing
so that a longer term investor, which is typically what a with
profits fund is for, is able to take benefit over a period of
years which has been earned by that individual rather than the
level of the stock market or the gilt market or whatever at a
27. Could you tell us what the precedents are,
either in the UK or abroad, for a relaxation of resilience tests
or similar as applied to life assurance companies?
(Sir Howard Davies) It is worth saying that relatively
few overseas countries have a life insurance industry structured
like us with the kind of with profit funds and also with the size
of the equity portfolios as large as is typically the case for
the UK. Most other countries do not have that kind of life insurance
industry. In the countries where they do, and probably the Canadian
position is the most relevant as their industry is probably the
most like ours, they typically do not have resilience tests which
are specified with the precision that ours have been in the past.
They have tests which are couched more as our regime now is in
fact following this temporary relaxation. In other words, each
individual company's actuaries must take a view, must make a reasonable
margin of assets above liabilities and they are not required to
do so in relation to a specific percentage figure. It is more
of a judgement. I could not point to an example of where another
country had specifically relaxed a resilience test, but mainly
because I do not think I could point to another country which
has resilience tests of that sort.
28. Clearly you think the tests are flawed for
the circumstances of volatile markets. Are you going to get rid
of the old test permanently?
(Sir Howard Davies) Two of the three tests which we
relaxed we had already decided were no longer appropriate and
they were consulted on as part of our prudential sourcebook, as
we call it, the new set of capital rules for the new regime. We
had explained why we thought they were no longer necessary and
there had been broad agreement in the market that they should
be relaxed. The third one we had left in place, but as part of
our continuing review of our insurance regime it is something
we wish to question and we wish to assess whether or not in future
to have that particular type of formulation is appropriate. I
should say that I would not look at this as purely about relaxation
because we believe there are other issues in insurance portfolios
where there needs to be more stress testing and indeed we think
that some of the evaluations in insurance funds need to be reviewed.
It is not just about relaxing that particular test, we believe
there needs to be an overhaul of the prudential rules for insurance
companies more generally.
29. That is a very helpful answer because there
is a view that relaxation makes the regime look a bit sloppy.
Some commentators have pointed that out. Could you very briefly
explain what the other areas of stress testing might be and when
you might be bringing forward consultation on those new and needed
(Sir Howard Davies) The kinds of things that we have
in mind are first of all the way in which certain liabilities
are valued. A particular example of that is guarantees in policies
where we believe there are some issues. There are also ways in
which portfolios are stress tested against different combinations
of economic circumstances, where we think that the technology
of doing so in the banking sector is possibly rather further advanced
than it is in the insurance sector and we wish to learn some lessons
from the banking sector into the insurance sector. This issue
is likely to come up when we next meet because there are some
recommendations flowing from an analysis of the Equitable affair
which will be in this area.
30. In one of your press releases you described
the relaxations as temporary. I am not now quite clear, given
what you have said in the last few minutes, whether they are or
not. Can you just clarify the situation on that?
(Sir Howard Davies) They are temporary certainly in
a sense, but the regime we currently have with those relaxed and
nothing else put in their place is unlikely to be what we want
to be for the future. We should like to open up this issue in
a broader way in terms of what kind of tests we have. It may be
that if it is going to take us some time to do that, we would
want to reinstate the ten per cent for a period, but as a long-term
objective we would not wish to go back just to having that ten
per cent test and no other reforms.
31. This is the puzzle. In what circumstances
would you reintroduce a test? Is it not worthless if the market
knows that if difficult circumstances return you take it away
(Sir Howard Davies) While we have removed the particular
number, we have not removed the requirement for companies to take
a prudent view of the margin of the relationship between their
assets and their liabilities. That particular relaxation has not
had the significance that some have wanted to give it.
32. Who is defining "prudent" in these
(Mr Tiner) It is the responsibility of the appointed
actuary to make prudent provisions for sensitivity of their assets
and we have provided guidance to them through the resilience tests.
In fact, by relaxing the resilience test which tests for a ten
per cent fall in equity prices, we have relaxed some guidance,
not a rule. It has nevertheless always been the responsibility
of the appointed actuary to work out prudent provisions. It is
our feeling that in more stable market conditions the ten per
cent test in the short term, up until we introduce new ways of
modelling variations in market prices and stochastic models, and
so on and so forth, should be reintroduced at some stage. What
we found in the past, and we last found this in 1998 after the
long-term credit management problems and the default of the Russians
on their rouble debt, that in very, very highly volatile and sharply
falling markets, the resilience test can actually have a perverse
effect. If there is a steadily declining market, the resilience
test is absolutely right to be applied, but in very, very volatile
and sharply falling markets, it can have a perverse effect.
33. So you are planning to bring some resilience
tests back in some form or another. Are you saying to us that
those are the ones which will hold in all circumstances, or are
they also only going to be good for stable markets and you will
dump them as soon as there is a difficult market?
(Mr Tiner) No, what we are saying is that we need
to work up some new overall test for resilience which perhaps,
though not as linear as the single ten per cent reduction, can
then stand the test of different types of market conditions.
34. Do you not feel in the interim that you
are relying pretty heavily on actuaries making their judgements
free from defined or linear guidance from you? Is it not risky
to be in that situation?
(Mr Tiner) Yes, we are relying on the appointed actuaries.
The appointed actuary has a legal obligation in fact to make what
he considers to be prudent provision. What we have done since
relaxing the resilience test, the ten per cent, is to increase
our involvement significantly in talking to appointed actuaries
to make sure that we are satisfied with the models they are applying
in the current market circumstances.
35. Were you worried that without those relaxations
there were life assurance companies out there which were on the
verge of going insolvent?
(Sir Howard Davies) No, what we were worried about
was that in order to remain solvent, they would be selling equities
in a declining market in a way they would not wish to do except
to meet this technical limit. Therefore it was a market disturbance
point, not that they would be going insolvent, because they could
remain solvent, but they would have had to shift much more massively
from equities into debt in a very, very short time, which might
have been destabilising for the market and against the interests
of their policyholders.
36. Are you concerned about the explosion of
with profits bond products and high income bond products with
very high profile initial rates of return which are in fact conditional
upon the stock market performance or rather complex supporting
(Sir Howard Davies) Yes, we are.
37. What are you doing about it?
(Sir Howard Davies) What we have done about it is
to issue a number of consumer alerts about this and emphasise
to people that there was a general problem of which this is a
specific example, that in the transition to a low inflation environment
there was still an expectation among many investors but also perhaps
more dangerously among many advisers that it was perfectly possible
still to achieve double digit rates of return without putting
your capital at risk. We have identified a number of products
which in our view are risky for investors and which ought to have
particular health warnings attached. With profits bonds are one
category. Another category was several what we call exotic ISAs
which were ISAs based actually on European hedge funds which had
income units and capital units but where the capital was at risk
and was maintaining a high income. There have also been split
capital investment trusts or so-called barbell trusts with zero
shares and capital shares and income shares designed to produce
a high headline income figure but where the capital shares were
volatile. So we have put a lot of effort into alerting people
to the risks of these products. That is probably the most effective
thing we do. If in our monitoring we identify that there are particular
financial advisers or brokers who are advising relatively unsophisticated
investors to go into these products and not alerting them to the
appropriate risks, then we would take regulatory action in those
cases. We have a consumer focused activity and then we have a
firm focused activity to try to deal with this.
38. It is fair to say that you are reminding
financial advisers of the dangers that investors might take, but
what are you doing with the architects, with the designers of
these products, High Street names who have billions of pounds
worth of investment locked into these kinds of products? What
are you doing with those?
(Sir Howard Davies) We are not in a general way a
product regulator, financial firms are entitled to design products
of this kind if they wish and there will be people, high net worth
individuals particularly for whom these may well be suitable as
long as they understand the risks they are taking on. It is not
open to me to ban products of this kind and I would not be justified
to do so. The issue is: for whom are they suitable and do the
people who buy them understand the risks they run?
39. Are you saying that at no stage has the
FSA held up yellow cards to some of these High Street names who
are pushing these products?
(Sir Howard Davies) We did do so in the case of what
we called exotic ISAs last year where we issued a very stern alert
and we had a major impact on that market. These products were
not very extensively sold as a result. I do not think that we
are able to outlaw with profit bonds full stop. Indeed I would
think it not justifiable to do so.