Select Committee on Treasury Written Evidence

Memorandum from the Financial Services Authority


  1.  The purpose of this Memorandum is to update the Committee on regulatory issues arising from the EU's Financial Services Action Plan (FSAP). In particular, the Memorandum:

    —  Outlines the background to the preparation of the FSAP, at the instigation of the European Heads of Government (section B).

    —  Summarises recent developments in preparing legislation under the FSAP and examines some current initiatives likely to influence the post-FSAP agenda (section C).

    —  Comments in more detail on two of these initiatives—the Report from the Financial Services Committee to ECOFIN on Financial Integration (17 May 2004; FSC 4156/04) and the reports of four expert "Forum groups" of industry practitioners (section D).

    —  Notes the position on an integrated retail market for financial services in the EU (section E).

  2.  Negotiation and implementation in the UK of EU legislation is, of course, the responsibility of HM Government. The vehicle for implementing Directives affecting financial services is (for the most part) rules made by the FSA. For this reason we work very closely with the relevant Government Departments (mainly Treasury) in the relevant EU fora. Our work is guided by our statutory objectives: maintaining confidence in the UK financial system, promoting public understanding of the financial system, securing the appropriate degree of consumer protection and helping to reduce financial crime. The Financial Services and Markets Act requires us to take into account the international character of financial services and the UK's competitive position. We aim to promote a well regulated wholesale market which is efficient, orderly and fair and to help retail consumers achieve a fair deal.

  3.  To help achieve our aims in these truly global markets, we continue to devote significant resources to policy development at the European and international levels. We are committed to producing better regulation in the EU, in recognition of the need to facilitate competition and innovation and maintain the competitive position of the EU, and of the UK within it. We believe that better regulation will be best achieved by cooperation with other EU financial regulators through the "Lamfalussy" committee networks. These networks will play a critical role in identifying whether, and if so where, new measures are needed to achieve a more effective EU regulatory environment. In doing this, we see a need for greater use of cost-benefit analysis and impact assessments of any new measures.

  4.  Our principal focus is now on timely implementation and effective enforcement of FSAP measures. We have worked to implement several major pieces of EU legislation, including directives on Insurance Mediation, Distance Marketing, Financial Groups and Market Abuse. Our general approach is to implement directives straightforwardly and in a way which does not introduce additional layers of regulation (known as "superequivalence") unless a rigorous case can be made that such superequivalence is in the interest of maintaining appropriate standards in UK markets.

  5.  The financial services directives will have a significant impact on issuers, firms, investors and consumers. We are aware of the heavy implementation burden on firms and have urged them to consider the implications for their business. To facilitate this process we are working with the Treasury to sequence our implementation work and where possible to produce joint consultation papers to lessen the burden on firms.


  6.  In June 1998, the Cardiff European Council invited the European Commission to table a framework for action to develop the Single Market in financial services. In May 1999, the Commission published a Communication containing a Financial Services Action Plan which was endorsed by the Lisbon European Council in March 2000. The purpose of the FSAP was to produce a set of measures intended by 2005 to create a legal and regulatory environment which would support the integration of EU financial markets. The FSAP focused on three specific objectives:

    —  to create a single EU wholesale market;

    —  to achieve open and secure retail markets; and

    —  to revisit prudential rules and structures of supervision.

  7.  The programme of legislation set out in the FSAP is now almost complete. It has been accompanied by a new approach to developing and adopting EU financial services legislation, based on the recommendations of a Committee of "Wise Men", chaired by Baron Alexandre Lamfalussy. The "Lamfalussy" approach was adopted on 6 June 2001 for securities measures, and since its formation a number of the FSAP measures have been adopted using this new process.

  8.  The Lamfalussy Committee recommended a four-level decision-making process for EU securities legislation:

    —  High-level framework legislation is proposed by the Commission and adopted under the "co-decision" procedure (level 1).

    —  The framework legislation is supplemented at level 2 by more detailed implementing measures, adopted by the Commission and endorsed by a qualified majority of Member States. The detailed level 2 legislation is prepared by the Commission on the basis of advice provided by representatives of national supervisory authorities, acting through level 3 committees. In finalising their advice, the level 3 committees consult extensively with providers and users of financial services.

    —  The level 3 committees also work together to facilitate consistent implementation of Community law and to foster supervisory convergence and best practice.

    —  Finally, at level 4, the Commission ensures that Member States are complying with the applicable legislation and pursues enforcement where required.

  9.  The system is designed to provide for greater flexibility to modify the applicable legislation as and when market and supervisory developments require it. These new arrangements also ensure that open consultation procedures, expert regulatory input and greater transparency are an integral part of the legislative process.

  10.  Although initially introduced for securities legislation, this approach has now been extended to cover legislation on banking, insurance and pensions and asset management. Two new level 3 committees have been formed. The Committee of Banking Supervisors (CEBS) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) will fulfil for banking and insurance the role which the Committee of European Securities Regulators (CESR) has been undertaking in the securities field.


  11.  Good progress has been made in the legislative phase of the FSAP. This is only the first stage, however; effective implementation of the measures included in the legislative programme is an essential next step. With the completion of the legislative programme, the attention of all interested parties has turned to the extent to which the objectives for the single market have been met, identification of the remaining gaps and barriers and the means by which these might be addressed.

  12.  In May 2004 the UK authorities—HM Treasury, the Bank of England and the FSA—published two papers setting out their contribution to this discussion. We have supplied the Committee with copies of both documents. Firstly, The EU Financial Services Action Plan: Delivering the FSAP in the UK reviews the progress of the FSAP, sets out in some detail the state of play on individual measures, and provides an explanation of how EU financial services legislation will be implemented in the UK. Secondly, After the EU Financial Services Action Plan: A new strategic approach sets out five UK priorities for guiding action in future. These are as follows:

    —  There should be better implementation and enforcement of EU measures affecting the financial sector.

    —  Greater consideration should be given to alternatives to EU regulation.

    —  There is a need for a "better regulation" approach, including the use of market failure and cost-benefit analysis, as well as full consultation with financial market participants.

    —  The Lamfalussy arrangements now need to be fully developed to reach their potential.

    —  There needs to be full recognition of the global nature of financial services.

  13.  At the EU level, two particular initiatives are likely to play a key role in influencing the form and content of the post-FSAP agenda.

  14.  Firstly, the Financial Services Committee (FSC), comprising senior officials from EU Finance Ministries presented a report to the June ECOFIN meeting of Finance Ministers [FSC 4156/04, 17 May 2004]. The report assessed the current state of financial integration and offered advice on the next steps in completing the Single Market in financial services.

  15.  Secondly, the Commission established four expert groups of industry practitioners and other market users from the Banking, Securities, Insurance and Pensions and Asset Management sectors. These expert "Forum groups" were asked to assist the Commission's work in assessing the state of integration of European financial markets. The Forum groups have produced reports proposing how to advance financial market integration. These have been the subject of wide consultation and a high-level conference in June. Public consultation is continuing until early autumn, after which Commission officials will prepare recommendations for the new Commission.

  16.  Inevitably, the FSC report and the reports of the Forum groups reflect the particular priorities and preoccupations of their respective authorship. However, a number of themes and key points in common do emerge and these seem likely to inform the work programme on financial services when the new Commission comes into office on 1 November. Encouragingly, the UK priorities detailed above have also been largely picked up by the FSC and Forum group reports.


  17.  This section outlines the principal recommendations which emerge from the FSC and Forum group reports. Key points are set out in italics below, followed by FSA reaction and comment.

Full and consistent implementation and effective enforcement of all FSAP measures must now have priority.

  18.  This is a key priority. Full implementation and enforcement of the FSAP measures in all Member States is essential before the FSAP programme as a whole can be judged to be a success. The legislation can only make a difference to the efficiency and openness of markets if it is fully and consistently implemented throughout the EU.

  19.  Although some of the FSAP directives have been implemented in the UK and other Member States, the majority of the measures will need to be implemented over the next two to three years. All the directives require (or have already been the subject of) action in the UK. This represents a significant challenge for the legislative authorities and firms in the UK. The FSA's role will be to make new rules in accordance with the procedures set out in the Financial Services and Markets Act.

  20.  The FSA is working closely with HMT to ensure the consistent and prompt implementation and effective enforcement of the FSAP measures. In particular, we are seeking to ensure that implementation is effective, proportionate and consistent, making use of consultation and cost-benefit analysis at an early stage. A minimum approach—which does not go beyond that which is necessary to comply with the directive—will be the general policy approach. Superequivalence in the implementation of measures will be the exception and will need to be fully justified on cost benefit grounds. The UK authorities are committed to consulting closely with the financial sector throughout this process and will aim to provide adequate lead time (at least three months of certainty and, where possible, six months) before firms are required to operate within the new rules.

  21.  Implementation of the FSAP measures will be a substantial challenge for firms. To take full advantage of the opportunities presented by the new legislative environment, senior management need to prepare for the strategic implications of a more integrated financial services market. At the micro level, they will need to ensure that their business practices and systems are compliant with the new rules. The effect of this will undoubtedly place a heavy demand for implementation resources on authorised firms over the next few years.

The Lamfalussy committee structure is of central importance in ensuring effective implementation of financial services legislation and in promoting supervisory convergence and co-operation.

  22.  The Lamfalussy arrangements have made a good start. Within the securities field, in particular, CESR has already played an important role in providing technical advice on a number of FSAP directives, including those on Market Abuse, Prospectuses and Markets in Financial Instruments.

  23.  There are significant challenges ahead, however, if the arrangements are to work well in practice. The new Level 3 committees (CEBS and CEIOPS) need to establish themselves quickly and prioritise their work effectively to meet the demands of providing technical advice on a significant amount of level 2 legislation. All three committees will also need to focus increasingly on implementation issues and the convergence of supervisory practice. Further co-operation on enforcement will also be required.

  24.  Notwithstanding this forthcoming period of intense activity for the committees, it is important to remember that these are still relatively new arrangements and that they will need time and space to demonstrate what they can achieve. The FSA fully supports the Lamfalussy arrangements and the transparency, consultation and technical expertise which they bring to the EU legislative process. We believe the arrangements will lead to closer links between national regulatory authorities and promote a co-operative, practical approach to finding solutions to everyday regulatory problems. The UK is keen to emphasise and develop a broad approach to the work of the level 3 committees in particular. While advising on legislation and developing detailed rules is an important function, we would wish to see them using a broad range of regulatory and supervisory tools to facilitate supervisory convergence and co-operation.

  25.  The FSA acknowledges the considerable effort that will need to go into making the system work at each of the four levels. We are fully committed to providing appropriate support and resources. FSA is an active participant at a senior level in all three committees, with FSA Chairman Callum McCarthy as a member of CESR, Chief Executive John Tiner as a member of CEIOPS and Managing Director Clive Briault as a member of CEBS. FSA is also committed to providing suitably experienced personnel both to serve on the Committees' working groups and to work as secondees within the secretariats.

Further measures towards integration should be based on a systematic analysis of remaining obstacles and the impact of any measures which may be taken to address them. Legislation should only be introduced where it is demonstrably appropriate.

  26.  This is consistent with the message which the FSA has been communicating for some time and which we aim to apply to our domestic policy formation. Regulation imposes costs on market participants and it is important to be able to demonstrate that the benefits of individual regulatory measures justify such costs. It is important that decision-making disciplines are fully integrated into the Commission's approach to any future work programme on financial services. In particular, the Commission needs to use market failure and cost benefit analysis when assessing whether legislation is appropriate. The UK will also keep up pressure on the Commission to consider the range of possibilities offered by non-legislative policy options. Finally, the UK is strongly of the view that, while legislation may have an important role in removing barriers to the development of a single market, its role is essentially an enabling one. Once barriers are removed, the extent to which a single market develops and the pace of this are matters for the market itself. There is no role for regulation in forcing the pace in this regard.

  27.  The Commission's 2002 Better Regulation Action Plan introduced a system of extended impact assessments for all significant proposals. An initiative by the Irish, Dutch, Luxembourg and UK Presidencies of the EU (Joint Initiative on Regulatory Reform, January 2004) offers further proposals to enhance the impact assessment process. These initiatives offer a good basis for improving the quality of new legislation.

The importance of promoting financial stability and market integrity

  28.  Co-operation among EU supervisors, central banks and finance ministries will be key to ensuring the right framework is in place to address financial stability and market integrity concerns. This needs to be accompanied by dialogue with key international players. In those areas such as accounting and auditing standards which are best addressed at the international level, it is essential that the EU plays an active part in the negotiation and conclusion of the relevant international agreements.

  29.  The FSAP recognised the need to modernise the EU's accounting directives and there is clear agreement in Europe that a single set of consistently applied accounting standards is crucial to the development of integrated EU capital markets. The EU is committed to require all listed European groups to use International Accounting Standards for their consolidated accounts from 1 January 2005. The process of endorsing the standards for use in the EU works reasonably efficiently in most cases, but has run into major problems on the standards on financial instruments (particularly IAS 39 Financial Instruments: Recognition and Measurement). The continuing uncertainty about the extent and timing of a standard on such an important topic is potentially damaging for market confidence and does not create a good precedent for the way in which difficult and controversial issues will be dealt with in the future. The European Commission has suggested that it might remove some paragraphs of IAS 39 to overcome some of the banking sector's concerns and so achieve consensus. The FSA is clear that it would not be in the interests of markets and investors for the Commission to seek to change the detail of an accounting standard that has been set by an independent internationally respected standard setter. We would prefer some form of deferral of the endorsement decision which would allow companies to apply the standard on a voluntary basis.

  30.  The FSA would also highlight three important FSAP sectoral initiatives which are still under negotiation and which will be crucial to ensure that prudential requirements for EU financial services firms are flexible, efficient, relevant and risk-sensitive.

  31.  The Capital Requirements Directive (CRD) will implement, in the EU, the proposed new Basel Framework that updates the existing capital adequacy rules for banks and will extend those rules to other credit institutions and investment firms in the EU. Basel II and the CRD represent an important opportunity to make capital requirements more risk-sensitive and to enhance the practice of risk-based supervision, including improved dialogue between firms and their regulators and greater transparency.

  32.  Solvency 2 offers the opportunity to update the capital regime for insurance firms in the EU, improve the distribution of capital among regulated firms and provide incentives for better risk management. The UK has, in a domestic context, been placing prudential requirements for insurance on a more realistic basis. Solvency 2 provides the opportunity for extending such an approach throughout Europe.

  33.  The Reinsurance Directive will bring pure reinsurers within the regulatory net across the EU and encourage the development of robust international standards on reinsurance supervision.

  34.  We see these initiatives as helpful to ensure that the EU financial framework is sound, flexible, efficient and capable of evolution in line with changes in regulatory approach and in industry risk management practice. Working with the Treasury, we will continue our efforts to secure favourable outcomes in all of these initiatives, both during the negotiation and in subsequent implementation phases.

The global dimension is of key importance

  35.  Both the FSC and the Forum group reports highlight the importance of recognising the global nature of financial services. In view of London's position as Europe's largest financial centre, it will be essential to ensure that all future EU financial sector policy initiatives are framed with appropriate regard to their global impact. This will help to ensure that European financial services firms remain competitive and that London is able to compete effectively to maintain its pre-eminent position within Europe and globally.

  36.  Dialogue with key global centres, particularly the US, will remain an integral element of future strategy. It is important that, in developing policies that potentially have a global impact, the authorities in the EU and other global financial centres are aware, at an early stage, of each others' thinking. An encouraging start has been made. In particular, dialogue has brought the EU and US closer to agreement on key issues such as auditor registration and accounting standards issues. This now needs to be built upon, both to widen the dialogue to include relevant and timely input from other key players (for example, the level 3 committees, the financial sector and its users) and to create a more forward-looking agenda which can anticipate issues and exploit opportunities for global convergence.

  37.  This approach should help to foster understanding and promote greater openness and integration. Such co-operation is vital to addressing global financial problems. It will also offer the EU the possibility of promoting FSAP objectives on the world stage.

Areas for future action

  38.  Clearing and settlement arrangements within the EU currently fail to provide efficient processing of cross-border transactions and impede the development of a fully functioning single market. The FSC report invites the Commission to propose an initiative in this area, on the basis of its recent Communication. The Commission has committed to conducting a full impact analysis of any initiative.

  39.  We are inclined to support a framework directive in this area to tackle the market and regulatory failures which have been identified, providing any directive could be shown to promote a competitive and innovative clearing and settlement market and can be justified on the principles of good regulation. Our own preliminary analysis suggests that there are indeed some barriers to the effective operation of an EU market for clearing and settlement which may require a public policy intervention. We believe such an intervention should be narrowly focused on enhanced rights of access and choice and a common regulatory framework for addressing systemic risk.

  40.  In addition to this, the FSC report highlights four key general areas which are particularly influential in the financial services sector and which might be the subject of further examination within the post-FSAP framework: general consumer protection, private law, competition policy and taxation.

  41.  This provides an important reminder that the achievement of financial integration within the EU will depend upon a range of factors which go beyond the legislative programme set out in the FSAP. At the level of specific legislative initiatives, there are a number of single market provisions which affect financial services, but which do not form part of the FSAP, such as the Electronic Commerce Directive, the Unfair Commercial Practices Directive and the Consumer Protection and Co-operation Regulation. Action by the Commission to iron out ambiguities stemming from compromise positions and to identify and address inconsistencies between existing Directives (the FSC report alludes to the need to do this in respect of the e-commerce framework) will be a useful contribution to creating a more certain legal environment in which business can undertake financial services within the EU.


  42.  A single EU retail market remains a considerable way off. The FSC report does not explicitly propose any specific action plan to address this, although, it does indicate that general consumer protection, taxation and private law should be the subject of further examination within the post-FSAP framework. None of the Forum reports comes out in favour of a specific retail market action plan. Indeed, they urge the EU to take a very cautious approach, based on careful analysis of the existing barriers and adhering to better regulation principles. The FSA's view is that many of the barriers are not removable through financial services regulation.

  43.  We will keep pressure on the Commission to conduct an in-depth review of retail financial services markets and consumers across the EU, so that the context and requirements for change can be fully understood before any proposals (legislative or non-legislative) are made in this area. While supporting the objective of a single market for retail financial services, we believe that the authorities' role in promoting this should be confined to identifying and, where possible, removing barriers to this using the tools available to them if these are appropriate. It is up to the market itself to deliver an appropriate degree of integration within this framework.

8 September 2004

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