Last week Tracey McDermott, Acting Chief Executive at the Financial Conduct Authority, delivered a speech addressing a pressing issue in the world of financial regulation. It was driven upon the fact that most policy makers create new rules following periods of crisis. This is soon followed by a period of complacency assuming things have been figured out. This creates a perpetual, oscillating motion of regulations: Over-regulating one moment and oblivious the next. Creating rules that are fair, balanced and that promote efficient markets and competition is not easy. Fostering an environment that empowers innovation is a rather tall task.
Politicians on one side, a group that never wants to waste a crisis, too frequently create incomprehensible rules. Regulators are compelled to enforce with both sides at risk of missing the clues of the next crisis. The FCA in the UK is a bit unique. Its charter not only requires them to make and enforce regulations – they must also engender an environment of competition and innovation. This fact adds balance to their important mission.
McDermott states, “We become caught in a loop where we regulate, deregulate, repeat on an infinite cycle.” She is not alone in her recognition of the cyclical nature of financial regulations. But McDermott speaks at an interesting time where the UK stands at the forefront of rule-making enlightenment; something that is almost difficult to write. The UK, for the moment, possesses a dynamic innovative Fintech sector that is challenging all aspects of established finance with UK officials acting as co-pilots.
I believe that US policy-makers may benefit from the UK experience. Financial services today spend an inordinate amount of time in productivity killing and costly compliance. This is a cost that is inevitably born upon consumers.
“We are often told that boards are now spending the majority of their time on regulatory matters. This cannot be in anyone’s interests. If that continues indefinitely we will crowd out the creativity, innovation and competition which should present the opportunities for growth in the future,” states McDermott.
McDermott gives credence to self-regulation and the demand for an effective industry which serves consumers and fosters competition;
“…And a key point to make here is that regulators cannot, ourselves, deliver that outcome. Only the industry can do so. But regulators can, and should, play our part in helping it to happen.”
The key to breaking the wash, rinse, repeat regulatory cycle IS competition. It is innovation. And it includes thoughtful regulations that protect both consumer and financial firm. Of course the proof is in the pudding, but if there is any regulatory regime positioned to challenge the well-trodden path of the regulatory pendulum – it is the UK.
The speech, in its entirety, is reproduced below.
THE RAPIDITY OF CHANGE
My Lord Mayor, Ladies and Gentlemen. Thank you for that kind introduction. It is a great pleasure to be here this evening.
We are joined in London this week by the Chinese president. His presence here made me reflect on the phrase “may you live in interesting times”. This is often described as a Chinese saying although according to scholars there is, in fact, no equivalent phrase in Chinese and thus there is some doubt about its true origins. There is, however, no doubt that the last few years have indeed been interesting times for the financial services industry. And it is fair to say that it has been pretty interesting for regulators too.
The financial crisis and the conduct failures which subsequently came to light have had far reaching effects. They highlighted fundamental errors made by both firms and regulators. They identified deficiencies in the regulatory framework and structure. And they called into question some of the most fundamental aspects of fair dealing and integrity for which London’s financial markets are known.
And the response has been an unprecedented wave of legislative, regulatory and structural change and a deep, and critical, re-examination of the cultures, behaviours and incentives – of regulated and regulator – that created the conditions which allowed this to happen.
Implementation of the post crisis reforms has been, and continues to be, a challenging task. But, the job is not yet done. If we are to reap the benefits of the work to date we must maintain our focus and ensure that, together, we complete the process of reform we have started.
But it is also true to say that we are starting to see some light at the end of the tunnel.
Thanks to the work of Andrew Bailey and his team, our major financial institutions are now safer and stronger.
The work of the FCA has ensured that conduct is firmly on the agenda in the boardrooms of financial services companies.
Individual accountability is being enhanced through the Senior Managers and Certification Regime.
Once embedded, these changes should go a long way to addressing some of the root causes of the failures we have seen.
So, with that in mind, it is now a good time to turn our attention towards the future. To ask ourselves the question of what good regulation looks like in 2015 and beyond.
I do not think I will get much argument in this room when I say that the intensity and volume of regulatory activity over recent years is not sustainable – for regulators or for the industry.
We are often told that boards are now spending the majority of their time on regulatory matters. This cannot be in anyone’s interests. If that continues indefinitely we will crowd out the creativity, innovation and competition which should present the opportunities for growth in the future.
So while none of us would want to return to the problems of the past I suspect we will all be in violent agreement that we do not see the experience of recent years as the model for the future. But do we all agree on what we do want to see? Do we have a shared view of the appropriate role of the regulator as the reforms bed in.
I believe there are three key roles regulators need to play, in good times and in bad, to ensure a long term sustainable approach.
PENDULUM SHIFTS IN REGULATION
But before I talk about those three roles I should say why I think it is imperative we have this debate now.
If we look at the history of regulation we see an unloved model.
Bursts of activity after crisis or scandal followed by periods where regulation is less visible and less intense.
There is no doubt that this approach has produced some important and enduring reforms.
The most recent crisis gave us the new approach to accountability as a result of the work of the Parliamentary Commission on Banking Standards led by Andrew Tyrie. We owe modern principles of disclosure to the Great Depression. And the lender of last resort model to the Panic of 1873.
But, inevitably, among the many good and rational changes that arise from crises, there will be some that don’t have the intended or expected impact. We should not be afraid to acknowledge that and make changes where required.
Indeed, in many ways a periodic recalibration of the regulatory approach is both unsurprising and healthy. After all if regulation achieves its aim – of changing behaviour – the result should be a need for less, or at least differently focused, regulation.
But in that recalibration we must be conscious of the lessons of the past.
There are two main risks here.
The first is that regulatory phases become locked into feedback loops with economic ones. The appetite for reform reduces as the economy recovers. We start to believe that we have conquered the challenges and to become complacent. This creates the potential for new risks to build up in the system and for new strains of financial shock in the future.
And the second, is that as memories fade, and things improve, we forget the lessons of the past. As Governor Carney put it recently, there is a risk that we, or our successors, will start to believe again the “three lies of finance”:
- this time is different;
- markets always clear; and
- markets are moral.
The danger is that a sensible and intelligent desire to reduce unnecessary regulation leads the pendulum to swing too far in the other direction. We become caught in a loop where we regulate, de-regulate, repeat on an infinite cycle. And if we do that, if we take too big a step back when things are going well then history suggests we will fail to anticipate and prevent the problems of the future.
So the challenge for all of us is how we avoid this cycle? How do we develop a sustainable approach to regulation which helps financial services to live up to its aspirations, and society’s expectations? To be known as an industry which serves its clients in a way that is innovative, vibrant, competitive and clean. Not just today but for the long term
And a key point to make here is that regulators cannot, ourselves, deliver that outcome. Only the industry can do so. But regulators can, and should, play our part in helping it to happen.
In the past few weeks I have spent most of my time out and about talking to people – within and outside the industry – about how we tackle these issues. How do we work together to create a sustainable model that works for markets, consumer and industry?
In my brief moments of leisure I have also watched the depressing spectacle of the home nations crashing one by one out of the Rugby World Cup. And, perhaps because the only Englishman left is the referee Wayne Barnes, I have found myself reflecting on the many people who help the competition take place. And how these roles map across to us as regulators.
The first critical role of the regulator is to make sure that those we regulate play by the rules. And in this regard a good regulator, to steal an analogy from a colleague of mine, needs to be like a good referee.
Constantly on the pitch, keeping up with what is going on, respected, fair and consistent. Tough where required. At the centre of the action without being the centre of attention.
This requires rules to be set and to be enforced. Foul play to be dealt with fairy and decisively. But ultimately the rules will be of little interest or value to the customers of financial services firms if there is no competition between the players in the first place.
So, where we can, we should look to use regulation to drive the right incentives and conditions for healthy, competitive and innovative markets, which deliver good outcomes for markets and consumers.
And that is easy to say, but significantly more difficult to do. Financial services markets – both retail and wholesale – are characterized by complexity, customer biases, potential conflicts of interest and information asymmetries. The demand side is, therefore, less likely, or less able, to correct market excesses.
This is one of the reasons that the FCA has led the thinking in the use of behavioural economics in a regulatory context. Seeking to ensure that our interventions reflect the reality of how people and markets actually behave, not how we might hope, or even expect, them to behave.
We are not alone – the worldwide interest in this is illustrated by the recent US presidential executive order to agencies to use behavioral economics across policy making.
THE POLICY MAKER – OR THE GROUNDSMAN
Which brings me on to the second critical role – that of the effective policy maker. And to continue (perhaps beyond its natural breaking point) the rugby analogy I see this role as akin to that of the groundsman.
The FCA is currently one of only two regulators in the world to have both competition and more traditional regulatory powers. Our challenge and our strategic aim is to maximize the benefit of this – sharing the skills and disciplines of both to achieve better outcomes across the markets and sectors we regulate.
We want to create the best environment we can to allow competition to take place. To have a level playing field which does not advantage one participant over another. To set boundaries that are clear, consistent and predictable but, within those, enable firms to innovate and develop new approaches and provide new services.
Each of our regulatory interventions needs to be judged against how it will contribute to these aims. Our interventions need to be carefully considered and rigorously evidence based.
Thanks to advances in technology and data availability we now have the means to tap into much deeper wells of evidence. And, as I have already mentioned, we can make much more sophisticated assessments of how market dynamics are affected by consumer psychology.
We are now making full use of these advances across all areas of our work, from the pay-day cap and annual summaries in personal accounts, to market studies and our work to support innovators.
But even with all of that care and thought the results will sometimes be unexpected. The benefits an intervention is expected to deliver may not be realized or there may be unintended consequences.
To be effective as a policy maker we need therefore to be prepared to review our work. To look at rules which are not working and be prepared to change them.
By way of example, we have today published proposals to remove various disclosure requirements that our research shows customers do not use. We also recently proposed to modify the requirement for standard retirement risk warnings that need to be given to customers with smaller pension pots as the evidence demonstrated that receiving the warnings did not change their behaviour.
This constant assessment, and reassessment, of whether our rules are delivering the expected benefits will be built into our work as we review the various markets and sectors we regulate through our programme of market studies and thematic work.
We also need to be aware of the danger that regulation itself protects incumbents from competition. Our work on Project Innovate is designed to encourage disruptive innovation. The Call for Inputs on the Financial Advice Markets Review (which I am delighted to co-chair with Charles Roxburgh of HM Treasury) is designed to draw out examples of regulatory requirements that might be impeding innovation so that we can ask ourselves the question of whether these are still justified.
But, effective sustainable regulation is not just about challenging rules that are no longer needed. It also requires regulators to have the confidence and the courage, at times, to swim against the tide. To recognize and act to address emerging risks or developing practices that are undesirable.
History is again instructive. Regulators have too often allowed issues to grow in size and importance when rapid action may, although unpopular, have prevented much larger problems.
To quote Winston Churchill we have too often seen that “when the situation was manageable it was neglected, and now that it is thoroughly out of hand we apply too late the remedies which then might have effected a cure.”
A sustainable long term model for regulation requires us to get this balance right more often than we have in the past.
THE POST-MATCH COMMENTATOR
And this brings me to my final point.
My firm belief is that if the financial services industry is to restore the trust and confidence of those it is here to serve firms should not just aspire to meet our rules. They should aspire to be better than that.
No-one imagines London’s rise to global excellence was turbo-charged by a knack for tick-box compliance.
It was driven by professional excellence, creativity and integrity. And I cannot imagine a future under which that will be any different.
Put simply global clients will come to London if they believe they will receive high quality, innovative services and be treated fairly and honestly. And if they do not believe that they will go elsewhere.
And as I have described we have a key role in that – ensuring we create the conditions to allow competition and innovation to flourish within a set of clear, proportionate and well enforced rules.
But I also see another role for us. To conclude the rugby analogy, I would compare us to the post-match commentator.
Facilitating debate which reflects on, and analyses, past performance. Supporting and working with industry and other interested parties to try to find new solutions to old problems.
Constantly challenging the industry to do better and pushing them to go further and faster in the quest for change.
And we should be in no doubt that these methods – the push for higher than required voluntary standards – can be a very effective tool.
To take an example from another industry. The introduction of the European New Car Assessment Programme, or NCAP ratings (which, for the avoidance of doubt, has nothing to do with emissions testing) were dubbed by the motor industry in 1997 as ‘so severe, no car will ever be able to achieve four stars’. By 2001 the first five star car had rolled-off production lines. New standards continue to be set and exceeded. An achievement I am sure the FICC Market Standards Board and the Banking Standards Board will wish to emulate.
This approach of constant improvement, constant innovation and a desire to be better year on year needs to be part of the DNA of both market participants and regulators.
So to conclude, we have a common interest in ensuring that the UK continues to have a world leading financial services industry known for its integrity and creativity.
We need to make sure that we have a landscape that ensures clean markets and protects consumers through fostering competition and innovation.
A sustainable approach to regulation, which breaks the regulate, de-regulate, repeat cycle is critical to that.
This requires all of us – regulators, firms, and individuals alike – to play our part in changing the way financial services operates, not just for now but for the long term.