Examination of Witnesses (Questions 860
- 879)
WEDNESDAY 9 JULY 2003
SIR HOWARD
DAVIES AND
MR ANDREW
WHITTAKER, FINANCIAL
SERVICES AUTHORITY
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.
Chairman
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 www.fscc.gov.uk Back
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