The independent action group for current and ex Equitable Life policyholders, funded by contributions.

Equitable Members Action Group

Equitable Members Action Group Limited, a company limited by guarantee, number 5471535 registered in the UK

Documents: 18/07/2002 - FSA ANNUAL MEETING, Howard Davies' address


Howard Davies
Chairman, Financial Services Authority

I speak at a time of great nervousness in financial markets, both here in London and around the world. There have recently been significant swings in the foreign exchange market, as the dollar has fallen significantly against the euro. But it is the equity market which has been particularly weak and more than usually volatile. As of yesterday, the FTSE 100 was down 40% from its peak two and half years ago, and the last two weeks have seen some of the sharpest daily moves in the markets' history. In fact, the UK market has fallen less far than those in France, Germany, Italy and The Netherlands. But that is little consolation to those who operate in the markets from day to day, and to those investors whose financial circumstances have significantly deteriorated in recent months.

It is hard to interpret the recent moves and impossible to forecast where we go from here. If I were able to do so reliably, I would be working elsewhere. But it would seem that the soft economic background is a factor, as is uncertainty about the strength and durability of the recovery in the US and Europe.

But the most recent sharp falls, which seem to have been triggered by the earnings restatements at WorldCom, appear to have more to do with investor confidence and trust, than with the economic fundamentals. Many investors have been shocked by a series of unpalatable revelations from US companies, in particular. Some of the previous comfortable certainties about corporate earnings, and the integrity of company accounts, have been thrown into question. There has been uncertainty, too, about the nature of the regulatory response in the US, with continued debates surrounding a number of different proposals for reform.

How far is it appropriate for these fears to be shared by investors in the UK?

I have said before that we cannot afford to be complacent, even though our accounting standards are different from those in the US, and the approach taken by accountants here is in a number of respects to be preferred. We also have a greater degree of independence already built into our regime for accounting and audit oversight. Nonetheless, the prudent assumption is that it could happen here. If, that is, by "it" one means a fraudulent attempt to inflate earnings for personal gain. So it is right for us to look hard at our regulatory regime, to see whether improvements are required. A paper on options for reform produced by a group convened by the Treasury and the DTI, to which we are contributing, will be published shortly.

But while "it" could happen here, so far it hasn't. So investor fears in this market look to be overdone. We do appear to be being buffeted by winds from across the Atlantic, rather than by any domestically generated bad weather. This makes it slightly odd that the fall of the FTSE 100 has been greater than either the Dow Jones index in the US, which has fallen by only 27% from its peak, compared to our 40%. And valuations in UK markets, as measured by price/earnings ratios, remain lower than in the US. The p/e ratio of the FTSE is currently 17, compared with 24 for the Dow Jones.

Now of course, as the health warnings would have it, we can expect share prices to go down as well as up. And a weak stock market does not, in itself, necessarily justify any regulatory response. Indeed, in some respects, the fall we have had from the dizzy heights of early 2000 has been a healthy correction to what can now be seen to have been an unsustainable bubble. But the speed and scale of the price falls can be expected to have some consequences for financial markets and, perhaps, to generate some collateral damage.

In fact, overall, financial institutions have behaved prudently and sensibly through this turbulent period. Very few financial firms were excessively leveraged as we hit the difficult patch. That is particularly the case in relation to the banks, who remain strongly capitalised and profitable, performing a reassuring role as a sound anchor in our financial system. But there are some areas where problems have been created, or perhaps revealed.

The losses sustained by investors in some split capital investment trusts, where those trusts were highly leveraged and invested in each other, are the most striking example. This is an unhappy episode, where exaggerated and in some cases absurd claims about the security of particular investments, misleading some investors into believing that they were putting their funds into relatively safe vehicles. We have disciplinary investigations under way, and the Ombudsman is actively considering the circumstances of a range of individual investors.

The falling stock market has also put pressure on the life insurance sector and indeed - though responsibilities for these lie elsewhere - on occupational pension schemes.

Equitable Life remains a particularly difficult case, due to the finely balanced financial position the society has been in ever since the House of Lords judgement in the middle of 2000.

On 28 June this year we issued revised guidance to the life insurance industry on the stress testing of their portfolios, generally referred to as the resilience test. The resilience test is an important element in the prudential framework which is designed to protect policyholders, as it helps to determine the appropriate mix in risk assets to the term, size and nature of policyholder liabilities. We had been considering possible changes to the test for some time, in anticipation of the new prudential rules that will come into effect in 2004. In the light of market conditions we considered it appropriate to make a change at an earlier stage, to head off potential market distortions.

The change to the test on 28 June was not made with any immediate pressure to sell in mind. The suspension of the test on 24 September last year was under very different circumstances and we have seen no need to further suspend the test in recent market conditions.

Since we revised the resilience test on 28 June, the equity market has fallen a further 9%. We continue to monitor closely the impact of market movements on the life industry as a whole and on individual firms. We continue to be satisfied that the insurance industry is meeting the minimum solvency requirements. Of course it is bound to be the case that the weak equity markets will affect firms with a large proportion of shares in their asset base. We are working with firms to ensure that all their actions are taken in the best interests of policyholders. It is also useful to remember that, whilst changes in asset prices on a day to day basis must be monitored closely, the liabilities of insurance firms arise over the longer term.

Regulators cannot, of course, prevent markets falling. Nor, as we have often said, do we aim for a zero failure regime. But that does not mean we are powerless. We can, through our prudential controls, help to build a financial structure which can withstand pressures and strains. And, through our behind-the-scenes work with individual institutions, we can head-off particular problems, and resolve others, as (or even before) they arise.

This kind of tactical work inevitably occupies a lot of our time in circumstances such as those we are experiencing today. But it is important, even now, to keep in mind the strategic aims of the regulator. They are set out in the Plan and Budget we published in January. And in our Annual Report, which is the basis of today's Annual Public Meeting, we reported for the first time on the achievement of our statutory objectives.

Our four strategic aims for 2002/3 are that, as a result of our work:

  1. consumers are better able to make informed choices and achieve fair deals for themselves. Our consumer education work is largely oriented towards achieving that objective.
  2. regulated firms and their senior management understand and meet their regulatory obligations. Our legislation explicitly requires us to regulate in a way which emphasises senior management responsibilities. Management are best able to motivate their employees to deal fairly with their customers.
  3. consumers and other participants have confidence that markets are efficient, orderly and clean. That objective incorporates both our code of market conduct and also our financial crime initiatives, and
  4. we establish an appropriate, proportionate and effective regulatory regime in which consumers, firms and others have confidence. Unlike most other regulators internationally we are statutorily required to consult both market practitioners and consumers in developing our regime, and we are required to prepare cost-benefit analysis on the vast majority of the requirements we set.
This year, for the first time, we have attempted to organise our report around the Authority's major aims. There is not time this morning to review all of them - you will be pleased to hear. So I will limit myself to drawing attention to just a few points which were of particular significance during the year.

Our new regime was introduced on 1 December last year. For a while, as the Parliamentary process inched forward, it seemed that N2 was retreating as we approached it. But, in the event, the lengthy preparatory period paid off, and we were able to bring in the new regime with a minimum of disruption to firms and their customers. That we were able to do so is a tribute in particular to the work of firms themselves and their trade associations, who helped greatly throughout the process. It was a genuinely collaborative effort, and one in which our three Panels of practitioners, consumers and small business representatives, played a particularly important part.

More recently, we have introduced a new credit union regime which brings a large number of small voluntary organisations into a regulatory regime for the first time. A second theme of the year, which I would hardly describe as a highlight, was the effects of the terrorist attack on New York on 11 September.

In the immediate aftermath our focus was on disaster recovery. A considerable volume of business previously transacted in New York was routed through London, which required a collaborative effort between firms and regulators on both sides of the Atlantic. While that process passed off remarkably smoothly, in the circumstances - which is a tribute to the spirit of collaboration demonstrated - the experience taught us a lot about the stresses generated for financial systems by a terrorist attack. We also paid close attention to the strains caused by the knock-on effects on a wide variety of firms and markets. Since then, in collaboration with the Treasury and the Bank of England, we have overhauled our own contingency plans, moved our back-up sites and re-trained key staff. We hope this effort will turn out to have been wasted.

Since 11 September we have also devoted considerable effort to enhancing the anti-money laundering regime in London. Inevitably, this causes some inconvenience to individual consumers, and to financial institutions. I am pleased to say that, with very few exceptions, we have had good co-operation from institutions, and understanding from individuals that the inconveniences they suffer are worthwhile, and inevitable if we are to make life difficult and uncomfortable for terrorists and drug dealers, in particular.

The third important theme of the year was the continuing clean-up of the problems inherited from the past. There, I believe, we can claim some credit for the progress made. At the end of last month we explained that 98% of the pensions review mis-selling cases had been satisfactorily resolved by the target date we set three years ago. At the time, many thought this was an unrealistic deadline but, faced with the need to meet it, firms stepped up their efforts and, as a result, hundreds of thousands of investors who previously faced uncertainty and anxiety now know their position. While the final figures for redress will not be known for a little while, we expect that around 11.5 billion will have been paid to some 1.1 million investors, in what is almost certainly the largest consumer compensation exercise undertaken anywhere in the world.

We do not wish to go down that road again, which is in the interests of neither consumers nor the life insurance industry. That is why we are engaged in a substantial programme of reform of retail regulation. That reform programme has been boosted, recently, by Ron Sandler's report on the long-term savings and investments market.

I recognise that many investors, and even some of the firms most closely involved, are confused by the number of and scope of initiatives under way. That is, to some degree, understandable. But now that Ron Sandler has reported, it is possible to sketch out, somewhat more clearly than before, the way ahead.

There are four main strands of work, covering:
  1. the regulation of distribution;
  2. the governance and structure of with-profits funds;
  3. the design and regulation of simpler products targeted at the mass market, and
  4. consumer education.
The first strand of work is well under way. We consulted earlier this year on some radical proposals to reform the polarisation regime. We have received much support for those proposals, and in particular for the removal of the basic polarisation rule, which we believe to be anti-competitive and constrained the market unhelpfully. The Office of Fair Trading take the same view. Ron Sandler's report supports our propositions in that area. Given the depth and scale of his analysis for the sector, I believe that support is highly significant.

But both Ron Sandler, and a number of representatives of the IFA sector, argued that our proposal to require independent financial advisers to be remunerated on a defined payment basis is too restrictive. A number of alternatives, designed to achieve a similar objective, have been put to us, and we are looking positively at those suggestions. Our aim is to reach a final view on the way ahead in the autumn and to move quickly to the necessary rule changes thereafter.

The second strand of work, reforming with-profits funds, is also well under way. There, also, Ron Sandler has supported the broad lines of our proposed approach. In some respects, however, he has argued that we should go further, and that funds should be reconstructed on a "charges less expenses" basis. That would be a radical change, which requires careful thought and analysis, in particular to look at the implications of a transition from where we are now to where Sandler would like us to be. That will require a satisfactory method of handling issues about the ownership of estates within life funds.

We aim to pull these ideas together with our recent proposals on governance of funds in a comprehensive paper around the end of the year.

The third area is not solely a matter for the FSA. The Treasury will need to take the lead in designing the simplified suite of products for which Ron Sandler calls. Alongside that, we shall need to look at the way in which the sale of such products would be regulated in the future. In our consultation paper on the polarisation reforms we put forward a proposition for a different type of financial adviser, with lower qualifications. Ron Sandler's ideas go rather further, and are clearly conditional on product features which are not typically available in today's market. I hope that, through the autumn, we and the Treasury will be able to move forward in this area. But there is some difficult work still to be done on product features, to ensure that it is possible to free up the conduct of business regulations without the risk of widespread mis-selling. We already know that the Consumer Panel has strong views on this issue.

The fourth and last area concerns consumer education. Up to now, we have built up our consumer education work on a modest scale, in effect by making savings elsewhere, so allowing us to keep regulatory costs to the industry broadly flat. Even within that constraint we have been able to develop curricular materials in both primary and secondary schools. And we have prepared a wide range of documentation for adults to help them think through the kind of financial decisions they need to make. If, however, as Ron Sandler recommends, we are to step up a gear then there would undoubtedly be a need for additional funding from the financial services industry.

So our plan in this area is to put forward some preliminary proposals early in the autumn for augmenting our consumer education effort in the next financial year. Then we will consult early in 2003 about the long-term strategy we should follow. That will cover major issues such as whether we should work primarily alone, or in partnership with financial firms. It will cover the governance arrangements, and the distribution mechanism we should be aiming to develop.

In this whole complex area, we need to balance two potentially conflicting pressures. First, the need to keep the period of uncertainty to a minimum. There is undoubtedly a risk of planning blight over the long-term savings sector. So we must get as much clarity into the future product and regulatory environment as we can, as soon as possible. On the other hand, we must get it right. And there are many plausible propositions around for reform which, on reflection, may not deliver what is claimed for them. Sadly, the history of the last 15 years is littered with examples of that latter phenomenon, and the law of unintended consequences is a powerful force in this industry.

I conclude with a few thoughts on the FSA's progress as an organisation. Those of you who have been through corporate mergers will be well aware of the challenges involved. With our own 9-way merger and N2 firmly behind us we are now more in control of our own destiny and are embarked on implementing our risk-based approach in everything we do. This is making a difference to the decisions we take on where to focus our attention and on how to tackle particular issues. Some high and medium-impact firms have now been through a risk assessment new-style and are experiencing our new approach at first hand. We plan to roll out assessments for most of the remaining firms over the rest of this year.

I do not underestimate the challenges facing my management team and staff in implementing the new regime fully, while continuing to bear down on costs. I have recorded in my Statement in our Annual Report my appreciation for the hard work which our staff have put in, but I repeat it here, along with my thanks to all the others, in regulated firms, and the practitioners and consumers on our statutory panels, from whom we shall now hear.