Select Committee on Constitution Minutes of Evidence

Examination of Witnesses (Questions 860 - 879)



  860.  But in terms of the way the system operates would it be fair to say that really the accountability comes through openness?
  (Mr Whittaker) Yes, I personally think it comes through openness but also clarity about what that openness should be. Just a requirement to be open and transparent is quite difficult for the outside world to bite on, because it is quite difficult sometimes if you put out a set of proposals for people to see what the implications of them are, but what our legislation does is require us to explain what we are trying to achieve, how that relates to our statutory objectives, and it also requires us to explain how we meet these various different criteria, which I think allows people a purchase on the consultation which they would not otherwise have if you simply had a consultation part.

Lord Fellowes

  861.  I confirm my interest, which I think is already recorded, as being employed by a bank. Luckily we have started in an area I think which is not tainted by that interest so perhaps I could follow the train of questioning. I think it is fair to say that part of your accountability is delivered by the exercise of the quite severe disciplinary powers available to you: I have always wondered where the boundary lay between those and those to be exercised by the law, and when you decide for instance that you will not exercise your powers in a case and you instead hand it over to the Serious Fraud Office. Can you tell us a little bit about that?

  (Sir Howard Davies) The aim of the legislation generally was to try to bring more of the responsibilities for policing misbehaviour in markets, if I may use a non technical phrase, into the hands of the Authority, because in the past the regulators handled disciplinary matters within their rule book but the DTI handled, in theory, market abuse so the key innovation under the Financial Services Authority—and in many respects, although we talk about a brand new regulatory authority, we are doing what the regulators used to do but the key innovation was to bring those two powers together so we may decide, faced with a particular set of market circumstances, to elect to go the disciplinary route, if that is appropriate, to elect for a civil prosecution, to elect for a criminal prosecution, which in certain circumstances of market abuse we can do, and the idea is that that should produce, if you like, the most proportionate and the best approach because I think the analysis which led to that conclusion was that in the past the pursuit of criminal action in some cases has been unsuccessful and has therefore led to no remedy and no punishment, whereas a civil or a disciplinary action could perhaps have been successful. Now, there is a requirement on us also to discuss particularly serious cases with the other potential bodies involved and there is an agreement between prosecutors where we are then supposed, if we see a particularly difficult case, a collapse of a major company where there could be fraud involved, to sit down and say "Whose is this", based on the initial review we can do. In some cases this has led to us pursuing action: in some other cases—Independent Insurance is one—that led to the SFO taking the lead on the action. That is how the system is intended to operate. There are probably too few examples so far for us to be able to prove definitively that it operates effectively, but at the moment I would say that it is working quite sensibly.

  862.  So you would judge the degree of grossness, if I can put it like that, and also this question of fraud: in a way, abuse of markets always contains elements of fraud, does it not, because somebody is being defrauded, so to say you would think about it and to say you would bring in an outside disciplinary party if fraud was involved—
  (Sir Howard Davies) I think "nearly always" may be true but there are cases of abuse in the markets, and we have had one or two recently, where people have lost money doing it, so you may say nobody else has been defrauded but nonetheless their intent has been to manipulate the market, so I do not think that is always the case.
  (Mr Whittaker) I think we have published the criteria as to the factors we would take into account in considering whether a case was more appropriately dealt with by us or the Serious Fraud Office. Those include issues such as whether any potential defendants would be people outside our jurisdiction, and where obviously it would make sense for the Serious Fraud Office to deal with the issue as a whole rather than have two different sets of proceedings.

Lord Elton

  863.  You have a very wide spectrum of bodies to regulate in terms of size and function. To what extent do you have a common rule book, and to what extent do the different sectors have different rule books, and to what extent do you think I should be asking these questions one after the other? I will stop there.

  (Sir Howard Davies) We have one hand book of rules and guidance so we have got an integrated handbook. That is, however, divided into different chapters and sections depending on the type of business that you are regulating. The essential architecture, and the best way of thinking about it I think, is that there is a single authorisation these days to do any kind of financial business so no doubt all of you receive letters from some financial institutions and they will now say at the bottom "Regulated by the Financial Services Authority". However, if you apply for authorisation to the Financial Services Authority, it is essentially like applying for a driving licence—in other words, there is one driving licence but then it will say, "These are the things you are entitled to do with this driving licence" and we call those "permissions". For example, you are entitled to drive a car but not a road roller or a tank transporter, etc. Different authorisation criteria apply to different permissions and different sections of the rule book apply to different permissions, so if you are just a financial adviser and you only want permission to give financial advice and you do not want to hold client money or make investments, you just apply for that and then only parts of the handbook will apply to you. The more permissions you have the more parts of the handbook apply to you. That is the essential architecture of it.

  864.  Has any element of self-regulation survived the Financial Services Authority?
  (Sir Howard Davies) Yes. If I may give two examples of where that is the case, we were given in the act the power to endorse the takeover code, for example, so the takeover code remained in being as essentially a self-regulatory document with a panel which is essentially self-regulatory, and we have a specific power to endorse that. The only difference now is that the takeover code must be compatible with our code of market conduct—so, as it were, the takeover code cannot give you a safe harbour from something which we would regard as market manipulation but in other respects that is self-regulation. There are other examples where self-regulation persists in that we would be entitled under our Act to impose conduct of business standards on certain aspects of banking, for example, but we have chosen instead to allow the banking code to continue in operation which is a self-regulatory code because we believe that is a proportionate response to such potential mischief as there might be in ordinary borrowing and lending powers of retail banking. We do not have the power generally to endorse other people's codes of practice but we can take them into account, and I might just give you two examples of that: one is the raising standards initiative promoted by the Association of British Insurers, and we have taken account of that in devising our requirements for disclosure, etc, and also in setting up our regime of general insurance regulation we have said that we will take account of people's existence within the General Insurance Standards Council when we authorise people, so we will take account of people who are in good standing in the self-regulatory body as we organised, but what we can do is somewhat constrained. We would not be able under the European Directive simply to say that anybody who is already organised by GISC can come under our regulation without further application because that would not be consistent with the directives.

  865.  I was many years ago a member of the Takeover Panel. Do I understand that really little has changed there since you became the Authority except that you acknowledged that what they are doing is, provided it is consistent with other legislation, approved?
  (Sir Howard Davies) Yes.

  866.  Does that affect their authority at all? Have you become a Court of Appeal from the Takeover Panel?
  (Sir Howard Davies) No. Your description I think puts it as well as I could. There has been no effective change. When the legislation was passed this was the subject of extensive debate, indeed a rather narrow vote in your Lordships' House, and the government maintained, and this has been borne out so far, that the way it was structured and ensuring that the code was compatible with our code of market conduct would make it very difficult for people to draw the Financial Services Authority into a dispute on a takeover. They could only do so if they could prove that the takeover code was incompatible with our code, and we would not say they could do that because we had certified that it is compatible, or that the Takeover Panel had somehow misdirected itself in relation to its own code. We have regarded that as a remote possibility and no one so far has sought to argue that, so at the moment I would say that at the moment the Takeover Panel is operating precisely as before.

  867.  Are there any other areas of regulation really left to be run by an organisation which you give broad approval to?
  (Sir Howard Davies) I think only in relation, as I have said, to the banking code, otherwise it is not open to us to delegate our statutory authority to a self-regulatory body and endorse it. That is not something we are generally able to do.

  868.  On a slightly different area, you tell us in the fourth paragraph of your memorandum that the FSMA requires the Financial Services Authority to pursue four objectives of which the third is securing the appropriate degree of protection for consumers, while having regard to the general principle that consumers should take responsibility for their decisions. Do you find any tension between those two requirements? Is it quite clear the extent to which consumers must be free to use their own money, and the requirement that they should do so more often than necessary?
  (Sir Howard Davies) This might seem like a semantic point but I do not think it would be correct to say that there was tension between the two because the first part of the sentence is about "appropriate" and that is defined, if you like, in the second half of the sentence. What I would say is that it is quite difficult to calibrate it and to decide at what point you should set it, and the Parliamentary Ombudsman's report on Equitable Life published last week referred to what she saw as a mismatch of expectations in what the public, represented by some of the people who had complained to her, expected a prudential regulator could achieve and what prudential regulation was designed to achieve, and certainly it is quite difficult to explain that we are not even aiming at a non zero failure regime, and we do not think it would be appropriate to aim for a non zero failure regime because to do so would only constrain financial institutions and make it impossible for them to carry out the function of taking risk that we believe is essential to financial markets. Explaining where you are drawing that line and where you are setting that level of protection is probably the biggest single challenge we face in gaining acceptance and understanding for the nature of regulation we seek to maintain, but setting that balance is inherent in the Act. It is quite clear, if you construe our objectives and principles, it would be impossible to construe those and produce a policy statement saying, "We are able to prevent all failure in financial institutions", because I do not think you could justify that against the need to be proportionate, and with cost benefit analysis and competition analysis you would clearly be damaging competition and would clearly be damaging competition and producing regulations where the costs could not be justified by the benefits. I do not think it is possible.

  869.  All of which is readily understood by the Select Committee but how do you make it understood by the general public who had not got the right perception when it came to Equitable Life?
  (Sir Howard Davies) You have hit on, as I said, the most difficult question we face. We have been as clear as we could be in setting out our stall; we articulated all of this in a policy paper called the New Regulator which is the main document which describes our philosophy of regulation; that is not secret—it has been reported extensively—but it is clear that whereas you may get a theoretical support for the notion that a non zero failure regime would be incompatible with the legislation, whenever there is an actual failure that theoretical support tends to drift away from you, and we are working at the moment on a further redefinition of this, a further explanation and we hope a more popular language which we believe will be helpful, but it is a difficult thing.


  870.  And that is going to be supported by the fulfilment of the second function, promoting standards, so that gives you the opportunity to be proactive and raise an awareness?

  (Sir Howard Davies) It does, yes.

Earl of Mar and Kellie

  871.  I believe that the Financial Services Authority is a private company and therefore I want to ask a rather naive question. Can the Financial Services Authority become bankrupt? I am mindful of the fact that the Sporting Authority recently became bankrupt following a defamation suit over drug-taking, or indeed, not drug-taking. Could such an issue of bankruptcy affect your disciplinary issues, and does the possibility constrain your approach at all?

  (Sir Howard Davies) Well, in a general way I think that it would be difficult for us to go bankrupt, if not impossible, because we do have in effect a kind of tax-raising power. We are selling licences, if you like, and we can increase the price of those up to the point of our costs. Now, I guess there might be like anything some reasonable limit to that which might be reached if for some reason the regulator incurred some absolutely enormous liability which would involve a totally unreasonable increase in its fees. In relation to a particular disciplinary case, my board has taken the view that that possibility of not being able to pursue a case which we thought particularly important justifies our holding some level of reserves. In theory you might say we did not need any reserves because the income and expenditure each year will balance out entirely but my board has said, "Well, they think maybe reserve of about 5 per cent, £10 million, is reasonable because precisely because of that possibility we might be out of pocket for a serious amount if we believed a case was very much worth pursuing or we had to defend a case up to some quite high legal expense", but I think as a general proposition we cannot go bankrupt with the few raising powers of the sort we have. It is also relevant to say that we do have a form of statutory exemption except for actions taken in bad faith which is balanced by the Competition and the Complaints Commissioner's ability to make a recommendation for an ex gratia award of compensation, but we are to some degree protected against claims against liability, and we do have some directors' and officers' insurance as well.

Lord Acton

  872.  I wanted to ask about promoting public awareness. In paragraph 15 of your memorandum you speak of the consumer helpline and the consumer help website and you did some figures of calls and hits. How would you promote them? How do I know about them—because I do not.

  (Sir Howard Davies) Well, the main way in which we have done so is through mailings which have been sent out by financial institutions themselves. For example, in relation to endowment mortgages, and it is clear from what you say you do not have one because if you did—and there are ten million of them, you would have received an Financial Services Authority fact sheet, and I know this works because I have received three myself—

  873.  You have got one of mine!
  (Sir Howard Davies)—and we agreed with the industry that in that circumstance where people did have to make some difficult decisions and needed clear explanation as to why their endowments might not be about to pay off their capital sum it was reasonable for them to send out a Financial Services Authority fact sheet which explains the background and which gives them a website and a call number. Under the pensions mis-selling review about two million Financial Services Authority fact sheets went out, again sent by the firms themselves explaining to people what they needed to do if they needed to make a mis-selling claim. In terms of overall coverage and reach that is the single biggest thing we have done, but we have also found that the personal finance pages of the national newspapers have been very ready to advertise our services so they reach the awareness of the readers through that route. If, however, you were to ask whether that was enough, I would say no, it is not. I think we are satisfied with the progress we are making, and we are measuring the awareness of the regulator and it is going up, but we did start from really a standing start because the previous regulators had not seen their role as having a direct consumer dimension to it—they did not have that responsibility and they did not operate in that way. So we are happy to start from scratch in this area and against that background I would defend what we have done so far as being eminently reasonable and, indeed, perhaps more successful than I might have expected partly for the slightly odd reason of the endowment exercise, which has given us the opportunity to get ourselves into the doormat of ten million policy holders. The review carried out on behalf of the Treasury into the retail investment market argued that there was justification for a considerable increase in activity in consumer education, and that has coincided with a change of heart, certainly on the part of our Practitioner Panel, who initially were rather resistant to this. In our initial consultations they said, "We do not see why we should pay for consumer education funds—indeed, the budget we have produced for that has been squirrelled away by managing to make savings elsewhere and only the top line has remained the same", but they have rather changed their view and seen that a regulatory system based on a caveat emptor principle which is about informing people and enabling them to make good decisions must go hand in hand with a bigger effort on consumer education. We are therefore working on some proposals for a significantly enhanced approach to consumer education which will be publishing for consultation in the autumn.

  874.  Secondly, in paragraph 17 you talk about the independent Complaints Commissioner. In part asking the same question again, she deals with different firms, employees, listed companies and consumers. I wanted to ask really three questions: firstly, how many complaints has she handled in the last 18 months; 2: How many of those complaints are directed at consumers; and 3: How do consumers know of her existence?
  (Sir Howard Davies) I can answer the third and we can send you a note on the others but this is in her annual report published a couple of weeks ago[2]. The total number of complaints that have come to her is somewhere between 100 and 200 I think, but relatively few have been resolved and so far one has involved the recommendation for an ex gratia payment, which the board agreed to make, for £250. The way in which people have become aware of it is, I think, reasonable. We have published something about making a complaint. Most tend to originate being a complaint about a firm, and the complaint would then typically go on, if it is a consumer, to being about the regulation of the firm. The rule is you complain to the firm initially, the firm, let us say, in this case gives you an answer which you are not satisfied with and then you make a complaint to the regulator, and the regulator may give you an answer which you are not satisfied with but that answer will say, "If you are not satisfied with this answer, you may complain to the Complaints Commission". So that is the trail people follow.

Lord MacGregor of Pulham Market

  875.  Can I begin by declaring an interest as a director of a life assurance pension and asset management plc? I have two sets of questions, if I may: the first is wearing my hat as a former chief secretary; although I realise there is no public expenditure involved but it is the value of money aspect. Your paper and the initial legislation is full of references to cost benefit analyses, value for money, etc, but in terms of cost benefits, regulatory impact assessments and so on, the deputy chairman of the Financial Services Practitioner Panel last week put to us, and I think it is in his letter to the Treasury in the N2+2 review, an area concerning them, "I think we would like to see the process defined more tightly particularly in respect of research and supporting cost analysis. It is a difficult area and I know the Financial Services Authority are looking at it and in particular looking at the post-hoc reviews which we would also like to see carried out". Can you tell us where you are on that?

  (Sir Howard Davies) The post hoc review point is probably going to be one that is principally for my successor, and I think one needs to be open and straightforward about this, because we are not required in the legislation—and Parliament considered this but decided it was not reasonable—to conduct a cost benefit analysis of the whole of the regime we inherited. You could not really put the whole thing on ice and then have a look at it to see if it made sense. The cost benefit regime applies to anything new we put in place or anything we change. It would be fair to say that since December 2001 we have not changed a lot. We have changed some things and have put some new things in place—indeed, the industry perhaps thinks we have done too much. Basically we have changed the disclosure requirements for the retail area, we have changed the polarisation rule, although that does not take effect until early next year; we have introduced a new code of market conduct on market abuse so that is a significant change—so one can point to some things we have changed. However, I think it would be fair to say that the changes we have made have either not yet happened or have not been in for long enough for us to be able to do a post hoc review of those changes. Now, we have done some post hoc reviews of aspects of the old regime which of course have led to the changes—for instance, we did a review of what we thought of polarisation, in particular its impact on competition, which led us to the conclusion that that could not be justified any longer as a rule because of its impact on competition and therefore we changed it. I think in future you will see more of these post implementation reviews, and I would see that as a continuing part of the process. On the first point, the more general point the Practitioner Panel make, there are one or two specific cases which they were concerned about in relation to our research—I think on those we have broadly satisfied them now—but the point which I am not quite sure came out of the sentence you quoted that they are most concerned about, which is not unreasonable is the interaction between different changes and the cost benefit of the system more broadly, if you like.

  876.  They raise that as well. The number of reviews going on, for example, and the number of consultation documents.
  (Sir Howard Davies) Yes, they raise that, and I think they say fairly, as they did to you, that only some of those are us. Sandler was not us, Cruickshank was not us, and of course the biggest changes we are implementing at the moment are European directive driven. That is the biggest single influence on the changes to our rule book. I would accept that the technology of cost benefit analysis in this area is not as well-developed as we would like, but I would assert without fear of contradiction that it is better developed here than anywhere else. We have looked around the world for examples of cost benefit analysis and financial regulation and we have not found much. The Australians have done some work which has been helpful to us but not very much and we are really at the leading edge here. The IMF commented on that in their review of us.

  877.  Where you are looking at a particular set of complaints made by whoever it might be and you are pursuing them in a certain way when you are asking firms to do all sorts of things, do you also apply cost benefit there?
  (Sir Howard Davies) If I might parse that question, if it is a question of requiring firms, for example, to handle complaints in a particular way, which we have done, then the answer is yes because we would need to prove that that was a reasonable way of handling complaints and not too costly. If, however, it is an enforcement action based on breach of the rule, we would not be required to perform a cost benefit analysis in that form but we do, and I have said explicitly, take a risk-based approach to regulation and we take a proportionate approach to enforcement and therefore we do not pursue every contravention that we find: we use what we call creative policing where, if we find some breaches which we believe to be significant but not significant enough to go through the full enforcement process, we haul people in and explain that we do not like it and invite them to change their behaviour, so we have a flexible range of enforcement tools, our use of which is informed by the principles of good regulation, proportionality, etc, but it would be fair to say we do not carry out a cost benefit analysis before we decide to investigate mis-sellings for capital investment trusts, for example.

  878.  Lastly on this aspect, if the Financial Services Practitioner Panel felt at any particular instance, and I realise at this stage it is pretty theoretical because there is no example, but if at some point they wanted to challenge your cost benefit analysis, there is no process of appeal beyond you, is there? The buck stops with you.
  (Mr Whittaker) The way in which it works is that we are required to take into account a cost benefit analysis when our board makes rules, so that if we made rules on an inadequate basis and the cost benefit analysis had been produced on a mistaken basis or it did not justify the rules, then those rules themselves could be potentially challenged by judicial review on the basis that they had been made irrationally or unreasonably.
  (Sir Howard Davies) And I can tell you that our board is very alert to this point and is very keen at any point on rule-making to know what the Practitioner Panel may have said and to know whether there are any areas in this checklist where we have not been able to respond to their points. I think it would be highly unlikely if the Practitioner Panel said, "We believe your cost benefit analysis is fundamentally flawed". I think it would be a brave board that would proceed on that basis without having produced a reasoned argument as to why they did not think it was flawed because they would certainly be open to judicial review on that point.

  879.  On the second set of questions, I wanted to ask you a little bit about the appeal and accountability process. You have indicated all the various areas where appeals can take place and so on and you have just referred to judicial review as being one of them. Which are the ones you are most watchful of, and are most in your mind when you reach decisions?
  (Sir Howard Davies) We need to separate out the rule making from the enforcement here. We have mainly been talking about rule making this afternoon, and on the rule making the three we have been concerned about is to talk extensively to our two panels so that they do not believe that anything we are doing is obviously unreasonable or incompatible with the principles and also, as I have said, the competition oversight point is very much in our minds. I do not think it would be difficult to rank them more than that but those three would be certainly very strongly in our minds, and our board is very aware of that and anything that comes forward. If someone has not put in a paragraph saying "What does the Practitioner Panel think?", you can be sure someone will say "What do they think and what does the Consumer Panel think", and then we would need to go to that. On the enforcement side we are talking about a different kind of process where we have a regulatory decisions committee which is of completely separate people from the Authority, designed to meet the European Convention of Human Rights requirements, and from that there is a move to the Financial Services and Markets Act Tribunal which is where people do not like the outcome of the disciplinary process within the authority. That is of great concern to us but probably it is fair to say that I and the board are less concerned about that because the decision has already been made by a set of people who are outwith the Authority including serving practitioners and serving public interest people, so I do not think the board gets terribly anxious about it because at that point a group of independent people have reasonably taken the view that this is a contravention and if someone disagrees we had better go to court and find out who is right. I think on that side the board observes that process and it would only become anxious about it if every single decision from the RDC was being overturned at the Appeal Tribunal. Then I think the board would say, "Well, there must be something wrong with the construction of the RDC". But I think it is the panel's oversight that is more important on the regulation.

2   Note by the witness: The Commissioner received 140 new enquiries and complaints during 2002-03. Of these, 55 per cent related to the FSA. The Commissioner's Annual Report can be viewed at Back

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