Building on experience

It may be five years since the start of the financial crisis – a crisis that has continued to evolve from US sub-prime mortgages to eurozone debt – but we are now seeing an accelerating pace of change in response to it, notably the regulatory response.

The future of financial services is unfurling before us quickly – perhaps more quickly than we previously imagined – so I want to focus my remarks on what I think the years ahead hold for financial conduct regulation.

But before I look forward, before I talk about where we’re going, I want to look at how we got here because the FCA is very much a product of what has gone before it.

So while the Authority itself is very new, only officially opening for business in April, our principles are directed and governed by the experience of multiple financial events stretching back many years. Not just here in the City. Not just here in the streets of one of the world’s oldest economic centres. But also in New York, Tokyo, Hong Kong and Frankfurt: London has always had more global connections than any other centre.

These global events have not always been positive, they have not always reflected well on either regulators or firms, but they do provide important lessons. Giving us a much better sense over the years of what effective regulation should look like and how it should operate.

One of the most important lessons we’ve learnt from these experiences all over the world, is that the traditionally mechanistic response of regulators to a crisis was not the right one. I will not comment on the response to capital and leverage – I will leave that to Andrew – but on the response to conduct failings.

Too much was based on what we recognise were imperfect economic models: that prices respond efficiently to new information (or if not efficiently, that they do at least respond); and that decision making is rational, not always, but certainly rational for sophisticated decision makers with access to data. Faced with a breakdown of price efficiency or rationality, the standard response was to provide more information and provide it more quickly.

If someone did not appreciate the risk of a product, we extended the description; if it looked too risky, we pushed people to the risk profile that allowed a sale. People were required to tick the boxes – that they had high risk appetites; that they had read and understood the terms and conditions; and that the decision was their own, that it is was a non-advised sale.

Too often our response was overly reliant on regulation by rote. We built ever more rules and guidance about how to build a compliant process. It was robotic. Too captured by the interests of firms. What we did too little was look at outcomes, so not ask ‘was the sale compliant?’, but ‘did it achieve a good outcome?’.

Looking back now, you can see that. You can see that these mechanistic processes and procedures – like more and more disclosure – fitted the needs of the huge compliance industry like a glove, but were an uncomfortable fit for the more specific and arguably more important needs of consumers.

My favourite example was not from London actually but from my previous job in Hong Kong. There, individuals who had term deposit accounts maturing were invited to meet the bank manager – the banks would then offer them a new deposit rate paying one per cent or an alternative ‘safe’ product paying seven per cent. ‘Why does one pay seven per cent?’ was the question that consumers didn’t ask. They didn’t because it was offered to them by their bank and they trusted that the bank wouldn’t sell them a ‘risky’ product.

Had they known the seven per cent product was a complex structured product that was effectively writing credit insurance, they might have thought twice. But they didn’t know that because nobody thought it was relevant.

We now know, thanks to experiences like these and the hard work of many campaigners, as well as our own work on behavioural economics that disclosure and box ticking are not the firm-friendly panacea once imagined. In actual fact, in many cases – like PPI – tick-box regulation simply encouraged a tick-box service. Leaving firms with often huge clean-up bills and badly damaged brands.

Pro-consumer – pro-business

I think this is an important point for both politicians and business leaders to take away as we move forward. We need a new model that is less narrowly focused on whether a process is compliant with a set of rules and more focused on whether it achieved an appropriate outcome.

The idea that financial regulators have to choose a path between being either pro-consumer or pro-business has always struck me as oddly binary thinking.

Indeed, if the last decade has demonstrated anything at all, it’s that the best interests of wider business are not served by a regulator that neglects the needs of consumers or tries too hard to curry favour with compliance departments. They are served by a regulator that is close to both customers and to markets.

It is difficult to argue today that our financial services industry wouldn’t be in a happier place if we’d seen a firmer, more customer-focused regulatory hand on the tiller on mis-selling – on pensions, endowments, insurance and savings.

Each of these financial scandals was avoidable. Each was at least partly a product of the regulatory age we lived in at the time.

So, I see no great tension between the role of the regulator as a champion for consumers and a champion for markets. There’s no great existential crisis for industry to deal with, as regulators become more pro-customer.

Financial regulation is not a zero-sum game. It is not like a tennis match or an election where for one side to win, the other has to lose.

It is – to paraphrase Bill Clinton – a non-zero sum game. Like a good partnership or positive business relationship in which the welfare of one participant  is closely aligned to the other.

The great challenge for the FCA in the years ahead is to strike this balance. To make sure we are close enough to consumers and firms to identify and deal with the next big conduct issue – the next PPI or LIBOR – and to do it quickly. To make sure we have the methodology in place to avoid damage to market participants and customers alike or if we cannot avoid it completely – and frankly we cannot guarantee we will prevent the next calamity – to respond quickly and decisively when we do confront it. And the new regulatory structure has given us some new powers to achieve this.

New identity

So, today I want to look at some of the specific structures and powers we will be employing to support this goal as we move forward. To achieve this balance. And I’m going to start by looking at the new FCA identity. The FCA DNA if you like.

What will our approach to regulation be? How will it compare to the FSA? What will be our strategic and operational priorities?   

The most important point to make is that the FCA has been given a very clear, uncomplicated remit by government. Our overarching strategic objective is to make markets work well.

And just to be clear – a market that works well has to work for all players in the market. It’s not a market where consumers never lose money – markets are about risk and in the appropriate product, consumers may gain or lose. It’s also not a market where firms never make money – the provisions of services is rarely for free and firms have to be allowed to make a profit.

So, a market that works well must work well for all – profits for good firms; exits for bad ones. Innovation and choice for consumers – hopefully good products that meet consumers’ needs and not bad products that simply obscure cost or risks.

This means the FCA will continue to support the growth of financial services in the years to come and to make sure our firms operate well in a competitive market.

But our operational objectives, the objectives that lie beneath this first goal, very deliberately reference the importance of consumers to fully functioning, flourishing markets, both in the retail and wholesale space.

In other words, the government expects us to be that balanced regulator. We are expected to work for and on behalf of business and consumers. And that is why the FCA is looking not just at systems and processes, but asking serious questions about major moral hazards like buyer beware – or caveat emptor.

Is it sensible for the consumers of financial products to be held solely responsible for selecting a product unwisely? Particularly when these products are complicated, when they are made up of many different moving parts, when you may not know if it works for 25 or 40 years.  

Is it fair for businesses to rely on a defence of caveat emptor if they sell a product they know is not suitable for the customer? These are the kind of challenges we will be working on in future - and I’ll be looking for my colleagues to answer them with imaginative, intelligent responses.

Could we, for example, make better use of behavioural economics to support consumers and businesses? To help customers to avoid falling foul of marketing, and sales processes that accentuate and distort the effects of complicated human biases: teaser rates that take advantage of consumer inertia; bizarre insurance exclusions tucked away in the small print; and terms and conditions that are longer than Hamlet but usually far less interesting - even for the most committed regulatory analysts.

Finally, can we use the early findings in our new behavioural economics approach to support business? Can we use its research and findings to provide a better customer service, to target products more efficiently, to encourage more people to save for the future?

New structure

These new questions we are asking, these new philosophies we’re implementing, these new approaches we’re adopting, will be underpinned and supported by a far more proactive structure within the FCA.

The most visible change for regulated firms will be in our supervision of firms. The FCA will be more forward-looking, more focused on where firms are heading and more willing to step in if needed.

Sitting behind this will be a new analytical approach that will help us spot issues sooner, to analyse them more intelligently and to prioritise them more effectively. This is the FCA’s new radar. Our window to the world ahead.

That work has now begun with the publication of the FCA’s first risk outlook earlier this month, providing a preview of our direction of travel.

It has already flagged up the risk to financial services and consumers of ‘inherent’ factors – those issues engrained into the fabric of our daily financial lives like information asymmetries, biases and inadequate financial capability. 

It has also highlighted the risk in certain structures and behaviours, like ineffective competition, culture, incentives and conflicts of interest.

Finally, it has flagged up environmental factors, like economic, regulatory and technological trends and changes.

One of the most serious questions arising from this work is the difficulty for firms of balancing prudential soundness and profitability, with good consumer outcomes. An issue that both myself and Andrew are very aware of.

This is a hugely tricky issue, which is made trickier by a low-interest environment placing significant pressure on net interest margins – a key source of profits for firms.

This is not rocket science. A firm will want to maintain that interest rate spread to be profitable. But we also need to be aware of the consequences this has for consumers.

We are in unusual times. Nobody expected base rates to drop quite so low – and then flatline for such a long period.

At what point can and should a regulator take action? Can you censure a provider for changes that are clearly explained and flagged to consumers as risks? Or should you only take action where there are clearly unfair changes to an existing policy?

What about when they are allowed for in the terms and conditions but are not consistent with the reasonable expectations of a consumer?

Decisions like these will always require an element of judgement. There are too many moving parts within them to be decided by a computer program.

So – no – we won’t always have the luxury of choosing an uncontroversial or uncomplicated answer.  And that requires a sensible and sensitive approach to regulation. One that balances the needs of business – the same businesses that provide employment, opportunity and wealth – with the needs of consumers.

New powers

But where we do need to take action, we will. And that brings me on to the final area I wanted to look at today: the new FCA powers that underpin this new identity and new structures.

One of the criticisms of UK regulation in the past has been its perceived lack of muscle and sinew. It has been described as ‘toothless’.

So, this is the final part of conduct regulation that I want to concentrate on this morning. Looking first at our new competition powers.

As many here will know, one of our new functions will be to build on this new mandate to promote effective competition across markets, with a wide range of tools to achieve it.

From general rule-making powers – such as requiring firms to submit information to price-comparison websites, to firm-specific orders, such as requiring a business to change practices that prevent switching, or to cease or divest certain operations. We will also be able to refer issues to the OFT.

This is an important new power. It is a necessary power and we need firms to be aware that the FCA will be taking this duty seriously.

Market forces left to their own devices do not always reduce mistakes or provide a perfectly competitive environment, regulation is sometimes needed.

One of the most frequently cited examples is in retail banking, where we know people are statistically more likely to change their spouse than their current account.

But this is not the only example. Add-on protection products are often monopolies at point of sale, offered like salt and vinegar with your Friday night fish and chips. ‘A refinancing to a small business – you’ll want some interest rate protection with that’; ‘a loan for a new car – I’ll add a little PPI on the side’.

And this is why we have new, already well-publicised powers to step in and ban or amend financial products.

Finally of course, from 1 April next year, we will be taking on our regulation of the consumer credit industry. This is as much a new responsibility as it is a new power. Easily trebling the number of firms we are responsible for overnight.

But I think everybody would agree that parts of this industry – payday loans spring to mind – are in dire need of a new regulatory approach.

Conclusion

I said at the start that the pace of change in financial services is accelerating. The creation of the new structures – the FCA and PRA at the beginning of the month are a big part of that change.

We should be proud, I think, that in many areas of conduct regulation the UK is now firmly setting the example for others to follow: in the use of more intelligent, decisive approaches; in the use of more forward-looking structures; in the use of more effective powers. 

Finally, and most importantly I think, we should remember that good regulation should never be caricatured as a simple choice between consumer interest and business self-interest.

It is, and always should be, in all our interests.