Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

TUESDAY 16 OCTOBER 2001

SIR HOWARD DAVIES, MS CAROL SERGEANT AND MR JOHN TINER

  20. What does that amount to? Abuse, obviously.
  (Sir Howard Davies) I was trying to clarify. It is reasonable to be confused because there has been some somewhat confusing reporting, mainly from misunderstandings arising in a private meeting. We have nothing against short selling as a matter of principle, it provides liquidity to the market, it is a perfectly normal market practice and we have no intention of banning short selling or anything like that at all. It would be a particularly odd thing to do in circumstances where market liquidity is important. At the other end of the spectrum, however, we have set out now in our code of market conduct a set of definitions of what we see as good and bad market practice as the underpinning for our market abuse regime, which comes into effect on 1 December. We consulted on that code, we produced two or three versions of it and we have now reached one with which we are happy and which I should say has achieved a broad degree of consensus in the City. That explains the particular circumstances in which we might consider short selling to amount to abuse. Effectively we describe things like abusive squeezes where perhaps a group of investors might collude as a concert party to drive the price of a stock down by taking aggressive short positions in the hope that they could then go bottom fishing afterwards, pick it up cheaply. We have defined the sort of practice we would think was abusive and inconsistent with our code of market conduct and if we identify things like that we shall take action. What I said when I characterised aggressive practices was that we had been observing some rather aggressive short selling practices by individual firms, individual funds, which appeared to us to be close to the line, but where there was no evidence of actual collusive practice or that this really qualified under our code of market conduct. Investors had been concerned about it, we had had some complaints raised with us about it on occasion and I therefore made those remarks as a sign to people that they should be a bit careful about which side of the line they chose to be on and drawing their attention to the fact that there were rules about short selling embedded in our code of market conduct. That was in the nature of a warning shot.

Mr Tyrie

  21. Is there any abusive practice in respect of short selling which applies uniquely to going short and not to going long?
  (Sir Howard Davies) I am not sure, though an abusive squeeze is a little bit hard to conceive of in a long position. You could do the mirror image of it of course. Yes, you could push the price up and then quickly sell short as it fell. Yes, I suppose you could reciprocate.

  22. In which case I am not sure that there is anything new to regulate in the area of short selling which is not already something you should be considering in the field of standard stock market.
  (Sir Howard Davies) I was drawing people's attention to the fact that there is a new code which covered certain elements of the way in which people were using short positions. I think you are right that that code will apply to short and long practices. Yes, it will apply to abusive practices generally.

Chairman

  23. In his speech yesterday the Chancellor mentioned that he will be funding within the National Criminal Intelligence Service a new multi-agency terrorist finance unit. In particular the focus of that will be to improve financial intelligence further with a new task force which will bring to the anti-terrorism effort the best of academic, financial and commercial expertise. What role will you be playing in that? May I also ask about the Financial Action Task Force which you mentioned? I have read press reports in the past month or two which would indicate that in terms of staffing and budget it is perhaps not up to the job internationally of monitoring the new regimes against money laundering.
  (Sir Howard Davies) As far as the Financial Action Task Force is concerned, we are members of that task force. It is staffed largely by the OECD in Paris. The new chairman of it, Jochen Sanio, who is my German banking opposite number, who is a very energetic character, has said that he wishes to strengthen the resources of the FATF and I am sure he will get political support for doing so. As for the domestic arrangements, we shall play our full part in that, essentially to ensure that the financial institutions are providing the raw material for that new intelligence network to work on.

  24. And the Chancellor's unit.
  (Sir Howard Davies) Yes, I would hope that we would play a full part in that.

  25. We will now turn to the issues relating to the with profits funds. Given the decline in stock markets since 2000, how widespread is the problem of "smoothing account deficits" among with profits funds where the policy values exceed the asset share?
  (Sir Howard Davies) What we have seen is that a number of companies have felt the need to impose exit penalties, or what are sometimes called market value adjusters. This came to public attention particularly in the case of Equitable, but now a large number of with profits funds have imposed such adjusters in order to ensure that exiting policyholders do not take more than their asset share out of the fund. The extent to which a company is vulnerable to this depends to some extent on its bonus policy as well as on the strength of its fund, in that at one extreme in the Equitable case, the Equitable allocated bonuses as they went along and pursued a full bonus allocation policy to individual policyholders. Other companies allocate lower bonuses year by year and a larger proportion of the return is a terminal bonus. Therefore they can in the light of market conditions adjust the terminal bonus and that has a bigger effect. Given the size of the market fall we have seen in the last 18 months or so, most firms—I would say most now—have felt it necessary to impose some exit penalties to ensure that people did not take away more than their asset share.
  (Mr Tiner) Yes, that is right. A number of companies have introduced market value adjusters to create fairness between policyholders who stay in a fund and policyholders who leave early. It is interesting to note that over the last ten years payouts as a percentage of asset share, in every year except one, exceeded 100 per cent; it dipped in 1993. It will be quite interesting to see therefore what that sort of background has done to create policyholders' reasonable expectations in the event that bonuses need to come down and policy values are reduced. Our feeling is that life offices are taking a careful look at what they can do to make sure that the asset share ratios are preserved. That is why we have seen some reduction in bonuses, it is why we have seen some increases in market value adjusters and for those who have not had them at all, that has been introduced. I think that, going forward, they are getting their liabilities properly matched to their assets. I do not think there is a widespread problem at the moment with this.

  26. Is not the essence of smoothing that at times some individuals get more than their precise asset share and some get less?
  (Mr Tiner) That is the exact purpose of smoothing so that a longer term investor, which is typically what a with profits fund is for, is able to take benefit over a period of years which has been earned by that individual rather than the level of the stock market or the gilt market or whatever at a particular moment.

Mr Ruffley

  27. Could you tell us what the precedents are, either in the UK or abroad, for a relaxation of resilience tests or similar as applied to life assurance companies?
  (Sir Howard Davies) It is worth saying that relatively few overseas countries have a life insurance industry structured like us with the kind of with profit funds and also with the size of the equity portfolios as large as is typically the case for the UK. Most other countries do not have that kind of life insurance industry. In the countries where they do, and probably the Canadian position is the most relevant as their industry is probably the most like ours, they typically do not have resilience tests which are specified with the precision that ours have been in the past. They have tests which are couched more as our regime now is in fact following this temporary relaxation. In other words, each individual company's actuaries must take a view, must make a reasonable margin of assets above liabilities and they are not required to do so in relation to a specific percentage figure. It is more of a judgement. I could not point to an example of where another country had specifically relaxed a resilience test, but mainly because I do not think I could point to another country which has resilience tests of that sort.

  28. Clearly you think the tests are flawed for the circumstances of volatile markets. Are you going to get rid of the old test permanently?
  (Sir Howard Davies) Two of the three tests which we relaxed we had already decided were no longer appropriate and they were consulted on as part of our prudential sourcebook, as we call it, the new set of capital rules for the new regime. We had explained why we thought they were no longer necessary and there had been broad agreement in the market that they should be relaxed. The third one we had left in place, but as part of our continuing review of our insurance regime it is something we wish to question and we wish to assess whether or not in future to have that particular type of formulation is appropriate. I should say that I would not look at this as purely about relaxation because we believe there are other issues in insurance portfolios where there needs to be more stress testing and indeed we think that some of the evaluations in insurance funds need to be reviewed. It is not just about relaxing that particular test, we believe there needs to be an overhaul of the prudential rules for insurance companies more generally.

  29. That is a very helpful answer because there is a view that relaxation makes the regime look a bit sloppy. Some commentators have pointed that out. Could you very briefly explain what the other areas of stress testing might be and when you might be bringing forward consultation on those new and needed areas?
  (Sir Howard Davies) The kinds of things that we have in mind are first of all the way in which certain liabilities are valued. A particular example of that is guarantees in policies where we believe there are some issues. There are also ways in which portfolios are stress tested against different combinations of economic circumstances, where we think that the technology of doing so in the banking sector is possibly rather further advanced than it is in the insurance sector and we wish to learn some lessons from the banking sector into the insurance sector. This issue is likely to come up when we next meet because there are some recommendations flowing from an analysis of the Equitable affair which will be in this area.

Mr Plaskitt

  30. In one of your press releases you described the relaxations as temporary. I am not now quite clear, given what you have said in the last few minutes, whether they are or not. Can you just clarify the situation on that?
  (Sir Howard Davies) They are temporary certainly in a sense, but the regime we currently have with those relaxed and nothing else put in their place is unlikely to be what we want to be for the future. We should like to open up this issue in a broader way in terms of what kind of tests we have. It may be that if it is going to take us some time to do that, we would want to reinstate the ten per cent for a period, but as a long-term objective we would not wish to go back just to having that ten per cent test and no other reforms.

  31. This is the puzzle. In what circumstances would you reintroduce a test? Is it not worthless if the market knows that if difficult circumstances return you take it away again?
  (Sir Howard Davies) While we have removed the particular number, we have not removed the requirement for companies to take a prudent view of the margin of the relationship between their assets and their liabilities. That particular relaxation has not had the significance that some have wanted to give it.

  32. Who is defining "prudent" in these circumstances?
  (Mr Tiner) It is the responsibility of the appointed actuary to make prudent provisions for sensitivity of their assets and we have provided guidance to them through the resilience tests. In fact, by relaxing the resilience test which tests for a ten per cent fall in equity prices, we have relaxed some guidance, not a rule. It has nevertheless always been the responsibility of the appointed actuary to work out prudent provisions. It is our feeling that in more stable market conditions the ten per cent test in the short term, up until we introduce new ways of modelling variations in market prices and stochastic models, and so on and so forth, should be reintroduced at some stage. What we found in the past, and we last found this in 1998 after the long-term credit management problems and the default of the Russians on their rouble debt, that in very, very highly volatile and sharply falling markets, the resilience test can actually have a perverse effect. If there is a steadily declining market, the resilience test is absolutely right to be applied, but in very, very volatile and sharply falling markets, it can have a perverse effect.

  33. So you are planning to bring some resilience tests back in some form or another. Are you saying to us that those are the ones which will hold in all circumstances, or are they also only going to be good for stable markets and you will dump them as soon as there is a difficult market?
  (Mr Tiner) No, what we are saying is that we need to work up some new overall test for resilience which perhaps, though not as linear as the single ten per cent reduction, can then stand the test of different types of market conditions.

  34. Do you not feel in the interim that you are relying pretty heavily on actuaries making their judgements free from defined or linear guidance from you? Is it not risky to be in that situation?
  (Mr Tiner) Yes, we are relying on the appointed actuaries. The appointed actuary has a legal obligation in fact to make what he considers to be prudent provision. What we have done since relaxing the resilience test, the ten per cent, is to increase our involvement significantly in talking to appointed actuaries to make sure that we are satisfied with the models they are applying in the current market circumstances.

  35. Were you worried that without those relaxations there were life assurance companies out there which were on the verge of going insolvent?
  (Sir Howard Davies) No, what we were worried about was that in order to remain solvent, they would be selling equities in a declining market in a way they would not wish to do except to meet this technical limit. Therefore it was a market disturbance point, not that they would be going insolvent, because they could remain solvent, but they would have had to shift much more massively from equities into debt in a very, very short time, which might have been destabilising for the market and against the interests of their policyholders.

Mr Cousins

  36. Are you concerned about the explosion of with profits bond products and high income bond products with very high profile initial rates of return which are in fact conditional upon the stock market performance or rather complex supporting contracts?
  (Sir Howard Davies) Yes, we are.

  37. What are you doing about it?
  (Sir Howard Davies) What we have done about it is to issue a number of consumer alerts about this and emphasise to people that there was a general problem of which this is a specific example, that in the transition to a low inflation environment there was still an expectation among many investors but also perhaps more dangerously among many advisers that it was perfectly possible still to achieve double digit rates of return without putting your capital at risk. We have identified a number of products which in our view are risky for investors and which ought to have particular health warnings attached. With profits bonds are one category. Another category was several what we call exotic ISAs which were ISAs based actually on European hedge funds which had income units and capital units but where the capital was at risk and was maintaining a high income. There have also been split capital investment trusts or so-called barbell trusts with zero shares and capital shares and income shares designed to produce a high headline income figure but where the capital shares were volatile. So we have put a lot of effort into alerting people to the risks of these products. That is probably the most effective thing we do. If in our monitoring we identify that there are particular financial advisers or brokers who are advising relatively unsophisticated investors to go into these products and not alerting them to the appropriate risks, then we would take regulatory action in those cases. We have a consumer focused activity and then we have a firm focused activity to try to deal with this.

  38. It is fair to say that you are reminding financial advisers of the dangers that investors might take, but what are you doing with the architects, with the designers of these products, High Street names who have billions of pounds worth of investment locked into these kinds of products? What are you doing with those?
  (Sir Howard Davies) We are not in a general way a product regulator, financial firms are entitled to design products of this kind if they wish and there will be people, high net worth individuals particularly for whom these may well be suitable as long as they understand the risks they are taking on. It is not open to me to ban products of this kind and I would not be justified to do so. The issue is: for whom are they suitable and do the people who buy them understand the risks they run?

  39. Are you saying that at no stage has the FSA held up yellow cards to some of these High Street names who are pushing these products?
  (Sir Howard Davies) We did do so in the case of what we called exotic ISAs last year where we issued a very stern alert and we had a major impact on that market. These products were not very extensively sold as a result. I do not think that we are able to outlaw with profit bonds full stop. Indeed I would think it not justifiable to do so.


 
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