UK: Financial Services Bulletin - Regulatory Review

• Reports on the FSA’s clarification of its new regulatory approach (particularly the FSA’s development of a new risk assessment framework to deal with consumer, product, market and industry-wide issues).
• Examines the FSA’s single firm specific risk assessment framework.
• Describes the proposals for the implementation of the European E-Commerce Directive (in broad terms restrictions on the provision of cross-border services by electronic means are to be removed with the introduction of a "country of origin" approach requiring member states to impose requirements on the outward provision of services and remove requirements on inward bound services).

• Analyses the implementation of the outstanding proposals of the final report of the Committee of Wise Men on the Regulation of the European Securities Markets (the outstanding proposals are on market abuse, financial conglomerates and international accounting standards).

• Reports on the Basel Committee’s proposals on the relationship between banking supervisors and external auditors.

The last quarter has been relatively calm in regulatory terms certainly in comparison with the immediate pre-N2 period in the United Kingdom although some important initiatives have nevertheless either been launched or continued.

The two most important areas of activity within the last quarter have been the clarification of the larger ‘New Regulatory Approach’ being constructed, and the implementation of the European E-Commerce Directive.

New Regulatory Approach
Focusing on its New Regulatory Approach, the FSA has issued a second report on Building the New Regulator (February 2002). This follows the original paper, A New Regulator for the New Millennium (January 2000) and a first progress report, Building the New Regulator (December 2000). The FSA’s goal remains to maintain efficient, orderly and clean financial markets and assist retail consumers to obtain a fair deal. For this purpose, the FSA will assess risks which if realised would prejudice the fulfilment of its statutory objectives (taking into account the principles of good regulation also set out in the Financial Services and Markets Act). It will then prioritise activity having regard to relevant risk. A single firm specific risk assessment framework is to be constructed based on a number of impact and probability factors. This will replace, for example, the earlier bank RATE and securities FISBAM frameworks. In the last year, the FSA has developed further its strategic planning framework. This sets out its strategic aims over a three year period as well as providing a yearly review of regulatory priorities. It has tested the firm risk assessment framework on a desktop basis with sample institutions and completed work on the jurisdictional implications of the new regime including, in particular, how the FSA will work with other authorities abroad. It has also developed a new risk assessment framework to deal with consumer, product, market and industry-wide issues and has prioritised its initial work and resources for the 2002/2003 financial year.

The new operating framework set up under Progress Report 2 is based on a ten-stage cycle which includes its statutory objectives, an environmental assessment, the firm and non-firm regulatory risk analysis, its new responsibilities, strategic aims, strategic outcomes, prioritisation and resource allocation, regulatory response, performance evaluation and report on performance against objectives. The regulatory response stage is also now supported by two further eight part (parallel) risk assessment frameworks for firm risks and consumer, product and industry risks. These new frameworks included an impact assessment, discovery, probability assessment, decision on regulatory response and resource allocation, use of regulatory tools, ongoing assessment and response to risk change and performance evaluations.

The FSA has issued its Plan and Budget for 2002/2003 which is the first under the new regime. This includes a list of new strategic aims and priorities as well as performance measurement methodology and budget. The strategic aims are stated to be directed at consumers (putting consumers in a better position to be able to make informed choices and achieve fair deals), firms (ensuring that regulated entities and senior management better understand and secure their regulatory objectives), markets (ensuring that markets are efficient, orderly and clean, leading to enhanced confidence for market users including consumers and participants) and the regulatory regime (establishing proportionate and effective arrangements in which consumers, firms and other FSA stakeholders have confidence). The total budget for 2002/2003 is £180.5 million (which includes £9 million to cover additional responsibilities since December 2001). This is 2.9% higher than 2001/2002 and 8.5% higher than 1998/1999.

The FSA has also issued its first Financial Risk Outlook (January 2002) which considers the changing economic, financial, social and legal background to FSA activity. This attempts to consider recent changes in market development as well as possible future effects. The periodic publication of the Financial Risk Outlook is to be used to establish the larger environmental assessment which will form part of the new operating framework.

Although it may seem that the new approach discussion and regulatory framework may be increasingly removed from day-to- day financial supervision and regulation, the new approach discussion and regulatory framework are important in understanding what the FSA is trying to achieve and will become of increasing significance in determining the nature of the operational relationship established between the FSA and regulated institutions. Although apparently still somewhat removed at this stage from detailed regulatory practice, it has to be expected that this will become more fully incorporated into daily supervisory and regulatory activity. The attempt to construct a new operating system is also understandable although the difficulty that the FSA has had to deal with is how to build a new mechanism or methodology that incorporates all of its separate statutory objectives (financial regulation, consumer protection and financial education as well as financial crime). The associated problem that has arisen subsequently is that the initial operating framework announced in January 2000 was relatively straightforward, only being based on a six part cycle (risk identification, risk assessment and prioritisation, decision on regulatory response, resource allocation, use of regulatory tools and performance evaluation). With each subsequent discussion document, the framework has become increasingly more complex and removed. It is essential that the FSA settles on a final methodology that is both sufficiently developed to be effective in practice and simple enough to be properly understood and applied.

Of possible more immediate importance in regulatory terms than the larger approach and operating methodology is the specific framework to be applied with regard to risk measurement and management within financial institutions. The FSA has continued almost all of the earlier sector specific frameworks with regard to financial (solvency and liquidity) and control issues in the interim prudential sourcebooks. This includes the Bank IPRU (BANK) and securities IPRU (INV). It was nevertheless confirmed at an early stage that these would be replaced by a single integrated prudential sourcebook (IPB) in due course. This new framework is to be based on a ‘risk by risk’ approach which will examine each of the major exposures faced by financial institutions separately and then aggregate them. These exposures will include, in particular, credit risk, market risk, operational risk, insurance risk, liquidity risk and group risks. The final IPB will then replace the earlier bank RATE and other sector frameworks (presently continued within the interim prudential sourcebooks such as BANK (IPRU)). It was originally intended that this would be achieved by early 2004 although this is now to be postponed, certainly for banks, until 2005 or later to allow the FSA to be able to give effect to the proposed Basel Committee amendments to its original 1988 Capital Accord. The FSA has since announced that certain aspects (referred to as candidates) may still be implemented early in 2004. These include systems and controls, insurance firms, investment firms outside the Investment Services Directive, operational risk, market risk and certain other general matters.

The desire of the FSA again to create a new risk-specific framework is understandable with its assumption of full cross-sector supervisory and regulatory responsibility under the Financial Services and Markets Act. It is nevertheless unfortunate that such a simple but effective system as bank RATE is to be replaced so quickly. Bank RATE was only introduced in 1988 as part of the post-Barings supervisory review conducted by the Bank of England. RATE operates by setting a bank’s risk (its CAMEL (capital assets, management, earnings and liquidity and business risks (B)) against its control capability (its com (that is control, organisation and management)). Hopefully much of the simplicity of RATE can be retained within the new IPB and larger new regulatory approach and operating framework being constructed.

European E-Commerce Directive
The other main issue considered by the FSA recently has been preparing its proposals for the implementation of the European E-Commerce Directive. The objective of the Electronic Commerce Directive is to ensure that Europe is able to realise the benefits of e-commerce especially through the promotion of competition and consequent benefits in terms of employment, economic growth, innovation and consumer service. The Directive had been adopted on 8 June 2000 with the United Kingdom Government announcing on 14 December 2001 that it would be implemented during summer 2002. Implementation is being managed through the Department of Trade and Industry (DTI) although a number of separate agencies are also involved (including the FSA and HM Treasury). The Directive operates by removing potential restrictions on e-commerce and attempting to develop consumer confidence in this new business form. Restrictions on the provision of cross-border services by electronic means are removed through the introduction of a country of origin approach which requires that Member States impose their requirements on the ‘outward’ provision of services and remove them with regard to ‘inward’ service arrangements. Certain ‘derogations’ are permitted by way of exception. The Directive generally applies to ‘information society services’ (ISSs). This is defined as any service, normally provided for remuneration, at a distance, by electronic means and at the individual request of the recipient of the service. This would, for example, include internet services as well as solicited e-mail and interactive digital television. Financial related ISSs specifically are to be referred to by the FSA as ‘electronic commerce activities’ (ECAs).

The latest consultation is on the revisions necessary to the Handbook to allow e-commerce activities to be carried on in the United Kingdom. This will require amendments, in particular, to disclosure and other related conditions, the facilitation of outward provision of ECAs and removal of restrictions on the inward provision of ECAs. The FSA will also include a new E-Commerce Directive sourcebook (ECO) within the Handbook. Comment closed on 10 May 2002 to allow the FSA to bring the changes into effect during the summer and still allow a three month transitional period.

The effective implementation of the E-Commerce Directive is of essential importance to the United Kingdom financial services industry. It should, in particular, allow United Kingdom-based firms to provide a full range of new services across Europe through the internet and other digital communication devices. This is of particular significance to the extent that, although passport rights were created under all of the main financial directives some time ago in the areas of banking, securities and insurance, this has not been as successful in practice as intended. The main reason for this has been local reluctance to conduct business through overseas firms. This is, in turn, essentially based on loyalty, language and local cultural identity as well as different national traditions and practices. For many firms, European expansion has only been possible through consolidation (takeovers, mergers or joint ventures) rather than through the exercise of passport rights. It is possible that more significant benefits will arise as a result of the new e-commerce directive than has occurred as a result of the existing financial passports.

It must nevertheless be stressed that a number of difficulties still arise with regard to the Electronic Commerce Directive. Country of origin is not the same as home country control. Inconsistencies will necessarily arise in the application of the existing financial and the new e-commerce provisions. Difficulties may also arise with regard to scope of the new measures, especially with the adoption of the somewhat complex concept of the ISS (even with the FSA’s simpler ECA). The scope and application of the derogations may also significantly undermine the value of the rights created. The derogations, for example, include small e-money institutions, insurance companies, collective investment scheme advertising, unsolicited commercial communications by e-mail and consumer contracts. The creation of the basic e-commerce right is nevertheless of value. Hopefully the derogations can be qualified over time to the extent necessary and all other areas of uncertainty or difficulty corrected.

The FSA has also been involved with the Equitable Life compromise scheme and in investigating alleged misconduct surrounding trading in the shares of Railtrack.

Work has also continued on the construction of the new insurance industry framework, the regulation of credit unions and its review of polarisation (see Part V of the Bulletin which contains an article on the FSA’s proposals for reform of polarisation). The FSA has been working to pull together the new regulatory framework established under the Financial Services and Markets Act.

This has included completion of the new UKLA (United Kingdom Listing Authority) Sourcebook which is made up of the revised Listing Rules and the new UKLA Guidance. Recent consultation has also been conducted in connection with extending the mechanisms for disseminating regulatory information, the content of information supporting listing, and the electronic submission of relevant requirements.

Within Europe, discussion has mainly centred on the completion of the Financial Services Action Plan and implementation of the Lamfalussy recommendations. The Financial Services Action Plan is to be implemented generally by 2005, with specific work in the area of creating a European capital market being completed by 2003

Implementation of Outstanding Proposals of the Lamfalussy Committee
The Final Report of the Committee of Wise Men on the Regulation of European Securities Markets under Alexandre Lamfalussy recommended in February 2001 that all European financial services and securities legislation should be based on a framework of general principles that should be consistently applied. It was intended that these should either be given effect to through a framework regulation jointly agreed by the Council of Ministers and the European Parliament or possibly through future Treaty amendment. The general principles recommended included the maintenance of confidence in European securities markets and high levels of prudential supervision, contribution to the efforts of macro- and micro-prudential supervisors to ensure systemic stability, ensuring appropriate levels of consumer protection proportionate to different degrees of risk, respect for subsidiarity and proportionality, the promotion of competition and ensuring that the Community’s competition rules are fully complied with, ensuring that regulation is efficient as well as encouraging not discouraging innovation and taking into account Europe as a larger international marketplace.

Adoption of Measures on International Accounting Standards, Financial Conglomerates and Market Abuse
The three key secondary measures still outstanding at the European level highlighted by Lamfalussy and the Financial Services Action Plan are the Commission’s proposals on international accounting standards, financial conglomerates and market abuse. The European Parliament supported the adoption of each of these measures on 12 and 14 March.

The Parliament voted, in particular, on 12 March to approve the proposal for a regulation on the application of International Accounting Standards (IAS) for all listed companies in the European Union from 2005. Member States will be able to extend this requirement to unlisted companies and to the production of individual accounts. The objective is to improve market efficiency and reduce the cost of raising capital by creating an open cross-border market in securities trading. The Commission agreed to support the Parliament’s amendments. The Council should now be able to adopt the Regulation in May.

A report was adopted by the European Parliament on 14 March on the proposed Directive on financial conglomerates. The aim of this is to secure effective group-wide supervision of all financial conglomerates and require closer co-operation and information exchange between relevant supervisory authorities. Specific rules would also be adopted with regard to common capital requirements, the calculation of total solvency position and further requirements on intra-group exposures and group management. A Common Position should now be possible by June 2002 which will be followed by a second Parliament reading.

The European Parliament also issued a separate report on 14 March in connection with the proposed Directive on insider dealing and market manipulation. The objective of this Directive is to increase standards for market integrity in securities and contribute to the harmonisation of the rules for market abuse across Europe. This should improve transparency and equal treatment of market participants. Increased co-operation and exchange of information should also be secured between relevant national authorities. The Council should now be able to adopt a formal Common Position by June 2002 to be followed by a second Parliamentary reading later in the year.

Alternative Trading Systems
The Committee on European Securities Regulators (CESR) has separately released a second report on the creation of common European standards for Alternative Trading Systems (ATSs). This was prepared by a working group under Howard Davies, Chairman of the FSA. The revised proposals include seven standards to ensure that users of qualifying systems are protected, market integrity secured and systemic risk avoided. These relate, in particular, to registration and notifications, fair and orderly trading, publication of trading information, monitoring, relations with regulators on market integrity and investor protection, systems and clearing and settlement. Further recommendations were also made with regard to the application of conduct of business rules to alternative trading systems.

All of this is important work. It is essential that Europe continues to attempt to create an open and competitive marketplace that can assume a dominant position in the new global financial markets. The concern that arises is that many of these proposed measures are still selective and limited. It is for this reason that the achievement of an overall financial plan is necessary. It may be that the existing FSAP is still too limited and that the institutional reforms proposed by Lamfalussy are too optimistic. Howard Davies is correct (as he recently stated) to stress the importance of core standards but with sufficient implementation flexibility and necessary implementation review. The relationship between Europe and the new global financial marketplace must also be taken fully into account and continuing differences in retail market operation and preferences respected.

At the international level, the Basel Committee is presently trying to process all of the responses received in connection with its proposed capital revision. Almost everyone has been surprised by the volume and quality of the responses received to the proposals announced last January. Some of these have been particularly critical, such as with regard to the new proposal for the inclusion of mandatory operational risk charge within the new framework. As a result of the comments received, the expected implementation date of the revised framework has now been put back until 2005.

The Basel Committee has also issued a recent paper on the relationship between banking supervisors and external auditors. This had been prepared jointly with the International Auditing Practices Committee (IAPC) of the International Federation of Accountants (IFA). The intention was also to issue this as an International Auditing Practice Statement (IAPS) in due course. The importance of the relationship between bank auditors and supervisors was stressed. This is, in particular, important following the Enron scandal. The primary responsibilities of the board and management of companies have to be understood and auditors and supervisors need to ensure that these are properly discharged. The report is of particular interest to the extent that it attempts to set out ways in which auditors and the auditing profession contribute further to the supervisory process. This is of particular importance in such countries as the United Kingdom where a large degree of information and validation work is carried out by auditors and accountants. This contrasts with the system of direct examinations by retained staff within the supervisory agencies in the United States.

The BIS has issued a number of important statistical papers during the last quarter. Despite a substantial decline in some parts of the derivatives market, total nominal global OTC positions had reached $100 trillion as at the end of 2001 which represented a 38% increase on comparable 1998 data. Total consolidated claims have been reduced as steps were taken to reduce existing exposures. Credit lines had, in particular, been cut to Argentina and Turkey although total claims with regard to the Asia region remained unchanged.

The BIS has also issued a number of interesting research reports on such matters as futures hedging, currency boards, and bank runs.