Select Committee on Treasury Minutes of Evidence

Exmination of Witnesses (Questions 163-179)




  163. Good morning, Sir Howard. Welcome back again to another evidence session of the Committee. For the sake of the shorthand writer, would you introduce yourselves, please?
  (Sir Howard Davies) Howard Davies, Chairman of the Financial Services Authority; accompanied by John Tiner, Managing Director of the Authority, responsible for Consumer Investment and Insurance affairs.

  164. Thank you, Sir Howard. Do you think that a good relationship between regulator and those you regulate is necessary for the FSA to do its job properly?
  (Sir Howard Davies) Yes.

  165. If so, does this reliance on a good relationship indicate that the FSA should have stronger powers in order to avoid being bullied?

  (Sir Howard Davies) The regime we have established for the future rests on a set of principles, which we think anchor the regime and give regulated firms an idea of their responsibilities and the relationship they ought to have with the regulator. Those principles, which begin with the simple expression that a business should treat its customers with integrity, also include the requirement to be open with the regulator; and, indeed, in the case of international business, open with regulators of other parts of the business. I think that general principle, which we regard as being an enforceable principle, is and ought to be for the future adequate to require firms to develop the relationship that we would like.

  166. I am thinking here about your answer to question 8 at a previous session which I put, when you said with regard to Equitable: "I am afraid here, Chairman, we were dealing with a company which had an arrogant superiority . . . and did not deal with the regulator in the way we would expect. Quite out of character with the relationship that we have with most firms, certainly with most banks and, indeed, increasingly with most insurance firms". When I mention the word "bullying" I took it from the answer to that question. Do you think more powers are needed to deal with another Equitable Life?
  (Sir Howard Davies) I do not think so for the future because, as I have said, the new regime will be anchored in these principles. These principles have been adapted from those which were used by the Securities and Investments Board in the past; they did not in the past, however, apply to insurance companies. Therefore, what we have done, as we see it, is to take the best bits of the different parts of the old regime and use them for the new. I would hope that, resting on those principles, the new regime and new sets of relationships we have with insurance companies will be better than they were in the past and will avoid the kinds of situations that we had with the Equitable developing in the future.

  167. Could I take it then that the regulator was impotent with regard to Equitable Life? The reason I say that is you mention in your evidence that the company resisted your attention; they went ahead with a court case without consulting you; "the company resisted us at every turn, complained to ministers, threatened judicial review". It does not seem to me as if a regulator has much handle on a company that acts and behaves in that particular fashion?
  (Sir Howard Davies) I think that "impotent" would be much further than I would be prepared to go; because we were prepared to fight them on judicial review, would have done so and, I believe, would have won that case (or I hope we would have done), and the company backed down on that point. Also, of course, the minister concerned gave them a dusty answer when they attempted to use that route. I do not think one could use those particular examples to say that the regulator was, in the end, impotent. I think the question that is more relevant, and where the Baird Report makes its strongest points, is that if the regulator is to have a proactive relationship with companies, and to act in an anticipatory and problem-solving way, which is the way we like to do, then you need to have a relationship whereby companies come and explain their problems to you and seek to discuss sensible solutions to them. I think it is more speaking to the character of that kind of relationship, to allow us to use our problem-solving abilities to the full, that the report is speaking to. That is typically the relationship that we seek to have with banks and insurance companies now.

  168. That is to the future; we are looking at the moment, to the past, with Equitable Life. I would put it to you that, to many people on the outside, the regulator looked powerless and, indeed, vulnerable to being overtaken by events. It is a matter of record that the regulator sat and watched three court cases going through. No doubt they were alert to the problems but you felt, from what I can gather, that you could not take any action until the cases had been heard. With hindsight, as a regulator, I would put it to you that you did nothing effectively. It does not seem to us as if you had any contingency plans. Would you do things differently in the future; and how could you avoid another Equitable Life situation?
  (Sir Howard Davies) I am afraid, Mr Chairman, I would not wholly accept that characterisation. I do not think any scheme of financial regulation will avoid the fact that there are aspects of the regime which will go through the court system; and that will be the case in the future as well. I think, as the Baird Report explains, there is an interrelationship between the regulations and the rules of the prudential regulators and the interpretation the courts put on contracts, and that is just something one has to live with. Indeed, the Report addresses the question directly, which we have thought about ourselves, as to whether it would have been possible for the regulator in some way to intervene in the case to try to promote a more satisfactory outcome; but the review team, with the benefit of their own legal advisors, have concluded that that would not have been an appropriate thing for the regulator to do; and it was not clear what the regulator's locus would have been in an action which is essentially about the interpretation to be placed on contracts. I think one always has to live with the fact that there is that interrelationship between regulation and the law: but what we hope to do with companies is to seek to game plan how they can get through difficult positions, and we do that all the time. We always have a number of companies who are potentially in difficulty, and we normally try, certainly from a prudential regulatory point of view, to seek ways with them of managing them through that difficulty.

  169. What did you do in the case of an Equitable Life contingency plan?
  (Sir Howard Davies) What I was coming to was, we did look at what the potential outcomes of the case were; but, as the report points out, when the case started, which was at the time when the regulation was still in the Treasury, the company did not discuss with the regulators whether it was sensible to take the case in the way that it did, and how it should manage the process through; it did not seek to do that and presented the Treasury regulator at the time with a fait accompli. That is not the way we like to operate with companies. Prudential regulation is a matter where you have to be in problem-solving mode; because, frequently, to precipitate a crisis in a company can be very damaging for its depositors or its policyholders. That is the character of the relationship we want. What I was drawing attention to in the last hearing was that we clearly did not have that relationship in this case; I hope that in the future we will. Certainly I have been encouraged by the fact that a number of insurance company chairmen have said to me that one conclusion they have drawn, both from this episode but also from the fact they have now looked at the way banking supervisors have operated in the past, is that we should be having much more of that kind of relationship with insurance companies; and that the remote relationship there was in the past, which was a very distant one with the government departments and with the government actuaries department, is not one which is best suited to the uncertainties and the difficult environment in which insurance companies work.

  170. If I may say so, Sir Howard, I consider that was an opaque answer to the relationship between the regulator and Equitable Life. You have mentioned what you are going to do in the future; but we still have no further idea about what I consider to be the impotence of the regulator with regard to Equitable Life. Notwithstanding that, you mentioned in your last session that Equitable Life has always met its regulatory requirements. Are you concerned, therefore, that the regulatory requirements are a poor guide to the true financial state of a life assurance company?
  (Sir Howard Davies) In some respects, yes, they are. The Baird Report draws attention to the most obvious drawback in relation to the Equitable—and that is the way in which guarantees are valued, or not valued, in insurance company balance sheets: in that there was no value placed on these guarantees unless interest rates fell below the level of the guarantee. Whereas in the normal way, when one is thinking about valuing an option in securities markets or in the banking industry, one considers that the option clearly has a value, even if that particular day it cannot be exercised, because there is clearly some probability in the future that it may be valuable; therefore, you do attach a value to a guarantee or an option. In a sense, these were uncovered interest rate options that the company was writing. It is clearly inadequate that the current rules for insurance companies do not capture that kind of liability. We are determined that in future they will, and that is a specific recommendation of the Baird Report which we are carrying forward.

  171. Are other companies complying with the regulatory requirements yet, or could find themselves in a serious problem like Equitable Life?
  (Sir Howard Davies) There are certainly companies who are complying with the regulations at the moment and where, in the past, there have been no values attached to guaranteed liabilities. I have to say that, since the House of Lords' judgment has clarified that, those companies have put in reserves for those guaranteed annuities. I am fairly certain there is not a company at the moment that has an obligation in relation to guaranteed liabilities which has not now been disclosed; but that certainly was the case before the House of Lords' judgment.

  172. There is nothing on the radar screen which would indicate any alarm on your part with regard to any other companies?
  (Sir Howard Davies) That is a fairly strong statement.

  173. It is a question.
  (Sir Howard Davies) Certainly not alarm. There are always a number of companies in the insurance sector and elsewhere which we are watching more carefully than we are watching other companies, because their solvency position may be close to our trigger point—and that may be the case in banks. There is always quite a number of companies which we are looking at carefully. I certainly would not put that at the level of alarm at this point.

  174. You did mention there were going to be big changes to the regulatory regime—that would imply big changes perhaps to the solvency regulations. If the FSA tighten the regulatory regime, are you concerned that some life assurance companies may find that they are unable to meet the new requirements?
  (Sir Howard Davies) I think that, as we change the regime, we would clearly want to do so with appropriate notice. Indeed, we would almost certainly be obliged to do so in terms of our EU obligations etc. Quite a number of the solvency requirements are international in nature. I am quite sure that as we change we will want to give companies time to adjust their balance sheets and adjust their capital position in order to meet them. It would not be fair to look at what we might do and look at the current position, because companies would have time to reserve more appropriately if we did not choose to change the solvency rules.

  175. You mentioned earlier about Equitable valuing its options—if it had valued its options, as you would have wished, would this problem now have been avoided?
  (Sir Howard Davies) It would have been addressed earlier. I think what would have happened is that, over time, the company would have had to keep a reserve in relation to the cost of these guarantees; and that reserve would have needed to be built up over a period. I think that, as interest rates fell in the 1990s, it would have been necessary for that reserve to be increased; but the company could have done so over a longer period of time. I think the position of non-guaranteed policyholders might well not be so significantly different today at the end point - because it is important to note that no money has disappeared from the Equitable by fraud or anything; this is a question of distribution within the fund as to which policyholders are entitled to what—but it would have been necessary to provide at an earlier stage, through lower bonuses and higher reserves, for the cost of those guarantees. The rather painful and sudden adjustments that have had to be made within the Equitable's reserves would have been done over a longer period of time.

  176. It would have implications for marketing?
  (Sir Howard Davies) Yes, it would have, certainly.

Dr Palmer

  177. Does that mean that during the transition period for historical reasons, which I do understand, the regulatory requirements will not be an adequate guide to financial health for certain other life assurance companies?
  (Sir Howard Davies) No, I think one frequently faces the position that, in the light of better information and better understanding of risks and markets, one changes prudential rules. We are in the course of doing that on a huge scale in relation to banks at the moment in the Basel committee which has overhauled banks' capital rules in a fundamental way. Technically you could say now that there are banks who currently perhaps do not hold as much capital as the new rules will indicate that they should. I think it is a little bit harsh to produce a conclusion from that, that they are wrong at the moment. They are meeting the current regime, and no doubt when the new one comes in they will meet that as well.

  178. I am not seeking to blame the companies, but you did say in response to an earlier question from the Chairman that the regulatory requirements were a poor guide or inadequate guide to the financial state of life assurance companies under certain circumstances, and that is why you are changing the rules?
  (Sir Howard Davies) Yes, indeed that is true.

  179. I think it is a point of fact, is it not, that there may be companies at present for whom the current regulatory requirements do not adequately show the position, otherwise you would not change the rules?
  (Sir Howard Davies) Yes, that is most logically true. It would be possible to give a clearer view of the risks inherent in their portfolios through different rules, yes, that must be true.

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