UK : FSA's approach to intensive supervision

Speech by Jon Pain, Managing Director, Supervision, FSA
City and Financial Intensive Supervision Conference

Good morning, I am pleased to be here to talk to you today on intensive supervision. As we emerge from the embers of the worst financial crisis in over 70 years, firms and regulators alike need to ensure that lessons are learnt and that behaviours and the way we operate changes, so that the same mistakes are not repeated.

The changes we have made in our approach to supervision are designed to make regulation more effective and reduce the likelihood of a future crisis – however, effective supervision and regulation will only get us so far. The life support given to the financial sector over the last two years should be a sobering enough effect for firms to recognise that significant changes are needed. As profits return to the sector with increasing frequency, firms must not be lulled into a false sense of security. To restore trust in financial services we need ensure we are not blind to the challenges that remain. I would like to cover three key questions:

• What does the FSA’s intensive approach to supervision mean in practice?
• What outcomes are we seeking to achieve?
• What are the outstanding challenges we face?

What is intensive supervision?

However, before I go on to talk about what this means in practice, I want to briefly recap on what we mean by intensive supervision.

Previously the FSA rarely intervened until it was clearly evident that something had gone wrong. Intervention needed to be based on evidence that risks had crystalised. This approach was described as ‘light touch’. The old approach was never going to stop firms making mistakes, as that was not its intention. This approach was of course the mandate for the FSA set by the city and society at that time.

The new approach we have moved to is ‘outcomes-based’ and this is delivered through intensive supervision. This approach is centered on intervening in a proactive way. To do this we needed to operate entirely differently, changing both our philosophy of ‘what supervision means’ and our approach to and the use of resources. We now:

• undertake more extensive business model analysis, to understand the key drivers of risk and sustainability of your business;
• make judgements, on the judgements of senior management;
• act quickly and decisively;
• proactively look to influence outcomes, not merely react to events;
• apply a greater depth of analytical rigour – for example, through embedding severe stress tests into our assessment, of how much capital a firm should hold; and
• we back up our intensive supervision with credible deterrence when standards are not met – as evidenced by fines of over £33m for last year.

This intensive approach is not just a battle hungry FSA looking for confrontation for its own sake. Our message to firms is clear – where necessary we will intervene and we will not be pressurised to back off. Firms will be well advised to engage with us in a proactive and open-minded manner rather than believe they can bulldoze the regulator at the last minute. To successfully deliver better outcomes we will of course need to deliver intensive supervision through more effective engagement and understanding of firms business.

What does this mean in practice?

So, how have we made this change and what does it mean in practice? We regulate over 20,000 firms, which spans from an independent financial advisor to the largest global banks. There are two important myths about our approach to intensive supervision.

The first is that intensive supervision only applies to our largest firms. We in fact require our supervision across the total spectrum of firms to adopt this intensive philosophy – to make any interaction with firms count. But of course, the second myth is that our supervisors approach and resources are the same for all firms. It simply isn’t feasible to deploy that level of resources for all supervision of firms – so our approach has to be risk-based.

The largest firms are subject to a close and continuous approach, where dedicated relationship teams are assigned to one firm with a structured programme of work in addition to regular risk assessments. For medium-sized firms, a dedicated relationship manager is assigned to a firm who will be subject to a periodic risk assessment – the frequency of which will vary depending on our view on the level of risk the firm or sector poses. Both large and medium-sized firms will also be subject to thematic sector-wide reviews.

Small firms are not subject to an individual specific risk assessment. These firms are monitored by a combination of baseline monitoring, risk alerts and thematic sector-wide reviews.

Enhanced supervision capability

For the largest, most systemically important firms, we have already more than doubled the resources allocated to their supervision, we now have teams of 15-20 supervisors plus specialist prudential and conduct risk resource – creating an FSA-wide integrated team of 60-80 for certain portfolio or deep dive reviews.

We are also continuing to develop a more rigorous analytical approach to how we regulate the largest institutions. This will be rolled out to large banks and insurers later this year and will involve regular deep-dive reviews throughout the regulatory period.

For prudential issues we will be undertaking more intensive reviews – for example, on capital, liquidity, risk management, governance and business models – through which we will increase the depth of our analysis, undertake a broader range of stress scenarios and include more peer group and sectoral analysis in our assessments.

For conduct issues we will be assessing the key drivers of potential conduct issues by better understanding the risks posed by the firm’s business model. Intervening much higher up the product chain and undertaking detailed outcomes testing work across the sales process and post-sale handling. This will be supported by an increased use of mystery shopping and consumer research.

Through this enhanced approach to both prudential and conduct issues, we will be supervising these firms in a more indepth and structured way than ever before, to build a rolling programme of assurance that will reduce the likelihood of risks crystallizing. And, over time, we will be applying the learning’s from this approach in a proportionate way to our medium-sized firms.

However, as I mentioned, not all firms will have dedicated supervisory resource. For the thousands of smaller firms we continue to deliver supervision through our assessment programme, which includes regional roadshows, firm visits and follow-up workshops, and feedback from the firms involved has generally been positive. In addition, as a result of risk alerts and thematic work, we will make more intensive individual firm interventions. The recent banning of 80 mortgage advisers for fraud with fines of over £1m was one such intervention.

To deliver our intensive approach to supervision we have significantly increased our capability by:

• recruiting over 350 staff in the last year across supervision, specialist areas and enforcement – my team of direct supervisors is now 1,200 people;
• increasing our capability to undertake in depth financial and business model analysis; and
• creating a specialist Conduct Risk division to focus on ensuring firms are delivering fair outcomes for consumers.

But this is not just about quantum of resource – we are also building our supervision capabilities and quality of supervision by:

• implementing a new comprehensive, eight week induction programme for all relationship-managed supervisors;
• introducing mandatory assessments of competence, in core areas for our lead supervisors; and
• enhancing our T&C regime that requires all supervisors to demonstrate adequate levels of technical skill, behavioral competence and sector specific knowledge.

Delivering intensive supervision

Now we recognise that intensive supervision will be felt by firms but will not always be visible to the external world. By definition our interventions are designed to deliver better outcomes, but preventative action is not always apparent. But we have fundamentally changed our approach – let me bring it alive with some examples:

• For a number of mergers or acquisitions over the last 18 months, we have been at the heart of the analysis and judgements being made by senior management, ensuring that customers’ interests are protected, that there are financially viable plans in place, that integration does not bring undue regulatory risk and that management and governance are capable and able to deliver. In the past our role would have been more passive in assessing the change of control of the firm much later in the process.
• Our ‘finger prints’ have been increasingly felt where we have actively encouraged a change in management or board members. Where we have identified weak or ineffective management or governance. To do this we have increasingly used our section 166 powers, to appoint independent skilled person reviews, to bring issues to the table.
  
• We have intensified our interventions on firms, with weak business models, where we have shaped and facilitated market solutions by encouraging boards and management to seek realistic strategies, to face up to current realities, look at alternatives and engage with possible suitors.
  
• We have stepped in to ensure that even when margins are under pressure, firms continue to act in the interest of customers, do not impose unfair contract terms and treat their customers fairly. Where consumers interests have not been met we have taken decisive action – this includes:
  
• the action we took against GMAC for unfair treatment of customers in arrears, which resulted in a fine of £2.8m and redress of £7.7m; and
• on MPPI, where we had concerns over how contract terms were varied and we agreed with industry that £60m of redress would be paid and contract terms realigned.
  
• And at the onset of the crisis our analysis and stress testing of capital and liquidity were integral to the government’s re-capitalisation of the banks. And for Lloyds and RBS, we played a pivotal role in assessing if they needed to participate in the Asset Protection Scheme, or sought alternative market-based solutions.
  
• As well as increasing the intensity of the firms and individuals already regulated, we have also toughened our supervision of the gateway for new applications or changes in control. Banking applications are now subject to intensive scrutiny, whether they are new start-up banks or existing authorised firms applying for deposit-taking permission.
  
• We are challenging firms to ensure their application includes a detailed, well thought through business model that is believable not just aspirational and has already been stress-tested and challenged as to its viability, that they have robust liquidity and capital financial resources, and that management are capable with relevant experience.

Outcomes

So, as you can see, we are already delivering our more intensive supervisory approach, but what outcomes are we seeking to achieve through this approach? I think these can be summarised into three broad categories:

• that firms are well-managed and have good governance;
• that firms are prudentially sound on a forward looking basis; and
• that consumers achieve a fair deal and are treated fairly.

Taking the first of these, it is clear to us that the financial crisis exposed significant shortcomings in governance and management across numerous firms.

And although poor governance was only one of many factors that contributed to the financial crisis, it was an important one. We are therefore looking closer at behaviour and culture in firms, particularly ensuring two key things:

• one – that good culture and behaviours in firms is being driven by senior management; and
• two – that good culture and behaviours are being reinforced by effective corporate governance and the role of the boards.

Through the crisis we have also seen examples where boards did not sufficiently challenge the executive or understand their firms’ business models and their inherent risks, and where boards did not simply receive the relevant management information to be able to carry out their important oversight role. Boards need to make sure they have the right people, asking the right questions, informed by the right information. As I said earlier, where this is not the case we will take action.

We also now place much greater emphasis on the role of senior management at firms. In October 2008 we implemented significant changes to our assessment of candidates who wish to perform functions of significant influence within firms. This included considerably increasing the number of candidates we interview. While it remains the duty for firms and shareholders to ensure the right people are in key functions, we will also make sure that these key roles are performed by people who are up to the job.

Since we adopted this more intrusive approach, we have completed over 400 interviews, of which more than 30 individuals have subsequently been withdrawn by the firm. Firms therefore need to take note that this is not just a box-ticking exercise.

Where we find issues with how individuals have performed their roles we will continue to take action, as demonstrated in our successful enforcement action against two former Northern Rock Directors for failing in carrying out their responsibilities.

Of course, part of changing behaviour and culture is about looking at the incentives on offer. We know that another contributing factor, albeit not a key one to the financial crisis, was remuneration practices, notably in the banking sector. Individual incentives can either reinforce or undermine a firm’s strategy and risk profile, so we have created a remuneration code of practice to ensure firms’ remuneration policies promote effective risk management. Earlier this year we undertook extensive supervisory reviews to ensure compliance with the code. We plan to publish a review of our code later this year.

Moving onto the second outcome that firms are adequately capitalised, it’s clear senior management need to ensure they have plans in place to remain resilient throughout economic cycles. We also expect firms to develop a robust and effective stress testing programme, which assesses their ability to meet capital and liquidity requirements in stressed conditions.

To ensure firms are financially sound, we have significantly strengthened both our prudential policy framework and our supervisory interventions in this area:

• We have implemented a new liquidity regime, which requires firms to hold adequate liquidity on a self-sufficient basis, has a narrower definition of what constitutes liquid assets, requires enhanced liquidity risk management and has more granular and frequent reporting requirements.
  
• We also continue to work internationally on ensuring we have a more robust capital framework that improves firm’s quality of capital and strengthens areas which were underweight pre-crisis, such as trading book capital, eligibility of hybrid capital and management of large exposures. Indeed, in the interim, we have increased the required levels of capital that banks and building societies need to hold to better cover their risks and protect their depositors’ capital sufficient to maintain their core Tier 1 ratio above 4% of their risk-weighted assets over a three to five year horizon.
  
• We have undertaken detailed, indepth stress tests on a number of firms across different sectors to ensure their capital and liquidity is sufficient to absorb any future shocks.
  
• And we have begun work on recovery and resolution plans – sometimes called ‘living wills’ to tackle the risk that certain banks are ‘too big to fail’.

However, we should be under no illusion that, on its own, regulatory and supervisory reform will be enough to prevent future crises. We are still working with the Tripartite to develop a more effective macro-prudential framework and the relevant tool to use when appropriate.

The third and equally important outcome is that firms treat their customers fairly and ensure they achieve a fair deal. The financial crisis has shaken the public’s trust in financial services to its roots.

And, as many consumers have found their financial situation less secure, the need to ensure consumer protection has never been greater. Continued failures in this regard (such as PPI, MPPI, complaints handling and treatment of with-profits policy holders) points to a lack of focus by firms on consumer needs. Indeed, product innovation has led to more complexity and a focus on profitability, rather than a clear unambiguous focus on consumer needs. Firms need to prove by their actions rather than their words that the consumer is genuinely at the heart of their business.

To increase consumer protection we have recently announced our new, more proactive approach to conduct regulation, where we will intervene earlier in the product chain to spot potential risks to consumers and prevent consumer detriment.

As for prudential risks we will do this through increased business model analysis to understand the key drivers of profitability and the risks this poses to consumers. We will increasingly test outcomes through mystery shopping and on site visits.

We are also seeking to improve the long-term efficiency and fairness of markets. Our initiatives in both the Mortgage Market Review and the Retail Distribution Review are two examples of how we have undertaken whole of market reforms to fundamentally reshape markets to deliver better outcomes for consumers.

And where we do spot failure, we will continue to secure the appropriate level of redress and compensation for consumers and ensure we provide credible deterrence by taking tough action against firms and individuals. Only last month we announced the results of our review of banks complaints handling where the results were less than impressive –.as a result two banks have been referred to Enforcement for further investigation of their complaint handling and we will conduct follow-up work later this year to test whether the changes being made in the banks we reviewed have been effective in raising standards. Where firms continue to deliver poor outcomes, we will take tough action to drive an improvement in standards.

We will continue to ensure consumers receive good outcomes through our proactive approach to conduct risks and our intensive supervision. However, rebuilding confidence will not be a simple task and it’s essential for the benefit of society at large that the industry collectively heeds the call and takes decisive action to treat its customers fairly.

Challenges we face

I wanted to end by briefly touching on three key challenges that we face.

The first is that we need to secure international consensus and maintain the required momentum to deliver an enhanced prudential framework that delivers a more resilient and robust banking sector. Within this we are fully aware of the need to ensure that the total package of measures that we agree and the glide path to improved standards must not cause the instability we are seeking to avoid.

However, industry also needs to recognise that the world has changed. That the life-support governments and central banks have and continue to provide around the globe are a stark reminder of the need for a more resilient financial sector. The financial sector must be capable of standing on its own two feet and not have the expectation that the taxpayer will always be the provider of the last resort.

The second, evidenced by the events that have unfolded across the Eurozone, is that the worldwide economic recovery remains fragile. These secondary sovereign shocks pose risks to the UK recovery that we at the FSA, alongside our Tripartite colleagues, remain very alive to. And while the exact path of the UK recovery remains uncertain, firms, regulators and governments alike need to be alert to these risks.

Finally, the FSA faces a number of internal risks and challenges for our people. To continue to deliver and fully embed our intensive approach, we need to continue to increase our overall resource and ensure that the training provided enables supervision to deliver our agenda. But we also need to continue to deliver a cultural shift, where supervisors have a much tougher role, which demands supervision have a well-balanced analytic capability, good industry understanding and are prepared to take tough decisions.

In conclusion, I firmly believe that our more intensive supervisory approach is already achieving results. We have significantly improved our capability to deliver the outcomes that society demands of us, but we still have more to do.

Thank you.