UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 329-ivHouse of COMMONSMINUTES OF EVIDENCETAKEN BEFOREREGULATORY REFORM COMMITTEE
THEMES AND TRENDS IN REGULATORY REFORM
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Transcribed by the Official Shorthand Writers to the Houses of Parliament: W B Gurney & Sons LLP, Hope House, Telephone Number: 020 7233 1935
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Oral Evidence
Taken before the Regulatory Reform Committee
on
Members present
Andrew Miller, in the Chair
Gordon Banks
Lorely Burt
Judy Mallaber
________________
Memorandum submitted by Financial Services Authority
Examination of Witness
Witness: Ms Verena Ross, Director, Strategy and Risk, Financial Services Authority, gave evidence.
Q86 Chairman: Good morning. Ms Ross, first of all, thank you for agreeing to come and give evidence today. Obviously as part of our inquiry some thoughts from the FSA are welcome. You may have seen some of the previous evidence sessions. We are following a similar theme of questions. First of all, could better regulation have avoided the financial crisis, at least in part? What principle failures of regulation or regulators have come to light in your investigations since the problems have started?
Ms Ross: Thank you very much, Chairman. Good morning. I think it is very important to look at the crisis in quite a broad way. It is clearly a global crisis which had some of its origins in quite fundamental macro imbalances in the global economic system and so on, so it is clear that to my mind there were things which were building up in the broader macro- economy and through financial innovation and other things over the last ten/15 years which eventually led to a situation which then exploded, probably in a way that no-one quite imagined would ever happen. That does not mean that there are not things that we can learn from the way the build up of these various different aspects developed. We are certainly keen to make sure that both globally and domestically we learn the lessons from that. We are looking very closely at how we can make sure that we have a proper understanding of the type of developments and causality of different parts of the financial system working together, and working very closely not only domestically with the Bank of England and the Treasury but also internationally with other regulators, other central banks and so on, in getting better at looking at the macro picture and having mechanisms which allow us both to do that analysis and also to decide what we need to do in terms of actions to try to prevent such a scenario occurring again.
Q87 Chairman: The failures on the part of the FSA were that you did not have the tools in place to measure what was going on.
Ms Ross: No. There were quite specific issues which we have been very open about in terms of how we conducted our supervision on the ground, and we have obviously published the internal audit report on Northern Rock and taken some action as a result. I was trying to put it into the bigger picture. Basically there are lessons to be learned for the FSA specifically about how it conducts supervision; for example, the kind of capabilities of the staff, the type of way in which we do supervision, the ability to look not just at the micro, individual institutions when we supervise but to look at the broader business model of the individual sectors of the financial services industry, and then to work with our colleagues, both domestically and internationally, to put that picture together and make sure that we then have the right tools, such as better capital requirements, looking more closely at liquidity and things like that, which all were outlined in the Turner Report, in terms of our policy responses.
Q88 Chairman: What risks are there in risk-based regulation? Are risk-based regulation and principles-based regulation fine in theory but flawed in practice?
Ms Ross: I do believe that, ultimately, you have to take a risk-based approach to regulation because in any regulator your resources are ultimately limited to some degree. You need to focus the effort on the things that you think are the most risk. Having said that, clearly the crisis has told us that maybe we did look at the risks from a slightly narrower angle, and looked specifically at institution-specific issues and not enough at the broader picture. I think it has also shown that, although risk-based regulation to my mind remains an important tenet of how you do conduct regulation, you need to be sure that your risk appetite is properly adjusted to what is going on. For example, clearly the view has changed as to what is an acceptable failure in financial services and what is not an acceptable failure. Those are the kinds of things which clearly need to be debated in the public domain and amongst regulators. We need to decide with the public in terms of where that is. Risk-based regulation certainly will continue. We also believe that moving and making sure that we focus the rules very clearly on the outcomes that we want to achieve - which was part of our principles-based regulation outcome, focused regulation - is something which remains very, very important. We have, however, said that some of the assumptions we have made and other people have made that markets ultimately adjust themselves - it is going back to a market mean that senior management of the firms know best how to run their business and so on - we have hardly needed to question, and part of what we are now doing is being much more intrusive in our regulation in terms of saying that we need to make judgment calls on the types of judgments firms' senior management take and we need to make sure there is proper governance in place to take those types of judgments in the firms concerned.
Q89 Chairman: In summary, carrying on with a risk-based approach but making sure that the underlying principles stand up to more rigorous scrutiny.
Ms Ross: That is right.
Q90 Chairman: Are there any particular actions that you are thinking of in that respect?
Ms Ross: We are, for example, spending and have been spending a lot of time looking at the position of certainly our highest impact banks. Not surprisingly, a lot of our focus has been on that recently, but we have also at the same time, for example, said that we would focus more on testing some of the outcomes in the consumer protection area. We are generally trying to make sure that where we are clear about what the outcomes are we want to achieve -first we need to articulate those, obviously. We then are able to test that and check whether that is happening on the ground.
Q91 Gordon Banks: Principles-based regulation never got the chance to prove itself properly. I am interested, following on from the Chairman's questions and your answers, in how outcomes-based regulations differ. Where you have talked about risk-based regulation and principles-based regulation, you have joined them together.
Ms Ross: Yes.
Q92 Gordon Banks: How do we do that practically? How do we take the risk and the principles, merge them together and deliver a system that not only prevents what happened recently from happening but also may well deliver improved standards and an improved ability to regulate and to monitor. I am a little bit confused as to how they can be merged together.
Ms Ross: It is quite subtle that you have different types of aspects of how you can describe regulation. As part of our statutory responsibilities we have principles of good regulation which we have to follow when we do regulation and supervision. Those also talk about proportionality and about being conscious of impact on innovation, competition and things like that. Already in the statutory framework it is recognised that when you take decisions about what to intervene in, where to focus, you have a whole range of different objectives to meet, and it is always a fine judgment call of where you focus your attention. I think that will be a continuing challenge for any regulator, whether that is financial services or anywhere else. To my mind what is particularly important in financial services is that we do revise, given the lessons we have learned, exactly what are the outcomes we want to achieve. We want to achieve a more stable banking system. How do we do that? We try to make sure that our capital regime works better than it did, we focus more on liquidity supervision, we focus more on our day-to-day supervisory attention at the high impact firms (for example, we strengthen our supervisory resource vis-à-vis that), so it does all come together ultimately. That might make it a bit confusing, I appreciate, but it is very hard to pull it entirely apart.
Q93 Gordon Banks: Do you think outcomes-based regulation can be restrictive? Do you think the industry might think that is restrictive?
Ms Ross: I think industry does in a way like the fact that we describe what we want to achieve and then we leave a bit of flexibility around how to get there, because that is what outcomes-based regulation and ultimately principles-based regulation is about. On the other hand, that clearly means that there is something about the issue of how do we then judge whether the right outcome has been achieved, and there have been debates about that, and in terms of how far a regulator then second-guesses what is happening. One of our purposes is to be very clear about describing the outcome and then, also, through, for example, putting out examples of good and bad practice, putting out descriptions of what we are expecting to see, talking to firms in road shows and so on, what the expectations are, trying to be as clear as possible so that it does not feel like 20:20 hindsight when we then go in and say, "No, that hasn't quite worked right."
Q94 Lorely Burt: In the future, how are you going to identify major risk areas? How do you think your enforcement approach is going to change to ensure that these areas are properly overseen? Also you talk in your memorandum about the "intensive supervisory model" and "creditable deterrence" strategies. Do you have the resources to implement them? And more importantly for me personally, what are they?
Ms Ross: There are a lot of different aspects to that question. Obviously when I talk about taking risk-based approach to regulation, we have a whole different range of different tools that we can deploy in terms of how we regulate. We can make policies, we can then do individual supervision of firms, we can use enforcement tools. In all contexts, we need to choose quite carefully how we deploy those and how we can be most effective and efficient about employing those different tools. As you rightly say, as part of the lessons learned out of the crisis, we have been very clear that we feel we need to up our supervisory game. We need to make sure that we do have the right people, we do have the people who have the knowledge and expertise to stand up to senior management in big firms, first of all to fully understand what that firm is doing and then to be able to put it into a broader context of the broader sector, so you can see whether there is an outlier or anything like that, but also so we are able properly to challenge and have discussions at that senior level. That is all about making sure we are as focused and clear about what we expect and have the right people to deliver that, but obviously there will always be people who, despite our best efforts, will not follow the rules, will decide to do things which are clearly against the regulatory principles and outcomes that we have described. In those cases, we do need to have that enforcement tool at our hand. We are very keen and have over the recent past taken great effort in making sure we take that very seriously, so we have taken, for example, more criminal prosecutions than we have ever taken before, we are generally making sure that we use our enforcement tools as effectively as we can.
Q95 Lorely Burt: These two wonderful terms, the "intensive supervisory model" and the "credible deterrence" presumably you have covered that, have you?
Ms Ross: In what I was just saying, yes. The intensive supervisory model is the fact that we will have more supervisors on the ground focusing particularly on our highest risk institutions and that we have more specialist resource flowing into it. We have put in place a training and competence scheme for the regulators to make sure that we have the best people and a consistency in how we go about it.
Q96 Chairman: In simple terms during the recent past, you have not had the right number of high quality people on the ground capable of challenging the perceived wisdom inside some of the bigger institutions.
Ms Ross: The fact is, to my mind, that that is an ongoing challenge and always has been a challenge. Even if you go back three years or something, you will hear us talking in similar terms about the need to have the right people who can make the right judgments. Certainly one of the lessons learned out of the Northern Rock report was that in relation to the biggest institution, the highest impact institutions, we did not have enough people on the ground dealing with those institutions on a day-to-day basis, yes.
Q97 Lorely Burt: Is not the best way of ensuring good behaviour maximising the certainty of being caught? If you have the people there, then they are able to see just what is going on.
Ms Ross: Absolutely. The likelihood of detection is a big part in any deterrent strategy. Having said that, we do supervise 30,000 firms, and there is a limit as to how many people you can have on the ground constantly checking to a degree where you will be able to detect every single shortfall. It will have to be a risk-based approach and we try to do that through data collection as well as on-site supervision and the supervisory approach.
Q98 Judy Mallaber: You have mentioned 30,000 institutions and also wanting to be concerned about the riskiest. In what proportion of those institutions would you seek to use this intensive supervisory model? How do you choose? Do you choose the biggest? How do you assess which is the riskiest if you have not been supervising them enough to know which are the ones which have the risk?
Ms Ross: That is a very fair question. The way we try to make this judgment is we look at impact and probability. Impact is basically how important is the firm in the context of the wider market. For example, for a bank, how many deposits does it have? For an asset manager, how many assets are under management? That is how we measure the impact. Then we also look at the probability. Is there a particular risky sector? Is this firm very close to its capital requirements or not? We try to gather that data for all 30,000 firms as far as we can, but we then concentrate our supervisory resource on the relationship "managed firm" population. I might have to come back to you on the exact figure. I think it is about 800 or so, 100 of which are what we call high impact firms, so on 100 firms is really where the recommendations of the Northern Rock report have focused, as saying that for the top 100 firms we do need to have at least two supervisors wholly responsible for that firm at all times.
Q99 Judy Mallaber: Should you have been able to spot which institutions were going to get into trouble or were the circumstances so out of the control and expectation that you would never have spotted them even with this system?
Ms Ross: We have been very open in our
risk report on the Northern Rock incident.
We think we could have been done more to spot the issue. The question is whether, even if we had
spotted it, we could have done much to prevent the ultimate outcome, because
what happened was such a liquidity crisis which was globally generated that,
even if we had tried to shift that one institution which maybe we should have
spotted as a bit of an outlier earlier, it would have been very hard probably
to get it into a position within the timeframe that was there to prevent the
crisis completely. There are some
mistakes but it fits into the global picture.
Whether we could have fundamentally changed the course of the crisis is
very unlikely. It is a global
crisis. Ultimately it has hit not just
Q100 Judy Mallaber: In your evidence you have talked about the increasing complexity of the sector. Does increased supervision of sectors like hedge funds succeed only in the transference of risk to where it is invisible? How will financial regulation deal with that?
Ms Ross: That is an ongoing challenge, certainly for financial regulation, but I suspect for regulation generally. Within the scope - which, after all, we are statutorily given by Parliament - how do you make sure that you spot the issues that are coming up and the risks that are coming up, and how do you also make sure that you keep an eye on what might just be outside but has a fundamental impact on what you are responsible for? We do regulate hedge fund managers already and we are thinking about what more information we can gather about the activities of hedge funds to make sure that we do spot where risks might be arising, but it is a general challenge because it is not just in relation to hedge funds, it is effectively in relation to any activity that is not done in the "poor" entity that we supervise and how we can monitor those relationships with these things which are just under the perimeter of our scope and make sure that we understand what the risks are to the core system.
Q101 Judy Mallaber: If you put greater pressure on those sectors, is it your assessment that they will then come and transfer into new vehicles? What is going to be the effect of having more intensive regulation, if that is what you are aiming to do, on overall productivity? Will firms come back and say, "You're stopping us making any money," and is this going to be even more disastrous?
Ms Ross: To your first question, there is always the risk that by focusing more intensive supervision on a certain sector you do create the incentive to look for other opportunities to deliver profit and return in another way. That is where our overall better and, hopefully, more comprehensive work with the Bank of England and others on getting the broader picture of what is influencing the macro picture of how the financial services sector works as a whole, is very important. Moving on to your second question in terms of what it would mean for sector productivity: certainly the banking sector - let us be precise, because there are other parts of the financial services industry which have been less impacted by the crisis - is going to look very different going forward, and no-one quite knows yet what that new norm ultimately will look like. We need to find a regulatory regime which still allows the sector to conduct its business, but look carefully at where are the risks that are arising and dealing with those in a regulatory way. But we want to do that in a proportionate way. It is really important that we do not just regulate any sector out of existence. It is very important that we are clear about what the risks are and why we are intervening.
Q102 Chairman: Without naming names - because obviously it would have market implications - are your 100 target high impact companies in a particular sub-sector or are they right across all financial services? Are they judgments you have arrived at because of people‑based weaknesses or in the structure of the business sector?
Ms Ross: They are all across the business, but the way in which we determine whether something is high impact is based on the impact, so it is not necessarily that they have bad management or they are particularly risky for other reasons. That is the kind of probability judgment which then overlays that impact judgment. The core to determining what are our most important firms which we will spend a significance base time on, that is the impact. We then overlay that for all firms with the probability judgment: Is that firm particularly likely to cause us problems or not and for what reasons?
Q103 Chairman:
How
will the
Ms Ross: We very firmly sit in the
international global and European financial market and regulatory regime. Financial markets are such an international -
business because we cannot sit here in isolation regulating what is the UK
industry and have no regard to what is going on outside. First of all, EU legislation and regulation directly
feed through as to how regulation happens here, and so we are very firmly and
actively engaged in working with our European counterparts to make sure that the
kind of lessons we have learned from the crisis also get translated into what
is coming out of
Q104 Chairman: Have you learned lessons from some of your sister organisations in other countries?
Ms Ross: Yes, we have. We continuously learn lessons, I would say, because we work very closely with them. The fact is that no regulatory regime has necessarily come out of this looking wonderful around the globe. Most regulatory regimes have faced one problem or other. But we are looking at, for example, some of the ways in which other regulators have looked at regulating capital requirements for banks, which varies a bit across different countries, and we are learning some of the lessons from that. We are also looking at how certain sectors are looked at, how you do the more macro-prudential, systemic-wide assessment. We are working very actively with other regulators and learning lessons from them.
Q105 Chairman: Does the complexity and global nature of the financial system make the sector unique? Or are there lessons that other regulators need to think about from what has happened, given the global nature of the economy?
Ms Ross: I would say there are certain aspects to the financial services industry which you might call unique or which at least have certain characteristics which I think make it particularly relevant; that is the fact of how financial services link into the macro-economy. I think that is something which this crisis has exemplified. There are probably more transmission mechanisms from certainly the banking system into what then happens to lending in the wider economy and, therefore, what that means for GDP growth and so on, so there is a kind of direct link into the macro-economy which maybe makes financial services a slightly special thing to look after. Having said that - and I spent quite a lot of time talking to some of my fellow regulators here domestically of other sectors - I think the fundamental principles of how to do regulation, some of the underlying principles, are not that different. Looking at where you focus your resource - how do you make sure you deal properly with the highest risk and highest impact institutions but at the same time still regulate the large chunk of smaller institutions and so on - is something which not only financial services regulation faces but regulation generally.
Q106 Gordon Banks: You were saying to my colleague about working with the business. Do you see the FSA has any master plan? You said you did not know how the banking sector is going to come out. Does the FSA have a vision or a view of what it would like to see at the end of the day, other than stability and accountability?
Ms Ross: We do not have the kind of blueprint which says, "This is what an ideal bank should look like." We do have, and have outlined in the Turner Review to quite a large extent, the type of characteristics that hopefully would characterise a more stable but still innovative and properly working banking sector going forward. Things like having counter-cyclical ratios, to make sure that you balance against the cycle. You build up capital in the upturn and hopefully can absorb then the losses in the downturn.
Q107 Gordon Banks: Principles as opposed to a blueprint.
Ms Ross: Yes, that is right.
Gordon Banks: Thank you.
Chairman: Thank you very much for your comments. If anything else comes to mind, we would be grateful if you would drop us a note. We are grateful to you for your contribution.
Memorandum submitted by Association of British
Insurers,
Association of Chartered Certified Accountants and EEF
Examination of Witnesses
Witnesses: Mr Stephen Laddrill, Director General, Association of British Insurers, Professor Robin Jarvis, Head of Small Business, Association of Chartered Certified Accountants, Mr Roger Salomone, Head of Business Context, and Mr Steve Pointer, Head of Health and Safety Policy, EEF, gave evidence.
Q108 Chairman: Good morning. There appears to have been a slight communication problem with the ABI. We had the name of a different witness. Perhaps you would like to introduce yourself.
Mr Haddrill: I am Stephen Haddrill. I am the Director General of the ABI.
Chairman: Thank you very much. The rest of the witnesses, of course, we already knew. Perhaps we could go straight on to the questions.
Q109 Lorely Burt: Do you think better regulation could have avoided the financial crisis? What failures of regulation or regulators have come to light as a consequence? Was there a lack of management capacity or sector expertise or enforcement resources? What do you see as the main culprits in this?
Mr Haddrill: We have just heard from the FSA of some of the things that were particularly lying behind the crisis. First, I think the question of the implementation of regulation is something to which they need to pay more attention and was a big part in the failure. It is all very well to get the right framework of rules or even the right framework of principles, but unless you know what is going on within the firm and you have effective supervision going on, then that rulebook will not deliver what we need in terms of safe outcomes. Another part of better regulation is that regulators work effectively together. Clearly we saw some gaps emerge between the role of the Bank of England and the role of the FSA and those need to be closed. Equally, good and effective working together across national boundaries I think is very important. That is something that has started to be addressed in the EU, and obviously the G20 process has started to address it, but I think there is much further to go there. I guess the other issue, which should come out of a better regulation approach, is: Are we really looking for the dynamics in the market, the potential unintended consequences in the way that firms will inevitably take changes in rules or change in regulation and try to find ways round it? I suspect too much of the analysis in the past has been a bit static: This is the market, we make this change, people then look like that, rather than trying to anticipate how the market itself will change.
Professor Jarvis: Regarding the formulation, the development of better regulation, if you like, it seems to me there is a deficiency. Fundamentally, hardly ever are consumers really consulted, so you have a situation where you have the industry and you have then the regulators - and we have already heard that there is some questioning about the expertise of the regulators. Where is the end-user in this process?
Q110 Lorely Burt: Do they know what is going on? When the products are so complex, sometimes even the people in the industry cannot understand them. Surely it is up to the regulator to protect the consumer in their own interests.
Professor Jarvis: You may think that, but there is still a strong case for involving consumers. Like yourselves. Fundamental questions should be asked. There is no reason why they are not consulted. In the main they are not consulted.
Q111 Lorely Burt: Who are the consumers you are talking about in this case?
Professor Jarvis: I am talking about the consumers of the end product; that is the product of banking or what-have-you, of all the products in the financial services industry.
Q112 Gordon Banks: All of us.
Professor Jarvis: Yes, exactly. My particular interest is small business, in fact, because I perceive that the small business owner is in a very similar situation in their needs, et cetera, as a consumer. As there is something like 3.8 million one-person businesses out of a total of 4.7 - that is, 70% of businesses are one-person businesses - I think it is a very relevant point.
Mr Salomone: I would say, briefly, that we represent the manufacturing industry, so our expertise is not in financial services, although, of course, ultimately our members are consumers of some of those products. Probably the easy and honest answer, but maybe not the most helpful one, is that it is too early to tell what the implications are for the wider economy. The post-mortem of the banking crisis and regulatory reforms are ongoing, but we would certainly like to flag upfront that we think there is very much a continuing role for risk-based regulation - or whether you want to call it proportionate regulation - where in the approach to regulation you take the level and the nature of it as proportionate to the risks and the activities you are regulating. For example, for our members there is environmental regulation or health and safety, and that still very much has a role to play. For example, if the outcome of this is that it is seen as a failure of the implementation of risk-based regulation in, say, particular parts of the financial services, that does not invalidate the general approach when properly implemented.
Q113 Lorely Burt: Thank you. Mr Pointer, do you have anything to add?
Mr Pointer: No.
Q114 Lorely Burt: Mr Haddrill, I understood from what you said and the previous witness said that you seem to be in a situation where certain aspects of the financial service industry are whizzing around and changing so quickly that it is almost like a virus, and the FSA and the other regulators are like a team of doctors chasing it around, that as soon as they pin it down to one aspect, then it will mutate and they will find something else. Do you see that as a valid question? Do you think we will ever have the tools in order to be able to regulate properly?
Mr Haddrill: Yes and no really. If you take the insurance industry, which is
the bit I know best, then it is a highly competitive industry. In fact, financial services generally is
highly competitive. That drives that desire to innovate and find that extra
margin, knowing full well that you will not preserve that margin for very long
before new people come in and compete it away. So, yes, that is part of the
industry, but of course that can be extremely beneficial for the consumer. It is beneficial to the consumer that these
days you get a courtesy car if you have an accident. You did not used to get anything like
that. That may be a trivial example
compared to what we are talking about, but it is an example of innovation. I think the FSA does have some of the tools
it requires. To take an insurance
example: the insurance industry got into a certain amount of trouble in about
2002/2003 when the dot.com bubble brought the stock market down, and the FSA
then introduced a new approach to setting capital requirements, capital
reserves in the insurance industry which was based on a very detailed
assessment of risk with very high levels of capital required. That has been extremely successful.
Chairman: We are inquorate now so we will take the remaining evidence informally.