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Financial Services Authority Annual Report 2008-09 - Treasury Contents

Written evidence submitted by the Financial Services Authority (FSA)

  1.  We are submitting this memorandum in advance of our evidence session on 25 November. It gives an overview of our work in 2009, in particular on:

    — our key areas of current focus;

    — implementing The Turner Review;

    — contributing to developments of the regulatory framework in the UK and the EU; and

    — financial capability.

  2.  This memorandum supplements our Annual Report for 2008-09, published in June 2009.


  3.  As set out in our Annual Report, this year our principal focus has been on managing the consequences of the financial crisis, modernising our supervisory practices and laying out proposals for change to the global regulatory architecture as set out in The Turner Review. This has included:

    — embedding our intensive supervision model in our day-to-day work;

    — managing the immediate impact of the financial crisis on firms and consumers;

    — setting out our proposals for changes to our bank prudential regulatory framework;

    — continuing to deliver our long-term wider policy agenda, notably on Solvency II;

    — ensuring we maintain our focus on conduct risks through establishing a new approach to conduct regulation;

    — continuing our work on financial capability; and

    — continuing to ensure efficient and orderly trading markets.


Dealing with the consequences of the financial crisis

  4.  Our senior management continue to devote significant time and attention to identifying and dealing with the challenges in specific firms. In particular, we continually assess the financial health of banks and building societies in order to identify emerging problems arising from the current economic environment and from their poor risk management in the past. We draw on this analysis to inform our stress testing, which is designed to ensure that firms sustain adequate capital and liquidity for the future, including in the face of severe macroeconomic conditions. We have greatly intensified our stress-testing techniques and practices. These tests have informed individual banks' decisions on whether they require access to the Asset Protection Scheme, and building societies' decisions on whether they require access to the Credit Guarantee Scheme. This more intensive stress testing is now an integral element of our continuing supervisory approach.

Intensive supervision

  5.  In moving to a more intensive model of supervision over the last 18 months, our regulatory style and philosophy have changed significantly. As part of this, we have reorganised and strengthened our risk identification and mitigation capacity, particularly our sector analysis and specialist support for prudential and conduct risk mitigation. We have also revised the supervisory risk assessment framework to include greater focus on business models and to embed stress testing based on our own assumptions as an ongoing part of the process. We remain unconvinced that all firms' senior management have taken on board the need to change and operate in a genuinely different manner. It is essential for us to facilitate further behavioural change in the firms and individuals we supervise.

  6.  We have now completed the operational changes necessary to deliver this new model. We have hired 280 new specialist and supervisory staff and introduced a new training and competence regime to ensure that our staff are properly equipped to do their job. We have continued to make the necessary improvements to the way we work as an organisation to ensure that we are staffed by the right people, in the right jobs, with the right infrastructure.

  7.  From 1 October we underpinned these operational changes by reorganising the FSA's structure along functional lines. We created a business unit with responsibility for all supervisory activities and a further single unit for all risk and policy activities, abolishing the old retail and wholesale distinction. The new structure also reinforces our strongly held belief in the benefits of integrated risk assessment and integrated supervisory oversight of individual firms.

Significant influence functions

  8.  The financial crisis exposed shortcomings in the governance and risk management of some regulated firms and raised serious questions about the competence of individuals in regulated firms holding roles such as the chair, CEO and the finance or risk director. Our regulatory philosophy and more intensive approach continue to place great emphasis on governance and, consequently, the responsibilities of senior management of firms.

  9.  We recently wrote to the CEOs of 5,000 regulated firms to reinforce how this approach applies to approving and supervising people performing senior functions in regulated firms. We are also placing greater emphasis on monitoring the performance of people already performing significant influence functions (SIFs), which includes reviewing more critically their competence as part of our ARROW assessments and taking action where we find evidence of senior management incompetence. For this reason, in June, we banned a compliance director from performing significant influence functions in any authorised financial firm. We found that he lacked competence and capability, which led to the firm being used by third parties to obtain mortgage applications fraudulently. This shows that we are putting what we say into action.

  10.  We continue to work with Sir David Walker to support his proposals for improving the governance practices in financial institutions. We are also considering how we can encourage the promotion of the right culture in the institutions we supervise.


  11.  Following our consultation on remuneration, we introduced a new code which requires large banks, building societies and broker dealers in the UK to establish, implement and maintain remuneration policies that are consistent with effective risk management. This new code will achieve two objectives: that boards focus more closely on ensuring that the total amount distributed by a firm is consistent with good risk management and sustainability; and that individual compensation practices provide the right incentives. We have added eight principles to our Handbook to ensure that firms understand how we will assess compliance with this code.

  12.  We required firms to provide us with a remuneration policy statement by the end of October. This had to be signed off by their remuneration committees and will enable us to check whether their policies comply with our code. Firms which do not comply with our code could face enforcement action or, ultimately, be forced to hold additional capital should they pursue remuneration strategies that encourage individuals to engage in high-risk activities for short-term gain.

  13.  We have now received the remuneration policy statements of the relevant firms. We are using these statements to assess compliance with the code and to review and sign off firms' 2009 remuneration awards. This will involve asking questions about the governance of remuneration, including the responsibilities of the remuneration committee and the role of the risk and compliance functions.

  14.  We are also asking the firms about the extent to which their accrued bonus pools and planned payouts are compatible with the likely need for them to build up capital over the medium term.

Credible deterrence

  15.  We are giving much greater emphasis to the use of enforcement action than we have done in previous years in order to achieve credible deterrence. This means that we want to demonstrate that people who are guilty of misconduct will be held to account, and that the penalty they will face—whether a financial penalty, a ban from the industry, or even imprisonment—will deter future wrongdoing.

  16.  Our commitment to delivering credible deterrence is demonstrated by the fact that:

    — in 2008-09 we imposed financial penalties of £27.3 million, which compares to the 2007-08 figure of £4.4 million;

    — we prohibited a record number of individuals from the industry for unacceptable conduct ranging from market abuse to mortgage fraud or failing treat customers fairly; and

    — we secured two convictions and a custodial sentence in our first criminal prosecution for insider trading and recently secured a guilty verdict in a second insider dealing prosecution (sentencing will take place later this year). In addition to these cases, we are currently prosecuting two other insider dealing criminal cases.

  17.  Changing behaviour through credible deterrence is a long-term strategy. As part of this, we recently consulted on changes to our fines policy. We have proposed imposing fines on a more transparent and consistent basis. This will include significant increases in cases where we believe appropriate. Our proposals aim to create a consistent and more transparent framework for calculating financial penalties. The full framework will consist of the following steps:

    — removing any profits made;

    — setting a figure to reflect the nature, impact and seriousness of the breach;

    — considering any aggravating and mitigating factors;

    — achieving the appropriate deterrent effect; and

    — applying any settlement discount.

  18.  In July, we set out our proposals on financial penalties in enforcement cases.[1] We proposed that fines should be linked more closely to income and be based on:

    — up to 20% of the company's income from the product or business area linked to the breach over the relevant period;

    — up to 40% of an individual's salary and benefits (including bonuses) from their job relating to the breach in non-market abuse cases; and

    — a minimum starting point of £100,000 for individuals in market abuse cases.

  19.  We expect to publish our decision on this early next year.

Conduct risks

  20.  Conduct risks are those that arise from the way firms transact their business with their customers that could lead to actual or potential consumer detriment. We want to raise standards in firms to drive a market that is efficient, delivers fair outcomes for consumers and addresses consumer issues when things go wrong.

  21.  Critical to the success of our intensive supervisory approach is that we form an integrated view of a firm's risk. Recent events support the proposition that effective risk identification requires single supervisory oversight, encompassing both prudential and conduct of business risk.

  22.  We are currently undertaking several thematic projects to deal with crystallised risks. As part of this, we recently secured redress of around £100 million for consumers whose mortgage payment protection insurance cover had been varied, or whose premiums had been increased, as a result of firms relying on unfair contract terms.

  23.  We continue to ensure that we take account of the consumer perspective in setting our priorities. This is demonstrated by our recent decision to appoint a new specialist senior adviser on consumer issues and to strengthen consumer representation on our Board. We are also continuing our active enforcement agenda to protect vulnerable consumers. As part of this, we recently fined GMAC RFC Limited £2.8 million for the unfair treatment of customers in arrears and repossessions and secured redress of up to £7.7 million (plus interest) for over 46,000 mortgage customers.

Mortgage Market Review

  24.  In October, we published our Mortgage Market Review[2] which took an in-depth look at the UK mortgage market and set out proposals for the major reforms required to ensure that it works better for consumers and is sustainable for all market participants. While we acknowledge that the market has worked well for many borrowers, some have suffered great financial distress. Our proposals seek to protect consumers not only by ensuring that the financial system is prudentially sound, but also by ensuring that firms conduct their business fairly. However, they are also based on greater realism about how consumers behave in practice. We propose to intervene where necessary to curb sales of high-risk products, or sales to particularly vulnerable borrowers, or both.

  25.  The review discusses the prudential reforms already under way and the impact we believe they will have on the mortgage market. It also discusses the conduct of business reforms we believe are necessary to constrain irresponsible behaviour. Among other things, we signal our willingness to intervene in product development and design where the risk to consumers is clear.

Solvency II

  26.  We continue to make progress on the Solvency II Directive, which will have a significant impact on all UK insurers. On a fully costed basis, we estimate that this Directive will lead to direct FSA costs in excess of £100 million over the lifetime of implementation. We will seek to staff this project without diverting resources from other prudential work.


  27.  We recently published a Feedback Statement[3] which set out our response to the feedback we received on The Turner Review and its associated Discussion Paper 09/2: A regulatory response to the global banking crisis. The Feedback Statement also reported on the progress made since March in implementing change and in achieving international agreement. The feedback we received raised some important issues relating to detailed implementation, but in general supported the broad thrust of the agenda proposed in the Review and now being pursued.

  28.  We also published a further Discussion Paper, The Turner Review Conference Discussion Paper, A regulatory response to the global banking crisis: systemically important banks and assessing the cumulative impact,[4] which focuses on two key issues where there is still significant debate.

  29.  Our current position on the first of these issues, how to deal with systemically significant "too-big-to-fail" institutions, is that:

    — There is a strong case for applying some form of capital (and perhaps liquidity) surcharge internationally for systemically important banks; surcharges could be proportionate to continuous and increasing measures of systemic importance, avoiding the dangers created by specific thresholds of systemic importance.

    — A capital surcharge could be combined with an approach to global banking groups that places greater emphasis on the standalone sustainability of national subsidiaries, with overt understanding that home country authorities will not be responsible for the rescue of entire groups. The more that groups are organised on this basis, the less the required surcharge at group level might need to be.

    — Action should be taken to reduce inter-connectedness in wholesale trading markets, with much over-the-counter (OTC) derivative trading moved to central counterparties (CCPs), and with effective collateral and margin call arrangements for bilateral trades which reduce the dangers of strongly pro-cyclical margin call effects.

    — Reform to trading book capital should significantly increase capital requirements and differentiate more strongly between basic market-making functions that support customer service and riskier trading activities, with a bias for conservatism in relation to the latter.

    — Systemically important banks should be required to produce recovery and resolution plans (living wills) which set out how operations would be resolved in an orderly fashion. If a supervisory examination of these plans reveals serious obstacles to resolution, then steps will need to be taken to reduce or remove them—this could require restructuring certain parts of the group. Restructuring could include clear separation between retail deposit-taking business and businesses involved in proprietary trading activities, with the latter able to fail even if the former were supported in crisis conditions.

  30.  The Discussion Paper also focused on the need to assess the cumulative impact of multiple reforms. There is strong international consensus that the global framework for prudential regulation must be radically reformed to create a more robust and resilient financial system. In future, the global banking system will hold significantly more capital and liquidity, and operate at lower levels of leverage. In theory, the optimal level of capital and liquidity in the banking system should reflect an optimising trade-off between the benefits of reduced financial instability and the costs which may arise from a higher price or reduced volume of credit extension and maturity transformation. We have stressed the need to assess the possible cumulative impact of multiple reforms to capital and liquidity regimes now being considered by international standard-setting bodies. This includes describing the case for significant increases in capital and liquidity requirements to reduce financial instability risks, while recognising the potential implications for lending volumes and the cost of credit intermediation.

  31.  We remain committed to the international process and continue to believe that the issues identified in this Discussion Paper should be tackled globally. International agreement will be particularly important in the development of coherent approaches to systemically important globally active institutions. We will continue to work with other national authorities, as they develop their own approach to systemically important firms, and bodies such as the Basel Committee on Banking Supervision (BCBS). The BCBS will be issuing proposals on a global standard for funding liquidity and the quality of capital by the end of 2009 and will consider the calibration of the overall regulatory framework in 2010. This work is likely to include analysis of the options for dealing with systemically important institutions, including systemic surcharges.

  32.  The International Monetary Fund, alongside the Financial Stability Board (FSB) and BCBS, is working to develop guidelines for assessing systemically important institutions, markets and instruments. These guidelines are due to be presented to G20 Finance Ministers and Central Bank Governors in November. The FSB will look at systemic issues through its Standing Committee on Supervisory and Regulatory Cooperation, chaired by our chairman, Lord Turner. It will also look at the international elements of recovery and resolution plans (living wills) through its crisis-management groups, which are due to meet in late 2009 and 2010.

  33.  We intend to press ahead with resolution and recovery plans in the UK and work is under way to produce guidance for systemically important institutions to use in developing living wills. The plans will build on requirements we have already put in place that contribute to a firm's preparedness for recovery. By the end of 2009 a small number of major UK banking groups will have begun to produce living wills as part of a pilot exercise intended to help us to develop policy in this area.


  34.  We have published new liquidity rules to ensure banks can raise cash funds more quickly when economic conditions are tough and market confidence low.[5] In The Turner Review, we highlighted that a lack of liquidity was a major factor in the economic crisis and recommended fundamental changes to the way banks finance themselves. Our new requirements are designed to protect customers, counterparties and other participants in financial services markets from the potentially serious consequences of poor liquidity risk management practices in financial firms.

  35.  We are the first major regulator to introduce tougher liquidity rules based on the lessons learned from the financial crisis. We are keen that firms learn the lessons from the recent crisis and our regime is sufficiently flexible to allow us to amend it through time to reflect any new international standards. We believe the new rules will bring about substantial long-term benefits to the competitiveness of the UK financial services sector, which depends on counterparties' perception of the financial soundness of the firms that operate here.



  36.  The new legislation on financial services will further strengthen the regulatory structure for the financial sector and provide us with an explicit financial stability objective. We have engaged in constructive dialogue with the Treasury and the Bank of England throughout the development of the Financial Services Bill and we will continue to work closely with the Government as this legislation passes through Parliament.


  37.  The financial crisis exposed a number of underlying problems with the EU's approach to macro-prudential regulation, particularly in relation to cross-border retail banking. On 23 September, the European Commission published its proposals to reform Europe's regulatory architecture. These will establish three European Supervisory Authorities (ESAs), which replace the previous Level 3 Committees.

  38.  The reforms will also create a European Systemic Risk Board (ESRB), charged with identifying major trends in the financial system and major threats to financial stability. Its focus will be on macro-trends and macro-prudential issues, not the micro-prudential risk assessment or supervision of individual firms. In addition, Europe's new arrangements should encourage and allow for global cooperation and standards.

  39.  It needs to be recognised that these changes will have a significant impact on our remit. In general, rule making will be undertaken in future at European level by the new ESAs (of which the FSA will be a voting member). We will remain focused on our supervisory work and will seek to influence rule making through our engagement with the new bodies.

  40.  Although the EU's proposed arrangements are different in a number of significant respects from those put forward by the UK (which broadly reflected The Turner Review), we are committed to making the arrangements agreed on in the EU work well. We will continue to work closely with the Treasury to promote an EU regulatory architecture which will help in the key task of identifying and mitigating risks to consumers and financial stability.

  41.  The new bodies must work effectively, particularly in the areas of rule making, mediation, peer review and enforcement. It will be particularly important that the new bodies bring about a swift improvement in the quality and consistency of national supervision. We welcome the prospect of stronger oversight of cross-border financial services groups in Europe, and a greater capacity to identify risks in the financial system, while keeping day-to-day supervision at the national level where it can be most effective. As a global financial centre, the City of London should benefit from these steps. The European Council has been clear that the new framework should support sound and competitive EU financial markets.

  42.  We believe that the success of these proposals will depend on a number of factors. These include the ability of the proposed ESRB to develop good quality risk analysis, the willingness of national supervisors and politicians to act upon this analysis, and the achievement of a commonly agreed and enforced rule book. Another important element of the proposals is the creation of a robust process of peer review between supervisory authorities—both looking at our resourcing and supervisory processes, as well as ensuring that national supervisory authorities are implementing EU requirements.

  43.  To have confidence in the firms which, through passporting rights, are allowed to operate in each host country on the grounds that their home country is supervising them effectively, we, ourselves, must be open to challenge and to the exchange of ideas on how to do supervision. In addition, the structures for cross-border business must recognise the national interests of the host country. Host states should have the right to receive prudential information about entire groups and should be given powers to restrict the activities of branches where prudential weaknesses are not being adequately addressed by the firm or its home supervisor.


  44.  We recognise that consumers are particularly exposed in these difficult economic times. We have a statutory objective to raise public awareness of the financial system. We fulfil this obligation through our financial capability programme.

  45.  The programme aims to enable better informed, educated and more confident consumers to take greater responsibility for their financial affairs and play a more active role in the market for financial services. Individual financial capability projects focus on specific groups in the population, targeting information and help to the specific circumstances they are facing. These include new parents, young adults, students, employees and people in further or higher education, as well as people requiring generic money guidance.

  46.  In April, we launched the Moneymadeclear Pathfinder, in association with the Treasury. This is a service offering practical and impartial help and guidance for people in the North East and North West of England on how to manage their money. This service delivers guidance on money matters face-to-face, over the telephone and online. The service aims to help people tackle their money worries and make informed financial decisions with confidence. The Government announced in its White Paper Reforming financial markets that the service would be rolled out nationally in 2010.

  47.  The Government also announced in the White Paper that, in order to strengthen our consumer education capability, it intended us to establish an independent consumer education and information body. The new body will take the strategic lead on consumer education and information provision relating to personal finance in the future. Subject to Parliament passing the enabling legislation, we expect this new body to be operational from the first half of 2010.

17 November 2009

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