Financial Services and Markets Appendices to the Minutes of Evidence


APPENDIX 13

Memorandum by the Association of British Insurers (ABI) and the British Bankers Association (BBA)

EXECUTIVE SUMMARY

INTRODUCTION

  1. Both the ABI and the BBA welcome the creation of a single regulator for the financial services industry, and believe it is important that good progress is made in underpinning the FSA with a legal framework that will enable it to function and adapt to changing circumstances. As such we endorse the framework approach to legislation in the Bill.

  2. A central theme in many of our comments is a concern in the banking and insurance industries that a much more formal system of supervision is being introduced, with a heavy reliance on detailed rules backed by a discipline and enforcement system for breaches of rules. Such an approach will tend to undermine the collaborative and open relationship that has existed, particularly with reference to prudential and control issues, which in the past has encouraged a constructive approach to resolving issues of concern as they arise.

Accountability

  3. The FSA will be accountable to Ministers in the first instance and through them to Parliament. Various additional mechanisms such as the FSA's Annual Report and the work of the Treasury Select Committee will further strengthen FSA accountability. In addition we believe the Treasury should have a right to comment on whether rule changes are consistent with the FSA's statutory objectives, and we also believe that the rate of fees set by the FSA should be regarded as a rule change, and therefore made subject to formal consultation.

Statutory Objectives

  4. The statutory objectives as proposed are broadly right, and it would be a mistake to caveat them with exemptions and exclusions. The only additional objective for which there is a strong case deals with competition, and would oblige the FSA to take international comparators into account. As advocated below, we believe this would sharpen FSA focus and provide a point of reference against which to judge its rules.

Discipline Enforcement and Market Abuse

  5. Issues related to discipline, enforcement and the Tribunal have been deeply felt by the industry. Although changes have been proposed, further change will be necessary if enforcement is to be fair and effective. A more neutral starting point for enforcement is needed; a stronger recognition that it will normally be inappropriate to discipline on prudential matters, or for breaches of general principles. The market abuse proposals must address the issue of intent and should be able to accept that dealing which fully fulfils the requirements of the code of market abuse should not be subject to fines.

Mortgages

  6. The Mortgage Code delivers an effective alternative to statutory conduct of business regulation, and managing the latter would bring real additional costs for members, and for the FSA. We believe the review of the Mortgage Code, currently under way by HMT, should be concluded before decisions are taken on mortgage regulation.

  1. The British Bankers' Association and the Association of British Insurers are the two largest trade associations for the financial services industry, covering together all major insurance, banking and financial services markets at both the retail and wholesale levels. Between them, they represent 96 per cent of insurance business written in the UK and 95 per cent of banking business. Their members are active throughout the UK, within the single European market, internationally in wholesale markets, as well as through a retail presence in some countries.

  2. The brief evidence given below supplements the original submissions of the ABI & BBA, which the Joint Committee has access to, and addresses the particular subjects raised in the Joint Committee's Press Notice 2 of 10 March.

PROPOSED ARRANGEMENTS FOR THE ACCOUNTABILITY OF THE FSA

  3. HM Government has chosen to establish a powerful independent regulator on a statutory basis, covering a wide scope of the financial services industry and most financial markets. To fulfil its objectives the FSA needs considerable rule making powers, and the capacity to enforce these in a manner which is fair and reasonable. The ultimate accountability of the FSA is to Parliament, which can amend its powers by primary legislation and has the opportunity to review its work through such bodies as the Treasury Select Committee. In addition the proposed Annual Report will enable Parliament to debate the FSA's work in full. At the same time, while the FSA must be given room to do its job, and not face operational interference from government, it is right that the general accountability of the FSA should not be delegated lightly.

  4. The proposals on accountability in the draft Bill as summarised in paragraph 3.2 of HM Treasury's Progress Report are necessary. The proposals to enhance consultation in paragraphs 3.6 ff. are broadly welcome, but do not go far enough. Given the importance of this matter it needs to be addressed in primary legislation. Without change, consultation, a key obligation in a statutory system, will be more formal than real. We consider that:

    —  As well as consulting on proposed rule changes and publishing a statement of alterations as proposed in paragraph 5.2 of the Progress Report, where FSA rejects widely argued positions from practitioners and/or consumers it should be obliged to make clear in full why it has done so.

    —  The Bill already provides that the FSA should give Treasury copies of any rules or standing guidance that it makes. In addition, Treasury should have the right to state whether or not they agree that any changes or additions are in line with the FSA's statutory objectives.

  5. While the statutory basis for the consumer and practitioner panels is welcome, as is the establishment of a market abuse panel, none of these are substitutes for effective consultation with the industry and with its Trade Associations. Indeed there is a danger that the FSA will come to rely unduly on these Panels, with the danger of indifference to the industry or consumers more generally, or worse the possibility that the Panels will cease to provide an independent view.

  6. The funding of the FSA, whatever mechanism is settled on, will be by the financial services industry via a specific and hypothecated tax. There is therefore a strong case for practitioner involvement in decisions about the setting of the tax rate, and means should be found to establish this in legislation. The solution is to make the rate at which fees are charged, and not just the funding mechanism, a rule change on which the FSA should be obliged to consult. In general the industry seeks a well-funded regulator paying salaries that will retain and motivate the quality of staff it needs for a demanding and important role.

PROPOSED STATUTORY OBJECTIVES AND PRINCIPLES OF THE FSA

  7. The thrust of the statutory objectives established in the Bill (clauses 3-6) is right, and it would be a mistake to undermine it by reference in the objectives to the circumstances of any specialised group. Creating enabling legislation which allows the FSA to adapt and amend rules in the face of new circumstances is right, and a restrictive set of statutory objectives would weaken that adaptive capability which is fundamental to regulatory effectiveness in the 21st Century. However, given the key importance of the objectives and the principles to which the FSA should have regard in the performance of its functions, Parliament will expect Ministers to be satisfied that the FSA is acting properly—after all the Rule Book will have the force of law. In delegating such powers to the FSA, there should be accountability that the powers are being exercised in a manner consistent with the statutory objectives.

  8. The broad definition of consumer is right for primary legislation and should enable the FSA to draw more carefully the lines between retail and wholesale markets as these develop and change over time. Equally this definition should enable a line to be firmly drawn between transactions undertaken in a personal rather than business capacity. Stressing the importance of consumer protection in general, not merely depositor or policyholder protection, is right, and given meaning by the explicit wording that such a right by consumers to expect protection brings with it a correlative duty to make informed decisions and take responsibility for them (Clause 5.2(c)). Competition is most effective in providing innovative and cost-efficient services when consumers make responsible and rational decisions on the basis of clear and adequate information.

  9. The FSA will have a general duty (Clause 2(3)(e) and (f)) to have regard to the international character of the financial services industry and the need for competition between authorised persons, but we believe this is not enough. Specifically there is a strong case for an additional statutory objective that requires the FSA to treat all firms operating in the UK in a like manner to the fullest extent possible, and to promote such competitive neutrality abroad. Her Majesty's Government's argument (4.16 of the Progress Report) talks of their "pervasive influence", but influence is not enough—a statutory objective would oblige the FSA to draft rule changes it could defend as consistent with an international competitiveness objective—something which needs to be established in legislation. In fulfilling this general duty, FSA will need to have regard to the burden its supervisory requirement places on regulated entities, compared to those placed on competitors with equivalent business regulated elsewhere.

DISCIPLINE, ENFORCEMENT AND THE TRIBUNAL

  10. We have expressed our concerns about the proposed disciplinary framework to the Government in our response to the draft Bill and to the FSA in response to their Consultation Paper on enforcing the new regime (CP17). Our concerns relate to the fairness of the proposed arrangements, the interaction of the enforcement regime with effective supervision, and compatibility with the European Convention on Human Rights. Our comments here take into account the revisions proposed by the Treasury in its progress report dated March 1999.

  11. At the outset it is worth stressing the very considerable enforcement powers that exist at present, and which will not be abolished with the passing of this legislation. It is already the case that banking and insurance supervisors can restrict the range of businesses our firms are involved in, and that they apply capital and solvency rates well above those required by EU legislation. These additional capital and solvency charges cost our members very significant sums, and they are variable by the regulators on the basis of their assessment of the performance of our members in delivering on their regulatory obligations. Powerful enforcement tools exist in the current arrangements, and there is a case for reviewing whether or not they should be retained in their current form, given the major new enforcement tools that are to be introduced under the Bill.

  12. Our concern with process of enforcement proposed in the Bill relates to the need to ensure a separation of enforcement into distinct steps, with independent parties involved to ensure that a subsequent step is not tainted by an earlier decision. The steps are

    (i)  investigation of an apparent breach of rules or law;

    (ii)  decision to proceed against the relevant person;

    (iii)  decision to convict, fine or censure;

    (iv)  appeal from this last decision.

  13. As proposed, the FSA is empowered to undertake all the first three (except for a criminal offence, when step (iii) will be for a court). The Bill will now require the FSA to establish and publish procedures and to act in accordance with such procedures. However, the FSA will have to work within the Bill framework whereby step (ii) consists of a Warning Notice, which is not just a decision that there is a case to answer but that the person will be fined or censured unless they can prove themselves innocent. This presumption of guilt is uniquely reserved for financial services and does not exist in criminal law. The process proposed is not commensurate with an open and constructive relationship with regulated firms. We believe that the process needs to have a more neutral starting point so that both sides can be heard before any decision to take disciplinary action is taken, even in principle. It is argued that, because the Tribunal will rehear the whole case, the person involved is protected. This ignores the reality of the costs involved in preparing and presenting a case at such a Tribunal, which lead individuals to settle when they should not. Indeed, the whole process needs to incorporate the possibility of legal representation and the reimbursement of costs by the FSA when they instigate proceedings which subsequently fail.


  14. Under the proposed legislation the FSA will be given unique powers to levy unlimited fines for breaches of its rules based on a civil rather than criminal burden of proof. Further efforts must be made to clarify that where very large and damaging fines are proposed, the burden of proof employed should be criminal not civil. While it is accepted that financial services companies deal in sums of money which may appear large to the man in the street, it is nevertheless unfair that they should be subject to arbitrarily large penalties, especially as it appears to be the FSA's intention to assess fines as a deterrent and our experience of SROs adopting a similar attitude is that fines are escalated without regard to the real mischief being penalised. For our members, the reputational damage caused by the publicity surrounding any adverse finding by the regulator is sufficient deterrent. It is even more invidious to increase fines merely in order to increase the point size of the ensuing press headlines. In general, the use of enforcement action should not come to be viewed as a mark of success in regulation and it is not an appropriate way to illustrate public accountability.

  15. Banking and insurance firms have a need for prudential supervision which is quite different from conduct of business regulation. This supervision works best when the supervisor and the institution develop mutual trust and understanding. We are concerned that if, when a firm voluntarily discusses a particular situation frankly with its supervisor, this results in enforcement action, the climate of trust will break down and the supervisory relationship will not function. The sanctions imposed when prudential solvency requirements are breached should focus on corrective action rather than retribution—the imposition of fines is only appropriate in cases of deliberate or reckless misconduct.

  16. There is a concern about privileged and confidential information and documents which continues in the financial services industry. The Government has stated its intention to amend the proposed information gathering and investigation powers of the FSA but it is not clear to us that they have met our concerns. Prudential regulation can often involve the supervisor seeking to assess how a regulated firm may be affected by particular developments, for example when a bank's major customer is in difficulties or an insurer receives many claims relating to a risk which has changed in nature. In these situations, firms will wish to share with their supervisor information which is confidential (because it is part of the banker-customer relationship) or privileged (because it has been prepared to assess the firm's legal position). We have therefore two issues: first where financial institutions hand over information or documents to the FSA, it must be clearly established in law that such material always carries any legal privilege with it. Otherwise financial firms will face uncertainty as to where privilege stops, and be unable to co-operate fully with the FSA.

  17. Second there must be a clear set of rules, underpinned by legislation, about onward disclosure of material by the FSA to third parties, including overseas regulators. Different legal systems or freedom of information requirements in other countries may make disclosure inappropriate. An example would be the disclosure of an insurers claims reserving policy being treated as acceptance of liability, something which can cause serious problems for firms. Disclosure to other regulators, subject to Memoranda of Understanding, should require the FSA to obtain assurance about the end use of any material disclosed—proper prudential purposes and the pursuit of financial crime are both legitimate purposes, broader civil or political actions are not.

  18. As we mention below under Market Abuse, it is one requirement of the ECHR that an individual should know what he is to comply with if he is at risk of a criminal sanction for non-compliance. It seems to us only fair that a similar criterion should apply for the sanctions at the FSA's disposal which, if not criminal, are equally devastating in their effect on individuals and firms. The Bill allows the FSA to make rules and evidential provisions relating to those rules. The FSA is proceeding to make very general rules ("Principles") and then more detailed rules and codes of conduct which are evidential. This provides a structure similar to that for Market Abuse where there is a general offence and an evidential Code established by the FSA. In both cases, the FSA reserves the right to take action on the basis of a breach of the Principle or Clause 56 of the Bill, as qualified by the Code of Market Abuse, even where no other rule or code provision has been breached. We believe that this cannot be fair and that the Bill should restrict the FSA's scope for action to breaches of Rules only. It should be possible to rely on compliance with an evidential code.

Rights of civil action in respect of breaches of the rules

  19. Further, the availability under the Bill of direct rights of action for breaches of rules is unhelpful and unnecessary. It is unhelpful in that it could lead to a legalistic and cautious approach to the drafting of rules (a danger which FSA recognise and feel they can overcome) and unnecessary given rights of access to the Ombudsman or the courts.

  20. The new regulatory regime should not incorporate a civil right of action for breach of a rule. Perhaps more than any other factor, Section 62 of the Financial Services Act, which provides such a right, increased the pressure for detailed provisions, rules and exemptions. There was a strong perception that without plenty of detail and certainty, the rules would lead to dramatically increased litigation. As the then Chairman of the SIB put it:

    —  "[Section 62] had a serious adverse effect on the SIB rulebook . . . the problem was that it focused the attention of practitioners and more particularly their lawyers on amending the rules not to improve them generally, but simply to minimise the possibility of claims. This led to long and complicated provisions, attempting to draw fine distinctions to produce safe harbours for legitimate industry practice, whilst maintaining the essence of the original objective of the rule".

  21. If this proposal is retained, it should be more clearly defined by amending Clause 80 (3) of the Bill so that a particular rule would have to positively provide for the right of action by a private person—something which may be more appropriate in specific cases, for example disputes about fair dealing.

SCOPE OF THE NEW REGIME: THE PROVISION OF MORTGAGE ADVICE AND RECOGNISED PROFESSIONAL BODIES

Mortgage advice and the regulation of loans secured on land

  22. Although the Committee has said it will be looking at the position of mortgage advice, it is not clear to us that this can be viewed in isolation of the broader question of the regulation of loans secured on land (to use the terminology of Schedule 2 of the Bill). We consider it very important that the regulatory regime under the Bill provides an appropriate level of consumer protection, taking into account, inter alia, the nature of the financial service in question and, where appropriate, the existence of alternative means of regulation, such as industry codes of conduct. The conduct of mortgage business is currently governed by such a code of practice, the Mortgage Code. All significant mortgage providers adhere to the Mortgage Code and, since last year, mortgage intermediaries have also been covered by the Code. We consider it to have been an effective alternative to statutory regulation, and the changes to the compliance machinery for the Code, currently in the pipeline, such as an enhanced monitoring and disciplinary role for the Independent Review Body, will further enhance its effectiveness.

  23. We recognise that HM Treasury is currently reviewing the efficacy of the Mortgage Code and will decide later this year whether the regulation of loans secured on land should be placed within the scope of FSA. Parliament will also wish to take a view on the desirability of the regulation of mortgage advice, and we would hope that the timing of this decision will be such as to allow the outcome of the Treasury's review to be taken into account.

Recognised Professional Bodies

  24. The approach to RPBs as indicated in Section 3 of HM Treasury's "Regulated Activities" paper (February 1999) is right. Where legal and accounting professionals provide investment advice in a manner which is subordinate to their main services, they should not have to seek authorisation. Where they provide financial services as free standing products, it is right that they should have appropriate authorisation from the FSA and be regulated on exactly the same basis as other authorised firms.

OMBUDSMEN AND INVESTOR COMPENSATION

The Financial Services Ombudsman

  25. Effective redress arrangements are essential for consumer confidence in financial services. We support the proposals for a single financial services Ombudsman (FSO) scheme for the resolution of complaints which are not capable of being resolved via a firm's own internal complaints procedure. It should help clarify the redress arrangements in the eyes of consumers and should ensure a consistency of standards of redress across the range of financial services to be regulated by the FSA.

  26. The existing Ombudsman arrangements available to customers of banks and insurers have provided a fast, effective means of impartial redress binding on the firm and at no cost to the customer. This will continue to be the case under the new FSO scheme, but other advantages of the existing industry Ombudsman schemes will be lost, we fear. This is because a statutory Ombudsman scheme will, inevitably, be more legalistic in its approach compared to the existing voluntary arrangements and this will have a detrimental effect compared to the relative openness and informality with which firms currently deal with the banking and insurance Ombudsmen. This will be a particular danger, if the FSA insists on sharing information received by the FSO.

  27. Whilst the new FSO will, as we have noted, provide welcome rationalisation, there will still be anomalies. For example, Treasury ministers recently announced their intention to extend the compulsory scope of the FSO, in respect of FSA-authorised firms, to certain financial services which are not covered by the Financial Services and Markets Bill. For banks this will mean, inter alia, that their non-mortgage lending business will fall within the compulsory jurisdiction of the FSO. However, other lenders, not authorised by FSA, will be under no obligation to join the FSO scheme, but may be subject to the Ombudsman's voluntary jurisdiction should they so wish.

Consumer Compensation

  28. An effective compensation scheme is fundamental to the Government's proposals for the new single regulator. We support the Government's aims of a single compensation scheme with a single board and a harmonised administration function.

  29. We also agree with proposals which FSA has issued separately (in their consultation paper 5 of January 1998) that there is a need to distinguish between the differing needs of customers of deposit-takers, insurance companies and investment firms. This can best be achieved by having three sub-schemes within the single scheme. This differentiation is currently reflected in the three existing schemes; namely, the Deposit Protection Scheme (and its building society equivalent), the Investors Compensation Scheme and the Policyholder Protection Scheme.

  30. We support the FSA's proposal that there should be no cross-subsidy between the sub-schemes and we would stress, also, the need for the compensation scheme to be seen to be independent of the FSA. Consistent with the statutory objectives set out in the Financial Services and Markets Bill, it is, we believe, fundamental that the FSA should not seek to remove all risk from customers, and some element of co-insurance should be retained.

  31. There is a particular difficulty in the delegation of powers to set the scope of the compensation schemes and the bases for levies. Parliament may prefer that primary or secondary legislation is the appropriate way to define the extent to which the customers of solvent businesses should pay for the losses of other consumers.

MARKET ABUSE

  32. The ABI and BBA agree with the policy objective behind Part VI of the draft Bill, namely to seek to ensure that UK markets operate in an open, transparent and fair manner. That said, the draft Bill gives rise to serious concerns under a number of heads, and needs to be amended in order to ensure fairness and certainty. Fairness and sufficient certainty are essential if firms are to feel confident in operating in UK markets.

Definition of the Offence of Market Abuse—Intent

  33. We strongly believe that there should be a test of intent in the manner in which the offence is drafted in Section 56. The absence of such an objective test has two effects: it means that persons may be unfairly pursued for the unintended consequences of their actions; it also means that the definition of the offence is defined in a highly subjective way. Agencies with a similar role to the FSA in other jurisdictions have to demonstrate intent or show recklessness—and the SEC has shown that it can be done in many hundreds of cases.

  34. In focusing on the effect of behaviour instead of on intent, the definition of market abuse in the draft Bill does not, as the Government concedes, give participants sufficient certainty as to the application of the market abuse regime. The Committee will be aware that, in the opinion of Lord Lester QC, "the Market Abuse offences as defined in the draft Bill are framed at such a high level of generality that they do not satisfy Article 7(1) of the Convention [the European Convention of Human Rights], which requires, in accordance with the principle of legal certainty, that an offence must be clearly defined in law so that a person may foresee the consequences of his or its actions."

Role and Status of the Code of Market Conduct

  35. The Government argues that it is the Code of Market Conduct drawn up under Section 57 by the FSA which is to provide the certainty that the legislation will not. This raises two objections. Firstly, as a matter of principle, as this part of the Bill applies universally and not simply to firms regulated by the FSA, it seems desirable that clarity should be delivered in the legislation itself. Secondly, the evidential status of the Code means that compliance with it is not conclusive, and yet compliance really ought to provide a safe harbour for commercial transactions.

Enforcement

  36. This is covered in a separate section. The concerns about due process have added force in the context of market abuse in that the FSA enforcement regime will be applied to persons not subject to authorisation by the FSA.

Overlap and Layering within the Market Abuse Regime

  37. While we understand that Government and regulators are keen to see compliance which goes beyond "lip service", it is important that there is an overall coherence to the regime, and that the layering of similar but not identical requirements is avoided. We are concerned that in several respects the proposed regime is unnecessarily complex. For example:

    —  The interaction of criminal, civil and regulatory provisions causes concern about the complexity of the overall regime which will emerge.

    —  The general definition of market abuse goes beyond the definitions of the criminal offence of insider dealing in the Criminal Justice Act, and of market manipulation in section 212 of the draft Bill, and does not recognise the defences allowed in those circumstances.

  38. Firms will have to consider whether behaviour is criminal or not, as well as whether it complies with the Code. Even if it meets these tests, Section 56 may still be breached. Authorised firms will, moreover, have to consider their behaviour against the FSA's rules and any exchange rules which might be applicable. There are also variations in the way that the various requirements are drafted when dealing with the same matter.

22 March 1999


 
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