UK: Securities And Banking Update - It’s All In The Balance

Last Updated: 11 June 2007
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Back to first principles

Central to the FSA’s work in the coming year is the move towards "more principles-based regulation". In launching its business plan for 2007/08, John Tiner said that the move would result in significant benefits for firms, markets and consumers, and an FSA better equipped to face future challenges and deliver better outcomes for its stakeholders.

How easy will such a move be? Evidence of serious intent can be seen in the FSA setting aside a budget of £50 million over the next three years to support this initiative, in particular by improving the effectiveness of its staff and its knowledge management systems.

This is serious money. Why might the change cost so much, given that many senior people in the financial services industry have always supported this approach? Put another way, how did we get into this position in the first place?

The first point to make is not to exaggerate the change. What is under discussion is a rebalancing; certainly, it has never been possible, let alone desirable, to write a rule to cover every specific situation. In that sense, an element of "principle" has been there from the start – indeed, it is unavoidable. But neither can financial services be regulated solely on the basis of the 194 words in the FSA’s Eleven Principles. It is often said, not least by senior FSA figures, that many of those operating in compliance or legal departments are uncomfortable with a principles-based approach and consistently seek detailed guidance on how to interpret principles in specific situations. But it is not unreasonable for compliance staff to seek to reduce legal uncertainty for their employers, if top management in these firms do not make clear, by their actions, that they will tolerate some legal risk in the interests of a more flexible and goals-oriented approach by the regulator.

Nor should principles-based regulation be seen as a soft touch for the firms. A core element within it is a greater emphasis on outcomes, as opposed to processes. This will require a rigorous and relentless focus from firms to ensure that their business delivers not just in commercial terms but in terms of meeting regulatory expectations. Firms will need to establish robust governance processes, strong internal procedures with which the business complies, and demonstrate vigorous action when these procedures are breached.

It is sometimes argued that EU legislation limits the capacity of the FSA to regulate on the basis of principles rather than rules. There is some truth in this, but it needs to be kept in proportion. Sometimes the EU Directive is itself a response to initiatives taken by the regulators, for instance in the Basel Committee. Moreover, there will be some instances where to regulate solely by means of looking at outcomes does not work well. One such area is capital adequacy: to regulate this solely by reference to financial resources being "adequate", without any further elaboration, is insufficient – firms want guidance from the regulator on what this means in practice, while the sanctions available to supervisors if the outcome is unsatisfactory and the firm goes into default are inadequate to protect customers. Put simply, rules as well as principles are capable of meeting the cost/benefit test. But whether this requires an 8500 page Handbook is a different matter.

So there is a balance to be struck:

  • between legal certainty, through official interpretation and rules, and inflexible and potentially soon outdated detail;
  • between firms being expected to observe the spirit of the standard, and being given sufficient detail to know the outcome being sought by the FSA;
  • between reliance on outcomes in some cases, and on preventative measures to protect customers in others;
  • between the interests of small firms (who may prefer to be given rules rather than devise their own solutions), and larger firms who are less attracted by such prescription; and
  • between simplicity and fairness. Much of the complexity in the tax system stems originally from a desire to marry fairness and efficiency, and some of the same drivers are to be found within regulation.

Done well, the new regulatory focus should enable greater innovation and competition, particularly in the way that business is conducted, and should make compliance work both more rewarding and also more cost-effective. Done poorly, the internal position of compliance may be weakened, there may be a loss of clarity and certainty, if interpretations by the FSA of subjective expressions ("fair", "adequate", etc.) are not appropriately consistent, and some riskaverse firms could even end up with more rules than at present, although these would be ones drawn up by internal staff.

The FSA understands the nature of the challenge in front of it, and the fact that this is a rebalancing rather than a revolution; indeed, Callum McCarthy is on record as saying that "for all the rebalancing we are doing, we will never be simply principles based".

But to make this work effectively the FSA will need to:

  • ensure, through practice as well as speech, that enforcement will be predictable, neither relying on the wisdom of hindsight on the one hand, nor on firms’ hazy promises of reform on the other. The choice of enforcement cases will be crucial to the success of this initiative;
  • encourage, through its actions, senior management to apply the core regulatory principles thoughtfully, and engage constructively with those who are prepared to be judged by outcomes, and live with some residual regulatory uncertainty;
  • employ high-quality staff, who have the confidence to live with greater uncertainty than at present, and make the judgments necessary for such an approach to work; and
  • support industry-backed solutions to issues, as has been done with some success recently, without outsourcing the core of the FSA’s rule-making function.

The industry is now on notice to expect a paper from the FSA on this subject in April, coupled with a conference on 23 April in which some of these ideas are due to be considered at greater length.

So there is now a real opportunity for firms to give the subject the serious consideration that it requires, and to do all they can to make sure that the new arrangements are set up in a way that will deliver on their promise.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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