Regulating in a recovery

Good evening. Thank you to the CASS Business School for hosting tonight’s event. It is a great pleasure to share with you some thoughts this evening on ‘Regulating in a Recovery’. I only hope that I am not tempting economic fate by using such a title; I do not mean to do so, as my remarks will largely relate to the regulation of conduct, rather than the regulation of prudence.

Lessons learned from downturns, especially where people lose money, have the habit of being forgotten in the subsequent upturn. Nothing creates memories better than disaster, and nothing blurs them better than success.

Experience has taught me to be wary of the phrase ‘this time it will be different’. If history has taught us anything, it is that we are destined to repeat the mistakes of the past, once we have lulled ourselves into believing that a problem has been definitively resolved.

This is particularly true in financial matters, where lessons learned from downturns, especially where people lose money, have the habit of being forgotten in the subsequent upturn. Nothing creates memories better than disaster, and nothing blurs them better than success.

I was in Washington two weeks ago and was reminded of the words of Hugh McCulloch, the first controller of the currency who, in 1863, wrote some good advice to bankers based on his experience.

Pursue a straightforward, upright significant banking business. Never be tempted by the prospect of large returns to do anything but what may be properly done…. Splendid financiering is not legitimate banking, and splendid financiers in banking are generally either humbugs or rascals.

Here we are, 150 years on, believing we have learnt some of this all over again.

There is, of course an equal and opposite danger, that of re-enacting the last war, rather than concentrating on preventing the next one.

So it is the responsibility of all involved to steer a wise course between these two, and thereby create a regime fit for the future.

And the relevant question therefore for tonight is – what is the direction of conduct regulation, in the context of a safe and successful financial services sector in the future?

I have in my mind a sequential four-point plan:

• structure
• clarity
• effectiveness, and
• continuous improvement

On structure, much good work has already been done. In the UK, the creation of twin peaks has provided the much needed separate focus on prudence and conduct by specialists in their respective areas. Fears of incompatible overlap expressed at the outset have proved, I would claim, so far largely unfounded. I expect periodic instances to emerge, but at least the tensions will be explicit, and any dilemma resolved in a more transparent manner than has hitherto been the case.

At the FCA we have been set one overriding objective of ensuring markets work well, supported by just three operational objectives concerning customer protection, competition and integrity. As a package they are refreshingly easy to understand. But make no mistake, making markets work well is a much greater challenge than preventing them from working badly, which can readily be achieved by preventing them from working at all!

Internationally, the FSB has made great progress in the prudential space, particularly in seeking to ensure that the phenomena of ‘too big to fail’, cannot re-occur, recognising that better international cooperation is an essential ingredient for success. As yet there has been less debate on ‘too big to behave badly’ but you may have noted that the President of Federal Reserve Bank of New York, Bill Dudley, made a speech in October in which he addressed this issue. And here in the UK the output of the recently launched Fair and Effective Markets Review led by the Bank, together with the Treasury and the FCA, will, I have no doubt, take our own thinking further forward, whilst recognising that the UK is no island when it comes to its central role in global financial markets.

Structure is all very well, but it is an enabler rather than the solution in its own right. And this leads me to the second point in my plan, the need for clarity of what we expect from 21^st century financial services. I had thought, or at least assumed, when I first joined the FCA, that our conduct requirements were generally understood by the industry and consumers, if not always accepted as being the right ones. I quickly learned that it was not so straightforward, and in particular there was much talk of the moving of goal posts, expectation gaps and retrospective regulatory activity.

Much of this was, with hindsight, sophisticated lobbying, but some reasonably founded in fact. Either way, it brought home to me the importance of a clear regulatory expectation, in ensuring that markets work well.

It may be, as historical perspective takes shape, that the standards of conduct generally accepted in the nineties and noughties, became unacceptable in 2010, and that the goal posts have moved on. The tectonic plates of the financial services industry periodically shift, just as they do in other walks of life. Up until 1869, we used to put people in prison for failing to pay their debts. In 1951 in the Money Lenders Act we described a 48% interest rate as ‘unconscionable’. In 2014, we have introduced rules to cap the costs of high-cost short-term credit.

What we need to do now is to re-establish equilibrium to the new norms, rather than hope for, or hark back to, the old ones. I hasten to add that I believe that we are well on the way to doing this, firms have undoubtedly prioritised conduct – including conduct risk – and certainly the FCA is trying to play its necessary part in explaining what is expected. Our recent paper on the Expectations gap, our launch of Project Innovate, our participation in the FEMR and our much closer monitoring of consumer views are evidence of a change of regulatory mindset.

Some things have not changed however. Egregious behaviour remains egregious. Our market integrity objective is not negotiable. The need for consumer protection has if anything increased rather than diminished, particularly with the proposed changes to the pensions regime. The inevitable complexity of some long-term financial decisions, the asymmetry of knowledge between producer and consumer, and the unfortunate history of products coming to market designed to benefit the industry rather than the public, demonstrate beyond all reasonable doubt the continuing need for an effective conduct regulator.

As to the future, I would like to believe, counterintuitively at first sight, that the improvement in conduct will move inversely with the quantity of new rules in areas that we already regulate.

Before I leave clarity, I want briefly to visit the Rules versus Principles debate. The FCA has eleven principles, and probably eleven thousand detailed rules. It is a fact that in all the major enforcement cases that it has successfully taken over the past five years, the breach committed related directly to one of the eleven principles. As far as I am concerned, the principles are therefore here to stay.

The question is how many rules do we need as well? I instinctively believe that less is more, on the twin grounds that (A) we have made a great many rules already but they don’t seem to prevent further problems arising, and (B) what starts as an attempt to provide clarity frequently ends up creating complexity.

Julie Dickson, previously at the Canadian Office of the Superintendent of Financial Institutions summed this debate up better than I can. She talked in 2010 about the Canadian system and its avoidance of some of the fallout from the crisis being related to a focus on principles. She said:

‘Having lawyers looking at this line or that clause and debating with you about whether something is do-able or not is not the right conversation to have. The right conversation is the principle.’

I would only add to her words the attractiveness of the ‘do-as-you-would-be-done-by’ test in having that conversation.

We are where we are, with a rule book that looks a bit like layers of sedimentary rock, eminently explicable as to how it got there, and extremely hard work to change radically. We shall have to live with that for now, particularly as we have to add to it the steady stream of European Directives and Regulations as they are introduced. As to the future, I would like to believe, counterintuitively at first sight, that the improvement in conduct will move inversely with the quantity of new rules in areas that we already regulate.

With an improved structure and greater clarity, I move to my third strand, the effectiveness of regulation.

When we launched the FCA we undertook to be different in various respects, and in particular to be forward looking, and thereby preventative, and to be deterrence based.

It is much too early to draw any definitive conclusions, but there have already been some interesting moments where the theory has been tested against reality.

We have learned the hard way that regulation by waiting for things to go wrong and only then attempting to clear up the mess is both low ‘value added’ and very unsatisfactory to the general public. It leads to the regulator being held in low regard, which in turn makes it more difficult for us to be effective in the future.

The lesson has been taken on board, there is now the not insignificant challenge of making a success on the ground of a preventative strategy.  It can be done. Take, for example, the case of interest only mortgages, where the ‘early’ intervention was to draw the issue to everyone’s attention and to highlight the need for a repayment plan. Take, more controversially, our intervention on interest rate hedging products, where a ‘voluntary’ redress scheme was entered into by the banks involved to a timescale that could never have been met in a wholly adversarial action. What we have found, in these and in other instances, is that the earlier or more actively we intervene, the more judgements we have to make. We find ourselves making some on balance decisions, which then meet hostility amongst those who believe themselves to be incorrectly or unfairly treated by our actions.

I maintain that this is the better way to proceed. The various rights of appeal against our decisions provide legal safeguards instance by instance. The overall benefit of good early intervention, graphically illustrated in the alternative by the cost of payment protection insurance (PPI) redress, is clear. Regulation is not a zero sum game. It places a considerable onus upon us to be wise in our judgement, a responsibility which we accept.

On deterrence, we have positive story to report. The combination of what we have said, and what we have done, in the past two years has put conduct firmly on the map for the future. Again the aim is quite simple. We need to get to a position where the chances of getting caught committing a serious breach, and the consequences of so doing, make it sufficiently bad business sense to allow it to happen in the first place.

I am encouraged by the direction of travel. On the consumer side, we have developed much closer links with representative channels, so that we get better intelligence earlier. And the great majority of the firms we regulate have got the message and are working hard on their own procedures. In particular there is a far greater emphasis now being placed on evaluating the benefits of products to the customer alongside their benefits to the business. This is surely how it should be, and it comes with the huge benefit of a significant overlap in regulator and regulated objectives.

On the wholesale side, there is an equal recognition that whilst the consumer protection issues do not arise to nearly the same extent, the market integrity ones are even more important. I am sometimes confronted with the argument that inappropriate regulation is in danger of making London uncompetitive. I maintain that inappropriate conduct is a far greater danger in the long run to our global standing.

In both the retail and wholesale spaces, we face some short-term challenges that we need to recognise. The public are less interested in the good intent than they are in the good outcome. But genuine culture change in large organisations does take time. Pending culture change, firms may need more rules and controls rather than less in order to ensure good behaviour at the customer interface. So we are now in that ‘exposed’ period where the words and the actions are not always in sync. Given the lack of trust that remains there is always the danger that the demand for ‘something more to be done’ becomes unstoppable just as the need for it begins to diminish.

We need to be mindful of this as we contemplate new rules. But it is not the job of the regulator to be either optimistic or pessimistic about the future behaviour of the industry. We are responsible for regulating the here and now.

And so to my last point, we need continuous improvement. Structure, clarity and effectiveness are essential to getting the existing regulatory model to work well, but they are not future proof in themselves.

Regulators have a big job ahead of us, but modest as compared to the changes required of some of the firms we regulate. Their future behaviour will shape the future of regulation, and over time they will get, from Parliament, the regime they merit.

Improvement may take many shapes, and none of us are clairvoyant. Technology for example is driving rapid change in what is possible, both for firms and for us.   But there is one new objective given to us as the FCA, of which I have considerable expectations. This is our competition mandate.

It is the case that in many parts of the financial services industry there are natural economies of scale. Add to these the desirable barriers to entry that the regulators have added in the interests of protection, and the less desirable ones caused by the complexity of complying with the rules, and it is not surprising that we find ourselves with some very significant oligopolies, not just in retail banking. And whilst there is clearly competition between the participants within these protected spaces, it is by no means clear that it always results in benefits to the customer as opposed to the reallocation of the not inconsiderable rewards to the players. It will be the role of the FCA with our newly created competition department, the new Payment Systems Regulator and of course the Competition and Markets Authority (CMA), to determine whether competition policy can be effective as a better long term tool of regulation, rather than the short term palliative of the incremental rule.

Let me conclude. We regulators have a big job ahead of us, but modest as compared to the changes required of some of the firms we regulate. Their future behaviour will shape the future of regulation, and over time they will get, from Parliament, the regime they merit.

The latest incarnation, following the financial crisis, is twin peaks. The FCA is a child of crisis. I have argued this evening that we know how to make the new regime work well from a conduct perspective. But we are the means to the end, not the end in itself. It is for industry to demonstrate that it has listened to my friend Hugh McCulloch, and can this time meet our objective, of making markets work well, under their own steam.