Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1-19)




  1. Good morning, Sir Howard. You and your colleagues are welcome to the first hearing of the new Treasury Select Committee. Hopefully all of us will be courteous but subject you to robust and real examination. You know that we have a number of themes we wish to talk to you about this morning, not least your annual report for the past year, but also relating to issues such as the 11 September attack, pensions, timely corporate disclosures, polarisation and others. May I speak first about Equitable Life and mention a number of things to you. I am sure you are aware that the Government has given notice of its intention to move in the House today a Motion for an unopposed return for the laying before the House of the FSA's report on the supervision of Equitable Life. In view of this we do not propose to ask any questions this morning specifically about that matter. However, in view of the ongoing public interest, we wish to return to it as soon as possible after the publication of that report. Ruth Kelly, the Economic Secretary to the Treasury, has already agreed to appear before the Committee to give evidence on the matter and it would greatly assist the Committee if you could return to give evidence on the FSA report on the same morning as her, on Tuesday, 30 October. Would that date be convenient?

  (Sir Howard Davies) That would be fine; thank you very much.

  2. Could you identify yourself and your colleagues for the sake of the shorthand writers?
  (Sir Howard Davies) Good morning. May I say that we are honoured to be your first witnesses for the new Committee. The team I have brought with me today is a new team for the Committee. On my left is Carol Sergeant, who was appointed by the Chancellor to the Board of the FSA on 1 June this year. She is responsible for what we call regulatory processes and risk, but that includes the authorisation functions, all of the enforcement area and also our Risk Assessment Directorate, which is essentially our strategic planning function. Carol Sergeant was previously a banking supervisor in the Bank of England and joined the Authority in 1997. On my right is John Tiner, who was also appointed by the Chancellor on 1 June. Immediately before this, John was the head of Arthur Andersen's global financial services practice and he is now responsible for what we call the Consumer Investment and Insurance Directorate. He is responsible for insurance supervision, for the supervision of all investment firms, the former IMRO, SFA and PIA firms, and also for our Consumer Relations Directorate and our direct to consumer work. May I make one introductory remark, because I know the Committee have a lot of subjects on their minds? We are now just over a month away from the full introduction of the new regime. N2 is at midnight on 30 November. The sense of excitement in the City is palpable. We hope that we are broadly speaking ready for it in that all our rule books are completed. At the moment what is going on is that firms are being "grandfathered"—as we call it—into the new regime in that there is no new authorisation process to go through; if you are authorised under the old regime you are automatically authorised under the new, but of course you have to be reorganised in terms of the type of business you want to do to fit in with the new statutory arrangements. We expect that all of that process will be completed by 30 November and at last, four and a half years after the Chancellor's initial announcement, we shall become fully responsible for financial regulation. In the meantime, of course, at present we are still operating under the old statutes but with just a month more of this transitional regime to go. That was really all I wanted to say by way of introduction.

  3. Thank you and welcome to both your colleagues. I was going to lead off by asking you what the main developments have been for the FSA this year to date and in particular whether you are satisfied that the FSA is ready for N2. I refer to your very helpful memorandum which you provided for the Committee last week, where you say, "With N2 nearly upon us, we have been working hard to ensure our readiness. A lot of work has been completed, although there is still more to do". You go on in your paragraph on your new responsibilities during 2002, "Much remains to be done". What exactly remains to be done and how confident are you that it can be done?
  (Sir Howard Davies) There are three main headings of work. One is the authorisation work and that is to ensure that everybody is accommodated in the new regime within the terms of the new legislation. Carol Sergeant is responsible for that. At present we think that will all be satisfactorily completed. The second area of work is the management arrangements of the Authority, to ensure that we are structured to cope with our new responsibilities. We implemented a major reorganisation in April, the main point of which was to realign our organisation structure against the new legislation and to remove the ancestry of the previous regulators in that we previously had a part of the organisation which was called PIA, a part which was called SFA, a part which was called IMRO. We have now reorganised, primarily to bring together the regulation of individual firms onto a team basis. For example, on insurance in future the prudential regulation of insurance and the conduct of business, the marketing and selling regulation for an insurance company, will be brought together. I think this is an important development for the future. That reorganisation has now been completely implemented and we are equipped in that sense for the new regime. The third area is the rule books. There we have produced two fully integrated rule books, both a prudential one about capital rules and a conduct of business one, about marketing and selling rules. They are ready and complete and have been properly made by the Board. However, there are some areas which are still to be completed because the responsibilities came into the FSA a little later. The two I think worth mentioning would be the mortgage regime, where the Government made an announcement somewhat after the point at which we were merged to say that we would in future be responsible for the regulation of mortgage lending. That is still subject to consultation and that in fact will take effect at a date which we are now calling N3. There will be a further date at which mortgage regulation becomes a part of our regime. There is also the question of credit unions, which again were put into our bucket a little bit later, where we are consulting on the rules to apply for the regulation of credit unions and that will come into effect at another date, possibly N4. Beyond that there are also several areas where we have said that we should like to review the new regime to see whether it remains fit for the purpose. We have already said, for example, that in the broking area we wish to review best execution rules, because the market is changing, there are different exchanges on which you can undertake stockbroking transactions and our old rules really presume that there is one London Stock Exchange on which equity transactions take place. There is the whole question of soft commissions, which has been raised by the Paul Myners report, and we are reviewing the rules on that. The point of the statements in that memorandum were really to make it clear that N2 is not an end point. It is a point at which all the responsibilities come together, but we believe that there is a lot of work to do to reform and update the system. Our priority for N2 was to create a fit-for-purpose conglomeration of all the previous rules to allow the system to proceed, but we have a little list of things which we wish to review and to examine, possibly to repeal, after N2 and that work is now ongoing.

  4. I shall focus now on the issues affecting the markets after the 11 September attacks. On behalf of this Committee may I put on record the work that individuals in the City have done following that; really heroic deeds have been performed there, a service not only to their companies but also to the country. We are very grateful for that. We are aware of a number of measures which you have put in place since 11 September, for instance a temporary relaxation of the resilience test for life assurance companies and the co-operation with firms to resolve their operating problems. Are you satisfied with the stability of the UK financial system at the moment? Could you outline for us the actions that the FSA has taken to assist this market stability? One month on, do you feel we are now back to normal?
  (Sir Howard Davies) I would also agree that there was a very encouraging rallying round in the City after 11 September and the animal spirits of the market—if you like—were subdued for a time in a mood of co-operation and collaboration, which has been very helpful. It might be helpful if I divide this into three bits. First of all, there is the question of the market infrastructure, by which I mean trading systems, settlement systems, payment systems, etcetera, where in fact we share responsibility with the Bank of England. The experience of the post 11 September events was actually quite positive as far as that was concerned. The London systems worked very well. There was quite a bit of business from New York which was re-routed through London, which was handled well and satisfactorily. We had to make some arrangements to allow that to happen, we had temporarily to authorise people to transact business of a different kind. We had to waive certain of our rules to allow companies to have greater exposures to each other temporarily in order to transact each other's business. On the whole that work proceeded behind the scenes satisfactorily. The basic infrastructure of the market stood up remarkably well and at the moment, while one is always cautious as a regulator to give anyone a clean bill of health, I am not aware of any infrastructural issues which remain after 11 September. That was quite a good story. You ask about the overall health and stability of the system. It is worth saying that in the case of this kind of event, one first of all looks to the banking system, which has a particularly important role. It is important to note that we do benefit from the fact that we have a very well capitalised banking system in the United Kingdom, partly attributable to a long period of healthy growth, but our banks are in a strong position by and large and are well capitalised and able to cope with financial strains. We have seen no anxieties about our banking system, which has been an enormously helpful underpinning. A stable banking system, which is currently what we have, is something one should never quite take for granted. The area which has caused the most concern and focus has been the insurance industry where two things have come together to create a particularly difficult climate for the insurance industry. One of course is the implications of the World Trade Centre attack in itself, which is an enormous event for the insurance industry. We require the industry to stress test against disastrous scenarios and one we require them to stress test against is a collision of two jumbo jets, actually over New York as it happens; slightly macabre but true. This of course was even well off the scale, even larger than that in terms of its overall impact. The overall impact is still very hard to determine because of the unquantifiable costs of business interruption insurance. One can say roughly what the building costs are, but there will be a lot of claims from firms who were not able to transact business, who lost profit and lost earnings. It is very, very hard to quantify those. Clearly this would be an enormous hit for the general insurance market. At the same time, this happened at a time when equity markets were also falling for quite other reasons, as the world got used to the idea that we were in an economic slowdown, and perhaps something worse than that. So the reserve position of insurers was also weakened by the falling equity market. In the light of that insurers have been taking a number of steps to strengthen their financial position. They have been switching out of equities and into gilt edged stock or other bonds. Quite a major shift has already occurred: on average the proportion of the portfolios of life companies in equities has fallen by about eight per cent this year, which has strengthened their liquidity position. That is welcome. Life insurance companies have also been increasing their exit penalties which is not popular but is necessary in these circumstances. They have also been reducing their bonus rates, also not popular but necessary in weak market conditions. What we found immediately after 11 September was that market conditions became enormously volatile and there were some days when the market moved up or down by 300 to 400 points between its peak and its trough on the day. In those circumstances we identified a risk, that our resilience tests, in other words the requirements we have on insurance companies to maintain certain levels of solvency, were risking creating pressure for technical sales which themselves could take the market down further and create pressure for more technical sales, so you could end up with a spiral. We looked at our rules and concluded that there was a case for a temporary relaxation during this particularly volatile period. The relaxation took three forms: two of them were measures which we had already agreed to take on 1 December in the process of reforming our prudential rules, one of them being the rate of discount to be used for future equity earnings, where we had been using the dividend rate and we were shifting to the earnings rate. It was already agreed that was to take place on 1 December: we brought it forward. The second one was that we had a stress test which said that insurance companies should model the impact on their balance sheet of a simultaneous 25 per cent reduction in the equity market and three per cent rise in interest rates. There have been circumstances in the past in the British economy where those two things have come together, but with an independent central bank and a low inflation environment, we judged that that was an implausible scenario and we had already consulted on removing that test. The third one was the need to model at any particular time a ten per cent reduction in the equity market. We concluded, after some careful consideration, that it would be sensible to relax that test, but not to relax the requirement on insurance companies to maintain a prudent margin of assets over liabilities. That puts the judgement with the company's actuary. Since we relaxed that test in fact the market has risen quite a bit and I suspect, though I could not answer for every single company, it may well be that no company has in fact taken advantage of that margin, though the odd one might have done at a particular point on a particular day. We felt it was justified in order to prevent technical selling. I should emphasise lastly that we do see this as creating a breathing space for companies, because there are other measures which they need to take to strengthen their position. I have mentioned some in terms of the liability side, bonuses and exit penalties, but also they need to strengthen their capital position. In some cases these companies are owned by banking groups who need to strengthen the capital position of the life insurance company. In other cases they can raise subordinated debt in the market which also strengthens their capital position. This is part of an overall picture of a variety of things which need to be done to increase the robustness and resilience of the insurance sector in these unusual circumstances and all of those things are being worked on by individual companies at the moment. I am sorry that was rather a long answer.

  Chairman: We are coming back to that at a later stage, so some of my colleagues will come in on that. Some other aspects follow from 11 September, not least the issue of money laundering. I know in your previous appearance before the Committee you made some comments on the inadequacy of the arrangements for the money laundering and with the Government introducing legislation on money laundering and an international debate taking place, it is obviously of great concern to ourselves.

Mr Plaskitt

  5. In your view, how easy is it to launder money through UK financial institutions?
  (Sir Howard Davies) It is more difficult than in most places, but I could not say that it was impossible. The City of London is of course the largest international banking centre, with more international banks in London than in any other place and considerably more than in New York. That we would normally regard as a benefit and as a sign of a vibrant and vital international financial centre, but of course it does mean that London is exposed to financial flows from many more countries in the world than any other financial centre is. As one of my colleagues remarked, if you want to hide a needle, then choosing a very large haystack is sometimes quite a sensible thing to do. We have to be particularly vigilant in London, because of the very openness of our financial system. As a result, we did agree with the Treasury some years ago that our money laundering regime needed to be strengthened in that at the moment all we can do at the FSA is monitor the systems and controls in relation to money laundering in the institutions we oversee, but we have no responsibility for prosecuting breaches of those money laundering regulations. The new legislation gives us the power to do that. We have been preparing for that and over the last couple of years City institutions have done a lot, because they have seen this coming since the Bill was published in the middle of 1998; they can see that there will be this and they have been strengthening their position. We have been undertaking a lot more work. I would frankly say that there is still quite a lot of effort to do before one can be satisfied as one would like to be.

  6. In fact you have been saying for some time that the system was not as it should be. You told us that when you were last before us. How long do you think it has been the case that there have been gaps and weaknesses in the system?
  (Sir Howard Davies) There have been weaknesses in the system. This is an evolving picture and the standards which are expected internationally on money laundering have been rising as people have seen the growth of financial crime and of large sums of money being laundered. We are now thinking about this in a terrorism context, but until 11 September, if we had been having this conversation, we would have been primarily talking about the drug business, for example, which has of course been the main source of large flows of money laundering, or indeed arms sales. The standards required have been rising and those standards are probably best codified in the work done by the Financial Action Task Force, which is an international body which has codified a set of principles of good practice on money laundering. I believe there are 28 of them and the last time the UK was assessed, we were assessed as being fully compliant with 24 of the 28 good practices and partially compliant with the other four. The main gap was in our own rules, which have been corrected as of 1 December, and also in the regulation of bureaux de change, on which the Chancellor made an announcement yesterday. For comparison, the Americans were fully compliant on 17 and partially compliant on 11. I am comfortable that we are in the leading pack in terms of our money laundering regime, but undoubtedly the changes now announced are needed in order to get us to the front of the leading pack.

  7. How far do you think we can get in terms of stamping out money laundering?
  (Sir Howard Davies) My own and our responsibilities are to do with the financial system and not to do with the ultimate financial criminals. Really we see our role as being hardening the target and the consequence of that is increasing the discount. How much does it cost you to turn bad money into good money? We can harden the target. We can make it more difficult for people to take bad money and turn it into good money through our financial system. Of course that does not itself deal with the financial crime and therefore we are only part of the picture and we liaise closely with the National Criminal Intelligence Service because we can harden the target and we can also produce intelligence which we then hand over to the criminal intelligence services and it is then for them to take action on it and deal with what we call in the jargon the predicate offence. We are target hardeners, trying to make it more difficult for people to use our financial system.

  8. Following 11 September and its aftermath, do you now expect this to be a larger part of your job at the FSA than hitherto?
  (Sir Howard Davies) We certainly expect that, indeed you were kind enough to remember that we had this discussion in the Committee before. We have chosen to undertake a variety of what we call regulatory themes and in our first set of themes for last year money laundering was one of the first themes we chose. We set up a FSA-wide project on it. We produced a paper about how we expected our new regime to operate and we shall be spending more effort on money laundering than we did in the past, particularly outside the banking community. The banking regulators always did pay quite a bit of attention to money laundering but less was done in insurance and also of course the regulation of lawyers and accountants, which we shall be focusing on now.

  9. What tests will you be applying to yourselves to see how much progress you are making on this?
  (Sir Howard Davies) There are some things you can measure, suspicious transaction reporting is one of them, where that is what the systems are supposed to produce. They are to throw up suspicious transactions which are then reported to the intelligence services, but the best test will be when we assess the strengths of the systems and controls in individual institutions, which we commission reporting accountants to do for us from time to time. Up to now, we have found that when we have done that on institutions, we have found quite a lot of problems and quite a lot of exceptions. I should like to think that in five years' time we would be finding far fewer bad reports when we put in accountants to report on money laundering controls and far more clean bills of health and at the moment we get too few of those.

Mr Beard

  10. After 1 December what will be the new money laundering rules which will be brought in by the FSA?
  (Ms Sergeant) The money laundering rules and regulations already exist in the 1993 legislation. What we get on 1 December is a specific objective to contribute to the reduction in the way the financial system can be used for the purposes of financial crime, which no previous regulator has had. Going with that we have rule making powers so that we can make specific rules setting very specific standards for how people should operate in terms of their systems and controls to prevent money laundering. We also get powers which we have certainly not had in respect of banks and building societies before, which are to sanction publicly and also to fine people who have been found wanting. Finally, under the money laundering regulations we shall also get the criminal prosecution powers which hitherto have sat elsewhere in the system.

  11. Under what circumstances will you be able to fine people or name them publicly?
  (Ms Sergeant) We have a general policy towards the way we will exercise our enforcement powers. We intend to use it as a strategic tool. There are plenty of things we can do in the supervisory process beforehand but if people conspicuously do not meet the standards, then we shall publicly name them and fine them. If it is very bad and following the Crown Prosecutors' code we consider it is appropriate to bring a prosecution, then in the same way as any other law enforcement authority would do, we would bring a prosecution.

  12. Is there any evidence of money laundering arising from the 11 September attacks?
  (Ms Sergeant) Nothing particular. I should say that the financial institutions have worked very hard indeed to support the law enforcement authorities to try to detect any suspicious transactions which they can report in that context. There is nothing particular arising out of that. We do not actually receive the reports. Our job is to try to ensure that the systems and controls the financial system has are strong enough to detect this in order that the financial institutions we regulate can report to the National Criminal Intelligence Service. We believe the level of reports has certainly gone up and that some of that material is proving to be useful.
  (Sir Howard Davies) One thing we have been doing since 11 September with co-operation from the security services here, the FBI in the States, etcetera, is giving information to institutions about particular names of companies or individuals and then they must search their records against those people. They have then been making reports to the National Criminal Intelligence Service. The number of those reports has gone up considerably, but it is a bit difficult for us to say how significant that is because of course it is NCIS who can piece together all that intelligence. I believe it is proving helpful to them, but I could not point you to any specific consequence.

  13. If strong evidence came up later on in the year of some money laundering arising from 11 September, would you be able to apply the new powers you get on 1 December retrospectively to cover these instances?
  (Ms Sergeant) What we should be able to do is look at the systems and controls aspects of this. If we find systems and controls lacking—and if they are seriously lacking right now, frankly the chances of them being sorted out by 1 December are probably not enormously high, although in some cases they might be - then we can certainly use our fining and public censure powers. The prosecution powers can be retrospectively applied because they exist already. It is just that we are being given them, whereas previously they have sat with the other criminal authorities.

  14. There was some indication that after 11 September the movements on the market indicated that there might have been some insider trading, probably from terrorists who had known what was coming. Have you discovered any evidence of this?
  (Sir Howard Davies) No. As you say, some interesting theories were advanced as to the possible ways in which you could have profited from a kind of macabre form of insider information if you had thought that this attack was going to be successful. Immediately after 11 September, we did look, and we asked our exchanges to look, intensively at trading patterns in stocks which might have been expected to be affected by 11 September. I am thinking particularly of airline stocks, but also perhaps of gold and perhaps of insurance companies, the three things you might have most immediately expected. In fact the net was drawn a bit more broadly than that. We have done a lot of work in collaboration with other regulatory authorities internationally, both Europe and North America. Although there were initially some transactions which looked a bit odd, and some of them have been written about in the newspapers, we have found that in each of the cases we have investigated, there was a plausible reason for those transactions. It was a difficult period in the market because the market was already going down and there was also rather a wide dispersion of views about where the market was likely to go, with some people saying they were just engaged in a small minor market adjustment and a modest slowdown which tended to be a broad consensus view, but quite a number of people, notably hedge funds, were positioning themselves against the possibility of a serious recession. There was quite a dispersion of market expectations and in those circumstances, it was not surprising that you saw people taking some quite aggressive short positions in volatile stocks; and airlines are particularly volatile stocks in recession. All of the investigations which we have undertaken so far, we have pursued to the point at which we are satisfied that there was a respectable market based reason for those transactions. We sent a report on this activity to the Treasury yesterday.

  15. Moving to the other aspect of the 11 September atrocities, the impact on the insurance industry, where it has been estimated that Lloyd's probably have a net exposure of £1.3 billion, but that is a net exposure after re-insurance, are you satisfied that the insurance industry generally, and Lloyd's in particular is capable of absorbing the sort of shock which is going to arise from the claims due to 11 September?
  (Sir Howard Davies) I am reluctant to be seen as the re-insurer of last resort here in giving a kind of blanket assurance about the industry, but I would say that the cost of the World Trade Centre disaster does seem to have been very broadly spread across the industry. There are many re-insurance contracts, but most of them end up in very large and well capitalised institutions. So far the institutions concerned have disclosed the costs and have made arrangements, as Lloyd's have done, to provide for those, to raise cash to meet their liquidity requirements and solvency requirements that they create. Of course this is a very large hit and it is impossible to say that the world's insurance industry can sail through a $30 billion, or whatever it might be, hit without suffering some consequences. There have already been one or two small corporate failures and it is possible that there may be more. We watch the position as closely as we possibly can, but at this point the estimates being put forward by the companies and the impact on them have been digested by the market. They are bad news, but they have not been seen to be terminal for any major player. This is something on which we are at a very heightened state of alert and in discussions with the industry on a real time basis. There is no doubt that there will be a need for injections of capital into the general insurance industry and that capital will need to be remunerated and that remuneration is likely to come partly in the form of higher premia. We can see the prospect of increased insurance premia for airlines and indeed for buildings, etcetera, and over time one hopes that will enable the industry to rebuild its capital base to cope with this hit.

Dr Palmer

  16. As you know, a committee of French MPs has recently suggested substantial money laundering activity in Britain and its dependencies. The suggestion seems to have had three elements: one was in the core financial services of the City. There the FSA have already commented that these suggestions are out of date because of the tightening which has already taken place. The second referred to the problems of bureaux de change where action has been taken. The third related to Crown dependencies. To what extent do you feel that the regulation of transactions in the Crown dependencies is as strict as it now is in mainland Britain?
  (Sir Howard Davies) Thank you for providing the answers to two of the points in the Montebourg report, which we did think was a slightly excitable document. As far as the dependent territories are concerned, I ought to preface my reply by saying that we carry no responsibility for the regulation in those dependencies. However, what I can say is that there have been international assessments of the regulation of offshore centres from a financial regulation point of view—I am not talking about tax here: I am talking about the quality of their regulation. The most recent was done by the Financial Stability Forum, of which I am a member, which is a grouping of the G7 finance ministries, central banks and leading regulators. So the Fed and the SEC are in it and the IMF and the World Bank. A working party spent a year under the head regulator of Canada looking at quality of regulation in offshore centres around the world. They divided them into three divisions. Division one was those which broadly met international standards in the onshore world and of course the onshore world has some good and bad in it too, frankly. Division two was ones where there were serious grounds for improvement needed. Division three was ones where the standards of regulation were seriously deficient by international standards. The Isle of Man, Jersey, Guernsey were all in division one. Monaco, for example, was in division two. I take that as an offshore centre entirely chosen at random. For example Nauru was in division three. This was a published assessment and what is now happening after that is that the IMF has set up a special unit to go around each of these offshore centres in order to do a more in-depth assessment and to confirm what needs to be done to meet such deficiencies as there are. All three divisions will be covered by that assessment. The Isle of Man and Jersey have volunteered to be early in, because they feel that they want to demonstrate what they have done and they will be assessed at a relatively early stage. That objective—international assessment—certainly puts them in the top division. Of course standards are rising all the time since people have appreciated internationally the scope for financial criminals to use centres. It is not right to be complacent about any of these things, but it is clear to me that the Crown dependencies are in the first division of offshore centres.

  17. That is encouraging. Just returning to my question, would you say that their level of scrutiny was comparable to the City of London under the FSA?
  (Sir Howard Davies) On money laundering, yes it is.

  18. There were widespread and surprisingly concrete press reports that 65 per cent of capital exported by bureaux de change comes from criminal sources. This figure seems to me slightly astonishing and I wondered whether you had a view on it.
  (Sir Howard Davies) I am afraid I do not have a view on it. We do not regulate bureaux de change and the proposition put out by the Government yesterday is that that responsibility should be with Customs and Excise. I am afraid I could not reliably confirm or deny that.

Mr Mudie

  19. A minor point on short selling. I am not clear what your position is on it. Following your speech which dealt with this, there seem to be three definitions: aggressive, unattractive aggressive and abusive. Which one are you prepared to take action on and what kind of action?
  (Sir Howard Davies) Abusive.

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