Local authority investments: Government, CIPFA, FSA and Audit Commission Response - Communities and Local Government Committee Contents

Appendix 3: response from the Financial Service Authority (FSA)

1.  We welcome the Committee's report on Local Authority Investments. In this memorandum we respond to those conclusions and recommendations which are relevant to the FSA. In particular we describe the framework, set out in the Financial Services and Markets Act 2000 (FSMA), which underpins our regulation of certain services provided by FSA-regulated firms to local authorities.

2.  Given the events that led the Committee to undertake this inquiry, we understand that your main concern centres on the decision by local authorities to place deposits in Icelandic banks and on the advice that local authorities received to make this decision. As we explain in this memorandum, advising on deposits is not a regulated activity and therefore we do not monitor the activities of regulated firms in this area.

3.  We understand from paragraphs 119 and 120 of your report that you believe that we were seeking to be deliberately unclear in our answers to your questions and that you also believe that we were not discharging our regulatory duties under FSMA. You ask that the FSA take a more active role in the regulation of treasury management advisors and conduct an investigation into the services they provide.

4.  For the reasons explained in our earlier memorandum to the Committee and the further answers that we provided, the application of FSMA regulation to the activities with which the Committee's inquiry was concerned is limited, and not straightforward. For this reason it would not be appropriate for the FSA to carry out the investigation, recommended by the Committee, of the services provided by local authority treasury management advisers. An investigation of this kind by the FSA would be appropriate only if the FSA's scope were extended to cover many more of the activities in question. This would be a matter for Government to decide. In those circumstances we would, of course, seek to address the concerns you raise.

5.  For future reference, if the Committee would like further written or oral evidence from us before they finalise a report, we would be happy to provide it.

Regulation of Treasury Management Advisers (Paragraph 120 and 121)

6.  The Financial Services Authority (FSA) should take a more active role in the regulation of treasury management advisers. The evidence which we have examined has raised concerns about potential conflicts of interest and questions as to whether there are any financial transactions between treasury management advisers and brokers that might compromise the independence of advice being given to local authorities. There is a strong case for a full investigation by the FSA of the services provided by local authority treasury management advisers. We recommend that such an investigation be carried out as soon as possible. (Paragraph 120)

7.  Our examination of the role of treasury management advisers in the Icelandic debacle has raised wider questions about their influence on local authorities' treasury management practice. First, there is confusion, and perhaps some deliberate ambiguity, about what services they offer. It is clear to us that some local authorities believed that they could place reliance on their treasury management advisers in a way that some of the treasury management advisers themselves now seek to argue was misguided. Second, there is concern about the independence of treasury management advisers that may be part of companies that will benefit from the investment decisions of the local authorities that they advise. Third, there is a lack of clarity about the extent to which local authorities can assume that treasury management advisers are properly regulated. While local authorities must ultimately take responsibility for their investment decisions, a range of regulatory and advisory bodies appear to us to have been complacent in their approach to the role of treasury management advisers. The Audit Commission, CIPFA and the FSA must all re-examine the role and reliability of treasury management advisors and their discharge of duties of care for local authorities in managing this aspect of treasury management. (Paragraph 121)

Legal position

8.  The activities for which FSA authorisation is required (regulated activities) are set out in legislation - the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. Changes to the definition of regulated activities are therefore a matter for HM Treasury and Parliament. Firms conducting regulated activities in the UK must apply to the FSA for authorisation, and we are responsible for regulating only those firms that we authorise. It is important to note that firms which we authorise commonly carry out a range of activities, only some of which we regulate; we explain below the relevance of that principle to this case.

9.  Treasury management departments within local authorities do not require authorisation by the FSA. In line with the overall approach set out in paragraph 8, whether a separate organisation providing services to a local authority to assist it in its treasury management requires authorisation by the FSA depends on whether that activity is a regulated activity as defined by FSMA. In that context the following points are important:

a)  A deposit by a local authority is not a regulated deposit under legislation.

b)  Moreover, advising on deposits is not a regulated activity. Therefore advising a local authority to place its deposits with a particular bank is not a regulated activity.

c)  Equally, carrying out deposit-broking services (for example, arranging for a client's money to be invested in deposits with particular banks) is not a regulated activity.

d)  Broadly speaking, advising on buying and selling government or private sector debt securities requires authorisation if the advice relates to specific transactions. Broader strategic or generic advice (for example 'we recommend that you invest in sterling denominated debt securities') are not regulated activities.

e)  Broking and arranging activities in relation to these investments are also usually regulated activities.

10.  Broadly, our rules do not apply to activities that are not regulated activities. However, if non-regulated activities (for example, advising on deposits) are conducted alongside regulated activities (for example, advising on investments), certain FSA rules (such as the suitability rules referred to below) apply to the nonregulated activities as well as the regulated activities.

11.  As others have pointed out in their evidence to the Committee, many of the rules governing regulated activities derive from the Markets in Financial Instruments Directive (MiFID). Broadly, under this legislation, the FSA is not allowed to set more stringent rules than those in MiFID, including the rules referred to in paragraph 12 and 13.

12.  If the firm gives regulated advice to any client, the suitability rules will apply: broadly, a firm must take reasonable steps to ensure that the advice it gives its client is suitable for that client.

13.  Generally, local authorities are 'professional clients' under the rules set by MiFID. The scope of a 'professional client' is determined by MIFID and our rules reflect the MIFID requirements. MiFID provides a lower standard of protection for professional clients. A regulated firm is entitled to assume that a professional client has the necessary level of experience and knowledge to understand the risks involved in the transaction when assessing the suitability of advice being given. So if advice is given to professional clients, the regulated firm is entitled to assume that the client is financially able to bear any related investment risks. Professional clients do not have access to the Financial Ombudsman Service.

14.  The Committee also expressed interest in what information the FSA makes available to local authorities about regulated firms and their activities. All firms regulated by the FSA are listed in our Register, which is publicly available on our website. FSMA sets out what we must include on the Register of regulated firms (for example the name of the firm, the regulated activities the firm holds itself out as able to provide, a suitable business address for the firm and the name of any approved persons carrying out controlled functions in the firm). FSMA also requires us to include other information that we deem appropriate for the public record. Under this heading we include any publicly available disciplinary history of a firm or individual and the regulatory history of a firm or individual for the benefit of consumers and market participants.

The FSA's supervisory approach

15.  For the reasons explained above, we do not regulate much of the activity carried out by the firms which provide services to local authorities. To the extent that we do regulate activities they carry out, we take a risk-based approach, taking into account the risk posed to the market and to consumers by the firm's regulated activities.

16.  Where firms form part of a wider group (for example; Sector Treasury Services Ltd is a small firm which is part of the Capita Group Plc. Butlers is the trading name of a division of ICAP Securities Ltd), we supervise them as part of the group. The extent to which we focus specifically on individual firms within the group depends on their size and their risk profile within the group. In their own right, Sector and Butlers are significantly below the size threshold to warrant a risk assessment. However, as they are both part of wider groups, we take their business into account when we carry out our risk assessment of the wider group.

17.  Sterling Bank and Arlingclose Ltd are small independent firms, not part of a wider group. We do not routinely carry out risk assessments of these firms but instead we monitor the information (covering, for example, financial position, volume of business, number of complaints received) which we require firms to submit to us regularly.

Conflicts of interest

18.  The FSA takes potential conflicts of interest within firms very seriously. Principle 8 of the FSA Principles for Business states 'A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client'. The FSA Handbook develops this principle in detailed systems and controls rules which prescribe that firms must (i) identify conflicts of interest, (ii) manage those conflicts to prevent them from harming their clients interests, and (iii) in the case that conflicts can not be managed, firms must disclose them to their clients. Compliance with this Principle and our rules is monitored through our risk assessment process.

19.  The FSA also regularly undertakes thematic supervisory work across a range of authorised firms in a number of areas, including conflicts of interest. The main objective of this thematic supervisory work is to promote good practice across particular industry sectors of the firms we regulate and to pinpoint and remove bad practice.

Review of Treasury Management (Paragraph 156)

20.  We seek reassurance that regular meetings at an appropriately senior level are held between the Audit Commission, the local authority associations, CIPFA and CLG to ensure that the treasury management system is kept under review. We also recommend that these meetings include links with the financial regulatory bodies—the Financial Services Authority and the Bank of England—to ensure consistent and up-to-date information is passed onto these bodies. (Paragraph 156)

21.  There is a well-established framework for such communication: the Capital Programmes Working Party (CPWP). This is a forum for the discussion of capital finance, treasury management, accounting and all related issues. Its members are: the Department for Communities and Local Government (DCLG); HM Treasury; other Government departments interested in local government capital spending; the Local Government Association; London Councils; CIPFA; the Audit Commission; the National Assembly for Wales; the Scottish Executive. We understand that the Capital Programmes Working Party (CPWP) already fulfils the Committee's expressed desire for regular meetings between these groups. We also understand that the DCLG is considering, with HM Treasury, how best to establish links between the CPWP and the FSA.

Regulatory scope

22.  As we have explained, the extent of our jurisdiction over the activities with which the Committee is concerned is very limited. It would therefore not be appropriate for us to take a more active role in the regulation of treasury management advisers. Decisions to extend our jurisdiction to cover other activities relating to advice given to local authorities are a matter for Treasury. The Government's recent White Paper on financial services does not propose any changes in this area. We would like to assure the Committee that we will continue to be active in our supervision of the firms where we have responsibility for their conduct of business.

  1. Finally, if the Committee has specific evidence that FSA-regulated firms have not complied with the applicable regulatory standards in carrying out FSMA regulated activities for local authorities, we would invite you to send it to us so that we can look into it.

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Prepared 28 October 2009