Back in July 2005, a consultation paper was issued by Financial Services Authority (FSA). Entitled ‘Reviewing the FSA Handbook’, it covered a number of subjects including reviewing the Conduct of Business rules. Peppered throughout the document was a four-word phrase that perhaps, with hindsight, to which we should have paid far more attention. Much as ‘prudence’ became the word of choice for our now Prime Minister back in his days at Number 11 Downing Street, and we all learned the seriousness and implicit connotations when used, ‘Principles of Good Regulation’ was about to become the foundations of a stock phrase for Messrs McCarthy, Tiner et al with just as serious connotations.
Of course it wasn’t until December of 2005 at his speech on FSA’s road map to better regulation introducing the ‘Better Regulation Action Plan’ that John Tiner, chairman of the FSA, changed the phrase slightly and the well-worn phrase ‘principles-based regulation’ was born as we all know it. The rest is history, culminating in ‘More Principles-Based Regulation’ which Tiner presented at the FSA’s conference on the subject in April of this year.
Principle basics
However, principles didn’t just start in 2005; they go back much further than that. Fundamentally the whole FSA is founded on principles. The FSA has four statutory objectives empowered to it by the Financial Services and Markets Act, and these in turn are supported by six principles relating to efficiency and economy, role of management, proportionality, innovation, international character and competition – collectively known as its Principles for Better Regulation.
Firms have their own principles too – known as Principles for Businesses, of which there are no less than 11. As someone recently commented, that’s one more principle than God required Commandments, which is telling.
The eleven Principles for Businesses are: integrity, skill, care and diligence, management and control, financial prudence, market conduct, customers interests, communications with customers, conflicts of interest, customers: relationships of trust, customers’ assets and relations with regulators. So it’s fair to say that principles really are at the heart of our regulator’s approach – they are in its blood.
Looking at the theory behind principles-based regulation is quite simple: fundamentally, the FSA can’t regulate every minute detail of the financial services industry; it simply doesn’t have the resources. If it wanted sufficient resources, it would require huge amounts of money, and in order to raise that much money it would have to charge such high fees that it would put us all out of business. I suppose that’s one approach to regulation, but perhaps not one that proliferates a durable market.
LPrioritising
Logically, therefore, the FSA has to prioritise and select areas of the market where it feels regulation and enforcement is most needed. In choosing how to tackle this, the FSA decided to address the areas that potentially could have the biggest and worst affects on consumers – a risk-based approach based on consumer outcomes.
Having decided on taking a risk based approach, FSA had two options. It could both develop and enforce a set of rules, or it could work to principles. Given that rules would be developed by the regulator and then enforced by the regulator, if the outcomes failed to meet the desired results, whose fault would that be? Advisers would have done as they were told, the results would be unsatisfactory and there would surely have been a regulatory failure? Conversely, it could assess outcomes against principles, and expect firms to find their own way there. Obviously, it is far easier to use principles to assess the results. If a firm then loses it’s way and doesn’t pass muster then that is a failure of the firm, not of the rules and certainly not of the FSA.
A sensible move?
It must be said, in some respects the move to principles-based regulation is actually quite sensible. AMI has long campaigned for ‘proportionate’ regulation and to an extent principles-based regulation allows for this.
The best firms should benefit from the ability to run their businesses as they see fit; to not be bound by prescriptive rules, and be able to service their clients as they deem appropriate. They should benefit from ‘regulatory dividends’ for their compliance, with lighter touch regulation and less time-consuming and expensive compliance procedures. Conversely, firms that do not pay due regard to their clients will still fall foul of the regulator, and can easily be disciplined for lack of adherence to the principles. The obvious example of this is the use of ‘failure to treat customers fairly’ as a reason for enforcement. If you read the FSA website, almost all fines or management or firm actions relate in some way to the failure in ‘Treating Customers Fairly’ (TCF).
It is also true that principles-based regulation succeeds in embedding compliance in the boardroom. It makes it absolutely clear where responsibility lies and forces management take compliance seriously, and install TCF in all areas of their businesses.
Problems
So that’s all fine then; principles work. Well, not quite. There are one or two problems related to principles-based regulation.
Firstly, smaller firms do struggle. AMI has highlighted this to the FSA, and continues to be of the opinion that the regulator doesn’t offer small firms enough help. For years we’ve lived on rules and while on occasions prescriptive rules can be awkward and tiresome, at least you knew where right and wrong lay. You could sit there and know that your file was water-tight, that if the FSA came knocking at the door everything was in order.
But in a world based on principles, there are so many shades of grey. While it can hold an opportunity for larger firms, who have the time and budgets to understand the theory, for the smaller firm it can be quite unsettling to have the rulebook pulled from under you.
We think the FSA should be doing more, and aiming more resource at helping smaller firms understand. Evidence suggests that smaller firms want to comply but ‘don’t get it’. When they are offered guidance, the proverbial light bulb switches on and they’re away, but the regulator should do more to help smaller firms with this.
Secondly comes the hanging yourself and ample rope analogy. There must be acknowledgement that principles could create a situation where the FSA gives a firm just enough rope to hang themselves. While for some firms adapting to principles is easy, some firms just haven’t understood it. While we have no sympathy for firms that flout rules, we do for those that genuinely struggle. Compliance departments rely on rules – without them compliance could become a subjective opinion which will never create a consistent and TCF approach.
AMI also has a serious concern about costs. The move to principles-based regulation is set to cost £50 million. Where is the cost-benefit analysis of this? Where are the regulatory dividends for firms that adopt this concept? And most worryingly, what are the long-term implications? Is this a huge cost that will only be overtaken by European regulation in years to come?
The Europe effect
Therefore the final overriding issue has to be Europe. Does principles-based regulation fit within Europe?
Historically, Europe has focused on product regulation – the complete opposite to principles based regulation. This is regulation-by-rule at the deepest level – within products.
However, on a regulator-to-regulator basis, Europe may well be starting to operate on a principles-based agenda. The irony with this is that the FSA itself has struggled on occasions to accept European principles. As recently demonstrated with the UK’s ‘strategic withdrawal’ of the Article Four exemption request for the Menu and Initial Disclosure Documents. So, sometimes the FSA find adhering to Europe’s principles difficult, preferring to interpret them as rules for our firms. Given that the Markets in Financial Instruments Directive is a maximum harmonisation directive, it is unlikely that this is the last we will see of such conflicts.
Looking to current issues, principles-based regulation is being tested given the FSA’s view that sometimes specific rules are needed. Reading the latest ICOB review, there are actually more rules for certain products – such as payment protection insurance. It is also noteworthy that in parts the FSA has used ‘copy-out’ of European directives in NewICOB – a nod to the power of the European regulator?
The Retail Distribution Review also poses questions of principles-based regulation. When considering ‘Primary Advice’, it is clear that ‘simple products’ could well come to mean ‘product regulation’. Of course, the industry could fill in the gaps between principles and practice without the regulator needing to introduce new rules. The meat in this sandwich is ‘industry guidance’ – where the industry provides its own ‘rules’ to operate within.
We are living in a complex world of rules and principles for quite some time yet and AMI will be helping its members steer between the icebergs.
