Financial Services and Markets Appendices to the Minutes of Evidence


APPENDIX 4

Memorandum by the Financial Services Authority

A. INTRODUCTION AND SUMMARY

  1. This Memorandum is submitted to the Joint Committee in the context of its consideration of the Financial Services and Markets Bill. The FSA looks forward to elaborating on this note in oral evidence on 16 March.

  2. The FSA welcomes the Government's commitment to introduce this legislation in the current Parliamentary session, and in particular the work of the Committee in considering the Bill by way of pre-legislative scrutiny. We recognise that Parliament will wish to take a close interest in this wide-ranging new legislation and in the way in which we propose to exercise the powers to be conferred on us to regulate financial business. The FSA has followed closely the responses to the Government's consultation on the draft Bill and welcomes the recent Progress Report by HMT, summarising the main issues raised and explaining the Government's response.

  3. This Memorandum summarises the FSA's preparations for assuming its new powers (paragraphs 4 to 8) and deals in turn with the six questions on which the Committee has decided to focus its inquiry (paragraphs 9 to 40).

The FSA's preparations for assuming its new powers

  4. The FSA is currently responsible, under the Banking Act 1987 and the Financial Services Act 1986 respectively, for supervising banks and for overseeing the regulation of investment business. Further powers for the regulation of other financial sectors (for example, building societies, insurance (including Lloyd's), credit unions and friendly societies) are to be transferred to the FSA by this Bill. In the meantime, the existing regulators continue to have responsibility under the various statutes for regulating individual sectors. For example, the Boards of the self-regulating organisations (SROs) remain responsible for authorisation and enforcement decisions in relation to the firms which they regulate.

  5. The FSA has agreed with the other constituent bodies to integrate relevant staff as quickly as possible, in order to reduce uncertainty for them and so minimise any risk to regulatory effectiveness. This managerial integration was completed in January this year, when the majority of officials from the Insurance Directorate of HM Treasury and the Registry of Friendly Societies transferred their employment to the FSA, joining colleagues formerly employed by the Securities and Investments Board, the Bank of England, and the three SROs. These staff, working under a single FSA management structure, supply services under contract to the other regulators in order to enable them to discharge their responsibilities.

  6. This managerial integration is already leading to a more efficient and focused approach to areas of common interest—for example, the response to turbulence in international financial markets, and handling Year 2000 issues. In some areas work will continue to integrate operationally ahead of the new legislation—for example, in consolidating the various complaints-handling arrangements established under current statutes.

  7. In its published Plan and Budget for 1999-2000, the FSA has summarised the work which it expects to carry out in the coming year to prepare for the new regime. In particular, in line with our open approach, we will continue to consult publicly on the broad range of policy issues which need to be settled. Annex I to this note lists the further consultation and other papers planned for the coming year.

  8. Developing the Handbook of rules and guidance which will apply to regulated institutions in future is a substantial and complex project. Following earlier consultation on the approach to be adopted, and in particular on the balance to be struck between developing fresh material and carrying over existing requirements, the FSA is now working on the various sections of the Handbook. We will take this opportunity to remove unnecessary rules and to adopt a common approach to the regulation of similar business, while maintaining appropriate differentiation for different types of business and for business done with different categories of customer.

B. QUESTIONS ON WHICH THE COMMITTEE HAS DECIDED TO FOCUS

  9. The rest of this Memorandum deals with the six specific topics identified by the Committee.

Proposed arrangements for the accountability of the FSA

  10. The FSA recognises that the establishment of a single financial regulator with wide-ranging powers raises important questions about the means by which it is to be held accountable for its actions, policies and costs.

  11. The draft Bill includes a series of mechanisms for securing the FSA's accountability and establishing checks and balances on its operations. These include:

    —  the statutory objectives and general duties, referred to below, which can be enforced through judicial review;

    —  the reporting mechanisms; our Annual Report to the Chancellor is to be laid before Parliament, and we will be required to hold an annual open meeting to present our Annual Report to the full range of stakeholders;

    —  our governance structures; the Board is appointed, and can be removed, by the Treasury. The Board will have a majority of non-executive members. There is to be a separate non-executive committee with responsibility, among other things, for setting the pay of the executive Board members and overseeing the economic and efficient use of the FSA's resources. That committee will be required to report on its work, as part of the FSA's Annual Report. (The first Chairman of the non-executive committee will be Stewart Boyd QC, recently appointed Deputy Chairman of the FSA);

    —  a variety of forms of external review. The Bill will require consumer and practitioner panels to be set up, which will contribute to our decision making and report publicly on their views on how we operate. The statute will require the FSA to have in place arrangements for independent investigation of complaints against itself. The Director General of Fair Trading will scrutinise our rules to ensure that they are not unduly restrictive of competition. HM Treasury will be able to commission periodic value for money audits of our operations. And the Treasury will have power to commission inquiries into regulatory matters of public concern;

    —  procedural safeguards on rule making and policy making. Rule making (including on fees to be paid by regulated institutions) will need to be subject to public consultation. There will be requirements for cost-benefit analysis, and proposed rules and rule changes will need to be accompanied by an explanation of how they relate to the FSA's objectives. Decisions on rule making are reserved to the Board itself;

    —  powers in the hands of HM Treasury to require the FSA to change our rules and practices when necessary on competition grounds or to achieve compliance with the UK's international obligations;

    —  an independent tribunal, administered separately by the Lord Chancellor's Department, to resolve disputed cases involving authorisation and enforcement decisions by the FSA.

  12. We acknowledge the very high level of interest in these accountability mechanisms and how they will operate. We believe that the mechanisms now in place, including the improvements announced by the Government in January in response to consultation, provide a sound and robust basis for the FSA's accountability.

The proposed statutory objectives and the principles

  13. The establishment of statutory objectives (in the areas of market confidence, public awareness, protection of consumers and reduction of financial crime) for the new single regulator has been widely welcomed. The draft legislation supplements these with a set of general duties; these require, in summary, that the FSA must have regard to:

    —  the need to use its resources in the most efficient and economic way;

    —  the responsibilities of those who manage the affairs of authorised persons;

    —  the need for proportionality;

    —  the desirability of facilitating innovation;

    —  the international character of financial services and markets, and the desirability of maintaining the competitive position of the United Kingdom; and

    —  the principle that competition between authorised persons should not be impeded or distorted unnecessarily.


  14. The FSA believes that these objectives and duties strike the right balance and provide an important means of accountability. We welcome the Government's commitment to consider ways in which the drafting of the consumer protection objective might be clarified or improved to ensure that the FSA's objectives in this area are not open to mis-understanding.

  15. We welcome the imposition of a duty on the FSA to take into account the desirability of maintaining the competitive position of the United Kingdom. Some have argued that we should have an objective to promote the competitiveness of the UK's financial services. We agree with HMT that this is not necessary; we believe that an objective in this area would sit uneasily with our other responsibilities. In particular, we believe that firms might well consider such involvement by the FSA in commercial (rather than regulatory) matters intrusive rather than helpful.

  16. These statutory objectives and duties provide a basis for the FSA's legal accountability; if we mis-construe them, or fail to take them into account, judicial review is available to those affected by our decisions or actions. Ordinary principles of public law will, where a general policy has been announced, require us to act in accordance with it unless there is good reason to depart from it or modify it for the future.

Discipline, enforcement and the Tribunal

  17. Responses to the draft Bill and to the FSA's consultative paper "Financial Services Regulation: Enforcing the New Regime" issued in December 1998 demonstrate a keen interest in the nature and operation of the FSA's enforcement processes in future. Whilst enforcement action is a vital element in the regulatory regime, and will continue to be so in future, it is important to set it in context. By far the greater part of the regulatory authorities' efforts is devoted to work designed to ensure that financial institutions have the systems and processes in place to minimise the risk of any contravention of regulatory requirements—on the basis that prevention is better than cure. Most of the supervision and monitoring work in all the areas coming together in the FSA is therefore a collaborative effort in which the interests of the regulator and of firms' senior management are quite closely aligned. Of the FSA's approximately 1,850 staff, only just over 150 are involved in enforcement work—and about 40 of these are engaged in "perimeter work", ensuring that non-regulated firms or individuals do not undertake business for which they have no authorisation.

  18. We are currently engaged on a major project to design appropriate structures and processes for enforcement work under the new legislation. The focus of this is the consultation paper we published last December, where we are now reviewing the responses received.

  19. The proposals which we have put forward so far incorporate four main features, seeking to balance the requirements of fairness with the desirability of securing a cost-effective, speedy and efficient process (in which firms, individuals and the FSA share an interest):

    —  a clear separation of functions between operational staff and decision-makers, so that the staff who investigate a case and recommend enforcement proceedings do not take the final decision to proceed;

    —  the Chair of the Enforcement Committee (whose responsibility includes issuing the notices which begin proceedings and the decision notices imposing sanctions) will be a full-time position. The appointment and removal of that person would be a matter for the Board of the FSA, which would make appointments following an open selection process, with the assistance of external advice. The Chair would report directly to the Board, supported by staff not within the enforcement directorate. Measures such as these are designed to buttress the independence of the Chair from operational staff.

    —  we propose to involve practitioners and public interest representatives in our enforcement decision-making processes. The Board will appoint a panel, including recently retired practitioners and others who are able to make the time commitment necessary to deal with the larger enforcement cases;

    —  we propose that the subject of disciplinary action should be able to make representations and, if appropriate, have an oral hearing.

  20. These proposals are consistent with the Treasury's announcement in December of four changes to the Bill to clarify the role of the FSA and the independent appeals tribunal, viz:

    —  a statutory duty on the FSA to establish and publish procedures on taking disciplinary action, and to act in accordance with them;

    —  an explicit right for those subject to disciplinary proceedings to request to see the evidence on which a case rests, and a duty on the FSA to disclose such evidence;

    —  an explicit bar on the FSA publicising enforcement action until the full process, including any tribunal proceedings, has been completed;

    —  dropping the Lord Chancellor's power to make rules on when relevant evidence might be inadmissible before the Tribunal. The Tribunal will be a tribunal of first instance, and the Government has said that its current working title ("The Financial Services and Markets Appeals Tribunal") may be changed to reflect this.

  21. The FSA Board attaches great importance to its ability to deliver effective enforcement action; such action can be effective only if it is fair and seen to be fair. We recognise the strength of feeling on this subject among the regulated community and will consider carefully the responses to consultation over the coming weeks. In the second quarter of 1999 we will publish a feedback statement, summarising the responses received and announcing any further policy decisions. We would hope to be able to give the Committee an early indication of our latest thinking in this area before they report at the end of April.[1]

Scope of the new regime

  22. The scope of the legislation—deciding which activities and products should be regulated and, broadly, in what ways—is a matter for decision by Government and Parliament. The Government has recently published for consultation draft regulations outlining the scope of the proposed new regime. This reflects the Government's approach, previously announced, to:

    —  give the FSA jurisdiction over the activities and products currently regulated by the predecessor bodies;

    —  give the FSA additional powers (for example, in relation to Lloyd's) where the case for change is already made;

    —  keep under review the case for including certain activities not currently regulated.

  23. As the FSA said in its evidence to the House of Commons Treasury Committee last year, it believes that decisions on any future extension of regulatory scope should be made in the light of a set of well defined criteria. The FSA is conscious of strong views in some quarters, including among some parliamentarians, that the marketing of mortgage products should be included in the legislation. The FSA attaches importance to the applications of cost-benefit analysis to proposals for further regulation of this sector and looks forward to contributing to HMT's review of the operation of the Code of the Council of Mortgage Lenders. Many firms—in particular, banks and building societies—which market mortgage products are already supervised for prudential purposes by the FSA. However, the FSA's very preliminary estimate is that around 6,000 further firms (including estate agents and credit and mortgage brokers) might need authorisation for this line of business.

  24. Discussions continue, to which the FSA looks forward to contributing, on the desirability of incorporating the regulation of some other products—in particular, long-term care insurance products—in the FSA's jurisdiction. Now that the Royal Commission has reported, and has made a specific recommendation that Long-Term Care should be brought within the ambit of conduct of business regulation at the earliest possible date, we are considering with HMT how this line of business should most effectively be regulated in future.

  25. Members of professional bodies (for example, solicitors and accountants) may, under the current legislation, conduct investment business on the basis of certification by their professional body. A large number of professional firms—of the order of 12,000, we estimate—are authorised essentially on a precautionary basis because they may from time to time conduct investment business in connection with their professional business. We note HMT's recent statement proposing a number of changes in the legislation to deal with unnecessary authorisation of members of the professions. We welcome the Treasury Committee's view that the definition of financial advice needs to be drawn as narrowly as possible to prevent unnecessary regulation in this area.

Ombudsman and Compensation Scheme

  26. Ministers announced at an early stage that one of the benefits of regulatory reform would be the opportunity to create "one-stop" shopping for consumers who need to avail themselves of dispute-resolution and compensation arrangements. The draft legislation therefore provides for the establishment of a single Financial Services Ombudsman and a single Compensation Scheme, replacing the multiplicity of existing schemes.

  27. The FSA's work in these two areas has been of two kinds: first, to establish the arrangements which will need to be in place when the new legislation is implemented; and, second, to examine the scope for bringing together the current schemes as far as possible operationally in advance of the legislation, in order to provide a more streamlined service to consumers at the earliest possible stage.

  28. The FSA has now appointed the Board of the new Ombudsman Scheme, to be chaired by Andreas Whittam Smith. The initial responsibility of the Scheme Board will be to work with the FSA in setting up the new Scheme. It will play a key role in deciding its design and structure. Our objective will be to ensure that the new Scheme delivers a cost-effective, accessible and fair dispute-resolution service. We plan to consult this year on scope, terms of reference and funding.

  29. Responses to the Government's consultation on the Bill highlighted a number of concerns about the operation of the proposed scheme. HMT recently announced a number of changes to respond to these concerns, removing the right to appeal on points of law, restricting the costs to which complainants could be subject and widening the potential scope of the compulsory jurisdiction of the Scheme. The FSA will also have the ability to exclude some categories of regulated firms where there is a case to do so (e.g., wholesale businesses which do not have customers who would be eligible to use the Scheme).

  30. The FSA and the Scheme Board will take these changes into account in their further work in this area. Proposals relating to the scope of the Scheme's compulsory jurisdiction (which will apply to authorised firms only) will be subject to cost-benefit analysis and consultation. We have considered carefully the potential impact of ECHR requirements on the proposed new statutory Scheme and have sought to establish whether concerns that the new Scheme will have to be more court-like in its procedures are well founded. We believe that it is possible to design an ECHR-compliant scheme which retains the benefits of flexibility and informality, which are key features of the existing non-statutory Ombudsmen Schemes.

  31. The FSA will consult shortly on its policy for the new single Compensation Scheme. Our earlier consultation exercise demonstrated broad support for a single Compensation Scheme Board, with division into three sub-schemes covering deposit-taking, insurance and investment business. The FSA will also take account of the strong views expressed by the industry urging us to avoid cross-subsidy between dissimilar business activities within these sub-schemes, except where there is a clearly identified need and the proposals have been the subject of specific consultation.

Market Abuse

  32. The proposal in the legislation to give the FSA powers to impose civil fines to deal with abuse of markets, and the Code of Market Conduct which the FSA published in draft for consultation, has attracted much comment.

  33. Before turning to the comments received, it is worth restating the rationale for the new regime: to preserve and enhance the efficiency of financial markets. Damage to those markets affects not only market participants but the economy as a whole. The current statutory protections for the major UK markets are widely perceived to be incomplete. On the one hand, the criminal offences of insider dealing and market manipulation cover only a limited range of very serious misconduct. On the other, the regulatory regime covers a wider range of misconduct but only a subset of market participants. There is a gap, in that conduct by unregulated persons which damages the market can only generally be addressed through the criminal law. The Government has decided—and we agree with this approach—that the FSA, in pursuit of its objective of maintaining confidence in financial markets, ought to be able to take administrative action against any market participant who abuses the markets.

  34. The Government has made it clear that the new regime is designed to complement the existing criminal offences and is not an alternative. Where people have committed a criminal offence, and where it is appropriate to prosecute, that will be done, following the guidance set out in the Code for Crown Prosecutors. The draft Bill gives the FSA the power to prosecute such offences itself. The FSA is currently drawing up guidelines with the other prosecutors both for determining when cases will be taken the civil or criminal route and for deciding who should take action in a given case. The FSA intends to publish these guidelines.

  35. The new regime in the Bill aims to bring about improvements in three areas:

    —  to reduce the fragmentation of responsibility, which has sometimes caused problems in the past. The current fragmentation—between the Serious Fraud Office, the DTI, the FSA, the SROs and the Recognised Investment Exchanges, all of whom potentially have an interest in dealing with market misconduct—is unsatisfactory. The FSA will have powers to deal with regulatory breaches, to take action for breaches of the new market abuse provisions in the Bill, and to prosecute the existing criminal offences of insider dealing and market manipulation;

    —  to allow the FSA to take effective administrative action where markets have been abused by any market participant. This is in line with the approach adopted in the US and a number of other overseas jurisdictions. Had the regulators had these powers in 1995, we would have been better equipped to deal with the damage inflicted on the London markets in the Sumitomo case. The effects of this behaviour are estimated to have cost industry many hundreds of millions of dollars in higher copper prices. The existence of civil powers in the US allowed the American regulators to tackle this problem more effectively than we were able to, even though the market directly affected was in London. Other cases currently being considered by the regulators could be handled more effectively if the proposed new powers were already available.

    —  to introduce greater transparency into the area of market abuse. The regulators can currently take action against regulated investment firms and registered individuals for breach of the FSA Statements of Principle in this area (Principle 3 provides simply that: "A firm should observe high standards of market conduct"). The new regime seeks to make clearer what are acceptable and unacceptable behaviours in this respect. The Bill itself defines abusive behaviour in broad terms, and requires the FSA to issue a Code of Market Conduct to clarify the behaviours which amount, or do not amount to, abuse. Abusive behaviour must be such as to damage confidence that the market is true and fair. The FSA supports the overall approach of establishing framework legislation which allows the FSA to provide clarity in a flexible and evolving Code.

  36. The comments received on these aspects of the Bill and on the draft Code reflected five main themes. A number of commentators argued that the FSA needs to be more specific in describing the types of behaviour which it will regard as acceptable or unacceptable. We appreciate this desire for clarity and are working closely with market participants on reviewing comments on the Code and discussing possible changes. We have set up a practitioner group consisting of members nominated by the main trade associations, including the BBA, ISDA, LIBA, and the exchanges. In parallel, the Markets and Exchanges Regulatory Liaison and Information Network (MERLIN) will be considering similar issues. This group consists of representatives from the recognised investment exchanges, the Panel on Takeovers and Mergers, the Bank of England, the DTI and HM Treasury. The industry has made it clear, though, that they do not want a prescriptive rulebook in this area. Overly detailed prescription risks increasing compliance costs and stifling innovation; there is a balance to be struck between the desirability of being specific and the need to produce a regime which is flexible enough to changing market practices.

  37. The second strand of comments reflected the desire for the insertion of a general test of intent in the Bill and in the Code. Respondents regarded it as unfair that they could be subject to administrative action if there was no proof of intent. We believe that in some circumstances, where conduct has fallen short of the standards reasonably expected of market participants, it should be possible to take enforcement action where there has been no intent. The economic efficiency of markets can be damaged by the unintended effects of actions, for example, of negligent behaviour.

  38. The third main area of comment was on a perceived increase in the "layering" of regulation in the area of market abuse. This broke down into two themes. First, there was some concern about the interaction between the FSA's powers in this area and those of other bodies. We have outlined above the steps we are taking to co-ordinate action with other prosecutors. We are also working with the exchanges and the Takeover Panel to make sure that the appropriate body takes action in individual cases. Our policy is that, where there has been a breach of the rules of a recognised investment exchange or the Takeover Panel, if those bodies have adequate investigative, disciplinary and enforcement powers to address the conduct in question, the FSA would not normally propose to take action. The second area of concern was how the new regime will relate to criminal offences and to the FSA's rules on the conduct of authorised firms. As to the criminal law, we have indicated above that it will remain distinct. In preparing the FSA Handbook, we will ensure maximum coherence and consistency between the Code of Market Conduct and other rules applying to authorised firms. Overall, therefore, there should be no additional layer of regulatory requirements on regulated investment firms.

  39. The fourth area of comments concerned the status of the Code itself (which is, of course, a matter for the Treasury). The Code carries evidential weight; some expressed concern that it would be possible for the FSA to take action for breach of the primary legislation even in circumstances where someone had complied with the Code. The FSA made clear in its consultative paper on enforcement policy that, generally, where a person has acted in compliance with the standards set out in the Code, it will not seek to impose a civil fine for market abuse.

  40. Finally, a number of respondents expressed a desire for the FSA to issue guidance, or even what are known in the USA as "no action letters", which firms could rely on, since a code cannot by its nature cover all the situations in which market users may find themselves. It has always been the FSA's intention to issue general guidance to supplement the Code. However, it is clearly not possible for regulators to provide no action letters unless they are given very specific details of the transactions envisaged. Any clearance procedures might not always be very rapid, except at very significant cost for regulated firms. So we are exploring ways in which the market's reasonable desire for certainty can be accommodated without excessive bureaucracy, while giving due weight to senior management's primary responsibility for their firms' compliance with regulatory requirements.

12 March 1999


1   See Appendix 9. Back


 
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