In reviewing the current state of the Financial Services Authority’s (FSA) move towards more principles-based regulation, there is no better place to start than its 2007 Business Plan. At its launch, John Tiner, the FSA’s chief executive, pointed out that ‘more principles-based regulation will produce significant benefits for firms, markets and consumers’. This is a big claim and only time will tell whether these aspirations will become a reality. In the meantime, what’s happening with principles-based regulation, and how is it affecting the day-to-day way we behave in our businesses?
‘Treating Customers Fairly’
The first topic under the overall heading of principles based regulation is inescapably ‘Treating Customers Fairly’ (TCF), which is number six in the FSA’s list of 11 principles for business, but number one when it comes to current exposure and emphasis. In a recent speech on the theme of more principles-based regulation and TCF, Clive Briault, the FSA’s managing director of retail markets, explained the six desired outcomes of TCF. The first, of these is that customers can be confident they are dealing with firms where the fair treatment of customers is central to the corporate culture. If this is news to any readers, they may be shocked to realise that the deadline for embedding this TCF culture expires today, 31 March. The point about this outcome is that TCF is a cultural issue that needs to be driven from the top of businesses, with senior management leading the process.
Looking at TCF as the prime example of principles-based regulation will help us to understand why the focus is on senior management’s role in creating the right culture, and how all the various strands of regulation knit together for the benefit of consumers. Weaknesses in a firm’s culture can lead to poor quality outcomes for consumers. For example, poor Training and Competence (T&C) arrangements tend to lead to poorer quality of advice. In addition, a system of rewards driven by sales-based commission may, without adequate controls, lead to mis-selling. Other elements of a firm’s culture, including leadership and internal communications, must combine with controls, rewards and T&C to create a culture that delivers TCF.
Three main responsibilities for principles-based regulation must be fulfilled by senior management. They must engage with the FSA’s desired outcomes and use the flexibility offered by principles-based regulation to set the direction and culture of their firm accordingly; they must make sure that necessary changes are made to ensure consistent delivery of the six consumer outcomes; and they must be sure that they are delivering at least the FSA’s minimum standards – for which they will need effective management information and measurement systems in place.
The next five consumer outcomes are explained as relating to different stages of the product life cycle. In summary these are targeting of products to specific areas; suitability of advice for individual consumer circumstances; products meeting consumer needs; clear information; no post-sale barriers and fair treatment over the whole product life cycle. In short, expressing the regulatory requirement in terms of what must be achieved downgrades the importance of following processes – but it does not remove the processes, for example, the rules.
Regarding the balance of principles versus rules, Briault points out that the principles do not displace the rules – because there will always be a hybrid approach containing both – and that the principles are themselves rules. However, rules have certain drawbacks. For example, they cannot cover all eventualities and, where there is a gap, it tends to be filled by retrospective rules, with the rule book growing larger and larger over time.
This brings us to the bigger picture that surrounds the TCF issue, and some examples of where the rule books are being made much smaller and – in the case of Anti-Money Laundering – have actually been scrapped. The process of simplifying the FSA handbook and removing unnecessary rules started back in July 2005 and it is ongoing. At the launch of the consultation process, the move towards more principles-based regulation was already the key goal, and the simplification of the handbook was described in terms of ‘eliminating or changing requirements which are more restrictive than needed to achieve the FSA’s statutory objectives, which do not deliver benefits that justify their costs, or which are not consistent with the FSA’s focus on senior management responsibility’.
Key areas
In the case of Anti-Money Laundering, the detailed rules were following the process described above – growing ever more numerous but failing to keep up with the fast moving pace of, for example, criminal money laundering practice. So, instead, the rules have now been replaced by brief, high level provisions in the senior management systems and controls sourcebook, making the whole senior management team responsible for delivering effective Anti-Money Laundering controls. Here, an important point has been made that also runs through the whole of the principles-based regulation versus rules concept. This is that principles give firms the flexibility to implement systems that are most appropriate for their own organisation, in order to deliver the desired outcomes.
Since the start of the handbook streamlining initiative, we have seen an number of other areas where rules have been cut back in favour of principles-based regulation. One example is the reforming of the approved persons regime, on which the policy statement and final rules were published in February 2007 and are effective from November 2007. The changes merge all the previous customer functions into a new single category and eliminate the need for firms to submit a form when an approved person wants to add or change their customer functions. It is estimated that these changes will save firms a total of £1 million annually.
Another key area where rules are to be simplified and reduced is that of T&C. At the end of February 2007 the FSA published CP07/4, the T&C sourcebook review. This sets out plans for ‘a shorter and more outcome-focused T&C sourcebook’. Again this is all about replacing detailed rules with high level rules and guidance, and it’s really only the rulebook that will shrink – not our obligations to ensure the appropriate level and quantity of T&C in our businesses.
The FSA needs to integrate the EU’s Markets in Financial Instruments Directive (MiFID) into its own rules by November 2007. Because of the MiFID requirements, the FSA was obliged to remove detailed T&C rules for wholesale businesses – those not dealing with private clients – which inevitably would have an effect on the equivalent rules for retail firms. The set of five ‘commitments’ currently outlined in TC1 are to be scrapped, because the MiFID competence requirement encompasses them, so there is no need for duplication within the rulebook, and the FSA now has to decide which of the old rules should be retained – at least for the time being. Overall, the aim is to give firms greater flexibility to decide how to achieve the desired T&C standards while still ensuring that consumers are protected.
CP07/4 also explains that the MiFID contains a high-level competence requirement that requires firms within its scope to employ people with the skills, knowledge and expertise necessary to carry out the responsibilities allocated to them. Skills, knowledge and expertise are already the cornerstones of the existing T&C requirements, and the proposed changes are only to reduce the detailed rules, not the principle or the desired outcomes. T&C is highly relevant to three of the FSA’s all-important principles for business – principle two, which is conducting business with due skill, care and diligence; principle three – organising and controlling affairs responsibly and effectively; and principle six, which is, of course, TCF.
As with most complex issues, there are benefits and drawbacks to the greater role of principles-based regulation. If Tiner is right, and it delivers significant benefits, then it will have been worth all the effort. Until that happy day arrives, there will be huge pressure on compliance professionals to interpret the FSA’s requirements in terms of delivering against the principles, and turn it into practical actions. mi
