Memorandum submitted by the Financial
Services Authority
A. INTRODUCTION
1. This memorandum is submitted in advance
of the FSA's appearance before the Committee on 8 November. We
look forward to elaborating on it in oral evidence.
2. The memorandum:
— provides background information on
the FSA, including on its scope and approach to regulation; and
— summarises the FSA's work during
the past year.
B. BACKGROUND
INFORMATION ON
THE FSA
3. Our starting point is the powers and
duties given to the FSA by the Financial Services and Markets
Act 2000 (FSMA). Central to this are the four objectives set by
the legislation (to maintain market confidence; to provide the
appropriate degree of consumer protection; to promote public understanding
of the financial system; and to reduce financial crime), and our
obligation to meet those objectives in ways consistent with the
principles of good regulation prescribed by FSMA (these include
proportionality, economy in the use of our resources, facilitating
innovation in financial services, taking into account the international
competitiveness of the UK and the responsibility of firms' senior
management). Our continuing concern is to discharge these duties
effectively.
4. We have translated our four statutory
objectives into three strategic aims, which guide our day-to-day
work and which reflect our organisational structure:
— helping retail consumers achieve
a fair deal;
— promoting efficient, orderly and
fair markets; and
— improving our business capability
and effectiveness.
The FSA's scope
5. We regulate an industry that contributes
5% of UK GDP and employs almost 1 million people, providing products
and services to millions of consumers. We regulate some 25,000
firms, ranging from major global financial groups to small financial
advisers, and around 165,000 individuals.
6. Our scope is decided by Government. FSMA
gives Treasury Ministers power to amend our scope through secondary
legislation. There have been several increases in our scope since
we gained our powers under the FSMA on 1 December 2001. In particular,
during the past year we have taken on regulation of mortgage business
and general insurance intermediation, which increased the number
of firms by over 14,000. As a result of this extension of our
duties, over 90% of the firms we now regulate are, in our terms,
small (in that they do not have a dedicated supervisor).
The FSA's approach to regulation
7. We want to promote effective working
of markets to deliver benefits for firms and consumers. We therefore
operate a risk-based approach, which enables us to focus our resources
and activities on the most significant risks. This approach accepts
that some failure neither can nor should be avoided.
8. We aim to work with the grain of the
market, introducing new rules, where we have discretion, only
where this is justified by market failure and cost-benefit analysis—in
other words, where we judge that market forces will not rectify
the problem, and where it is likely that the benefits of that
intervention would outweigh the costs.
9. While enforcement is an important part
of our regulatory apparatus, our day-to-day supervision of firms
and thematic work (where we seek to identify risks arising across
different types of firms and market sectors) play a vital role
in enabling us to achieve our statutory objectives, including
consumer protection. Where we identify emerging risks, we set
standards and work with the industry to mitigate them.
C. OVERVIEW OF
THE FSA'S
WORK DURING
2004-05
10. We published our Annual Report for 2004-05
on 29 June, giving a detailed account of our work during the year.
The Report was discussed at our Annual Public Meeting on 21 July.
Helping retail consumers achieve a fair deal
11. Our retail work is designed to make
a real difference to firms and retail consumers. We focus our
activities on four main aims: capable and confident consumers;
clear, simple and understandable information available for, and
used by, consumers; soundly-managed and well-capitalised firms
which treat their customers fairly; and risk-based regulation,
through firm-specific and thematic supervision, and appropriate
standards set out in our Handbook.
Financial capability
12. It is widely acknowledged that levels
of financial capability in the UK are unacceptably low. In pursuit
of our statutory objective to promote consumer understanding,
we have taken the lead in coordinating the work of a wide range
of partners in establishing a national strategy for financial
capability. Our own expenditure on financial capability has doubled
in each of the last two financial years, and now stands at £8
million. We established seven working groups for: schools, young
adults, the workplace, families, planning for retirement, borrowing
and generic advice. Achievements to date include: the development
of a web-based financial health check, now launched in partnership
with the BBC; developing a good practice guide, with case studies,
for improving the financial capability of young adults; and working
with various partner organisations to support students in higher
education.
13. The Financial Capability Steering Group,
which we chair, has agreed seven projects for substantial upscaling
from pilots already undertaken. The priorities are schools, higher
education, the workplace, maternity leavers, debt and financial
healthchecks, generic advice and the campaigns to promote the
FSA's services to consumers. Business cases are now being developed
to articulate the public policy and commercial benefits of the
individual projects. We expect to complete these by February next
year. Subject to persuasive business cases being developed and
sustainable funding being available, these seven projects will
be implemented nationwide. We are also analysing the findings
of our comprehensive baseline survey, which seeks to establish
the level of financial literacy among the population; its findings
will be published in February 2006. This will form the basis for
setting objectives for the implementation of the national strategy.
Consumer information
14. Good disclosure by firms to consumers
is critical to empowering consumers and enabling them to make
informed financial decisions.
15. As part of our new mortgage and general
insurance regime, we require intermediaries and lenders to give
their customers "Key Facts" documents. These provide
simple and focused information about a product, including risk
warnings, enabling consumers to access the key information easily.
We have worked hard to promote the Key Facts brand—through,
for example, advertising in the national press and through promoting
our Key Facts leaflets through libraries and Citizens Advice Bureaux—to
ensure that consumers are aware of, and look for, Key Facts when
considering buying products. Our research shows that consumers
value information which the regulator has required firms to provide.
16. Following the abolition of polarisation,
from the beginning of June this year we have required financial
advisers to give their customers a "Menu", explaining
the cost of investment advice. The Menu provides details of the
different payment options on offer (commission or fee), gives
an indication of what the costs will be, and provides information
on how the cost of commission for each product compares to the
market average. We regard this as an important step forward in
making the cost of advice more transparent to consumers.
17. In the light of the Committee's interest
in developing shorter, clearer information for consumers about
investment products, we have also published proposals for a short
"quick guide" summary sheet for investment products,
which highlights the most important issues consumers should consider
before purchase. This forms part of a package of measures we are
developing to help consumers better understand the risks and rewards
of packaged products such as investment bonds and personal pensions.
We plan to publish our proposals for consultation in March 2006.
18. An important resource is our consumer
website which, among other things, provides tools, such as comparative
tables and calculators, to help consumers make decisions. In October,
we launched a new jargon-free website for consumers to promote
our resources on mortgages. This site, designed as a first step
and not an alternative to advice, aims to promote awareness of
our range of tools and information for mortgage buyers. We also
produce, at any given time, over 30 publications on a wide range
of topics, including pensions, mortgages, basic bank accounts
and financial advice. We monitor developments in the market closely
and where we see trends that are a potential concern, we alert
firms and consumers to the risks and the actions they may need
to take.
Fair treatment of customers
19. A key element of our retail agenda is
our Treating Customers Fairly (TCF) initiative. Based on principles
rather than detailed prescription, our approach is to challenge
the senior management of firms to work out what TCF means in the
context of their business. We want TCF to be embedded within the
culture of a firm and within each stage of a product's life-cycle—from
product design right through to complaints-handling. To support
this, we have produced a number of real world illustrations of
good and bad practice as found by us in firms, and case studies
to show some of the considerations senior management should take
into account. We reported in July the progress that many firms
have made over the last year or so in undertaking a gap analysis—to
identify areas where they are not treating customers fairly—and
in moving forward into identifying and introducing any changes
arising from this. We have mainly focused on larger firms up to
this point, and on the retail savings market. We are now including
more medium and smaller firms, and we will also be reviewing TCF
issues in the mortgage and general insurance sector.
Our risk-based approach to the retail sector
20. We identify risks by monitoring information
from a number of sources, including market data, financial promotions
and our discussions with firms. For example, having observed a
rise in the number of so called "phoenix firms"—where
the directors of one limited company move with the assets to a
new company, leaving the liabilities behind and avoiding claims
from consumers—we thwarted 12 attempts to "phoenix"
in the last year. We have also undertaken work to maintain standards
among smaller financial firms, which has resulted in a number
of firms making changes to the way they operate, in order to address
serious failings, and has led to several losing their authorisation
to do business.
21. Through our risk-based approach we have
reformed regulation of the insurance sector, requiring all firms
to hold a level of capital that is sufficient to support the risks
they face. We have also worked with life insurers to bring about
improvements in the disclosure of with-profits products, to the
benefit of policyholders, and have taken steps to ensure that
acquirers of closed funds provide the appropriate level of service
and information to policyholders, and are fit and proper to manage
policyholders' interests.
22. As the Committee is aware, mortgage
endowments continues to be a priority area for us. Following our
intervention, firms have reviewed numerous sales in response to
complaints from consumers and have assessed whether compensation
should be paid; this has benefited tens of thousands of consumers.
By the end of 2004, major firms had paid around £1.1 billion
in redress to policyholders. We have worked with the industry
to ensure that consumers have clear and timely information on
the position of their endowment and assistance in considering
what action they may need to take in response. Consumer research
we carried out earlier this year showed that 69% of the 2.2 million
households with an endowment-linked mortgage had already taken
action to address their shortfall. We are now focusing our efforts
on those few firms that have not yet established appropriate complaint-handling
standards. We will require them to rectify the situation, and
where necessary, we will continue to use the full range of sanctions
available to us.
Mortgage and general insurance regulation
23. We began regulating mortgages and long-term
care insurance, following the Treasury's decision to extend our
remit, on 31 October 2004. In January 2005, the scope of our regulation
was extended further to include general insurance business, as
a result of the UK's obligation to implement the Insurance Mediation
Directive. In addition to brokers, other intermediaries and the
insurance mediation activities of product providers, it brought
within our remit the many firms which advise on and arrange general
insurance business as a secondary activity, for example, motor
dealers and property managing agents.
24. This was a major challenge—as
well as authorising over 14,000 new firms, we extended the permissions
of over 4,500 firms already regulated by us. Under both regimes,
consumers now have access to the Financial Ombudsman Service and
Financial Services Compensation Scheme.
25. Subsequently, we have been taking steps
to ensure that firms are aware of their new obligations. Where
firms give advice, they must recommend suitable products that
meet consumers' needs and, in the case of mortgages, consider
the affordability of any product they identify for individual
consumers. In the case of general insurance policies, consumers
must be given clear information on significant and unusual exclusions
from their policy before they buy, and on premiums and any fees
payable. Insurance intermediaries are also required to ensure
that client money is properly segregated and protected.
26. In the first year of these regimes our
supervision has focused on a number of areas, for example, policing
the perimeter (to identify firms that continue to conduct regulated
activities without authorisation to do so), adequacy of disclosure
(documents that should be handed to consumers before they decide
to buy a product), complaints-handling and sales of higher risk
products, such as Payment Protection Insurance and lifetime mortgages.
27. We commissioned a mystery shopping exercise
to test whether firms in the mortgage market were issuing the
Key Facts documents as required by our rules. The results were
disappointing. We will continue to monitor this area closely through
further supervision work, and if necessary, we will take enforcement
action. Our supervision of this sector has identified a number
of areas where we will need to continue to work with the industry
to ensure that consumers are protected appropriately, as we envisaged
when the regime was set up.
Payment Protection Insurance (PPI)
28. Before we began regulating general insurance
business, we identified PPI as a priority for thematic work because
of a relatively high potential risk of consumer detriment compared
to other insurance products. We have recently completed a review
of how firms have implemented our new rules. This involved visits
to 45 firms selling PPI with mortgages and secured loans (prime
and sub-prime), unsecured loans and revolving credit (credit and
store cards, and catalogues), and also mystery shopping across
19 firms. We will publish our findings on 4 November and will
ensure that the Committee receives a copy.
Lifetime mortgages
29. In establishing the new regulatory regime
for mortgages, in order to reflect the risks associated with lifetime
mortgages, we introduced additional requirements relating to advice
and selling standards and disclosure for these products. We also
identified lifetime mortgages as an early priority for supervisory
attention, given the higher risk nature of the product which offers
complicated terms to potentially vulnerable consumers.
30. We commissioned a mystery shopping exercise
at the end of 2004, to find out how the product was being explained
and sold to consumers. We found that advisers frequently failed
to get an understanding of customers' personal and financial circumstances
sufficient to enable them to make suitable recommendations. Advisers
often did not take proper account of situations where taking a
lifetime mortgage might affect a consumer's entitlement to benefits
or where they might be able to obtain grants and other help, for
example, from local authorities. We also identified significant
concerns in selling practices in seven firms we visited. We will
be undertaking further work in the first half of 2006 to test
whether firms have improved their standards in relation to the
key areas of concern identified in the previous exercise. Although
our general approach in the early stages of mortgage and general
insurance regulation is to give firms an opportunity to raise
standards of compliance across the sectors, we will take enforcement
action in the most serious cases.
Promoting efficient, orderly and fair markets
31. We seek to promote a well-regulated
wholesale market which is efficient, orderly and fair, and which
is internationally attractive and sustainable. The UK is the most
international capital market centre in the world: for example,
the most recent survey of the OTC derivatives market puts London's
share of daily global turnover at 38%, well ahead of any other
financial centre; the UK is the largest foreign exchange centre
in the world; and it is the largest centre of fund management
in Europe.
32. In the past year, we have concentrated
on ensuring that firms identify conflicts of interest which threaten
the proper working of the wholesale market and that they make
information available to the market in a timely and relevant way.
We have modernised and reinforced prudential rules and practices
and have acted firmly against behaviour that falls materially
below the standards we require.
33. We believe strongly that firms' adherence
to our Principles supports efficient, orderly and fair markets.
In a number of recent cases we have taken regulatory action where
firms have failed to conduct their business with due care, skill
and diligence and failed to control their business effectively.
We have also used our powers to bring criminal prosecutions against
individuals for market misconduct. We believe the outcomes of
such cases have sent strong messages to the market about the importance
of proper market behaviour.
34. An equally important issue in this context
is our work on market abuse. Our strategy involves tackling the
systematic abusers as well as the opportunistic ones; targeting
institutional abuse and insider dealing rings; and taking effective
action against cross-border abuse. Our emphasis is on detering
abuse rather than merely taking action after the event. We have
various initiatives in train here such as reviewing the anti-market
abuse measures which authorised firms have in place to ensure
they are effective. Our efforts to combat cross-border abuse are
strengthened by our close working relationships with overseas
regulators. We have increased the resources devoted to our general
anti-abuse work, enhancing both our market knowledge and intelligence
capacity. We are also upgrading the technology we use for monitoring
and analysing market transactions.
35. In recognition of the increasing influence
of EU legislation on our work, we are taking proactive steps to
influence the content of EU measures at the earliest possible
stage. We are also conscious of the need to influence issues at
a global level. Two areas on which we have taken the lead in this
way are hedge funds and bond transparency. On the former, we published
two Discussion Papers earlier this year setting out our view on
a range of issues including the role these firms play in the market,
the risks they pose and the extent to which retail investors should
have access to such funds. We have also recently established a
dedicated area of supervisory resource to monitor the activities
of the major hedge funds. In relation to bond transparency, we
published a Discussion Paper this year designed to stimulate debate
among market participants and allow us to develop an appropriate
policy in this area. The timing of the work was particularly important
as the European Commission will begin to consider this issue next
year.
36. In addition, we have worked with firms
and their trade associations to bring about industry-led solutions
to market failures. For example, in relation to soft commissions
and bundled brokerage arrangements, with our encouragement the
IMA, LIBA and NAPF created a credible solution to the transparency
and accountability issues we had raised. In addition, following
our concerns over the uncertainty in some aspects of insurance
contracts, particularly the delay between the inception of insurance
policy cover and finalisation of policy wording, we have challenged
the industry to develop a solution, as an alternative to regulatory
intervention.
Europe
37. The Financial Services Action Plan (FSAP),
endorsed by the Lisbon European Council in March 2000, was designed
to create an integrated EU financial services market by 2005.
The FSAP and other European directives shape the regulatory environment
in which we operate. A considerable amount of our policy work
is driven by the need to influence, help negotiate and then implement
European directives. Our Handbook is the main vehicle through
which directives affecting financial services are implemented
in the UK. We work very closely with the relevant Government departments
in the various EU fora.
38. Senior FSA management are actively engaged
in influencing the European agenda, including seeking to ensure
that the same disciplines that are applied to UK policy development
are applied in the EU. In particular, we dedicate a significant
amount of time to the "Lamfalussy" Committees, which
provide the Commission with specialist advice in preparing the
technical implementing measures for directives. Working to prepare
for timely and proportionate implementation of the Financial Groups
Directive, the Market Abuse Directive, Prospectus Directive, Transparency
Directive, Markets in Financial Instruments Directive and Third
Money Laundering Directive has been a key priority for us. At
the same time, we have continued to play an active role in negotiating
the Capital Requirements Directive, which implements Basel 2 prudential
standards for banks, other credit institutions and investment
firms within the European Economic Area.
39. In implementing EU legislation in the
UK, our approach is not to impose obligations beyond what is required
by directives (so-called "super-equivalence') unless this
is necessary to achieve our statutory objectives and can be justified
by cost-benefit analysis. However, there has not been an adequate
EU equivalent to our own approach to policy development, including
cost-benefit analysis and the requirement for proportionality.
We therefore wholeheartedly support Commissioner McCreevy's recent
emphasis on the need to undertake impact analysis from the earliest
stage for future directives. We encourage the UK financial services
industry and its representatives to take early opportunities to
contribute to policy thinking in the European Commission.
Financial stability
40. We work closely with the Treasury and
the Bank of England to test and develop the ability of the financial
authorities to respond effectively to a financial crisis. In December
2004, the Tripartite Standing Committee launched a resilience
benchmarking project to assess the robustness of critical components
of the UK financial services sector in the event of major operational
disruption (MOD). Its findings will be reported in December of
this year. On other, non-MOD sources of problems, we are active
participants in the periodic testing by the Tripartite authorities
of the financial crisis management arrangements; the latest such
test was held at the end of October. We have also worked on financial
stability issues in international fora, and have continued to
contribute to initiatives within the European Union to pursue
the financial stability implications of the increased integration
of financial markets, including the arrangements for managing
crises with cross-border significance.
41. Recent events have highlighted the potential
for terrorist activity to disrupt financial markets in the UK.
The City stood up well to the events of 7 July: information flowed
smoothly between institutions, the FSA, the Bank of England and
the Treasury; back-up arrangements, when they had to be used,
worked; markets operated without interruption, and accommodated
high levels of trading. It is important, however, that we learn
lessons from 7 July so that we are able to deal robustly with
circumstances that might in future threaten the financial system
more directly.
42. One of the Tripartite Authorities' key
roles is to work with the financial sector and other relevant
bodies to try to ensure that all are well prepared for any such
crisis. As one part of this, we hold an annual exercise to practise
co-ordination between key participants in the financial sector
in their responses to sector-wide disruption, to enhance market
understanding of and confidence in the role of the financial authorities
in the event of a major operational disruption and to identify
areas for improvement in existing procedures. This year's exercise,
which will take place on 28 November, will be the largest business
continuity exercise of its type ever undertaken. It will involve
some 80 firms across the UK, in addition to the Bank of England,
the Treasury and the FSA. In a further contribution to improving
the sector's robustness, we are encouraging the larger firms to
enhance stress-testing of their capacity to cope with adverse
scenarios.
43. In the current environment, we are also
actively reviewing with the Treasury and the Bank the possible
implications for the financial sector of any serious developments
on Avian influenza.
Financial crime
44. Much of our work on financial crime
is aimed at monitoring standards of systems and controls in the
firms we regulate to ensure they have in place the defences they
need to combat money laundering and fraud, while avoiding unnecessary
burdens on customers and firms; identifying financial crime risks
within the sector; and working in partnership with stakeholders
to this end.
45. Our work in this area has included:
— leading work with stakeholders to
improve identification procedures designed to prevent money laundering—moving
to a regime which is proportionate, commands industry and consumer
support and delivers value to law enforcement;
— working closely with the Treasury
to ensure that EU initiatives relating to financial crime are
risk-based, effective and proportionate;
— developing our fraud policy which
is founded on a partnership approach, working with the grain of
the market wherever we can and intervening only where we can make
a real difference. This has resulted in a more proactive role
being taken by trade associations in developing best practice
and sharing data on fraud trends; and
— developing intelligence and working
with law enforcement agencies on the criminal money flows presenting
the greatest risk to the UK.
Improving our business capability and effectiveness
46. We are committed to making it easier
for firms, consumers and other stakeholders to do business with
us; in particular, we have sought to reduce the time and effort
which firms—especially small firms—and consumers need
to spend dealing with us. As part of this commitment, in April
this year, in conjunction with an independent research agency,
we began a programme of work to measure levels of customer satisfaction
for eight of the regulatory processes we operate, including applications
for corporate authorisations and approvals of individuals. The
research indicates that overall customer satisfaction on these
processes is currently 73%. We now plan to extend our customer
satisfaction research to other services we provide, including
the Firm Contact Centre, which handles firms' queries on regulatory
matters.
47. We have recently published an account
of our performance against all published service standards for
the period April-September 2005. On 72 of the 74 published standards
we have achieved at least 90% of the targets we set ourselves.
This represents a significant improvement on results in previous
reporting periods, despite increased volumes of business arising
from the extension of our responsibilities to include mortgage
and general insurance. However, there is room for improvement
in some areas and we are working on this.
48. We have listened hard to justified criticism
of our processes and performance and have worked to make improvements.
In particular, we have been reviewing two aspects of our performance:
first, the costs we impose on those we regulate and whether, and
how, these can properly be reduced (see below); and second, the
effectiveness and fairness of our enforcement processes. In July,
we published the recommendations of our review of our enforcement
process. The changes we have now made, following criticism from
the Financial Services and Markets Tribunal, are designed to introduce
improved checks and controls during the investigation phase, increase
transparency, and bring greater clarity by more fully separating
those who investigate a case from those who decide.
Small firms
49. We have paid particular attention to
making it easier for small businesses to deal with us, introducing
a number of innovations, including:
— Tailored handbooks for small firms—in
June we launched 14 sector-specific tailored handbooks for small
firms. These new publications are 90% smaller than the full Handbook
and provide the most relevant information for each industry segment.
— Short-form application packs—for
firms applying for mortgage and general insurance regulation and,
more recently, for new applications to the securities and futures
sector. These have reduced the burden on firms and have led to
faster processing times.
— A consolidated single fee invoice
for firms, replacing the three separate invoices previously issued
for FSA fees, and the Financial Ombudsman Service (FOS) and Financial
Services Compensation Scheme (FSCS) levies.
— Payment by instalment—working
closely with the Smaller Businesses Practitioner Panel and the
FSCS, we have facilitated the provision of a market solution to
enable firms to pay their single invoice for 2005-06 by instalment.
50. Regulation of large numbers of small
firms represents a considerable challenge for them and us. We
believe we have made progress, but there is more to do.
Better regulation
51. Our better regulation work aims to deliver
regulation that meets our statutory objectives in a way that is
as risk-based and cost-sensitive as possible. We support the Government's
better regulation agenda, which accords with our pre-existing
commitments and the work we have been doing for some time in this
area.
52. In areas where have reviewed our regime,
we have sought to both liberalise markets and move to a principles-based
approach. Examples of this in practice are our "Listing principles",
where we have introduced a set of six principles for listed companies
(which has resulted in a 40% reduction in the size of the rulebook
for listed firms)1, and our "treating customers fairly"
initiative which encourages firms to develop their own approach
rather than complying with detailed rules. There will be times,
however, when we continue to use detailed rules. We will need
to do so, for example, in order to implement the detailed requirements
of EU directives.
53. We continue to seek to achieve targeted
reductions in our rules. As part of this, in July this year, we
set out proposals for change in three areas: money-laundering,
our approved persons regime, and training and competence arrangements.
54. We are also carrying out, in partnership
with the Financial Services Practitioner Panel, a study to establish
robust estimates of the costs of financial services regulation
on firms in the UK. This study is analysing the impact of regulation
on firms' operating costs and what firms would in any event incur
as part of their day-to-day operations. The study, being undertaken
by independent consultants, covers three sectors: retail advice,
investment banking and institutional fund management.
D. CONCLUDING
REMARKS
55. In the course of the next three months
we will publish our International Regulatory Outlook, Financial
Risk Outlook and Business Plan. These documents will
set out our future plans, and our view of the main challenges
facing us. We will provide the Committee with copies.
2 November 2005
1 The FSA subsequently clarified this sentence. The 40% reduction in the rules for listed firms was a consequence of the FSA's review of the listing rules, not a result of introducing principles.
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