Update from the FSA: Next Steps on Principles-Based Regulation
This article is based on the presentation made by Matt Lucas at the FT Compliance Summit on 9 October 2007 in London.
First of all, what does the FSA mean by more principles-based and outcome-focused regulation? That second aspect – ‘outcome-focused’ – is sometimes lost in abbreviating this approach to ‘more principles-based’ but it really lies at the heart of what we mean. More principles-based and outcome-focused means wherever possible articulating our requirements through principles and high level rules that describe the outcomes we want to achieve rather than prescribing detailed, process-oriented rules. And it means that in supervising those requirements we will focus on whether our regulatory outcomes are being achieved.
Financial markets are constantly changing. It is essential that financial regulation keeps pace with that. Continuous innovation and new product developments are important ways in which the financial services industry generates benefits for markets and consumers. At the most basic level, it is neither practicable nor desirable for regulation to seek to respond to each market development. More fundamentally, a regulatory approach that focuses on outcomes rather than prescriptive rules is more likely to encourage and respond to market innovation and development. Thus, a more principles-based approach is more durable in the longer-term.
I think it’s important to stress that the strategy paper in itself hasn’t changed our requirements; it didn’t add any principles, delete any rules, or add or subtract to the force they had before. It’s not about extending to all the principles the sort of programme of work we have undertaken on Treating Customers Fairly. It is an overall approach intended to complement our risk-based approach. The strategy paper helps us to identify the levers we have to bring this about and we will be concentrating on these over the next few years.
Changing our rules and guidance is one of the ways in which we are shifting to a more principles-based approach, mainly through deleting detailed rules. I should start by explaining that the word ‘more’ – as in ‘more principles-based regulation’ – is important. While we do not think that a 9,000-page rulebook is sustainable, equally nobody thinks that the 11 FSA principles alone would suffice. We are moving along the spectrum between these two ends.
Rules will still have an important part to play, for instance where market failure analysis
leads us to conclude that they are the right regulatory tool to deploy
or EU Directives require rules. We will look to make greater use of what we call high-level rules. These aren’t a new category of requirements and won’t be separately identified in the Handbook; it’s a way of saying that we recognise the need to clarify or amplify the principles in some cases and we will do this in the least prescriptive, most outcome-focused way possible.
Our most significant milestone so far has been the coming into force on 1 November of the new Conduct of Business Sourcebook (COBS). Reform of the FSA’s investment rules has been a flagship project in our move towards more principles-based regulation. COBS moves away from reliance on detailed prescriptive rules and is about half the length of the old rulebook. COBS gives firms the flexibility to achieve the regulatory outcomes we expect in a way that suits them best, but this comes with greater responsibility on firms’ senior management to meet these outcomes.
One of the areas of continuing – but necessary – detail is in the area of regulatory reporting, that is, the various data requirements we ask of firms on an ongoing basis.
Regulatory reporting helps us to reduce the burden of direct onsite supervision, while at the same time making sure that we can identify risks.
The way in which we apply our principles based approach on reporting is to align the data we request, as far as possible, with the management information that firms use for their own internal monitoring to meet their senior management responsibilities.
The changes that we have made in the area of data requirements also demonstrate our commitment to the better regulation agenda. The challenge for us is to collect only the data that we have a clear need for, in a way that is efficient for firms and us, and on which we can carry out timely analysis.
Through a process of detailed review, costs benefit analysis and public consultation, we have made significant changes to firms’ data requirements.
We have done a lot of work in this area recently – driven in part by the Capital Requirements Directive (CRD) and the Market in Financial Instruments Directive (MiFID). I will offer two recent examples of this in the sections below.
First, we used the implementation of the CRD as an opportunity to revise all our reporting requirements for the sector, which covers banks, building societies and certain investment firms. Overall, the net average change in the amount of data we collect represents a 45% reduction for banks, a 25% reduction for building societies and a 55% reduction for securities firms. Investment management firms, on the other hand, will see an increase that reflects the under-reporting required of these firms in their previous regulatory regimes.
How do increased data requirements for some firms fit with better regulation? Well, we have always been clear that better regulation means ensuring that the overall benefits of regulation outweigh the costs, and that we maximise those benefits. This means that there will be instances in which the costs of regulation are increased because there will be an overall benefit; in this case, that means maintaining the effectiveness of regulatory reporting as a supervisory tool.
The second example is that, last month, we concluded our consultation on the outcome of our review of the Complaints Return and the Retail Mediation Activities Return (RMAR). The Complaints Return is completed by most of our firms and we proposed a net reduction of 80% in the amount of data collected. The RMAR is submitted by approximately 20,000 firms, which act as mortgage, general insurance and retail investment intermediaries. We proposed a net 30% reduction in the amount of RMAR data collected. We plan to implement these changes when we roll out the second phase of our new strategic reporting system from October 2008.
Changing the Handbook in these ways is clearly a driver for principles-based regulation, but principles-based and outcome-focused regulation is wider than just the legal drafting in the Handbook. It is also about how we interact with firms and the industry in developing policy, supervising our requirements and – sometimes – enforcing them.
Going back to the step before rule making – to the identification of a market failure and the decision to act on it – an outcome-focused approach means that we will not reach for more rules (or even principles) straight away each time a market failure needs correcting. Being outcome-focused means working with the industry wherever possible to find the solution. This way we may be able to avoid rule-making altogether and give firms the greatest opportunity to align a regulatory solution with business practice. Our work on contract certainty in general insurance is an example of this, as is clearing the backlog in credit derivatives among investment banks. In each case, no rules were needed to solve the problem.
More principles-based regulation underscores our emphasis on senior management responsibility, with an important role for other functions supporting senior management. We will be looking to senior management to engage with the principles and to ensure that their firms deliver outcomes that meet these high level requirements. And greater flexibility for firms is likely to mean that decision-making moves up the organisation. We expect that as the outcomes we are seeking should be the same as any reasonable business is seeking, this will be a benefit for firms. But it does mean that senior management and boards will need to ensure that they factor regulatory outcomes into their decision-making and judgments.
Compliance, risk management and internal audit departments will need to be able to support this decision-making and then be able to follow this through to monitor the outcomes that are delivered. The rules will be less likely to tell you exactly what process you need to have in place, because we won’t be assuming that us designing a process will either deliver the regulatory outcomes we want or that our view is the only way to deliver the right outcome for each firm. So it’s also about having well controlled and managed firms that engage positively with us.
To take an example, one of the benefits of articulating our requirements more in principles and high-level rules is that they should be better ‘future-proofed’ for market developments. Less detailed rules will be more durable as markets develop. They’re harder to avoid. And by articulating outcomes rather than a prescriptive straightjacket they will better support innovation in the market.
That’s a real benefit of this approach – but what does it mean for firms?
Although outcome-focused rules should not need to be updated to a changing
environment, firms and the regulator will need to adapt to the changing circumstances in which those principles and high-level rules apply. Firms will need to be able to identify changes in their markets, products and services in order to work through the implications for how they will continue to meet their regulatory requirements.
I mentioned the importance of firms engaging positively with the FSA. To make this approach work will mean we put an emphasis on open, transparent relationships with firms founded on good dialogue. I’m sure that isn’t a surprise and is something to which most firms strive. This does not mean, though, that we will confine ourselves entirely to high-level conversations with the senior management of firms in order to establish that our requirements are being met. There remains a role for more detailed testing, not least to determine whether the aspirations and intentions of senior management are indeed being translated into putting in place appropriate procedures and into delivering the right outcomes.
In addition to our individual relationships with firms, we will continue to produce guidance and supporting material. There will continue to be scope for imaginative approaches to how the requirements set by our principles and other high level rules can be illustrated and interpreted. We have already produced a wide range of supporting materials, such as statements of good-practice (and of less good-practice); case studies; short guides to our key requirements; self-assessment tools for small firms; and reports of what we have found from our thematic work into various issues.
Furthermore, we published in August our position on industry guidance so that, if the industry wants it, it can produce its own helpful materials. We have recently used it, for example, in relation to the material produced by the MiFID Connect group.
Principles-based regulation is also about engaging with our material (which is not in itself a new feature) but with a greater emphasis on firms making their own judgments. It is for that reason that we have clarified that the material we produce – whether it is Handbook guidance or not – can be relied upon. But I think it’s also important to stress that the guidance and supporting materials we publish are by no means prescriptive, and we will not treat it as binding.
If firms are to really benefit from principles-based regulation, they must remember that they are free to develop ways of delivering regulatory outcomes in ways that are aligned to their business. In July, we published our Policy Statement on the new Enforcement Guide in our Handbook, which sets out clearly the role of guidance and supporting materials in that context.
We are conscious of concerns about the accessibility of the material we publish, particularly where it is outside of the Handbook.
Over the past few years, we have greatly improved the functionality of our Handbook website so that firms can tailor it to their needs. We are also investing in the skills of our people so that we can engage in helpful dialogue with firms about our expectations, not simply directing firms to the relevant rule. This will not always be easy. In particular, we often won’t be able to give a firm the assurance that a particular process is the right one to have in place. After all, the key question is whether that process delivers the right outcome. This again highlights the important role in firms of monitoring and assessing the outcomes that are being delivered.
This is a course on which the FSA it set – there should be no doubt that we will be following this through. It will be a continuing process for firms and the FSA. There will be significant changes in the way the FSA thinks about and expresses its requirements. And in translating those requirements into reality, there will be changes to the way the FSA engages with firms. This will be a challenge for us all.