Regulating Financial Services and Markets in the Twenty First Century 9781472559128, 9781841132792

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Preface this book contain revised versions of papers that were presented at a conference on The Challenges Facing Financial Regulation which took place in the Law Faculty, Cambridge University, in July 2000. The conference was organised by the University’s Centre for Corporate and Commercial Law (3CL). It was an opportunity for high-level examination of important issues at the forefront of financial services regulation. The conference organisers constructed a programme that would allow speakers to consider the far-reaching effects of the Financial Services and Markets Act 2000 on the UK financial sector in the context of rapid global change. They also sought to take an interdisciplinary approach and were fortunate that so many distinguished academic authorities on the law and economics of regulation, and also some of the most influential practitioners, regulators and policymakers agreed to present papers. The stimulating and wide-ranging discussion that took place at the conference is reflected in the chapters contained in this volume. Financial regulators grapple with the challenge of ensuring that their regulatory regimes do not fall too far behind developments in the markets. Those who write about financial regulation face the same problem. Our way of dealing with this challenge has been to invite contributors to use their extensive detailed knowledge of regulatory regimes so as to provide an authoritative analysis of the underlying issues affecting the broad development of financial services regulation. So the chapters in this book consider fundamental questions about the objectives of regulation, the responsibilities of the regulated community, the accountability of regulators, the regulation of electronic financial markets and the impact of stock market mergers, regional regulation within Europe and the development of global financial regulation. The chapters mainly reflect the position as at November 2000 but it has been possible to include references to some later developments. We would like to thank the contributors for their conference presentations and their revised chapters. We would also like to thank those who presented papers at the conference which are not included in revised form in this volume and also the conference delegates: the discussion that took place at the conference enriched that occasion and has influenced the views that are expressed in many of the chapters here. We are grateful to Richard Hart and his team for their unstinting support. A particular debt of gratitude is due to Felicity Eves who, single-handedly, provides all secretarial and administrative support for the 3CL and, without whom, the organisation of the conference and the

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vi Preface production of this book would have been an infinitely harder, and much less cheerful, task. EIL Í S FERRAN 3CL Law Faculty Cambridge 5 April 2001

CHARLES GOODHART Financial Markets Group London School of Economics

List of Contributors Kern Alexander is an Isaac Newton Trust Research Fellow in International Financial Law and Regulation, Judge Institute of Management Studies, University of Cambridge. Colin Bamford is the Chief Executive of the Financial Law Panel. Prior to that, he was a partner at Richards Butler, Solicitors. Thomas Beazley is a barrister at Blackstone Chambers specialising in commercial and public law. Howard Davies is Chairman of the Financial Services Authority. Before taking up that appointment, he was a Deputy Governor of the Bank of England. Rahul Dhumale is presently with the Policy and Analysis Function at the Federal Reserve Bank of New York. He has previously worked as a consultant with the World Bank, International Labour Organisation, the UNDP, and the International Monetary Fund and was a Faculty member of the Judge Institute of Management Studies, University of Cambridge. John Eatwell is a Lecturer in Economics at the University of Cambridge and President of Queens’ College, Cambridge. Lord Eatwell is a Labour member of the House of Lords. Amelia C. Fawcett is a Managing Director and Chief Administrative Officer of Morgan Stanley International Limited. Eilís Ferran is Director of the Centre for Corporate and Commercial Law and a Reader in Corporate Law and Financial Regulation, University of Cambridge. She was a special adviser to the Parliamentary Joint Committee on Financial Services and Markets. Charles Goodhart is the Norman Sosnow Professor of Banking and Finance and Deputy Director of the Financial Markets Group at the London School of Economics. Between 1997 and 2000 he served as one of the four independent members of the Bank of England Monetary Policy Committee Andrew Haldane is Head of International Finance Division, Bank of England. Martyn Hopper is Head of Regulatory Enforcement at the Financial Services Authority. Howell Jackson is the Household International and Finn MW Caspersen Professor of Law, Harvard Law School.

x List of Contributors Rosa Lastra is a Senior Lecturer in International Financial and Monetary Law at the Centre for Commercial Law Studies, Queen Mary and Westfield College, University of London and a Member of the European Shadow Financial Regulatory Committee. Colin Mayer is Peter Moores Professor of Management Studies at the Saïd Business School, University of Oxford and Director of the Oxford Financial Research Centre. Alan Page is Professor of Public Law at the University of Dundee. He was a special adviser to the Parliamentary Joint Committee on Financial Services and Markets. Sir Adam Ridley is the Director-General of the London Investment Banking Association. Mary Schapiro is President of NASD Regulation, Inc. Steven Schwarcz is Professor of Law at Duke Law School, USA and Faculty Director of the Duke University Global Capital Markets Center. Heba Shams is a Research Fellow at the Centre for Commercial Law Studies, Queen Mary and Westfield College, University of London. David Shrimpton is the Head of Market Supervision at the London Stock Exchange. Gilles Thieffry is a Partner and Head of Capital Markets at Andersen Legal. He is a Solicitor of the Supreme Court of England and Wales and a Member of the New York Bar and the Paris Bar. Daniel Waters is Director of Enforcement at the Financial Services Authority. He previously worked at the Investment Management Regulatory Organisation (IMRO), where from 1996 he was Director of Monitoring and Enforcement. Prior to that he was Director of Enforcement at IMRO for three years. Gay Wisbey is the Director of Markets and Exchanges, Financial Services Authority. Eddy Wymeersch is the Chairman of the Belgian Banking and Finance Commission and Director of the Financial Law Institute and Professor in Law, Ghent University

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Regulating Financial Services and Markets in the Twenty First Century: An Overview EILÍS FERRAN AND CHARLES A. E. GOODHART

THE DAWN OF A NEW ERA IN UK REGULATION OF FINANCIAL SERVICES AND MARKETS

and Markets Act completed its passage through Parliament and received Royal Assent in June 2000. When the Act (or FSMA as it is sometimes referred to in this book) comes into force it will establish the Financial Services Authority (FSA) as the single statutory regulator of financial services, including insurance and banking as well as securities markets, activities in the UK. The Act is expected to come into force some time in 2001, a date referred to by the FSA as N2. The transmutation of a policy initiative to establish a single regulator, announced soon after the Labour government took power in 1997, into legislation was a long, complex and, at times, controversial process. The conference at which the ideas discussed in this book were first presented was ideally timed, just after Royal Assent, to abstract from the politically-charged debates surrounding the passage of the legislation and instead to look at the structure put in place by FSMA and to consider its likely practical effect. One thing is very clear: although FSMA is a major landmark in the development of financial regulation in the UK, it is only a framework instrument. The detail of the practical operation of the new regulatory system will be found not in FSMA but in the policies, rules and procedures that are adopted by the FSA in the exercise of the extensive statutory powers that are vested in it by the legislation. The rulebooks and manuals which the FSA is developing in order to be fully operational by N2 will thus be the usual primary point of reference for those concerned with the regulatory requirements on a daily basis. So, from one perspective the question asked in relation to FSMA at the conference—“Will the New Regime Succeed?”—might suggest an exercise in crystal-ball gazing that only the foolish would attempt at this stage when details remain to be filled in, it has not become practically operational and the FSA’s

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2 Eilís Ferran and Charles Goodhart stated1 intentions with regard to the use of its regulatory tools have not been tested. But, as the chapters in this book make clear, it is important that debate about how the FSA should interpret and apply its powers should begin when policies and practices are being formulated and should not be held back until after practical implementation. Whilst the system has been designed to be flexible and adaptable and practical experience will inevitably lead to changes, the more that can be got right from the outset the more the regime will be likely to be judged a success. Modern financial services business is characterised by firms carrying on multiple functions and globalisation. These trends are underpinned by technological developments that change the way in which existing participants conduct their business, make it possible for new types of business and new participants to emerge, and open up access to information, thereby enhancing market transparency. New regulatory challenges at both the national and international levels which are brought about by these features were considered repeatedly and from different perspectives throughout the conference. The growth of “universal” financial services firms—financial conglomerates that operate across traditional sectoral boundaries—and the blurring of distinctions between financial products through secondary market techniques such as securitisation and derivatives trading had outpaced the old functionally-driven approach to regulation in the UK with a multiplicity of regulators responsible for different aspects of financial services business and played an important role in the formation of the case for the establishment of a single “one-stop” regulator.2 At the time of the conference, and subsequently, the regulatory response to these trends continues to demand attention, with particular emphasis on the consequences of globalisation for hitherto national stock exchanges, often structured as not-for-profit mutual organisations, which are now converting into international commercial businesses.

GLOBAL BUSINESS , GLOBAL REGULATION ?

The sophisticated transnational nature of financial services business gives rise to significant issues of concern. One regulatory response to the economic realities 1

A New Regulator for the New Millennium, FSA Policy Report (February 2000). The academic literature and comparative data on the regulatory structures in place in other countries provided plenty of alternative institutional arrangements that could have been considered as replacements for the old regime: e.g, M. Taylor, ‘Twin Peaks’: A Regulatory Structure for the New Century (London Centre for the Study of Financial Innovation, 1995); M. Taylor, Peak Practice: How to Reform the UK’s Regulatory System (London Centre for the Study of Financial Regulation, 1996). C. Goodhart, P. Hartmann, D. Llewellyn, L. Rojas-Suárez, and S. Weisbrod, Financial Regulation: Why, How and Where Now? (London, Routledge, 1998) ch. 8 outline another option: a system of regulatory agencies constructed on the basis of the objectives of regulation. They also provide an overview of the structure of regulatory agencies in several countries. But the single “mega” agency was clearly the politically favoured option. See further C. Briault, The Rationale for a Single National Financial Services Regulator, FSA Occasional Paper Series No 2 (1999). 2

Regulating Financial Services and Markets in the Twenty First Century 3 of globalisation emphasises the need for co-operation and communication between national regulators. This links in with the idea of achieving consistent and coherent transnational regulation through the development, by international standard-setting bodies, of agreed core standards of good regulation which national states then adhere to and enforce through their domestic laws. These regulatory approaches respect the traditional legal principles of national sovereignty and territorial jurisdiction, and their effectiveness depends on consensus building amongst major states which, in turn, creates market incentives for less economically powerful states to fall into line. But whilst some impressive elements of the current international financial regulatory structure have been built up in this way—the Basel capital requirements discussed in a number of the chapters in this book springs to mind as an obvious example—there are also shortcomings. Much thinking is taking place at a variety of levels, practical and academic, about possible ways in which international financial regulation might be strengthened. As many of the chapters here indicate, current thinking embraces relatively modest initiatives for improving co-ordination with regard to standard-setting and enhancing transparency with regard to countries’ compliance through to more ambitious proposals for a new international financial architecture with an international agency that has global jurisdictional power at its centre. Alexander (chapter 17) acknowledges that the informal and voluntary approach to co-operation and standard-setting has achieved some success but he contends that the changing structure of international financial markets and, in particular, the increased risk of systemic failure require a more formalised structure of binding international standards and effective supervision and enforcement. Alexander supports the view put forward by Eatwell (chapter 15) that “efficient regulation requires that the domain of the regulator should be the same as the domain of the market that is regulated”. Since financial markets are now global, Eatwell argues that, in principle, there should be a World Financial Authority (WFA). Even if the establishment of such an WFA is not (yet?) practical politics, the five main regulatory tasks (authorisation, provision of information, i.e., disclosure, surveillance, enforcement and policy development) will still, Eatwell argues, need to be performed at the international level. In some part the IMF, with its new Financial Sector Appraisal Program (FSAP), and using a “soft law” approach, may step into the breach. Even so, there is, Eatwell believes, a long way to go, and “the present conjuncture, in which the predominant rule making bodies are the Basel committees, IOSCO and the IAIS, whilst the predominant international surveillance body (in so far as there is any international surveillance at all) is the IMF, is an awkward hybrid”. Eatwell is rather dismissive of the Financial Stability Forum, established in the aftermath of the Asian crisis. Although the FSF is a useful meeting ground for the various main players involved, for example, regulators, politicians, practitioners and officials, he claims that it is “a think tank with nowhere to go”. Haldane (chapter 16) reviews the work of the FSF over its brief life to date, especially its

4 Eilís Ferran and Charles Goodhart emphasis on codes, transparency and market forces, which “three features run through all the four FSF working groups’ recommendations”. He concludes by noting that “[a]t conception, the FSF’s aims were modest. Its achievements to date have likewise been modest. But the FSF in principle fills an important gap in the international architecture, building bridges between the macro-economic and micro-supervisory dimensions to public policy. Unlike some international groupings, it is already more than just an acronym. How much more, only time will tell”.

MARKETS WITHOUT FRONTIERS — THE REGULATORY RESPONSE TO TECHNOLOGICAL DEVELOPMENTS

Technology has changed the way in which traditional exchanges conduct their business and has facilitated the emergence of new types of computerdriven electronic trading systems. Regulation needs to adapt in response to the existence of these new players and to the competitive pressures that exist between them and established exchanges. Old-style forms of regulation which involved the location of significant supervisory responsibility in exchanges are called into question once those exchanges start to compete for business with bodies that they supervise. Anti-competitive measures that restrict access to the market of providing securities market trading services can no longer be sustained. Technological developments open up markets and access to information to new investors but they also present new risks, or perhaps old risks in a more intense form. Protecting the interests of investors and consumers remains a central regulatory objective but new ways of achieving that goal may be required as technology advances and markets become increasingly complex. In chapter 20 three leading market regulators focus primarily on technological (IT) innovation, and its effects on their respective financial markets (Schapiro, Nasdaq; Shrimpton, London Stock Exchange; Wisbey, Securities and Derivative Markets), and hence on how regulation must adjust to this fast changing scene. Schapiro notes, for example, that NASD Regulation, Inc. (NASDR) has had “to spin off the Nasdaq and to sever nearly completely our governance and ownership” in order to be impartial between Nasdaq and its emerging competitors, other ECNs. Shrimpton records that the LSE has built a system to monitor in excess of 150,000 trades a day. Wisbey, like Schapiro, argues that recent innovations complicate the issue of what regulatory responsibilities existing exchanges, many of them metamorphosing into “for profit” organisations, should continue to have. She also wonders how far regulators should concern themselves with the risks of operating these new technologies.

Regulating Financial Services and Markets in the Twenty First Century 5

THE ENACTMENT OF THE FINANCIAL SERVICES AND MARKETS ACT 2000 : THE END OF SELF - REGULATION

In his keynote address at the conference, which is reproduced as chapter 2 of this book, Sir Howard Davies identifies the principle of a single integrated regulator, constructed on a fully statutory basis and the end of self-regulation as “dogs that did not bark”—i.e., they were not seriously questioned—during the legislative process. FSMA certainly marks a formal shift in regulatory culture from the self-regulatory approach that was, historically, a distinctive feature of financial services regulation in the UK. FSMA finally puts in place the type of statutory securities commission that had attracted support in principle at the time of the last full review of financial services regulation back in the 1980s but which was ruled out from the discussion that preceded the enactment of the Financial Services Act 1986 on grounds of practical politics. But whilst this change is important, its significance should not be overstated. The borderline between governmental and self-regulation of financial markets had become indistinct long ago.3 Also, the voices of powerful interest groups will continue to be heard within the FSMA regime. FSMA imposes obligations on the FSA to consult with practitioners and consumers and to institutionalise arrangements for such dialogue through the establishment of practitioner and consumer panels; but these requirements probably do little more than reflect what would be FSA practice in any event. Writing elsewhere Howard Davies has described the FSMA regime as a “statutory system with extensive practitioner involvement”.4 Of the FSA itself he has said that it is “a creature of the market it regulates” and, further, has acknowledged that “we really do depend on the contribution of financial institutions and trade associations to the work if we are to produce a durable and market-sensitive regulatory system”.5

EXAMINING THE FSMA REGULATORY OBJECTIVES AND REGULATORY PRINCIPLES

FSMA specifies four regulatory objectives: maintaining confidence in the financial system; promoting public understanding of the financial system; protecting consumers; and reducing financial crime.6 In discharging its general functions 3 L. C. B. Gower, Review of Investor Protection (Cmnd 9125, London, HMSO, 1984), pt. I, para 3.15. Black identifies four forms of self-regulation, only one of which involves no active direct or indirect state involvement: J. Black, “Constitutionalising Self-Regulation” (1996) 59 Modern Law Review 24, 26–8. See also A. Ogus, “Rethinking Self-Regulation” (1999) 15 Oxford Journal of Legal Studies 97. 4 H. Davies, “Law and Financial Regulation” [1999] Company Financial and Insolvency Law Review 1. 5 H. Davies, “FSA’s Strategy in Applying its Powers under the New Regime” [1999] Journal of International Financial Markets 51, 58. 6 FSMA, ss. 2, 3–6.

6 Eilís Ferran and Charles Goodhart the FSA must, so far as is reasonably possible, act in a way which is compatible with the regulatory objectives and which it considers most appropriate for the purpose of meeting those objectives. In discharging its general functions, the FSA must also have regard to seven regulatory principles: the need to use its resources in the most efficient and economic way; the responsibilities of those who manage the affairs of regulated firms; making burdens or restrictions proportionate to expected resulting benefits; the desirability of facilitating innovation; the international character of financial services and markets and the desirability of maintaining the UK’s competitive position; the need to minimise the adverse effects on competition arising from the discharge of the FSA’s general functions; and the desirability of facilitating competition between regulated firms.7 During FSMA’s laborious passage into law there were discussions about raising the regulatory principles about competition and international competitiveness into an objective. This was resisted by Davies who argued that it would risk dragging the regulator into essentially commercial issues and could create confusion in international financial regulation by impeding the FSA’s efforts to co-operate with other regulators.8 The Economic Secretary to HM Treasury also opposed the proposal, arguing that it could create overlap and potential confusion between the FSA and the UK’s competition authorities.9 But whilst the particular debate about the appropriate legislative category for competition and competitiveness issues has now run its course, more fundamental questions about the appropriate trade-off between protection of the financial system and competition still remain. Mayer (chapter 3), differentiates between those sectors of the financial system where risks of systemic collapse exist, for example, in commercial banking, and those where they do not, for example, in fund management. In the former there will remain some inevitable trade-off between protection of the financial system and competition, though Mayer believes that we have edged too far towards protection, with too little competition leading to less innovation in services, than would be desirable. In relation to the latter group, Mayer distinguishes between three approaches to their regulation; first, the continental European emphasis on capital adequacy, (partly because so much fund management is done by universal banks); secondly, the UK reliance on conduct of business rules; and, thirdly, the US weight on market systems of disclosure, ex post auditing and imposition of ex post penalties via the courts. Mayer favours the US approach. While he sees several desirable features in the FSMA, nevertheless, in his view, “the emphasis on avoidance of systemic risks at the expense of competition in banking and on ex ante conduct of business rules in financial 7

FSMA, s. 2 (3). Joint Committee on Financial Services and Markets Draft Financial Services and Markets Bill Minutes of Evidence and Appendices (HL Paper 50–II, HC 328–II) (1999), Q34. 9 Joint Committee on Financial Services and Markets Draft Financial Services and Markets Bill Minutes of Evidence and Appendices (HL Paper 50–II, HC 328–II) (1999), Q105. 8

Regulating Financial Services and Markets in the Twenty First Century 7 services remains . . . In general, there is inadequate emphasis on using regulation to promote competition and diversity in European financial markets, through disclosure, auditing and enforcement”. For Fawcett (chapter 4), too, the striking of a proper balance between enterprise on the one hand and consumer and investor interests on the other is essential to successful regulation. From her perspective at the heart of the investment banking industry, she identifies flexibility, fairness, transparency, integrity, efficiency and adaptability as being fundamental aspects of successful regulation. Her chapter provides a benchmarking exercise in which the FSMA regime is examined against these features. Whilst acknowledging that the real work of making the FSMA regime a practical success is just beginning, she concludes that there is much that is positive and that it presents an opportunity to create a “world-beating” regulatory system. But there are some concerns. One of these is whether there is a correct balance between certainty and flexibility in the FSA’s rule-making and concomitant enforcement powers. The FSA can issue high-level principles as well detailed rules: examples of high-level principles are that firms must conduct their business with integrity and must treat their customers fairly.10 The FSA can take enforcement action in respect of a breach of a high-level principle alone, and it has indicated its willingness to do so in certain circumstances.11 From the regulator’s viewpoint, this open-textured regulatory approach provides a solution to the problem of keeping pace with financial innovation. In its absence, it would be open to industry to exploit gaps in the detailed rules through new forms of financial misconduct unanticipated by the rules at any particular time. But Fawcett articulates industry’s concern that this approach leads to uncertainties that may present serious difficulties for those responsible for managing and ensuring compliance within a financial services business. One possible way of reconciling the competing concerns of the regulator and the regulated in this area would be through a pre-clearance system in which a firm that proposes to launch a new product or to act in a way that does not conflict with the existing detailed rules can protect itself by obtaining an indication from the regulator that the proposal does not contravene high-level principles. There is a strong existing precedent for this approach in the form of the US Securities and Exchange Commission (SEC) no action letters. Fawcett articulates industry disappointment that, although FSMA provides an opportunity for the FSA to adopt a similar regime, it has not done so. Fawcett also expresses concern about the possible impact of the FSMA market abuse regime on the regulation of takeovers. Despite general dissatisfaction 10 See further FSA Policy Statement, The FSA’s Principles for Business (1999). See also Beazley, Ch. 9, who deals with the high-level principles applicable to “approved persons”—that is the board, some senior managers and other employees of regulated firms. Beazley also makes the point that the high-level nature of principles raises concerns about compatibility with certainty requirements under human rights legislation (pp. 125–6). 11 See FSA CP 65, The Enforcement Manual (2000).

8 Eilís Ferran and Charles Goodhart with self-regulation, takeovers remain an area where its advantages, particularly the absence of opportunities to use litigation for tactical reasons during the course of a bid, are still valued. That the FSA’s powers to take action in respect of market abuse could, if the conduct took place during the course of a bid, threaten this successful area of self-regulation was an issue that came to the forefront of debate at the late stages of the passage of the legislation through Parliament and it generated much controversy. Attempts to change the draft legislation so as to give the Takeover Panel rather than the FSA the power to decide whether conduct during a bid was market abuse failed. As Fawcett points out, whether City concerns on this point will be assuaged will now depend on how the FSA uses its powers in practice and on the co-operative arrangements that are put in place between it and the Panel. The balance that most concerns Dhumale (chapter 5) is that between regulation based on externally imposed rules on the one hand and (self-)regulation induced by market discipline on the other. He recognises that market discipline will work effectively only when the incentive structures are properly attuned. If appropriate incentive structures can be put in place, then market discipline will tend to work better than rule-based regulation for two main reasons. First, regulators have less access to relevant information than the financial intermediaries themselves. Secondly, market discipline will be inherently more flexible. Dhumale is worried that some of the existing incentives on regulators themselves, for example, the possibility of subsequent lucrative jobs in the private sector, might distort the conduct of regulation. He next looks at the proposal to use external and internal credit ratings in the 1999 Basel Capital Accord, and at the Calomiris suggestion for the mandatory issue of subordinated debt. While this latter is, Dhumale argues, a good idea in principle, there are numerous technical issues that would need to be resolved in practice before the SD proposal could (and should) be introduced. In conclusion, Dhumale sees regulation as essentially being “an incentive mechanism”, and argues that regulators must focus on “how to best utilise these incentives to promote the public good or systemic stability”.

THE REGULATION OF APPROVED PERSONS

The financial sector is regulated for the protection of individual investors (investor protection regulation) and to maintain the stability of the financial system as a whole (prudential regulation). Regulation of the agents who control financial firms performs both an investor protection and a prudential function: vetting those who run financial firms should help protect investors from being defrauded or otherwise damaged by the failings of those to whom they have entrusted their capital; and it should also help to filter out those would seek to use their controlling position to operate their business in a way that would threaten the soundness of the industry.

Regulating Financial Services and Markets in the Twenty First Century 9 The FSMA regulatory requirements relating to individual agents are contained in the approved persons regime. An approved person is a person who carries out “controlled functions” for a regulated firm and who is approved for that purpose by the FSA. Controlled functions are functions that are specified as such by the FSA within parameters established by the Act.12 It is clear from draft rules that have been published by the FSA that those for whom approval is required will include the executive and non-executive directors of financial companies, as well as those responsible for compliance and for certain management functions relating to finance, risk control and internal audit. Between 1992 and 1995 the Law Commission conducted an extensive review of the relationship between fiduciary duties and regulatory rules.13 That review was prompted by concern about the possibility of mismatch between the duties that professionals and businesses might owe to customers and others as a matter of private law and their regulatory obligations. Market developments, such as the emergence of financial conglomerates, added weight to the concern. The Law Commission’s eventual conclusion was that there was not a problem that required general legislative intervention so as to allow regulatory rules to be taken into account in determining the content of private law duties. But, as Bamford indicates in chapter 5, concerns about the potential for these types of mismatch have not disappeared: he argues that there is, in relation to the FSMA regime, a real concern that the regulatory duties imposed on directors as approved persons may conflict with the duties that they owe to their companies under company law. In particular, he suggests that the financial collapse of a group of companies in the financial sector could result in the directors of the group companies facing a dilemma between their regulatory obligations which focus on the group as a whole and which are imposed for prudential reasons and to provide investor protection, and their company law duties which require them to act in the interests of the individual companies of which they are directors. Whilst Bamford is concerned with possible tensions between the regulatory responsibilities of senior management and their company law duties, Ridley’s chapter 6) focuses on the potential problems arising within the proposed regulatory regime. He is concerned about possible over-regulation resulting from the simultaneous regulation of firms and individuals and about the scope for possible divergence between what the FSA requires of a firm and of the senior managers of that firm. Like Fawcett, he is also concerned about certainty and the absence of safe harbours from disciplinary action based on general principles for those individuals who comply with detailed rules and codes: he asks: “[s]urely the authorities need to excavate and signpost safe harbours, rather than merely plastering the charts with vague warnings of danger everywhere”? 12

FSMA , s. 59. Fiduciary Duties and Regulatory Rules, Law Commission Consultation Paper No 124 (London, HMSO, 1992); Fiduciary Duties and Regulatory Rules, Law Commission Report No 236 (London, HMSO, 1995). 13

10 Eilís Ferran and Charles Goodhart

DISCIPLINE AND ENFORCEMENT

Undoubtedly there will be strong media interest in how the FSA uses its extensive disciplinary and enforcement powers. Past regulatory failures14 mean that it is vital for the FSA’s credibility that it is seen to have the “teeth” selfregulation was perceived to lack, and also the willingness to use them. At the same time the FSA will be concerned to avoid acquiring a reputation amongst the regulated community for being “trigger happy” with its enforcement powers, especially in view of the scrutiny that its actions may be subject to under the new human rights legislation. The calls for greater certainty or “safe harbours” voiced by Fawcett and Ridley here are indications of the type of concern that has arisen. That the FSA should use its enforcement powers in a manner which is proportionate to the regulatory infringements that may occur has become, and will remain, one of the key issues as the FSMA regime develops and becomes practically operational. The two chapters on discipline and enforcement in this book, by Waters and Hopper (chapter 8), and Beazley (chapter 9), provide some interesting contrasts. Both chapters look at the relationship between the discipline and enforcement powers in FSMA and the principles of human rights protection which are now enshrined in the Human Right Act 1998. One issue that attracts particular attention is whether the disciplinary powers in relation to authorised firms and approved persons might be classified as “criminal” proceedings for the purposes of the human rights legislation and, consequently, attract the enhanced procedural protections that the European Convention on Human Rights stipulates in relation to such proceedings. All authors agree that a simple mechanistic approach to the question of what constitutes a “criminal” charge for European Convention on Human Rights (ECHR) purposes is wholly inappropriate in relation to a specialist system of commercial regulation such as that provided for in FSMA. Case law from Strasbourg and from other jurisdictions does not provide clear “bright line” rules but points to the need to examine carefully “the underlying purposes and nature of regulatory proceedings in considering the nature of the procedural protections that should apply” (Waters and Hopper). But whereas Waters and Hopper conclude that the FSMA disciplinary sanctions relating to authorised firms and approved persons are addressed at misconduct of a nature which is “fundamentally different” from that addressed by the criminal law, Beazley’s view is that “no one can be absolutely certain of the outcome of the debate”. Beazley suggests that the FSA might consider applying the additional ECHR procedural safeguards for criminal charges in some disciplinary proceedings in 14 Enforcement of investor protection under the Financial Services Act 1986 is discussed generally in A.C. Page and R.B. Ferguson, Investor Protection (London, Weidenfeld and Nicolson, 1992) ch. 7.

Regulating Financial Services and Markets in the Twenty First Century 11 any event: “it may reach pragmatic decisions on a fair and equal basis to minimise the risk of serious disruption to the regulatory process”.

ACCOUNTABILITY

FSMA seeks to reflect the dynamic nature of financial markets by putting in place a system of regulation that can adapt to particular or changing circumstances. This translates into giving the FSA wide discretionary power to regulate in a way that is responsive to new developments and to specific situations. There is an obvious correlation between the amount of power vested in a regulatory body and concern about whether it is properly accountable for the manner in which its uses its power. In this context accountability is a multi-faceted concept: it can be thought of in terms of establishing the fairness of the processes by which the FSA arrives at its decisions but it can also be judged by reference to the efficiency or effectiveness of the outcomes of those decisions. As has been remarked: “different mechanisms will be needed for the different dimensions of accountability”.15 FSMA provides for political accountability, judicial accountability and industry and consumer accountability. The FSA must make an annual report to HM Treasury and the Treasury must then lay the report before Parliament.16 The Treasury also has some specific statutory controlling powers in relation to the FSA, including power to order independent reviews of the economy, efficiency and effectiveness with which the FSA has used its resources in discharging its functions;17 but the FSA’s powers are conferred on it directly by the legislation rather than by means of a formal delegation of powers from the Treasury (as was the case under the Financial Services Act 1986), with the consequence that the option of executive intervention to take back the delegated regulatory powers does not exist. As a public body, the FSA’s actions are open to judicial review and it may be challenged under the Human Rights Act 1998. FSMA adds to these forms of judicial accountability by establishing the Financial Services and Markets Tribunal to act as an independent adjudicator in respect of disputed FSA decisions in matters of authorisation, intervention and discipline.18 Industry and consumer accountability is provided through the requirement for the FSA to hold an annual public meeting so as to allow public discussion of its annual report to the Treasury and an opportunity for the public to put questions about the discharge of its functions.19 This is bolstered by extensive consultation requirements which are imposed on the FSA, both with 15 Joint Committee on Financial Services and Markets, Draft Financial Services and Markets Bill First Report (HL Paper 50–I, HC 328–I) (1999) Vol I, para 103. 16 FSMA, sch 1. 17 FSMA, s. 12. 18 FSMA, Pt IX. 19 FSMA, sch 1, paras 11–12.

12 Eilís Ferran and Charles Goodhart regard to general policies and practices20 and in the exercise of specific rulemaking powers.21 The FSA is subject to another line of control in the form of a requirement to have regard to accepted principles of good corporate governance.22 It is subject to the scrutiny of competition authorities in the exercise of its rule-making powers.23 Its actions may be referred for investigation under the independent complaints procedure provided by the Act.24 Three chapters in this book, by Page (chapter 10), Goodhart (chapter 11) and Lastra and Shams (chapter 12) examine critically the dimensions of accountability with regard to the FSA and, in the case of Lastra and Shams, wider issues about public accountability in the financial sector. For Page, the parliamentary passage of the legislation was a process of “muddling through” to a solution of the problem of regulatory accountability. He argues that the claim that the FSA is accountable to government and then, via ministers, to Parliament is one that carries little conviction.25 He suggests that FSMA contains the outlines of an alternative model of accountability to that offered by political accountability. Lastra and Shams agree that FSMA marks a development from conventional approaches to accountability that relied on political and judicial control towards what they describe as a “new paradigm” based on participation and transparency. Page and Lastra and Shams identify the statutory statement of regulatory objectives contained in section 2 of FSMA as being a key element of this new paradigm. Whilst taking care to distance themselves from some of the more exaggerated claims about their disciplining effect, these authors do see the statutory objectives as a helpful benchmark of accountability. Page makes the point that the lack of an equivalent statement of objectives in the Financial Services Act 1986 was widely regarded as one its main weaknesses and that it provided ample scope for disagreement about the intended purposes of that legislation. Goodhart’s view, however, is that for all practical purposes the statutory objectives are non-operational because no measurement of success can be achieved in respect of them. He sets out an alternative set of objectives that an economist would suggest for financial supervisors: these are to prevent systemic failure of financial institutions and/or markets, loss of competitiveness and efficiency, and exploitation of consumers. He argues that success (or just luck!) in respect of the prevention of systemic failure and consumer exploitation 20

FSMA, ss. 8–11. FSMA, s. 65 (statements and codes relating to approved persons), s. 121 (market abuse code), ss. 155 and 157 (rules and standing guidance applying to authorised persons), ss. 70, 125, 211 and 395 (policies and procedures relating to disciplinary and supervisory powers). 22 FSMA, s. 7. 23 FSMA, Pt X, ch III. 24 FSMA, sch 1, para 8. 25 Compare Joint Committee on Financial Services and Markets, Draft Financial Services and Markets Bill First Report (HL Paper 50–I, HC 328–I) (1999) Vol II, question 2, where Davies said that he saw “the prime accountability route as being through ministers to Parliament”. 21

Regulating Financial Services and Markets in the Twenty First Century 13 objectives could be measured by the absence of unwanted events, and that recognised techniques for measuring competitiveness could also be employed. Goodhart is also concerned with the prevention of over-regulation. He argues for the extension of transparency and market discipline mechanisms not only for the regulated but also for the regulators. In his view there is much to be said for introducing a mechanism that would provide ratings and gradings for regulators. He envisages that making gradings publicly available would act as an incentive to stimulate and improve the performance of regulators. It would also enhance public accountability. But he also recognises pitfalls in making detailed information about financial regulators’ operations generally available since this could conflict with the confidential nature of much of their work. Goodhart’s suggested solution to this dilemma is for national regulators and supervisors to be monitored on a confidential basis by an outside international agency and for that agency then to rate the regulatory agencies and to make public the gradings and the reasoning behind them.

EUROPEAN SECURITIES REGULATION

In chapter 13, Wymeersch summarises the current state of securities regulation at the EU level as “a partial body of common concepts and regulatory patterns, while a large part of the field remains uncovered”. This rather depressing picture is brightened by the mutual recognition principle whereby the need for double regulation is removed and by informal memoranda of understanding between regulators in different Member States that seek to achieve coordination, particularly in matters of prudential supervision. But such developments have not yet occurred in relation to the regulation and supervision of stock exchanges. For Wymeersch, the new trading environment emerging from the merger of existing exchanges and the arrival of new participants and new order execution systems presents the major challenge facing European securities regulation. In the new trading environment, established exchanges compete with each other and with new systems for securities business. For Wymeersch this market development makes it inappropriate for certain exchanges to continue to discharge public interest regulatory and supervisory functions in relation to the securities markets: they would be regulating their competitors. Also, since they are providing the same type of services, a consistent regulatory framework for the registration of exchanges and other systems is required. Normal competition rules and established EU principles relating to freedom of establishment and to the provision of services should apply. Wymeersch also addresses the highly topical issue of cross-border mergers of European stock exchanges. The pace of change here is such that it is fruitless to become engrossed in the details of any particular merger proposal—for example, the iX merger was a live proposal at the time of the conference but that had

14 Eilís Ferran and Charles Goodhart been overtaken by events by the time the papers were prepared for publication in this form. In broad terms, however, it is clear that such merger proposals can raise very difficult questions about the respective regulatory jurisdictions of the home states of the merging exchanges. Wymeersch identifies the complex regulatory questions that would arise in a variety of different arrangements providing for linkages between markets. A key concern is to define those parts of the regulatory framework that should be governed by regulations in the state in which securities are traded and those parts that should be subject to the laws of the home state of the issuer of the securities. Whilst recognising that there are no easy answers, Wymeersch suggests that disclosure and accounting requirements could be placed under the control of the market supervisor. Matters that should be classified as company law matters, for which an issuer’s home state would remain responsible, would include legal status and disclosure of major holdings. Matters in respect of which the correct classification might depend on the form of market linkage, or where requirements of both states might be applicable with a division of responsibilities, would include listing procedures and insider trading. Although the proposed Thirteenth Directive on Takeovers lays down its own division of competencies between states in cross-border takeovers, Wymeersch suggests that this may have to be reassessed in the light of market reorganisations. Thieffry’s chapter (chapter 14) proposes a more radical response within Europe to the challenges presented by the emergence of the new trading environment: the formation of an European Securities Commission (ESC). With the process of merging Europe’s stock exchanges and associated settlement and clearing systems already well underway, Thieffry contends that there is “a certain degree of inevitability about the creation of some form of central regulator”. As markets become more integrated, the emphasis will shift from co-operation between national regulators to a more formal approach to rulemaking and enforcement in a common institutional framework. The creation of the European Central Bank and European System of Central Banks provides a model than can be regarded as a starting point for radical rethinking in relation to securities regulation. The establishment of the US Securities and Exchange Commission also provides a useful precedent. Thieffry’s analysis of the case for an ESC addresses various objections that have been voiced: whether it is constitutionally possible within the framework of European law; whether it is a pragmatic solution to the problems presented by market developments; and whether it is politically tenable. He recognises that, ultimately, an ESC will not become a reality unless and until there is political will and momentum behind it. In this regard, the French government’s initiative in establishing in June 2000 the Group of “wise men” under the chairmanship of Lamfalussy to examine, amongst other matters, the co-ordination of securities regulation at the EU level is notable. In a postscript to his chapter, Thieffry briefly notes the contents of the Lamfalussy Report. Whilst the Report falls short of recommending the establishment of a single European regulator,

Regulating Financial Services and Markets in the Twenty First Century 15 Thieffry concludes that those who believe that an ESC is the only viable solution in the longer term can take comfort from the immediate actions that the Committee of Wise Men recommend to improve co-operation between national regulators and to remove inefficiencies from the current European regulatory framework. But, as Thieffry also notes, the major catalyst for political change will be the market: if market participants increasingly see the advantages of a “one-stop” pan-European regulator (as they have done at the national level in the UK and elsewhere), theirs will be a powerful voice influencing the setting of the political agenda.

INTERNATIONAL FINANCIAL REGULATION — THE ROLE OF RATING AGENCIES

Schwarcz (chapter 18) considers the role of rating agencies in global market regulation. The particular development that brings this issue into the spotlight is the proposal by the Basel Committee to incorporate the views of rating agencies, which are privately incorporated and not subject to governmental regulation, into capital adequacy supervisory procedures. For Schwarcz the unregulated position of rating agencies is not inherently problematic: his concern is whether any regulation of the agencies would make the rating system more efficient. His conclusion is that this would not enhance the efficiency of rating agencies, nor limit the negative consequences for rating agencies activities in terms of outside perceptions about their own lack of accountability, possible conflicts of interests and inherent bias towards debt market conservatism. He considers whether there is a case for a global recognition of rating agencies, as exists at the national level in some countries, but his conclusion is that such a global designation is unnecessary and that efforts to develop one could be costly and anti-competitive in their effect. Jackson’s chapter (chapter 19), which is by way of a commentary on Schwarcz, takes as its central theme the new and difficult questions of public policy that are raised by the regulatory incorporation of private credit rating, such as in the proposals of the Basel Committee. For Jackson the Basel Committee’s proposals have intuitive appeal. Whilst he recognises the force of some of the criticisms that they have engendered, he contends that there is no obviously superior model amongst alternative approaches that are currently under consideration—such as movements towards capital standards based on portfolio models or towards increased reliance on market mechanisms like subordinated debt issuance requirements. Jackson raises some concerns about the regulatory implications of the Basel Committee’s proposals. First, he is less confident than Schwarcz about the question of the lack of any need for some regulation of the rating agencies themselves: the increased importance of credit ratings under the Basel Committee’s proposals could increase the pressure to get better ratings which, in Jackson’s view, could increase the need for governmental oversight. On this point,

16 Eilís Ferran and Charles Goodhart Jackson is consistent with Dhumale who also expresses concerns about the creation of incentives for the rating agencies to act in their own interests or that of the borrower in the hope of maximising their own gains through favourable ratings. Secondly, Jackson points out that under the Basel Committee’s proposals bank regulators will become “consumers” of credit ratings, and he wonders whether these regulators will be as good monitors of rating agencies’ performance as are the traditional consumers of their services, namely, investors. Thirdly, he notes that the goal of maintaining uniform capital standards across national boundaries could be undermined by local rating agencies issuing inappropriately high ratings. In sum, these concerns point to the possibility that the Basel Committee’s proposals could generate a form of credit rating inflation.

2

Reforming Financial Regulation: Progress and Priorities HOWARD DAVIES

at the remarkably comprehensive conference on the new financial regulatory regime at which the chapters in this book were first presented addressed a number of the issues which continue to concern practitioners in the City. I might just note in passing that the issues which most worry consumers, in particular whether the new regime will be more effective than the old in preventing consumer detriment, and guarding against major misselling episodes such as those we have had in the past, received less attention. This certainly reflects the balance of debate about the Financial Services and Markets Act 2000 so far, whether in Parliament or in the press. The concerns of the regulated have been articulated more clearly and vociferously than the concerns of those in whose interests the system is designed. I would like to offer some general reflections on the progress we have made in reforming the system over the last three years, and on our priorities for the future. I propose to cover, briefly in each case, four topics: the legislative process; the dogs that did not bark; the accountability regime; and where we go from here.

T

HE INDIVIDUAL SESSIONS

THE LEGISLATIVE PROCESS

Reforming financial regulation is a race for marathon runners, rather than sprinters. Even now, while we have passed the signpost marked Royal Assent, I would say we are still only around 20 miles in, with some punishing stretches still to come. The government began to develop the outline of the Bill in June 1997. Instructions were delivered to Parliamentary Counsel over the following winter, and a reasonably complete draft Bill was published for consultation in July 1998. Submissions were then invited by end-October of that year. They dribbled in a little later, in some cases, and the Burns Joint Committee on Financial Services and Markets began life in March 1999, still using largely the original print. The Joint Committee’s work took a couple of months only, and a new

18 Howard Davies version of the Bill was introduced into the House of Commons in June 1999. It did not complete its committee stages in that session, but was carried over to the next, and finished in the Commons in February of 2000. The House of Lords processes took until June, leading to Royal Assent on 14 June 2000. In the course of this process around 2,800 amendments were tabled and 1,500 of them passed. This was, we understand, a record score. Perhaps there will be a place for us in the next edition of the Guinness Book of Records. At last the amending process is over. But there are still some 90 pieces of secondary legislation to table before the new regime is up and running. How should we view this parliamentary marathon? And what of the two constitutional innovations: the cross-party joint committee of both Houses, and the carry-over of a public bill from one session to the next? Both were supposed to ease the passage of the legislation and to iron out controversial points at an early stage. On the face of it, they do not seem to have been successful. Is that a fair judgement? My own view, both on the process overall and on the innovations, is not so pessimistic. In the first place, I note that it was a heroic endeavour to seek to reform the whole basis of financial regulation, covering all sectors of the market, in one go. I cannot think of another major economy in which that has been done. Even those other countries which have established single regulators have typically done so simply by administrative stitching together of different bodies, leaving their separate underlying pieces of legislation intact. That could have been done here, but the Government decided, instead, to undertake a more fundamental rewriting of the statute book to give us a more flexible, and we hope more durable, system for the long term. So it is not surprising that the legislation was complex. And since we are talking about a sector which accounts for around 6 per cent of GDP, and employs well over a million people, it is also not surprising that it was heavily contested territory. As for the Joint Committee, we found it an enlightening process. The Committee illuminated a number of areas of the legislation which otherwise might have remained obscure, and helpfully cleared the ground for parliamentary agreement on issues like statutory immunity, the role of competition in financial regulation and, crucially, the impact of the European Convention on Human Rights (ECHR). The Financial Services and Markets Bill was the first significant piece of legislation which needed to be certified by ministers as compatible with the ECHR. That process of certification could have been a formal process, without debate beforehand. The Joint Committee hearings exposed some important arguments and differences of view and left us, we hope, with a more robust statute in this respect than might otherwise have been the case. Of course there are those who still think that the regime will be tested in the courts, and could be found wanting. I would judge, however, that a balance of legal opinion favours the view that the regime is compatible with the Convention as it stands.

Reforming Financial Regulation 19 The issues that were comprehensively reviewed by the Burns Committee were more smoothly handled in Parliament as a result. But there were of course other points which did not surface then, and which attained headline status later, such as the relationship between the new regime and the Takeover Panel. I would not judge this to be an indication of the failure of pre-legislative scrutiny. Instead, I share the verdict of the Committee itself, which noted that its process would have been even more helpful had it had a longer period during which to take evidence and to reflect on it. My own conclusion on pre-legislative scrutiny is therefore that it can be constructive, but, if it is to be done, it would be best done less quickly and perhaps earlier in the Parliamentary session. And it is as well to have modest aspirations. Pre-legislative scrutiny will never close off political arguments, or prevent them being held on the floor of the House. Nor should it do so. The device of “carry over” from one session to the other strikes me as having been less central to the passage of the Act. Since it must be agreed by the Opposition, it puts a card in their hands. But, and here I speak as one who lives well outside “the usual channels”, the process seemed to be handled smoothly, and the Committee stage picked up seamlessly when the new session got underway. The Bill’s passage was perhaps more affected by the constitutional reform of the House of Lords. The Financial Services and Markets Bill was one of the earliest to go into the new, half-reformed House. My outsider’s impression is that there remains some uncertainty about the way in which the conventions of the Lords have and have not been affected by this transitional regime. That uncertainty may well have prolonged the consideration of the Bill.

THE DOGS THAT DID NOT BARK

I would like now to draw attention to four issues which have been extensively debated by academics, and which are the subject of lively debate in many other countries contemplating regulatory reform, and yet which were scarcely touched on in the 200 hours of Parliamentary debate to which the Financial Services and Markets Act 2000 was subject. These are what I categorise as the dogs that did not bark. The first is, simply, the principle of a single integrated regulator, constructed on a fully statutory basis. Around a dozen countries internationally have adopted this model, or something very like it, but in most of the rest of Europe, and in the United States, it is still a highly controversial notion. Yet the idea was scarcely questioned in Parliament, and indeed almost every single response from trade associations or City institutions supported the principle and accepted it as an idea whose time had come. There was also, interestingly, almost no debate surrounding the end of selfregulation. Indeed such Parliamentary discussion as there was on the subject tended to argue that those elements which remain (in the mortgage market, for

20 Howard Davies example, or general insurance broking) should be converted into statutory elements of the FSA’s regime. This may be partly because, in the old regime, selfregulation had—in many respects unfairly—been given a bad name. But I think there was also a widespread recognition that the greater certainty and predictability which should flow from a statutory regime was now to be preferred. A third and related issue, on which there was similarly little debate, concerns the compatibility of prudential supervision, on the one hand, and conduct of business regulation on the other, being brigaded within the same institution. This, again, is an argument which generates a huge amount of heat in regulatory conferences around the world. Yet the principle was accepted here without any difficulty whatsoever. That dog did not bark at all in Parliament. And a fourth, again related, issue which was little debated, though occasionally referred to, concerns the appropriate role for a Central Bank in financial regulation, and the particular relationship between the prudential supervision of banks and the responsibilities of the Bank of England. The new split of responsibilities between the FSA and the Bank was accepted by almost all commentators, and did not divide either House. Some care was devoted to devising a memorandum of understanding (MoU) between HM Treasury, the Bank of England and the FSA in the summer of 1997, and the operation of that MoU in practice, combined with the way in which it has been described by the FSA and by the Bank, appears to have given considerable comfort to financial institutions and to Parliament. But I have to record that in the United States it is not remotely accepted that the Central Bank can safely be relieved of direct responsibility for prudential supervision. The European Central Bank is now actively campaigning for a more extensive role in banking supervision matters, and other central banks around the world are strenuously resisting any suggestion that it is possible, and indeed advisable, to divorce the two roles. I hope that we are right in believing that these are not crucial issues. I am now satisfied in my own mind that they are not. I believe the relationships we have with the Bank of England are robust and, indeed, in some respects give the Central Bank a better and more comprehensive view of the financial system than it had before. Furthermore, they helpfully clarify the accountability of the two institutions. The view that the Bank of England may take on the appropriateness of lender of last resort support is not influenced by any responsibility for the continued supervision of the institution. I also believe that there is no necessary incompatibility between the roles of the prudential supervisor and the conduct of business regulator. They are both doing essentially the same job of protecting the consumer interest. I believe those who do see such incompatibility are confusing the responsibilities of the prudential supervisor, and tend to imply that he or she has some responsibility to the management of the institutions concerned, or indeed to their shareholders. And I am persuaded that it makes perfect sense to integrate the regulation of an increasingly intertwined financial sector. Of course there may on

Reforming Financial Regulation 21 occasion be difficult judgments to make on consumer compensation, and on the potential impact on the soundness of an institution. That balance needs to be struck, and my view is that it can best be done by an institution which sees both elements of this equation. But we are wise to continue to reflect on the fact that, in these areas, much of the rest of the world is out of step with us.

ACCOUNTABILITY

The rest of the world is out of step, too, on my third topic: the accountability of the financial regulator. We must operate in the future within an accountability regime which is quite unlike that which surrounds any other financial regulator we know. No other authority is required to hold an open annual meeting, on the corporate model, with the directors required to answer questions from the public and from financial services practitioners themselves. No other regulator is required to publish cost comparisons of regulation, across countries, in their annual report. Indeed, in preparing those cost comparisons, we have found that in a number of other countries it is not possible to ascertain even the out-of-pocket costs of the regulatory system, let alone the infirm compliance costs. There are several large European countries where the public authorities concerned indeed refuse to make public any assessment of the cost of supervising banks. We are subject to an elaborate procedure of issuing consultation papers, feedback statements on the consultation responses, and so on. We must prepare cost-benefit analysis on any regulatory proposal. We must decide how our proposals are compatible with the principle of senior management responsibility. All this may well produce a better outcome, though I note that the market is now complaining loudly at the volume of consultation material we produce. There are also special procedures relating to our consumer and practitioner panels whereby, if they comment on how our policies and practices fit with the principles of good regulation embedded in the Act, we must produce a reasoned response if we disagree with any points they make to us. And all this accountability and consultation architecture is erected around an institution run by a unitary board with a strong majority of non-executive directors, including a sizeable number of serving practitioners. Those directors carry full responsibility for the policies of the Authority, and have a defined oversight role as non-executives. There is no other regulator in a major financial centre of which we are aware where serving practitioners share full responsibility for the policies and practices of the regulator as board members. It is interesting to speculate on why the accountability framework has emerged in this way. Perhaps the very wide spread of responsibilities of the FSA, albeit that for the most part it amounts to a merging of the powers of the existing regulators, generated a political reaction. Certainly it became

22 Howard Davies common currency during the debate on the Bill to describe us as an overmighty regulator, prosecutor, judge and jury, executioner, sexton and body snatcher all rolled into one, even though this description is almost wholly erroneous. Perhaps, also, the sheer economic power of the financial sector in this country had an impact. Certainly the accountability regime within which we operate is quite unlike that which applies to other statutory regulators in the utilities sector. I am not complaining about these mechanisms. Who can be against accountability? And indeed I believe that we will generate both a more market sensitive and indeed a more effective regulatory regime if we are seen to be a regulator rooted in the markets, and one who carries the authority of responsible practitioners in making its policy judgements. But its practical operation will require considerable care if our procedures are not to become slow and cumbersome, and correspondingly unable to react flexibly to changing market circumstances. The same is true of our regulatory decisions. There has been considerable public debate already about the decision-making structures related to our authorisation and enforcement process. But the way in which those procedures may impact on what have, in the past, been supervisory decisions taken by the executive, has been less extensively debated. We hope it will be possible to devise procedures which allow most of these decisions, about capital requirements, for example, to be taken by FSA staff, under Board guidance, rather than in the formal Regulatory Decisions Committee, which will include practitioner and public interest representatives. We believe it to be in the best interests of the market, for the system to operate as it has done hitherto. These decisions are largely technical in nature, and need to be taken by expert staff, and often very quickly. Of course the Tribunal will continue to be available for those who wish to contest those decisions, just as for any other, where we fail to reach agreement with institutions on our judgement.

WHERE DO WE GO FROM HERE ?

I have focused attention so far on the problems still to be resolved, and legislation still to be introduced and the decisions still to be made. Perhaps it is inherent in the mindset of a regulator to focus on the glass half empty, rather than half full. So perhaps I might end on a more optimistic note. In spite of all the difficulties we face, and the complexities of our new architecture, I remain resolutely optimistic about the FSA, and the impact of the new regime both on consumer interest and on our financial markets. Three years’ experience of developing a single regulator has confirmed me in the view that there are many advantages, and relatively few drawbacks. Perhaps the main disadvantage is simple—that as a single regulator the attention of the City is very strongly focused on us. It is hard to slip decently into the background, which is where—most of the time—a regulator should properly be.

Reforming Financial Regulation 23 There is also the straightforward challenge of keeping abreast at the top of the organisation of developments across a broad front. That is particularly acute internationally, where the FSA is the UK member of 130 international organisations or committees. (If there were more single regulators around the world, I cannot help feeling that this number would be sharply reduced, to everyone’s benefit.) A third possible disadvantage is that our existing mass exerts a form of gravitational pull: if there is to be an extension of regulation on the financial field, the obvious thing to do is to give it to the single regulator! For example, the Performance and Innovation Unit report on Recovering the Proceeds of Financial Crime1 canvasses the idea of a light touch regulatory regime for Bureaux de Change “possibly administered by the FSA”. Running a single regulator is rather like having a skip in front of one’s house in London. All the neighbours dump things in it before you get round to using it yourself. But these disadvantages seem minor, by comparison with the strengths and attractions of an integrated regime. We are now beginning to make a practical reality of these hitherto theoretical advantages. We are, for example, exploiting the ability we have to look at the financial system in the round, to identify threats to financial stability which may emerge elsewhere than in the banking system. The Tripartite Standing Committee, with the Bank and HM Treasury, has proved a highly successful innovation already and now, at international level, feeds usefully into the global Financial Stability Forum on which all three organisations sit. These international developments are discussed in subsequent chapters, and I know there are those like John Eatwell who believe there is much further to go in developing international early warning systems and strengthening international standards.2 But I hope that even those commentators would admit that the UK is now better organised for the purposes of international collaboration than are most other countries. Domestically we have simpler decision-making processes on policy issues and shorter lines of communication within the organisation, which allow us to respond more quickly and comprehensively to problems. There is more work to do before we can say we are fully exploiting the opportunities for an integrated approach within a single regulator, but we are on the way. Our responsibility for promoting public understanding of the financial system gives us a more direct link with consumers, and allows us to consider information initiatives as an alternative to rule-based regulation. Our strategy statement earlier this year, grandly entitled A New Regulator for the New Millennium, explained how we proposed to harness the benefits of integration in the medium term.3 Since we published that document we have made considerable progress in two areas. First, we have now devised the main elements 1 2 3

June 2000 (http://www.cabinet-office.gov.uk/innovation/2000/crime/recovering/default.htm). J. Eatwell, “New Issues in International Financial Regulation”, ch. 15 below. FSA Policy Report (February 2000).

24 Howard Davies of a common risk model for application across all of the firms we supervise, which assesses the risk which each poses, or may pose, to our statutory objectives. We have also completed the major task of categorising all firms according to this risk model, a task involving 10,000 rapid risk assessments. Of course they may have to be amended as we go along, but it will give us a starting point and allow us to allocate our resources in a genuinely risk-based way for the first time. We are also making good progress in developing a “regulatory tool kit”. (Every organisation worth its salt develops its own jargon.) This will allow us to look at the appropriate response to any problem we encounter, across the whole range of tools available to us, from public information and education at one end of the spectrum, through to hard edged discipline at the other. We are developing an interactive web-based model which will allow supervisors to explore the different options in a comprehensive way. We say more about these two key developments in the follow-up paper to the New Regulator which we published in December 2000.4 It is clear to me that these developments will result in some significant reallocations of resources across the regulated universe. We think we have been doing too much work in some areas and too little in others. In particular, we think regulators have done too little anticipatory work in the past, and have not exploited the key competitive advantage they have to full effect. That competitive advantage is the ability to compare and contrast practice across the financial sector in search of best practice. That points to the development of more focused teams, looking at particular risk areas, and less atomised supervision of individual institutions. That is a direction of change which the New York Federal Reserve has recently followed, and we are encouraged to find that their analysis is rather similar to ours. Within the FSA these are the initiatives on which we are focussing most attention today. Of course at the same time we are putting together a rule book which embodies the statutory objectives and meets the process requirements set out in the legislation. But just as important from the point of view of regulated firms, and their consumers, is the way we deploy our resources from day to day and the style and culture of regulation we adopt. We have tried to define that culture in our “new regulator” work, pointing for example to the fact that we do not plan to aim for a zero failure regime. We also plan to make full use of the ability which the legislation gives us to rely on senior management responsibilities on the one hand, and to place weight on the consumer’s own responsibility for her decisions, on the other, as long as she is given adequate information on which to base those decisions. So far, this approach has attracted considerable support among all our stakeholders. We have a chance now, armed with a comprehensive, brand-new Act, to implement a state-of the-art system of financial regulation which is the envy of that tiny proportion of the human race who care about it. 4

Building the New Regulator Progress Report 1, FSA Policy Report (December 2000).

3

Regulatory Principles and the Financial Services and Markets Act 2000 COLIN MAYER*

INTRODUCTION

UK is undergoing fundamental change. Dissatisfaction with self-regulation and the self-regulatory organisations intensified steadily during the 1990s. The failure of regulation to avert the Maxwell pension collapse and the widespread selling of inappropriate pension policies was viewed as a serious deficiency of what many people had already come to regard as inadequate and expensive regulation. The Labour administration came to office with the clear intention of overhauling and strengthening the system. The Financial Services and Markets Act 2000 (FSMA) suffered a tortuous process through the Houses of Parliament. Most concern focused on questions of governance of the Financial Services Authority (FSA): how accountable should it be and to whom, should it have immunity from actions for damages, should it have an independent complaints procedure, should the roles of chairman and chief executive be separated. These are critically important questions, which several of the chapters in this volume address. Notwithstanding the concerns, the FSMA has been broadly welcomed for enhancing investor protection and eliminating the complex system of overlapping self-regulatory organisations that previously existed. The objectives of the FSMA are to maintain market confidence in the financial system, to promote public awareness of the financial system, to secure the appropriate degree of protection of consumers and to reduce financial crime. These objectives have their basis in the market failures that afflict financial markets: market manipulation, systemic problems, asymmetries in information, incomplete contracts and difficulties in the enforcement of contracts. To meet the need for a more effective system of regulation, the government proposed the creation of a new statutory body, the Financial Services Authority, to replace its predecessors, the Securities and Investments Board (SIB) and its accompanying

R

EGULATION IN THE

* I am grateful to Julian Franks, to my discussant Colin Brown and to participants at the 3CL conference at which this ch. was first presented for comments.

26 Colin Mayer self-regulatory organisations. Self-regulation was deemed to have failed to live up to the requirements of effective investor protection. But in the rush to bring in new legislation, there has been remarkably little academic debate about one of the most fundamental changes to financial regulation in the post-World War II period. The questions of governance, referred to in a previous paragraph, are important but may not prove in the long term to be the most significant. Instead, this chapter will suggest that there are more fundamental questions that the debate about the FSMA leaves unanswered. The primary issue that regulation is supposed to address, and many people might feel is the only relevant issue, is investor protection. The FSMA has been welcomed for strengthening this. But the financial sector does not stand in isolation. It plays a key function in linking individuals on the one hand with the corporate sector on the other. The financial sector facilitates the transfer of funds between savers and borrowers and oversees the allocation of resources in the corporate sector through a variety of governance mechanisms. The financial sector is therefore a critical determinant of economic performance. In designing financial regulation, it is therefore important to be aware of its repercussion on the wider economy. It is this aspect of financial regulation that the chapter will argue has received inadequate attention to date. The chapter will begin by considering how financial regulation impacts on the structure of the financial system. It will distinguish between financial institutions that are prone to systemic risks, most notably commercial banking, in the second section from those that are not, for example asset management, in the third section. Where there are systemic risks then there is an inevitable trade-off between protection of the financial system and competition. A critical issue that has received little attention to date is how an appropriate point on the trade-off should be determined. In other parts of the financial sector where systemic risks do not arise, the chapter will argue that regulation should promote competition through disclosure, auditing and enforcement. The second and third sections of the chapter will discuss these issues in the domestic UK context, which is clearly the main focus of the FSMA. The fourth section of the chapter will then consider international aspects, in particular in relation to the European Commission. Having considered how regulation impacts on the structure of financial systems, the chapter will then turn to how financial systems affect the real economy. There is a growing body of literature that points to the importance of the design of financial systems for economic activity. The fifth section will briefly review this literature. The final section will bring the two strands of the argument together in a consideration of the criteria that should guide the formulation of financial regulation and an assessment of current legislation.

Regulatory Principles 27

BANK REGULATION

An interim report on UK banking in 1998 co-ordinated by the UK Treasury and headed by Don Cruickshank raised a question which until then had received little debate: what is the appropriate balance between regulation and competition?1 In banking, the nature of the trade-off is clear. Charter values are the most significant incentives that can be provided for depositor protection. Charter values offer a cushion against poor performance and discourage the excessive risk-taking that otherwise afflicts banking. But the creation of charter values requires limitations to be imposed on competition and entry into banking. Depositor protection can be provided, but at a cost of limiting competition in banking. What is the appropriate balance between competition and investor protection? Since the 1840s, Britain has opted progressively for protection of depositors over competition. In the first half of the nineteenth century, Britain was populated with a large number of local banks. Local banks were important in the funding of manufacturing. Many bankers were originally engaged in a business for which banking was a sideline. They launched banks as a way of funding their activities.2 They were therefore knowledgeable about both borrowers and the trades in which they were engaged.3 However, the existence of 800 small, private banks, empowered to engage in note issuance, caused serious stability problems. Over the period 1809 to 1830 there were 311 bankruptcies of country banks. The Bank Charter Act of 1844 which created the supremacy of the Bank of England did not eliminate banking crises: there were further crises in 1847, 1857 and 1866. Large banks are less exposed to local disturbances and have more resources available to them than small, local banks. In response, banks withdrew from the illiquid investments in which they had been engaged and began to spread their activities geographically. In 1850, the average English joint-stock bank operated five branches; by 1913 it operated on average 156 branches. As a consequence, concentration increased dramatically: in 1850 there were 459 banks in the UK; by 1913 there were 88 and in 1920 the “Big Five” banks (Barclays, Lloyds, Midland, National Provincial and Westminster) accounted for 80 per cent of English bank deposits.4 A convenient relation between the Bank of England and the banks gradually emerged by which the clearing banks faced little competition and the Bank of England faced little failure. As a consequence, British banking became a club of a small number of large members. The cosy relationship was disturbed by 1 D. Cruickshank, Competition and Regulation in Financial Services: Striking the Right Balance (London, HM Treasury, 1999). 2 P. Cottrell, Industrial Finance, 1830–1914: The Finance and Organisation of English Manufacturing Industry (London, Methuen, 1980), 14. 3 P. Deane, The First Industrial Revolution (Cambridge, Cambridge University Press, 1965). 4 M. Collins, Banks and Industrial Finance in Britain, 1800–1939 (London, Macmillan, 1991), 37.

28 Colin Mayer the arrival of foreign banks during the 1960s and the diversification of the secondary banks from their traditional retail lending activities into more speculative asset investments, prompting the secondary banking crisis in the 1970s. Nevertheless, the UK has endured less failure than, for example, the USA. The critical question that this raises and has not been adequately addressed is how should an appropriate point on the trade-off be determined. Inadequate competition is thought to create problems of excessive pricing and cost inefficiencies. In fact, UK banking is not for the most part characterised by static inefficiency. On the contrary, it is quite efficient in comparison with most of its Continental European counterparts.5 Furthermore, it is unclear whether it is excessively profitable. Traditional measures of profitability do not take adequate account of the fact that banking involves relationships and risksharing between lender and borrower. If banks support firms during periods of financial difficulty then it is reasonable to expect them to earn high rates of return during periods of economic boom. One cannot therefore draw inferences from observations on the profitability of banks during a period in which the UK economy has enjoyed an exceptionally long period of sustained growth. The real cost of excessive regulation is probably neither static inefficiency nor excessive pricing but its impact on diversity and innovation of services. The failure of financial institutions to finance activities and investments that would have been funded under a more lax regulatory regime is difficult to measure and hard to observe. In contrast, bank failures are major events that create political storms. Unless considerable care is taken, there is therefore a natural inclination for the political process to introduce an inherent bias in favour of depositor protection over competition.

NON - BANK DOMESTIC REGULATION

It is not just in relation to banks and depositors that there has been extensive regulation in the UK. Ever since the South Sea Bubble, investor abuse has been a highly charged political issue. In response, minority investor protection has become more extensive in the UK than in virtually any other country. Recent international comparisons6 suggest that both the UK and the USA offer investors high levels of protection and that the UK and USA are not dissimilar in the degree of protection that they offer shareholders. However, the UK provides more protection to its creditors through its insolvency code than the US chapter 11. One area in which shareholder protection differs between the UK and USA is in relation to takeovers. The Takeover Code was introduced in the UK to 5 See, e.g., Z. Sarkis, General Cost Structure Analysis: Theory and Application to the Banking Industry (Boston, Mass., Kluwer, 1999). 6 See R. La Porta, F. Lopez-de-Silanes, A. Schleiter and R. Vishny, “Legal Determinants of External Finance” (1997) 52 Journal of Finance 1131.

Regulatory Principles 29 achieve fair play in takeovers and to ensure that minority investors were not disadvantaged. Unlike the UK, the USA has no 30 per cent equal price rule requiring a bid for all shares in a company once 30 per cent of shares have been acquired. There is no equal price rule in the USA as there is in the UK requiring all shareholders to receive the same price as the highest price offered to any shareholder. Instead, the USA relies on fair price rules to protect investors. While the regulation of banking is primarily concerned with systemic failures, the regulation of non-banks is not. The main market failures that afflict nonbank institutions are market manipulation, imperfect information and contract failure through poor enforcement.

Market manipulation The efficient functioning of markets requires the avoidance of market manipulation through private information and dominant positions. Individuals are deterred from participating in financial markets in which they believe there is a risk of manipulation and abuse. This requires the active policing of market transactions and the prosecution of market abuse.

Information Evaluating information of financial products and institutions is complex and expensive. Investors are discouraged from participating in markets in which they believe that they are at an information disadvantage. In particular, they avoid institutions and markets that they believe are afflicted by risks of losses from bad management or fraud. Disclosure rules and auditing of information are fundamental to the operation of and competition in these markets.

Contract failure Contract failure is primarily associated with fraud. Risks of fraud can be diminished through rules requiring assets and monies to be held by separate custodians. Active auditing by private as well as public auditors assists in the identification of fraud. It is widely recognised that financial fraud has been difficult to prosecute in the UK in the past. The strengthening of powers of the regulator in this regard is clearly welcome, though questions of accountability have been raised. Other chapters in this volume consider whether proposed appeals and compensation mechanisms offer adequate safeguards, but the UK is clearly starting from a position in which powers to prosecute have been weak.

30 Colin Mayer The regulation of non-bank financial institutions therefore hinges on information disclosure, monitoring and auditing and enforcement through the courts. Intermediaries that evaluate the quality of management and systems employed by financial institutions can help inform investors. Such institutions perform a function similar to that of credit rating agencies in bond markets, but instead of rating risks of bond defaults they assess investor exposure to losses from fraud and operating failures. Investors can be further protected through private insurance markets. Indemnity and fiduciary insurance are widespread in the USA but comparatively underdeveloped in Europe. In the absence of systemic risks, private insurance markets can enhance investor protection. There has been considerable variation in the way in which different countries have employed these regulatory instruments. In Continental Europe, asset management firms are for the most part subsidiaries of banks and insurance companies. They have large amounts of capital and are able to draw on the resources of their parent firms in the event of financial problems. The entry of small firms is limited. In the UK, there are many small asset managers employing modest amounts of capital and offering specialised services to particular client groups. Regulation imposes limited capital requirements that are, as far as is practical, risk based. However, there are detailed rules regarding conduct of business and best practice to which financial institutions are required to adhere. In the USA, there are few conduct of business rules, and capital requirements are restricted to certain classes of financial institutions, such as brokers and insurance companies. Instead, US regulation emphasises the importance of disclosure of information to investors, auditing of the behaviour of institutions and the imposition of penalties, in the event of failure being uncovered. Systems of regulation therefore vary between those treating financial institutions as banks, as in Continental Europe, to those relying on disclosure, auditing and enforcement, as in the USA, with the UK falling between the two. What is important to appreciate is that it is not necessarily the case that one system offers a greater degree of investor protection than another. Particular levels of protection can be achieved in different ways. The USA emphasises market systems. The UK has relied on conduct of business rules. Continental Europe has used capital. Europe has therefore opted for ex ante systems of regulation that pre-select on the basis of capital and conduct of business rules. The USA has rejected these in favour of the ex post auditing of firms and imposition of penalties where failure is uncovered. The example of regulation of takeovers mentioned above illustrates the difference in approach. The UK (and the European Union after the implementation of the Takeovers Directive) prescribe the rules of engagement in takeovers. The USA in contrast permits price discrimination but facilitates minority protection in the courts through, for example, class action suits. The advantage of disclosure, auditing and enforcement is that it does not prejudge what is acceptable. It does not require institutions to amass large amounts of capital before they are allowed to transact. It does not presume that there is

Regulatory Principles 31 a single best way of transacting business and impose common rules of conduct. Instead, it allows institutions and investors to choose how to organise their business and where to invest. If malpractice is uncovered then there is a significant probability that it will be uncovered through auditing and penalised through the courts. While competition in banking is limited by systemic risk considerations, this does not apply to many other financial services. Instead, where systemic risks do not arise, regulation should be designed to promote competition and the operation of markets through enhancing information disclosure, auditing and enforcement.

INTERNATIONAL ASPECTS OF REGULATION

What is meant by the location of financial institutions and markets when financial institutions can sell their services globally from any location and investors can transact in any financial market? In the absence of legal, regulatory or tax differences, there is probably no sensible answer to this question. Regulation and taxation effectively define the location of a financial institution. Conduct is regulated on a host country basis and prudential regulation on a home country basis. Operating in UK markets means abiding by UK conduct rules. Operating from UK markets means abiding by UK prudential rules. If institutions are mobile between markets then they will seek the regulatory and tax regimes that impose lowest burdens. If investors are mobile between markets then they will select the regimes that provide their preferred combination of investor protection and cost of investment. They will not necessarily select lowest cost regimes any more than they automatically choose highest risk investments. Where there are systemic risks then there are spillovers from one institution and market to another. Individual regulatory agencies will not take adequate account of the international repercussions of failures in their domestic markets. The protection of financial and monetary systems therefore requires international harmonisation of regulation. In the absence of such harmonisation, competition creates a run to the bottom. However, where systemic risks are not present, regulation need not and should not be harmonised. Competition between institutions and between financial centres in selecting different standards encourages product variety and efficiency in the delivery of financial services. There are substantial differences across countries in the structure and organisation of financial institutions such as investment managers, pension funds and venture capital firms. For example, the regulatory rules relating to capital requirements and segregation of client funds differ appreciably within Europe. This makes it difficult for investors to know on what basis they are transacting. The response of the European Commission is to seek harmonisation of rules.

32 Colin Mayer Whether it intends to harmonise following the UK’s relatively light prudential regulation or the much more extensive rules that apply to Continental investment firms integrated in banks, is yet to be determined and will be controversial. But there is an alternative approach that eschews harmonisation and seeks to improve disclosure, private insurance and enforcement. Investors are then free to choose the basis on which they wish to invest and transact. Provided they are informed about the degree of protection offered by different markets and institutions, investors should be able to select their preferred level of protection. Competition will then emerge between markets in the degree of protection that they offer and the types of institutions that they attract. What is crucial for competition to operate is that investors are aware of the quality of services and protection offered and the ability to enforce contracts where failures occur. As in the regulation of financial institutions, the key to the successful development and integration of markets is information. Rules on disclosure should be strengthened to allow investors to select the markets and institutions with which they transact. Regulatory rules regarding disclosure of accounting and market transactions are far tighter in the USA than in Europe. This is the proper focus of attention of the European Commission rather than extensive harmonisation of prudential or conduct of business rules.

THE REAL IMPACT OF FINANCIAL SYSTEMS

The argument to date has been that where systemic risks arise in relation to banking then there is a trade-off between competition and depositor protection and systemic risks necessitate harmonisation of prudential rules across countries. Where systemic risks are absent, as in many financial services, then the trade-off does not arise. Regulation should encourage as much competition and diversity in the provision of financial services as possible through information disclosure, auditing and enforcement. The development of efficient markets in custodianship and insurance should be promoted. Financial centres should be encouraged to compete in rather than harmonise the forms of investor protection that they provide. Competition and diversity in the provision of financial services can be justified from the viewpoint of investors alone. However, there is a more substantial argument in relation to the financial sector. The financial sector provides services not only to investors but also to the users of capital, most notably the corporate sector. There is accumulating evidence of a relation between the development of a country’s financial system and its economic performance. Several studies report a relation between the size of financial systems at the start of a period and subsequent economic growth.7 Controlling for other 7 See, e.g., R. Levine, “Financial Development and Economic Growth: Views and Agenda” (1997) 35 Journal of Economic Literature 688.

Regulatory Principles 33 considerations, financial development appears to contribute to growth. A range of measures of financial development are relevant—the volume of monetary assets, the size of banking systems and the size of stock markets. To the extent that it is possible to establish the channel by which financial development contributes to growth, it appears to be through the external financing of firms. Comparing the growth of different industries across countries or different companies suggests that there is an inter-relationship between their growth rates, the extent to which they are dependent on external finance and the development of financial systems in which they are operating.8 In other words, financial development confers particular advantages on industries and companies that are especially dependent on external finance. These results are clearly consistent with the view that a primary function of financial institutions is to improve the allocation of funds within an economy. Corporate, industrial and economic growth is assisted by institutions that direct financing to activities that are most dependent on external finance. The studies therefore provide empirical confirmation at an aggregate economy or industry level of the theoretical underpinning of financial institutions. Regulation is crucial to the successful development of financial sectors. Using data on degrees of investor protection in many countries around the world, La Porta et al.9 argue that there is clear evidence that financial systems are better developed and provide more external financing to companies in countries with strong investor protection. In particular, they demonstrate that financial sectors are stronger in common law than civil law countries and they suggest that this reflects the greater degree of investor protection that is generally provided by common law than civil law systems. Strengthening financial regulation, as in the UK, can therefore be justified by its beneficial influence on the operation of its capital markets. The question that these studies leave unanswered is which institutions and forms of regulation are particularly well suited to performing these functions. Do all institutions and regulatory rules serve all economies equally well or are there some that are particularly critical? The view is beginning to emerge that there may be a link between financial institutions and systems and the types of activities undertaken in different countries. For example, one study of the growth rates of industries in different countries reveals that information disclosure and protection of minorities increase growth and investment in some but not all industries.10 The main route through which financial systems influence activity in developed economies appears to be via R&D rather than fixed capital formation.

8 See R. Rajan and L. Zingales, “Financial Dependence and Growth” (1998) 88 American Economic Review 559. 9 N. 6 above. 10 See W. Carlin and C. Mayer, “Finance, Investment and Growth” (mimeo, Oxford, University of Oxford, 2000).

34 Colin Mayer An area in which the relation between structure of financial institutions and corporate activities is most pertinent is in the “new economy”. The financing of new high-tech firms is highly reliant on own funds, families and friends. Once these are exhausted, external equity initially comes from private investors, “business angels”, who are actively involved in the management of the investment. Venture capitalists come in at a later stage, acting at more arm’s length than business angels and seeking higher returns over short periods. A small fraction of the most successful firms are floated on stock markets; most are sold as trade sales and sales to other investors. In the USA, around 25 per cent of venture capital funds are invested in early stage firms. In the UK, start-up and early stage investments also accounted for around a quarter of venture capital investments in 1984 but this has fallen to a figure of around 4 per cent at present. MBOs and MBIs have substituted for start-up financing increasing from 20 to 70 per cent of UK venture funds’ investment. An important reason for the greater success of US venture capital in funding start-up businesses is the structure of the industry. Venture capital in the USA comprises two parties—the limited partners, which are the institutional and individual investors, and the general partners, which are the venture capital firms investing in individual companies and entrepreneurs. The general partners manage portfolios of companies and are frequently successful entrepreneurs themselves who want to manage larger portfolios of investments. They therefore provide intermediate technical expertise between the investing institutions on the one hand and the entrepreneurs on the other. Venture capital firms in Europe, including the UK, are generally captive funds that frequently lack the pool of entrepreneurial scientists on whom to draw to provide this intermediary function. Corresponding to differences in institutional structure of venture capital industries are differences in high-tech specialisations. For example, the rankings of industries by the intensity of patent registrations in one European country, Germany, relative to a 12-country average are almost inversely related to those for the USA. Information technology, semi-conductors and biotechnology, for example, are in the top six (of 30) industries by patent registrations for the USA and in the bottom four for Germany. Germany’s patent specialisation is highest in civil engineering and transport equipment, which are in the bottom three industries for the USA.11 Different financial institutions and systems may therefore confer comparative rather than absolute advantage on certain types of activities. There may not be a financial system that is best suited to all types of activities. What best meets the needs of old economy firms may be different from those of new economy firms 11 Patent specialisation indices for 30 industries are calculated from patents registered at the European Patent Office. The correlation between the German and US indices is -0.78: T. Cusack and D. Soskice, “Patterns of Innovation and Varieties of Capitalism” (work in progress) (Wissenschaftszentrum Berlin, 2000).

Regulatory Principles 35 and, even within the new and old economy, different types of activities may benefit from particular institutional structures. If this is the case then financial systems should be allowed to evolve to meet the financing and governance requirements of their corporate sectors. Regulation that constrains this process will adversely affect real activity. Regulation should minimise this risk by promoting competition and diversity within and between financial systems. This points towards a carefully considered balance between competition in banking and avoidance of systemic risks; using regulation to promote markets through information disclosure, auditing and enforcement; and promoting competition between rather than harmonisation of different countries’ regulatory systems.

CONCLUSIONS

This chapter has argued that there are three critical issues that arise in the design of financial regulation. The first is the trade-off between competition and investor protection in areas of the financial system where systemic risks arise, most notably in banking. The second is the form that investor protection takes where systemic risks are not present. The third is the degree of harmonisation of regulation of different financial systems in the presence and absence of systemic risks. In the area of banking, there has been a strong emphasis in the UK on depositor protection at the expense of competition in commercial banking over an extended period of time. In other areas of financial services where systemic risks do not arise, Europe has opted for forms of regulation that impose ex ante requirements on capital and conduct of business—Continental European countries emphasise the former, the UK the latter. In contrast, the USA places more emphasis on disclosure and ex post auditing and enforcement. There are several desirable features of the FSMA, most notably the strengthening of enforcement. However, the emphasis on avoidance of systemic risks at the expense of competition in banking and on ex ante conduct of business rules in financial services remains. At the European level, the Commission is pushing in the direction of harmonisation, even where systemic risks do not arise. In general, there is inadequate emphasis on using regulation to promote competition and diversity in European financial markets, through disclosure, auditing and enforcement. The costs of imperfect competition are of course in large part borne by the users of financial services, namely investors. But the repercussions of excessive or inappropriate regulation may be wider than that. There is growing evidence of a link between financial systems and the real economy. This is reflected not only in overall economic activity and growth but also in the balance of activities in different countries. In other words financial systems confer comparative as well as absolute advantage. The importance of financial regulation may

36 Colin Mayer therefore come not only from its influence on the trade-off between risks and rewards with which investors are confronted but also from its wider impact on the performance and structure of economies.

4

Examining the Objectives of Financial Regulation—Will the New Regime Succeed? A Practitioner’s View AMELIA C. FAWCETT*

H E D E C I S I O N T O reform financial regulation in the UK through the creation of a single regulator, the Financial Services Authority (FSA) represents a significant undertaking. Within Europe, only Sweden, Denmark and Norway have single regulators. The creation of the FSA in the Financial Services and Markets Act 20001 (FSMA) is the first time a major financial centre has undertaken such a radical reform of its regulatory structure. The process of consolidating regulation began in October 1997, when HM Treasury announced that the Securities and Investments Board would be renamed the “Financial Services Authority”. At the same time, it was announced that the FSA would assume responsibility for regulation of banks, building societies, investment firms, insurance companies, friendly societies, credit unions, other financial institutions, exchanges, clearing houses and collective investment schemes. Effectively, this consolidated regulators by placing them all under the umbrella of the FSA. Since then, the FSA has acquired further responsibilities, including regulatory responsibility for aspects of the Lloyd’s insurance market and responsibility as the UK listing authority. While the FSA has been functioning as a de facto single regulator for the past several years, it will formally assume its responsibilities and acquire its powers under the FSMA when “N2” occurs. At that time, the separate regulatory organisations which currently continue to regulate financial services and markets

T

* The author would like to thank Christopher Crozier and Jane Ibbotson, also of Morgan Stanley, without whose invaluable assistance this chapter would not have been possible. 1 The Financial Services and Markets Act received Royal Assent on 14 June 2000. “N2”, the date when the FSA will acquire its responsibilities and powers under the FSMA, is expected to occur some time in late 2001. See Announcement by HM Treasury, “Implementing Financial Regulation” (March 2001).

38 Amelia C. Fawcett under existing legislation2 will combine into a single statutory body. Under this new regime, the FSA will be the regulator responsible for a broad range of financial products and services, from current accounts, mortgages and insurance to investment management, securities trading and listing. Creating a single regulator and reforming financial regulation in the UK is indeed a noble goal. The magnitude of the undertaking, however, is reflected in the fact that the draft Financial Services and Markets Bill was first published for consultation almost three years ago. In excess of 1,400 amendments were made to the Bill, representing a mixture of technical and substantive changes, and the FSA itself has circulated over 90 consultation papers to the financial services industry, 50 of them since January 2000.3 Notwithstanding the length of time during which the FSMA was considered, much of the substantive consultation occurred in the final nine months of its passage through Parliament. This relatively tight consultation timeline increased the pressure on the financial services industry to consider carefully and respond to significant issues affecting the industry, the markets and the structure of regulation to be adopted in the UK. At the same time, this consultation period and the continuing consultation by the FSA have coincided with a period of significant change in both the financial services industry and the markets. In the past three years, industry participants, markets and exchanges alike have consolidated and established new alliances, in many instances cutting across traditional market and product boundaries and national borders. The changing environment has highlighted the need for a regulatory structure and philosophy that are firmly grounded in principle but also flexible and responsive. Notwithstanding the many changes which recent years have witnessed, the basic principles remain unchanged: fostering enterprise and protecting investors and consumers. The aim of this chapter is to provide a practitioner’s view of the FSMA, the FSA and the “new regime” they envisage, and it is divided into two sections. First the question—what will the markets and industry look like?—is addressed. Endeavouring to predict the future is a necessary part of strategic planning and is no less important in considering what structure of regulation will be appropriate than it is in general business planning. The one immutable certainty is change—and the experience of recent years indicates that change will occur at a rapid pace. This section considers briefly current thinking, anticipation and expectation as to what markets and industry will look like. 2 When “N2” occurs, the FSA will replace the Personal Investment Authority (PIA), the Investment Management Regulatory Organisation (IMRO), the Securities and Futures Authority (SFA), the Building Societies Commission, the Insurance Directorate of the Department of Trade and Industry, the Friendly Societies Commission and the Registrar of Friendly Societies. The Banking Supervision Division of the Bank of England was transferred to the FSA in 1998 under the Bank of England Act 1998. 3 The FSA’s consultation process began in October 1997, when the FSA published Consultation Paper 1.

Examining the Objectives of Financial Regulation 39 The second section discusses the fundamental attributes of successful regulation. The “new regime” will be considered in the context of these success factors to determine whether it will succeed, bearing in mind the expectations for the future of markets and industry set out in the first section.

WHAT WILL THE MARKETS AND INDUSTRY LOOK LIKE ?

Expectations about the future face of markets and the financial services industry reflect a combination of on-going and new trends. Markets will be open and transparent, networked and totally connected, “T+0”, straight-through, “24¥7”, fast and cost-effective. Online connectivity will be both common and necessary, and power will rest with consumers and not producers. In this new market, customers will be able to get the information and products/services they want, when they want them and how they want them. Players in this market will be obsessed with client service, globally networked, collaborative, technologically “cutting edge” and capable of responding and adapting to rapid change.

The Blurring of Boundaries In recent years, both the financial services industry and the markets have changed considerably as traditional product and sector distinctions have blurred and as market structures have adapted to developments. Historically, the focus in financial services was not on the industry per se but rather on individual sectors, such as banking, insurance and investment management. Regulation reflected and reinforced this approach, making clear distinctions between retail (“High Street”) banks, building societies, insurance companies, pension providers, investment banks and securities firms. A multitude of factors have contributed to the blurring of the traditional distinctions, including changes to tax laws which removed historic protections on certain products, and an increasing demand for long-term savings products to supplement (dwindling) state pension provision. The discussion of these factors is beyond the scope of this chapter—what is important is that the distinctions have gradually blurred to the point where today it is difficult to distinguish a “savings” product offered by a bank, life assurance company or pension provider. As boundaries have blurred, shifting the focus on financial services from sectors to the “industry”, many of the traditional features and structures of markets also have evolved. Traditionally, exchanges were based around trading floors where counterparties physically met to trade through “open outcry”. Both LIFFE and the London Stock Exchange have shifted from open outcry

40 Amelia C. Fawcett trading to electronic trading. The New York Stock Exchange now is the only major floor-based equity exchange in the world to use open outcry. “Virtual markets” are being created through technology, eliminating the need for participants to meet physically. The Nasdaq Stock Market was created through automated links and has provided a model for many “screen-based” exchanges. The $1.9 trillion foreign exchange market—the deepest, largest and most global market in the world—is a purely virtual market. Not only is trading occurring around the world, around the clock, but trades can be booked anywhere. Global financial markets are already markedly more open, transparent and efficient, much faster and more connected and display much greater symmetry of information than was the case 10 years ago. Moreover, most observers agree that the wave of change in global financial markets is far from complete. Ongoing trends, such as consolidation and globalisation, have combined with newer technology-based trends, including the arrival of new entrants and the impact of the internet, to create a powerful engine that is driving and shaping the development of both the financial services industry and markets.

On-going and New Trends The on-going trends of consolidation and globalisation have been fuelled by the erosion of boundaries between financial services sectors and have contributed to significant changes in the financial services industry. In Europe, there were more than 1,200 deals with an aggregate value of £160 billion between June 1999 and June 2000.4 Recent examples of consolidation in the UK financial services industry include, in banking, the combinations of Bank of Scotland and Halifax, Barclays and Woolwich, the Royal Bank of Scotland and NatWest and of Lloyds and TSB and, in insurance, the combinations of CGU and Norwich Union and of Prudential and Scottish Amicable. Consolidation can also occur cross-sector, which is sometimes referred to as “conglomeration”. An example of conglomeration in the UK financial services industry is Lloyds TSB’s (retail banking) acquisition of Scottish Widows (pensions). Globalisation can occur either organically, when operations grow and extend to new markets, or by acquisition, when businesses acquire new markets by combining with other businesses. Cross-border combinations driven by the need to acquire scale of operations and markets are, in effect, international forms of consolidation. Crédit Suisse First Boston’s acquisition of Donaldson, Lufkin & Jenrette and HSBC’s acquisition of Crédit Commercial de France are examples of this type of globalisation. Consolidation and globalisation have not been limited to financial services firms themselves—developments among the leading European exchanges hold 4 5

According to information published by Thomson Financial Securities Data. See “Frankfurt considers hostile LSE bid”, Financial Times, 13 September 2000.

Examining the Objectives of Financial Regulation 41 out the promise of the creation of larger and more liquid European capital markets. In March 2000, the Paris Bourse and the Amsterdam and Brussels stock exchanges announced that they would combine to create “Euronext” and, in May 2000, the London Stock Exchange and Deutsche Börse announced plans to merge to form “iX”, although the proposed merger subsequently collapsed.5 In June 2000, 10 of the world’s leading exchanges, including the New York Stock Exchange, Euronext and the Tokyo Stock Exchange, agreed to form an alliance and pledged to create a global equities trading market to be called “GEM” (global equities market).6 OM Gruppen, the owner of the Stockholm Stock Exchange, announced a hostile bid for the recently demutualised London Stock Exchange. Given that, until recently, hostile bids in corporate Europe were rare for a variety of cultural, legal, employment and public opinion reasons, OM Gruppen’s hostile bid for a public exchange was truly a revolutionary event.7 Indeed, it was the first hostile bid for a major European equities exchange and ultimately forced the London Stock Exchange to abandon the proposed iX merger. Even though OM Gruppen’s bid for the London Stock Exchange was unsuccessful, the shape of equity exchanges in Europe is clearly still in flux.8 All of these changes in the structure of equity exchanges will challenge regulators to develop new regulatory approaches. In Europe, in particular, this will require cross-border co-operation between regulators and further harmonisation of applicable rules and regulations, a fact that was recognised by the FSA and the German regulators in respect of the proposed iX merger.9 The rationale for these on-going trends remains strong: obtaining scale and markets sufficiently large and deep to nurture enterprise, fostering job creation and creating wealth. However, these on-going trends have been bolstered by the rapid and radical technological developments that have swept through financial

6

See “Exchanges to create global equities market”, Financial Times, 7 June 2000. According to information published by Thomson Financial Securities Data, in Europe from 1990 to 1998, hostile bids accounted for only a nominal amount of the aggregate value of deals done each year. This compares with 1999, when hostile bids accounted for nearly a third of the total by value. During the period from 1990 to 1994, the aggregate remained around $200 billion; from 1995 the value began to increase, reaching almost $1.4 trillion in 1999. 8 See “LSE shareholders reject Swedish bid”, Financial Times, 10 November 2000 and “Nasdaq to look into LSE alliance”, Financial Times, 15 November 2000. 9 The FSA, the Bundesaufsichtsamt für den Wertpapierhandel (the Federal Securities Trading Supervisory Office) and the Hessisches Ministerium für Wirtschaft, Verkehr und Landesentwicklung (the Exchange Supervisory Authority of the Hessian Ministry of Economics, Transport and Urban and Regional Development) published a joint statement on regulatory issues concerning the proposed iX merger on 21 August 2000 which acknowledged the need for the regulators to develop joint arrangements for the supervision of the exchanges in iX and for harmonisation of standards in a number of areas, including market structure, listing and disclosure, transaction reporting and market surveillance, insider dealing and market abuse, corporate takeovers, and clearing and settlement. See Financial Services Authority, Bundesaufsichtsamt für den Wertpapierhandel, Hessisches Ministerium für Wirtschaft, Verkehr und Landesentwicklung, iX—international exchanges—Joint Statement, (21 August 2000). 7

42 Amelia C. Fawcett markets around the world. Technological developments provide the foundations for many of these new trends—enabling new entrants to emerge, facilitating the development of a new kind of market participant (able to offer a combination of products, advice and, crucially, information) and changing the way traditional players conduct their business. Perhaps the most significant development, however, is the internet. New Entrants Technology has facilitated the development of new entrants and the creation of new “infomediaries”. New players have emerged in financial services and markets, including alternative trading systems (ATSs), electronic crossing networks (ECNs)10 (such as Island and Instinet), electronic fixed income trading systems (such as EuroMTS and BrokerTec), online broker/dealer consortia (such as WR Hambrecht and E*Offering), and buy-side consortia and new exchanges (such as Jiway and Coredeal). These new players are dramatically reshaping the trading landscape and are part of a trend toward disintermediation—the elimination of the need for a traditional financial intermediary—in a variety of transactions. Equity markets, which are currently fragmented in Europe,11 are threatened, in the short term, with further fragmentation through the development of ATSs and ECNs. This fragmentation has a negative impact on liquidity and transparency. However, the consensus is that, in the long term, new entrants bring increased competition, which helps facilitate restructuring, and leads, ultimately, to consolidation and the creation of larger, more liquid markets.12 In part, this theory rests on the defensive conduct of players who realise that (at its starkest) they must either co-opt/be co-opted or disappear. In contrast, the development of ECNs is actually contributing to consolidation in over-thecounter (OTC) markets in fixed income and commodities. Infomediaries Information lies at the heart of the financial system itself, as well as the system of regulation of financial services and markets. Many regulatory regimes, 10 ECNs have seen dramatic growth and success in the last two years. For example, the percentage of Nasdaq shares traded on ECNs has risen from 3.7% of shares in January 1998 to over 36.4% of shares in June 2000. 11 At the time of writing, November 2000, there are 33 exchanges in Europe, not considering the Euronext consolidation. 12 Since the beginning of 2000, we have seen the creation of or expansion of a wide variety of new exchanges, trading systems, ECNs, etc. The appearance of new entrants and application of innovative new technology to traditional ways of doing business are becoming a regular feature. At least 14 new exchanges and systems have appeared or been introduced since 1 January 2000, including completely new markets (like Intercontinental for oil and precious metals) and completely new systems (like Jiway), which increase transparency and efficiency by using electronic trading systems.

Examining the Objectives of Financial Regulation 43 including the UK’s, are intended to ensure that markets and investors have accurate and relevant information on which to make financial decisions. Transparency of markets and products—the provision of relevant information (“disclosure”)—is essential, both for efficiency and for fairness. A potentially significant development is the emergence of “infomediaries”— businesses which are transforming the delivery of information research (particularly in terms of speed). These “infomediaries” can be “aggregators” (such as CMC, Money Garden and Matchbook.com), media companies, information companies (such as Reuters and Bloomberg) or ratings agencies. Infomediaries affirm the adage that “knowledge (or, more accurately, information) is power”. Information has always been essential to the functioning of markets, and markets and market participants historically have placed a premium on possessing accurate information as rapidly as possible. As markets develop and change at an increasingly rapid pace, the combination of traditional financial services companies with information providers may represent an important strategic move, enabling the new entity to provide a package of independent advice and information, as well as products and other services to its clients. New Technology/the Internet Technology is having a marked impact on information. In most major equity markets, disclosure requirements have ensured that a minimum level of information has been available to the market. Established players in financial services and markets were able effectively to develop strong positions in the information market, assembling and consolidating information more rapidly than other participants could. This position enabled them to charge premium rates for access to this information. Now, however, the internet holds out the promise of making more information available more rapidly and accessible to more people (in many cases at no cost for the information itself). Traditional intermediaries will now need to provide new “value-added” services in order to get paid. Globalisation, discussed above as an on-going trend, increasingly is being driven by the internet. In common with other technologies, the internet does not recognise national or other borders, a fact that has profound implications for the structure of both markets and regulation. Traditional barriers of time and geography, which helped define discrete markets, effectively are eliminated. Markets, industries and entire economies are increasingly inter-linked with the result that decisions, actions and developments in one market, industry or economy will ripple through the global system. In effect, then, the internet “denationalises” industries and markets, permitting them to extend their reach beyond traditional temporal and geographic boundaries relatively easily, efficiently and effectively. Trading, for example, now occurs around-the-clock, around the globe. Many exchanges are extending trading hours. Frankfurt’s exchange has an official

44 Amelia C. Fawcett close of 8.00 p.m. (CET)13 and Milan permits trading until 8.30 p.m. (CET), although its official close is still 5.30 p.m. (CET).14 The Frankfurt, Milan and Amsterdam exchanges have all indicated that they intend to extend trading hours to 10.00 p.m. (CET).15 Nasdaq is currently pursuing a global market and has linked its New York-based market with Nasdaq Japan.16 The final link—Nasdaq Europe—was realised in March 2001, when Nasdaq acquired a majority stake in Easdaq.17 Genuine global markets, however, will be realised only when trading in any share, anywhere occurs in accordance with a single rulebook and liquidity is provided around-the-clock. The internet may also challenge the existing structure of exchanges. While many established exchanges are endeavouring to harness the internet to develop their trading systems and market reach, other new exchanges—entirely internet-based—herald a new form of buying and selling shares: directly over the internet. The result is likely to be further disintermediation of both exchanges and brokers. The impact of the internet on commerce and markets (to say nothing of “everyday life”) should not be underestimated. It is radically changing traditional business models in many industries, as indicated by the number of new business-to-business procurement exchanges which industries have announced they are creating. “Comparison shopping”, whether by a major manufacturer seeking a supply of steel or by an individual searching for the best product (whether tangible, like a book, or intangible, like a pension or mortgage), will increase the pressure on product and service providers to deliver more “valueadded” products and services to maintain commercial viability. The world is increasingly moving from a “product push” to a “demand pull” market. Accordingly, the internet will transform financial services from a productdriven industry to one in which consumers are empowered and determine how, where, when and which products and services will be provided. The fact that the internet is oblivious to geographical boundaries presents legal and regulatory challenges. Financial services regulators have relied upon those geographical boundaries to provide a natural constraint on some of the excesses that may occur in selling products and services.18

13

“High growth bourse opens in Madrid”, Financial Times, 10 April 2000. “Italy eyes after-hours trading sessions”, Financial Times, 26 January 2000. 15 “London holds back from opening all hours: Some European bourses are set to extend their trading times but others doubt the wisdom of such a move”, Financial Times, 20 April 2000. 16 Nasdaq Japan, which is a partnership among Nasdaq, Softbank and the Osaka Securities Exchange, was launched on June. See “Nasdaq Japan bolsters Tokyo”, Financial Times, 20 June 2000. 17 See “Nasdaq enters Europe with majority stake in Easdaq”, Financial Times, 27 March 2001. 18 Phillip Thorpe, The Transformation of Financial Services Regulation: Facing up to Markets Without Borders, FSA presentation at 2000 Global Internet Summit, George Mason University, 13 March 2000, Slide 4. 14

Examining the Objectives of Financial Regulation 45 Markets and market participants now operate both across borders and for longer hours, effectively providing round-the-clock activity. Lawmakers and regulators, in common with the entities they regulate, must adapt to meet the challenges posed by increasing globalisation of markets. The proliferation of new entrants, exchanges and markets will ultimately result in profound changes to how financial services, products and markets are structured and, as a result, how they are regulated. The ability to know the future would have obvious attractions to those interested in financial services and markets; however, the gift of true foresight is not ours. The certainty we have is that change will continue. New models that we have not yet defined will emerge, reinforcing dramatic change in global financial markets and the financial services industry. The sharp decrease in the cost of information, its increased accessibility and the “death of distance” will maintain a state of constant flux. The new regime must be relevant and appropriate not only to the markets of today, but to markets which are developing and which will emerge in the months and years to come.

WILL THE NEW REGIME SUCCEED ?

The question whether the new regime of the FSMA and the FSA will succeed will remain open for some time to come, precisely to provide time for the FSA’s practices to settle. The FSMA contains the principal aims of the FSA, set out as statutory objectives, and establishes the framework within which the FSA will promulgate rules and operate the system of regulation.19 During the period in which the FSMA was being considered by practitioners, politicians, regulators and others, the FSA has endeavoured, through the publication of a number of documents, to indicate its philosophy and the approach it proposes to take.20 How the FSA will exercise its rule-making authority and discretion, in particular in providing guidance, will become clear only in time, once the FSA has established its practice; however, the consultation, discussion and debate which have surrounded the development of the FSMA provide a reasonable basis for undertaking a benchmarking review.

19 The statutory objectives are broadly defined, as is appropriate, and are: maintaining confidence in the UK financial system, promoting public understanding of the financial system, securing the appropriate degree of protection for consumers and reducing the extent to which it is possible for a business carried on by a regulated person to be used for a purpose connected with financial crime. 20 See, e.g., the FSA’s Financial Services Authority—Meeting our Responsibilities (London, August 1998), and A New Regulator for a New Millennium (London, January 2000) and Building the New Regulator (December 2000).

46 Amelia C. Fawcett

This section both considers the fundamental attributes—the factors—which characterise successful regulation and “benchmarks” the new regime against these factors. This “benchmarking” exercise takes account of the expectations about market and industry developments set out in the preceding section. In addition, an “open issue” and several other factors also will be considered.

The Success Factors The factors for successful regulation include flexibility, fairness, transparency, integrity, efficiency and adaptability. Lawmakers and regulators must ensure that the regulatory structure and approach are appropriate and strike a balance between enterprise, on the one hand, and protection of consumer and investor interests, on the other. Over-zealous regulation often has a negative impact on markets, and both governments and regulators have been surprised by the speed with which business can disappear from one market only to reappear in another where the regulation is considered to be more favourable.21

Flexibility The tension between certainty and flexibility lies at the heart of successful regulation. Certainty means that those who are subject to the regulation know what conduct is permitted or proscribed, as the case may be. Flexibility means that the regulatory structure, including the framework legislation by which it is established, has provided for rules and regulations to be adapted or developed to address new or changing situations, providing the room (and incentive) for markets and industries to innovate and thrive. Flexibility is a structural attribute; actually adapting regulation—responding to developments—is more a cultural attribute of the regulator and is considered below. Arguably, the balance of flexibility and certainty is best maintained when the regulatory structure permits (or better, requires) the regulator to provide written guidance and interpretations. If a regulator is empowered to promulgate, repeal, amend and interpret regulation, then the system should be able to

21 The introduction of Regulation Q by the United States in the 1960s and the imposition of noninterest-bearing minimum reserve requirements on Deutschmark securities repurchase transactions by the German government in the early 1990s provide examples of business adjusting to regulatory changes by shifting to a different market.

Examining the Objectives of Financial Regulation 47 provide the right mix of certainty and flexibility, especially if the regulator publishes its interpretive decisions and guidance (in which case, transparency is also enhanced, see below). Is the New Regime Flexible? The new regime should eliminate the “transmission loss” which characterised the old, multi-regulator regime. The existence of multiple regulators and the blurring of traditional boundaries between products and sectors in the financial services industry contributed to uncertainty about boundaries and confusion and inefficiencies for consumers and the industry. Switching to a system with a single regulator and co-ordinated regulation should provide significant benefits to consumers and the industry—with the single regulator providing the focal point for balancing flexibility and certainty. The regulatory structure established by the FSMA is clearly intended to provide flexibility. The FSMA sets out statutory objectives and empowers the FSA to make and amend rules and high-level principles and to issue guidance. Whether or not this flexibility is retained, however, will depend upon the regulatory definition provided by the FSA through its approach to rule-making. The FSA acknowledges the importance of flexibility;22 however, the FSA’s approach to “regulatory architecture” and “guidance” strike a balance between flexibility and certainty which arguably tips the scale too far in favour of flexibility. The “regulatory architecture” is confusing. The FSA has articulated a series of high-level principles, rules and guidance; however, the hierarchical relationship between them frequently is unclear. Most would expect the relationships to cascade, so that principles would be transposed into day-to-day regulation through rules which would be illustrated or applied to fact situations through guidance. However, the FSA has indicated that it can take action on high-level principles alone.23 This is a serious issue for the industry, and the compliance implications are profound: threatening the expectation that rules provided a sound-basis for development of an effective compliance function. The benefit to the FSA of holding open the possibility of enforcement on the basis of principles alone is clear, but efficiency and fairness should point the FSA to the need for a clear statement that it will pursue enforcement proceedings on this basis only in genuinely exceptional circumstances where not to do so would be to permit a serious violation. “Guidance” is another area which offers cause for concern. The “guidance” offered by the FSA in the rulebook is both illustrative and prescriptive. While prescription may enhance certainty, in many instances the effect is to blur the distinction between the rules (with which one must comply) and the guidance 22 See the Chairman’s Foreword, Financial Services Authority—Meeting our Responsibilities (London, August 1998). 23 Consultation Paper 65, The Enforcement Manual (August 2000).

48 Amelia C. Fawcett (which should be illustrative and helpful). Even though guidance will not have evidentiary value, failure to have “complied” with the “guidance” may place on firms the onus to prove that it was appropriate to adopt a different approach, raising obvious concerns about managing a financial services business. This sort of prescriptive “guidance” contrasts with the interpretive guidance which is an integral part of successful regulation. The FSMA provides an opportunity for the FSA to adopt a regime of guidance and advice provision similar to the “no-action” letter system operated in the United States by the Securities and Exchange Commission (“SEC”). The no-action regime enables the (staff of the) SEC to interpret regulation in a changing market by providing guidance to market participants about the application of regulation to specific circumstances and, if appropriate, to grant relief (in the form of an indication that no action will be recommended to be taken against the market participant) if the market participant acts in accordance with the SEC’s letter. The SEC publishes its noaction letters, and, although officially the SEC is not bound by precedent, the body of guidance is available generally and helps regulated entities to understand how the SEC interprets rules and regulations and applies them to (new) specific fact situations. The benefit of this regime is clear—providing both flexibility and certainty—and it is unfortunate that the FSA not adopted a similar approach in the UK.24

Fairness Fairness is essential in regulation. It is linked to certainty and to integrity and must be predicated on clear and straightforward principles. The balance between enterprise and consumer protection must be “fair”—successful regulation addresses the differences between industry and consumers “fairly”. Fairness is a twin-headed attribute, describing both the outcome (the balance) and the mechanism by which that outcome is achieved (regulation). As a general matter, where there is a common understanding, for example in a given industry or sector, then “fairness” will not require the same detailed regulations which would be appropriate where there is no such common understanding, for example at the nexus of industry and consumers. Successful regulation acknowledges different levels of understanding of participants and provides an appropriate response. In financial services, fairness is reflected in the differences in regulation applied to markets which are purely inter-professional or “wholesale” (as

24 In Consultation Paper 64, The Supervision Manual (August 2000), the FSA acknowledged the industry’s preference for a “no-action” letter-type system of individual guidance, but reiterated its decision not to publish such guidance. The FSA did confirm, however, its proposals to provide rule waivers and acknowledged its obligation under FSMA to publish such waivers.

Examining the Objectives of Financial Regulation 49 enshrined in the London Code of Conduct) and those which contain a retail element. These distinctions are important, because regulation is a “manufacturing” cost which is reflected in the price end-users (consumers and wholesale purchasers) pay for products and services. The more complicated or extensive the regulatory requirements, the greater the likelihood that it will result in increased costs. Where a “lighter” (and, presumably, less expensive) regulatory approach is appropriate, as with professional or sophisticated investors, it should be preferred. In the regulatory process, fairness requires that a regulator consider the implications of its proposals, rules and regulations. Procedurally, fairness may be achieved through a meaningful consultation process and through the preparation of realistic cost-benefit analyses. Is the New Regime Fair? Whether or not the new regime embodies fairness will depend upon how the FSA pursues its mandate as a single regulator. It should be remembered that the FSMA is a response to the realisation that the two-tier system of regulation for financial services was not working. By replacing multiple regulators and layers of regulation with a consolidated system, consistency should be achieved. Consistency is an important component of fairness—market participants must have confidence that similar situations will attract the same regulatory treatment and response. However, fairness does not imply a “one size fits all” approach. There is every reason to believe that the new regime will embody fairness.

Transparency As the saying goes, “sunlight is the best disinfectant”. Transparency is fundamental, both as a goal of regulation and as an attribute of the regulatory system and regulator. As a goal, transparency is the result of disclosure of information which enables market participants to assess and compare the quality of the service or product being offered. [A]symmetries of information in financial markets . . . make it difficult for buyers to assess the risks and returns of the transactions they undertake.25

Only with accurate and relevant information will consumers (whether wholesale or retail) be able to engage in “comparison shopping” or participate in

25

FSA, Financial Services Authority—Meeting our Responsibilities (London, August 1998), 10.

50 Amelia C. Fawcett price-formation. Transparency, or the symmetry of information, is essential for protection of consumers. As an attribute of the regulatory system and the regulator, transparency requires that regulatory development and decisions be pursued openly and subjected to public scrutiny. Is the New Regime Transparent? The FSA has established a system of consultation and rule-making which is highly transparent. Generally, the FSA has published its views, thoughts and opinions on a wide variety of topics in a variety of formats, including consultation papers, discussion papers and occasional papers. There is room, however, for improvement in transparency in the consultation process. Occasionally, consultation on the new regime has been frustrating, especially with respect to some of the “feedback” published by the FSA. At times, it has appeared that insufficient account has been taken of concerns and suggestions raised in the consultation process, with feedback and other publicity issued by the FSA implying that no (serious) concerns or objections were raised when in fact they were26—a practice which risks undermining the credibility both of the FSA and the consultation process. At other times, the FSA has side-stepped difficult issues and bowed out of contentious debates. Perhaps the best example of this is provided by the FSA’s handling of the spirited debate surrounding the new market abuse regime. Key concerns raised by industry in the consultation process, including objections at the lack of an “intent” element, were avoided by the FSA on the basis that these were matters for HM Treasury. This gives cause for concern because it suggests a lack of co-ordination on policy and issues between HM Treasury and the FSA.

Integrity Stability or integrity in a market-place encourages investment.27 Maintaining confidence in a market requires the prevention of the development of (potential) systemic risks and, where prevention has not been possible or successful, the cure of such problems. Prudential supervision and requirements for internal controls and senior management responsibility are examples of regulation intended to prevent the development of systemic risks. Maintaining the integrity of the market-place, however, does not mean preventing failure or “negative” developments from occurring. A “zero failure” 26 E.g., Consultation Paper 60, Feedback Statement to CP34: Training and Competence Sourcebook (London, July 2000). 27 “There is persuasive evidence that a stable financial system provides a favourable environment for efficient resource allocation, and therefore promotes economic growth”: FSA, Financial Services Authority—Meeting our Responsibilities (London, August 1998), 10.

Examining the Objectives of Financial Regulation 51 approach would effectively inhibit market forces from acting—it is to be expected that some products or companies will not succeed. A wide variety of factors may result in the failure of a particular product or company, only some of which will fall within the regulatory ambit. However, where the failure of a product or company would pose a systemic risk, then maintaining the integrity of the market (or confidence in the market) may require a government or regulator to intervene to avoid damage to the system. Does the New Regime Have Integrity? In its paper A New Regulator for the New Millennium, the FSA clearly acknowledges that maintaining market confidence does not, in the view of the FSA, imply aiming to prevent all collapses, or lapses in conduct, in the financial system: Given the nature of financial markets, which are inherently volatile, achieving a “zero failure” regime is impossible and would in any case be undesirable. Any such regime would be excessively burdensome for regulated firms and would not accord with the statutory objectives and principles. It would be likely to damage the economy as a whole and would be uneconomic from a cost-benefit point of view; it would stifle innovation and competition; and it would be inconsistent with the respective responsibilities of firms’ management and of consumers for their own actions.28

The FSA’s statements about the need for consumers to be responsible and not rely on others to assess risks of financial decisions for them provide some comfort that the FSA will not be diverted from its approach to ensuring the integrity of the markets on the pretext of protection of consumers.

Efficiency/effectiveness Effective regulation is regulation which achieves the desired end. Efficacy, however, must be judged in the context of the other key factors, including fairness and transparency. In measuring efficacy, each rule should be considered to minimise unintended or unnecessary interference with the regulated entity or industry. Regulation must strike a cost/benefit balance: the most effective regulation may be the most inefficient if it exercises a significant negative influence on the entity or market regulated. Inefficient regulation will impact on the

28

FSA, A New Regulator for the New Millennium (London, January 2000), 6–7.

52 Amelia C. Fawcett price of the products or services subject to (or provided by entities subject to) the regulation—a fact which may actually (unintentionally) distort the market or drive business elsewhere. Regulators must demonstrate that the regulation they offer to investors offers value for money.29 Is the New Regime Efficient and Effective? In its strategy document, A New Regulator for the New Millennium, the FSA sets out its risk-based approach to regulation. The approach promises a high level of transparency and represents an exemplary statement of regulatory “best practice”, spelling out how the FSA intends to meet its statutory objectives. The FSA must be vigilant to ensure that no gap develops between articulate exposition of a policy and its implementation—to ensure that, in its day-to-day regulatory activities, the FSA manifests its policy statements. If a gap were to develop it could have a negative impact on the confidence of the financial services industry and markets in the new regime and the FSA. A single regulator should be able to secure a more efficient and effective allocation of supervisory resources. Theoretically, communication within one large regulator should be more effective and reliable than among a number of independent regulatory organisations and bodies, and rule-making should ensure that overlapping or contradictory provisions are avoided. In practice, communication within the FSA to date has been good as a general rule, particularly in the Major Financial Groups Division.30 While it is “early days”, Howard Davies has acknowledged on a number of occasions that the FSA must deliver value for money both to the industry (by which the FSA will be funded) and to the consumer, providing a balance between the costs added by regulation and the benefits provided.

Adaptability/agility Whereas flexibility is a structural attribute, adaptability and agility are cultural attributes. To be successful, the regulatory culture must positively engage both markets and market participants (including consumers) and be willing to change to meet changing circumstances and conditions. The benefits of creating a framework which permits flexibility will be realised only if in practice the regulator is agile and willing to adapt its regulation in the face of change. 29 See Howard Davies, Global Markets, Global Regulation, speech to IOSCO’s Annual Conference, 17 May 2000. 30 Many of the UK’s largest firms have benefited from the development of the Major Financial Groups Division, under which a lead supervisor co-ordinates regulation across all the businesses of a firm. However, smaller firms do not fall within the “jurisdiction” of the Major Financial Groups Division and so must continue to deal with multiple regulators within the FSA.

Examining the Objectives of Financial Regulation 53

Regulation is likely to be more effective if it is committed to working with and facilitating market developments. A regulator’s ability to do this is dependent upon his having a strong dialogue with regulated entities and the markets, as well as having quality personnel with a sufficient degree of knowledge and experience enabling them to understand the industry, products and markets. Is the New Regime Adaptable and Agile? In its various pronouncements, the FSA has indicated that it is prepared to use the flexibility of the regulatory structure to ensure that regulation remains relevant and effective. In his speech to the 2000 IOSCO Annual Conference, Howard Davies indicated that the FSA has a culture which embraces flexibility: The market is changing so fast that we [regulators generally and the FSA in particular] must be ready to change with it.31

FSA officials have repeatedly professed a commitment to adapt their regulation to suit changing markets and fulfil their obligations.32

Achieving Success Possession of these key attributes, however, does not automatically translate into successful regulation. For regulation to succeed, each element must work harmoniously with each other element in the system. As indicated in the foregoing discussion, many of the keys are inter-related, and success will depend, to a large extent, on the commitment of the regulator to constructive engagement with those whom it regulates. Generally, in its publications and in the public speeches and remarks of senior officials, the FSA has indicated a commitment to creating a regulatory culture which will enable the FSA and the financial services industry to realise success together.

Other Factors A number of factors, including the implications of the new regime on UK competitiveness, the input of consumers and practitioners and the necessity of 31 Howard Davies, Global Markets, Global Regulation, speech to IOSCO’s Annual Conference, 17 May 2000, 4. 32 See, e.g., Phillip Thorpe, The Transformation of Financial Services Regulation: Facing Up to Markets Without Borders, presentation at 2000 Global Internet Summit, George Mason University (13 March 2000), Slide 6, where it is stated “regulators need to recognise that the Internet makes a mockery of national boundaries, and the answer lies not in pretending that this hasn’t occurred, but in rising to the challenge, and devising new mechanisms for ensuring that the public good—protection of the consumer, adequate disclosure, exclusion of the fraudulent—continues to be available on a more or less consistent basis wherever the consumer chooses to seek products or services”.

54 Amelia C. Fawcett attracting quality, skilled people to staff the FSA, should be considered when assessing the prospects for the new regime. UK Competitiveness Regulation has implications for the competitiveness of a market, as demonstrated by the US’s experience with Regulation Q and Germany’s experience with the imposition of non-interest-bearing minimum reserve requirements on Deutschmark securities repurchase transactions.33 The FSA must ensure that its regulatory approach does not inadvertently or unnecessarily negatively impact on UK competitiveness. The far-reaching powers conferred upon the FSA under the FSMA raise the concern that the FSA could slip, one day, into a mode of over-regulating markets, thereby hampering UK competitiveness. The FSA must assess each regulatory initiative and proposed rule with specific reference to the competitive impact it will have. Likewise, rules and regulations must be interpreted, applied and enforced in the manner that achieves the objective with minimum negative impact on competition. A good regulatory environment will not necessarily guarantee a competitive advantage (although it can be very helpful), but a poor regulatory environment will certainly be a competitive disadvantage. The FSMA requires the FSA to consider “the need to minimise the adverse effects on competition that may arise from anything done in the discharge of [its] functions” and “the desirability of facilitating competition between those who are subject to any form of regulation by the FSA”. On the face of it, these considerations indicate that the Government and the FSA are aware of the need to consider the competitive impact of regulation generally, and of each initiative, rule and decision taken by the FSA. The mandate for a competitive-conscious regulatory philosophy is complemented by a procedural structure that puts the FSA and its regulations firmly in the realm of the UK competition authorities, including the Office of Fair Trading and the Competition Commission. Each of these bodies, together with HM Treasury, will have a role to play in reviewing the impact of the FSA’s rules and practices on competition. These are important procedural checks on the FSA’s approach to regulation; however, given the time and expense of competition assessments and the potential damage which can occur in a short time if

33 The introduction of Regulation Q in the United States in the 1960s is widely credited with fostering the development of the London Euromarket. Likewise, when the German government levied non-interest-bearing minimum reserve requirements on Deutschmark securities repurchase transactions (“repos”), the business began to migrate to London, where no such minimum reserve requirements existed. Only when repo transactions were freed from the 2% levy did business begin to return to Frankfurt from London.

Examining the Objectives of Financial Regulation 55 anti-competitive regulations are adopted, recourse to the competition authorities generally should be avoided. In this regard, the FSA will be assisted by a meaningful consultation process, with consumers and practitioners alike. Consumer and Practitioner Input The FSMA provides for consumer and practitioner input in the form of the Consumer Panel and the Practitioner Panel. Each Panel receives a budget from the FSA but operates independently of the FSA as a forum for consultation. The Practitioner Panel, for example, provides both industry input and scrutiny of the FSA’s proposals. The Panel has four principal functions: to monitor the FSA’s effectiveness, to communicate to the FSA issues of general concern about regulation in practice, to respond to the FSA, when asked, with practitioners’ views on key regulatory issues, and to contribute a broad financial industry view on the formulation of FSA proposals, including representations the Panel has received during any formal consultation process. Although the Panel acts as a bellwether, its role should not be confused with the very important role in the consultation process played by financial services trade associations. The regular consultation and dialogue with both the Consumer Panel and Practitioner Panel has been effective to date and should continue to be a factor in the success of the new regime. The Importance of Skill and Talent As with all aspects of the financial services industry, the FSA relies upon having talented and skilled people to carry out its regulatory obligations. Rules and regulations are proposed, considered, promulgated, interpreted, applied and enforced by people. Ultimately, the quality of the regulation provided by the FSA will be a function of the people it is able to attract and retain. Regulating the UK’s financial services industry and markets is a complicated undertaking, requiring an appreciation of law, economics, politics, finance, markets and a broad range of products and services. None of the success factors discussed in this chapter is self-executing—each is brought to bear because the people operating the regulatory system, the FSA in the first instance, understand the factors and issues and bear them in mind each time a decision is taken affecting regulation or the discharge of the FSA’s obligations. Whether the new regime succeeds will depend, in part, on the FSA

56 Amelia C. Fawcett having people who understand both the industry and the regulations, and the industry does have a role to play in this area: it can work with the FSA to develop an effective a secondment programme.34

CONCLUSION

In concept, the new regime is sensible, promising the possibility of focused and co-ordinated regulation to the benefit of the financial services industry, investors and consumers. The creation of a single regulator should enable more appropriate regulation of an increasingly cross-functional industry while eliminating (or at least dramatically reducing) potential boundary disputes between different regulatory functions. The structural and procedural keys to successful regulation, such as flexibility and transparency, have been provided in the framework of the FSMA and the FSA. The FSA’s public statements and publications evince an intention to provide in practice and culture those success factors which are not purely structural, such as fairness, adaptability and agility. Mere possession of these factors, however, will not guarantee that the new regime will be successful. With the passage of the FSMA and the focus now on “N2” and the FSA’s handbook, it might be thought that we are nearing the end of the process. In fact, we are nearing the beginning of the genuine challenge: implementing the new regime and making it a success in practice. Will the new regime succeed? Ultimately, its success is dependant upon close collaboration between the FSA and all market participants, industry and consumers alike. Working together, the FSA and all market participants now have a very real opportunity to create a “world-beating” regulatory system and the UK will be a better place for it.

34 As noted in its 2000 Annual Report, the Practitioner Forum has agreed with the FSA a secondments policy to encourage and facilitate a greater exchange of expertise between the industry and the FSA.

5

Incentive v. Rule-Based Financial Regulation: A Role for Market Discipline RAHUL DHUMALE*

N R E G U L A T I N G T H E market risk exposure of financial institutions, the approach taken to date has most often been a rule-based regime which sets a relationship between exposure and capital requirements exogenously. Recent discussions by the Basel Committee and other national and international authorities have suggested increasing the effectiveness of market discipline by using an incentive-based stance towards financial regulation.1 This approach has some appeal not only because it is endogenously determined so that market participants can use their own information to determine regulatory standards, but also due to its greater sensitivity to changes in risk profiles. Similarly, it is claimed that rule-based regulation makes inefficient use of managerial expertise whereas an incentive-based approach uses the insights of managers to gain an informational advantage in setting regulatory standards. However, as theoretical and empirical evidence has long indicated, there is a trade-off between fostering an efficient allocation of resources and assuring safety and soundness of financial institutions. The use of a well functioning safety net is one example of an important trade-off in this regard which—if appropriately designed—can prevent systemic complications but can also give rise to moral hazard issues. This chapter considers the role of market discipline and whether it is effective enough to be relied upon as the only tool of financial regulation. I shall argue from the outset that if the former holds true, there needs to be at the minimum an incentive compatible framework in place a priori. The recent allowance by the 1999 Basel proposals for financial institutions to use publicly available assessments of private credit rating agencies as well as their own internal credit ratings to determine capital standards is an example of an incentive mechanism

I

* The views expressed here are entirely those of the author and should not be attributed in any manner to the Federal Reserve Bank of New York or the Federal Reserve System. 1 The Basel Committee on Banking Regulation and Supervisory Practices consists of the banking regulatory authorities of the G-10 nations which meet semi-annually to discuss banking supervision. The Committee concerns itself with supervisory responsibilities including but not limited to capital adequacy, solvency, liquidity, and foreign exchange operations of financial institutions.

60 Rahul Dhumale which has been used to promote the idea of market discipline. An appropriate incentive framework, as outlined in the proposal, should also include a regulatory and supervisory framework, accounting rules and practices and disclosure requirements. However, better information disclosure alone will not suffice as long as the incentives for excessive risk-taking remain. That is, without an appropriate design for enforcement, albeit through market disciplinary measures, the use of internal ratings models and external assessments could be subject to strong incentives for manipulation through excessive risk taking. This chapter begins by briefly considering the “incentive problem” in regulation using a principal–agent framework. The following section considers the design of an incentive-compatible regulatory system which encourages prudent behaviour and efficient financial intermediation. The discussion continues by assessing the nature of the trade-off between incentive- and rule-based regulation by analysing the interaction between regulatory and agency incentives. Detailed analyses of some specific incentive problems from the 1999 Basel proposals and the mandatory subordinated debt (SD) proposal follow in the next sections. The chapter concludes by considering the challenges in designing appropriate incentive mechanisms to regulate financial markets through market discipline.

DO INCENTIVES WORK ?

The main characteristics of the regulator’s problem are that the opportunity exists for firms to improve their economic payoffs by engaging in unobserved, socially costly behaviour or “abuse” and the inferior information set of the regulator relative to the firm. These characteristics are related since abuse would not be unobserved if the regulator had complete information. The basic idea— that the firm has an information advantage and that this gives the firm the opportunity to take self-interested actions—is the standard principal–agent and moral hazard argument. The more interesting issue is how this information asymmetry and the resulting inefficiencies are played out in a regulatory setting. Does the firm have better information? Perhaps the best evidence that regulators possess inferior information to the firm lies in the fact that they employ incentive mechanisms rather than relying completely on explicit directives. Governments have tried to promote financial safety and risk avoidance by reducing abusive practices in different environments not only through direct quantitative limits but also through bonus schemes, for example, the promotion of energy conservation through bonus schemes for firms investing in energy conservation. Regulators believe that the firm has better information about the costs and benefits of conservation and the technology for achieving it, and a better result can be obtained by providing incentives rather than directives. A similar analogy could be made for containing systemic risk in capital markets through incentive-based financial regulation.

Incentive v. Rule-Based Financial Regulation 61 Systemic risk is to financial markets what dirty smoke is to the environment. In calculating the cost of production, the factory owner rarely accounts for the costs which the smoking chimney imposes on society. The dirty smoke is an externality. Its production has an impact on the welfare of society, but that impact is external and it is not priced through the market. The factory owner does not pay for the extra costs of laundry or for the medical bills the smoke precipitates. This failure introduces a fundamental shortcoming into the workings of the market so that the costs to the factory do not reflect the costs of the pollution to society as a whole. The result is pollution. The factory produces more smoke than would be the case if all society’s costs were accounted for in the factory’s balance sheet. Similarly, financial firms do not always price the costs that their losses might impose on society as a whole into their accounts. Taking risks is a crucial activity for financial institutions, but markets in reflecting only the private calculation of risk underprice the risk faced by society. Consequently, similar to pollution, investors in free markets may participate in excessive risk taking.2 Similarly, an argument can be made for containing systemic risk in capital markets through the introduction of mandatory subordinated debt (SD). As with environmental pollution, financial regulators could choose to limit the financial activities of firms through direct controls. However, as with the firms who invest in energy conservation, financial firms have better information about the costs of their activities than the regulator and are probably more knowledgeable about the risks they face. Moreover, given the highly dynamic and innovative nature of today’s financial markets with its various instruments, regulators might even be at a greater disadvantage than their counterparts who regulate the natural environment. Thus, given the greater information asymmetries in this setting, incentive mechanisms such as a SD requirement might be significantly more effective than using explicit directives on their own. The aforementioned conditions exist to some extent due to the inferior quality and quantity of information received by regulators about the circumstances of any regulated firm relative to the firm’s own information resources. This is true because the firm is the source of virtually all the regulator’s information, and the firm can effectively filter much of that information. The firm’s managers are likely to have better information despite the best efforts of regulators to stay informed, and the asymmetry is deliberately exacerbated by the choice of a judicial-type process for making regulatory decisions. It is not that regulators are unaware of what it is they regulate, especially as they collect much information about firms over time. Although the regulator is better informed compared to depositors/investors, their information about a firm will always be inferior relative to the information which a firm itself possesses.

2

J. Eatwell and L. Taylor, Global Finance at Risk (Cambridge, Polity Press, 2000).

62 Rahul Dhumale

AN INCENTIVE STRUCTURE FOR FINANCIAL REGULATION

The main question, and much of the focus of this chapter, is what government can do to ensure that owners, supervisors and the market itself exert sufficient pressure on managers to avoid excessive risk taking. In more developed financial markets, authorities use several measures including erecting entry barriers, enforcing modest capital requirements at or above the minimum 8 per cent BIS capital to risk-weighted assets ratio, and scrutiny by one or more of the supervisory agencies. The same problems encountered by supervisory authorities in emerging markets are even greater, due in some part to the small and often more concentrated nature of their economies where shocks often are larger and more volatile, and where everyone’s ability to monitor banks is hampered by poorer information. Thus, in both industrialised and developing markets, governments need to enhance the incentive mechanisms to encourage each of the potential monitoring groups—namely, supervisors, owners, creditors, and market participants—to curb excessive risk-taking activities by financial institutions. The discussion now turns to the role of incentives for each of these groups to provide a better regulatory environment. Today, most regulatory authorities have moved to engage in prudential supervision to ensure solvency as their main task. In the early years, bank supervision mostly involved ensuring compliance with government directives on credit allocation and other issues. There is still a need to provide the appropriate incentives for supervisors both to monitor market participants and to take actions based on their observations. To begin, supervisors need sufficient compensation to attract qualified personnel so that they are not lured into moving to the private sector. Moreover, the temptation of such high-paying private sector jobs might lead to possible corruption where one may accept lower pay now in exchange for a lucrative salary later. The disincentive for effective supervision can only be reduced by raising supervisory pay at least close to private sector limits. Similar efforts have been made to create “bonded regulators” so that some portion of a supervisor’s compensation is deferred and held as a bond from which deductions can be taken depending on the outcome in the financial sector.3 Another measure might be to limit the possibility of supervisors switching to the private sector for a certain period following their employment with the supervisory agency. For example, in the USA, bank supervisors above a certain level cannot take a job with a commercial bank which they have supervised until after a period of 12 months or more. Recommendations have also been made to commit supervisors to a certain course of action in advance such as “prompt corrective 3 For further information, see the Suffolk banking system in the US between 1820–1850: see A. Rolnick, B. Smith and W. Weber, “Lessons from a Laissez-Faire Payments System: The Suffolk Banking System 1825–58” (1998) 80 Quarterly Review, Federal Reserve Bank of Minneapolis 105–20; C. Calomiris and C. Kahn, “The Efficiency of Self Regulated Payment Systems: Leaning from the Suffolk System”, National Bureau of Economic Research Working Paper 52:42 (1996).

Incentive v. Rule-Based Financial Regulation 63 actions” and “structured early intervention and resolution”. Such quasiautomatic responses include mandatory re-building of capital; structured and pre-specified publicly announced responses by regulators triggered by decreases in a bank’s performance below established criteria; mandatory resolution, for example, by sale, re-capitalisation, or liquidation of a capital-depleted bank at a pre-specified point when capital still exists; and market value accounting and reporting of capital. A continuing problem with the establishment of such pre-fixed rules is that governments may be tempted to re-write them during difficult times as witnessed even in highly industrialised countries, for example, Japan in 1997–8 (when scheduled deregulation was deferred) and the USA in the 1980s (replacing the GAAP for Savings and Loans institutions with less stringent accounting standards). Investors or owners who own equity in a bank in principle have both the ability and the incentive to monitor the actions of their bank. They tend to provide effective self-regulation when they have much at risk in the form either of capital and/or of future expected profits. Moreover, well capitalised banks are usually better monitored by their shareholders. On the other hand, small shareholders might tend to free ride, so it is important that government make sure that there are large stakeholders or strategic investors who can bear greater responsibilities. Inside and outside investors need to face the loss of their investment, and they and their managers need to realise the very real possibilities of bank failure or exit from the industry to discourage excessive risk taking activities. In this light, some emerging markets have raised their minimum capital ratios above that for many industrialised countries to account for the riskier environments in which they operate. For example, in Argentina the minimum capital adequacy ratio is 11.5 per cent, with even higher requirements for banks engaging in riskier activities and weaker risk management capacity. Moreover, banks in most countries with 8 per cent capital adequacy requirements usually have capital ratios in excess of the minimum criteria, e.g., the USA has an average capital ratio of almost 12 per cent. Even then, capital adequacy ratios are by nature backward-looking accounting indicators of the solvency of financial institutions. The demise of banks with high measured capital ratios has not be an uncommon occurrence.4 The increased incentives to engage in excessive risktaking when the capital adequacy position is weakened makes it even more important not to rely on capital adequacy alone. As Table 5.1 indicates, countries have relied on various measures from limiting entry, to enhancing the liability of directors and shareholders, to the issue of subordinated debt (SD) as will be discussed in the following sections. While some of these methods may be relatively blunt, the costs of not using them can be quite high. Owners of financial institutions will behave more prudently, i.e., be more risk averse, if they have more to lose in the form of capital, future expected revenue, profits and so 4 R. Dhumale, “Capital Adequacy Standard: Are They Sufficient?”, ERSC Centre for Business Research Working Paper Series, No 165 (2000)

64 Rahul Dhumale on. Similarly, supervisors need to have the appropriate incentives both to monitor and to enforce the correction of any discrepancies they reveal through their evaluations. Finally, deposit holders tend to provide better market discipline if they are not always fully (100 per cent) covered by implicit or explicit deposit insurance schemes. Given the appropriate incentives and abilities, market participants who enter into creditor relationships with banks could serve as monitors. Their ability to monitor would depend on the quality and quantity of information they received which, in turn, would depend on the quality of accounting standards and practices. To solve the information requirements, some countries have recently enacted extensive disclosure requirements supported by greater liabilities, mandatory ratings by at least two private ratings agencies, and online credit reporting systems as in New Zealand, Chile and Argentina respectively. In addition to information, creditors need the appropriate incentives to monitor market practices such as the possibility that they will be allowed to suffer losses. Although small depositors are unlikely to be good monitors of banks, large debt holders are better equipped to fulfil this role. One example of using such incentives has been the mandatory issue of SD by banks so that if the current owners of a bank fail in ensuring a safe and sound bank, the subordinated holders can take over the bank. A more detailed discussion of this type of proposal will follow in the next sections.

THE PROS AND CONS OF INCENTIVE V . RULE - BASED REGULATION

As mentioned before, rule-based regulation makes inefficient use of managerial expertise whereas an incentive-based approach uses the insights of managers and market participants to gain an informational advantage in setting regulatory standards. But, incentive-based regulation is not without its problems, especially the large number of issues arising from the strategic interactions among the different decision-making agents within financial institutions. In general, incentive-based regulation promotes a more “hands off” style of regulation and gives financial institutions greater freedom to choose the amount and level of risk they wish to undertake. The flexibility of an incentive-based approach derives from the fact that it is not directly prescriptive but creates incentives through other means such as penalties. In more general terms, an incentive-based system tries to solve what is known as a “mechanism design” problem by specifying a framework, for example, a penalty device, which financial institutions take into account when choosing risk and committing regulatory capital. Ideally, the design of this mechanism makes it incentive-compatible for financial institutions to choose the socially desirable risk profile. The success of such a programme depends on how well the regulator anticipates the strategic opportunities which such a mechanism might create. Therefore, while an incentive-based system is less intrusive, it creates a host of strategic issues.

None 8% 4.25%

Korea Malaysia Thailand

5.75%

4% None 4%

Source: World Bank data

4% 4% 4%

Tier 2

90 210 90 180 180 90

£ tier 1 0% 4.25%

90, > 180 Non-Recover 90 for cmrcl; 180 for mortgages 90

At Bank’s Discretion At Bank’s Discretion 90

Loan Classification) Requirements (# of days before loan is NPL

4% < tier 1 4%

2.25%

11.5% < tier 1 Subject to Authority

4% 4% 4%

Tier 1

Minimum Capital Adequacy Ratio (Tier 1 +Tier 2)

Asia &Pacific Hong Kong India Indonesia

Chile

Latin America Argentina Mexico

G-10 Japan United Kingdom United States

Country

Table 5.1: Regulatory Framework for Selected Countries

25% of tier 1 10% single; 30% corporate 5%–25%

20% of tier 1 25% of tier 1 15% of capital, 10% for secure assts

Single Exposure Limit (% of capital)

Monitored by HKMA 25% of tot. capital Not Allowed Corp: 25%; Grp: 50% < 20% of capital; 85% < 25% exposure for single currency 20% of capital 45% No Restrictions None Net long 20% tier 1; 25% of tier 1 Net short 15% tier 1

Closely Monitored 15% in US$ + 2% in all others < 20 % of capital

Part of Mkt. Risk No limit Not Relevant given $US

Limit on Risk Exposure (% of FOREX assets to be held)

Incentive v. Rule-Based Financial Regulation 65

66 Rahul Dhumale Even more serious are the problems which arise as a result of a conflict of interest within the financial institutions. Similar to other large institutions, an integral feature of modern banks is the separation of owners from day-to-day decision-making. The ownership is diffuse as there are numerous small shareholders who have little impact on most decisions. In the end, in many cases it is the incentives of the traders of the bank, for example, which determine what specific strategies the bank might adopt on that particular day. Therefore, the extent to which the owners or managers can control the actions of their agents, their traders in this case, becomes very important. However, as most rule-based regulation takes the form of exogenous specification for capital for a given level of risk as well as some form of inspection, the effects of such agency problems on the success of regulatory mechanisms have often been ignored. Indeed, this agency problem, which a rule-based system cannot handle, is the central issue in determining the success of an incentive-based regulatory system. Herein lies the trade-off between setting the appropriate regulatory incentives under a rule-based system and agency problems under an managerial-based incentive system. Although a rule-based system avoids the agency distortions, it does not take into account the diversification benefits of holding different types of risks. As a result, banks often feel that they are forced unnecessarily to retain regulatory capital in excess of the risks they are undertaking. However, under a managerial-based incentive system, the owners and shareholders need to be assured that their interests are aligned with those who actually make the strategic decisions, i.e., managers or traders, lest they over expose themselves; moreover, the costs of such over-exposure can have systemic implications. Therefore, to understand the effectiveness of an incentive-based regulatory system, it is important not to consider the bank as a single entity whose actions are directly influenced by the regulatory incentives alone. Rather, to evaluate such a scheme, there needs to be a full understanding of the effect of regulation on the incentives of all the various relevant agents within the bank. Having considered some of the theoretical arguments underlying the debate between incentive versus rule-based regulation, the following sections hope to elucidate these and other issues by presenting two practical cases involving these very issues.

Case 1: The 1999 Basel Proposals: An Incentive Problem In June 1999, the Basel Committee proposed several reforms to its 1988 Capital Accord which suggested greater reliance on private credit rating agencies and internal bank ratings. These proposals tackled issues of credit risk which the Committee had come to feel that the 1988 Accord dealt with inefficiently. The reformed proposal of the Basel Committee specifically recommends replacing the existing system of credit weightings by one which would use private agencies’ credit assessments to determine the risk weights. They are also in the process of allowing some sophisticated banks to use their own internal ratings

Incentive v. Rule-Based Financial Regulation 67 of loans as a basis for calculating capital adequacy ratios. Unfortunately, there are some serious problems which arise by using outside agencies, namely, the issue of providing these agencies with the appropriate incentives to consider the full implications of their ratings on overall systemic risk. One risk in using these private economic rating agents to set prudential standards is the creation of incentives for them to act either in their own interests or those of the borrower in hopes of maximising their own gains through favourable ratings. These issues also then call into question the quality of each rating agency as well as the standards they apply. Consequently, there needs to be some mechanism to reduce such perverse incentive effects for both private credit agencies and their client banks so that they are unable to ignore the costs of increasing systemic risk when maximising their short-run profits—in economic terms, the public good problem. Another concern from the recent Basel proposal is the use of internal ratings in the absence of any documented consensus on capital accounting standards at an international level. If the internal ratings method is adopted, it needs to be scrutinised and acceptable to standards which are acceptable in all jurisdictions. Differences in financial innovations and technological advances in recent years could play a role in providing market participants with an incentive to engage in regulatory arbitrage. If financial regulation is too restrictive in one jurisdiction, both providers and users of financial services can simply move to a less restrictive and less costly jurisdiction. Competitive pressures could result in financial centres becoming engaged in competitive deregulation. This could lead to a bare essential approach to financial regulation as authorities compete to have firms locate within their jurisdictions resulting in a less than socially optimal level of regulation overall. If financial institutions engage in regulatory arbitrage, it is important for different national authorities to co-ordinate the regulatory policies in order to avoid not just the risks inherent in competitive deregulation, but also the dangers of lax rules in one country having an adverse effect on the ability of other countries to enforce financial regulations. Furthermore, to the extent that regulatory laxity represents a higher level of risk, the possibility of systemic spill-over effects on more conservatively regulated jurisdictions needs to be considered. Therefore, although different regulations to some extent will expectedly exacerbate distortions between markets by providing certain advantages and disadvantages to different participants, they should all uphold at least certain minimum standards. If capital requirements are to meet minimum standards, there is first a need for the co-ordination of regulatory policies at an international level. In this regard, national authorities will have to find a balance between national autonomy and co-ordination with other authorities. Since the economic case for international policy co-ordination in capital requirements is based on the presence of cross-border transactions and spill-over effects, these could be used as points of reference in determining the boundaries of co-ordination efforts on regulation. This issue raises questions whether the regulatory framework

68 Rahul Dhumale should be focused on the organisation of markets rather than institutions. Systemic stability regulations tend to be institutionally focused, and this follows directly from the nature of systemic risk which is assumed to be triggered by institutional insolvency. However, one of the features of financial markets today is the increasing blurring of differences between various types of financial institutions. The evolving nature of their various roles means that regulations which are too narrowly focused may be rendered obsolete very quickly. Thus, the importance of an institutional focus within an international context remains important for an incentive-based regulatory framework to be effective.

Case 2: Subordinated Debt: Towards Enhanced Market Discipline One of the more popular and widespread suggestions to increase market discipline has been the proposed requirement for banks to hold SD which is unsecured, uninsured and junior to deposits. The issue of such debt would increase market discipline not only by providing better and more timely information but also by creating a financially sophisticated class of creditors with better incentives for monitoring financial institutions. Although this proposal is not without its technical shortcomings and may not be the ultimate solution, many proponents of SD have argued that the use of SD is a significant step towards the stated goal of enhancing the effectiveness of market discipline. It does so by pricing risk more accurately, by increasing transparency through another observable market price, and by making risk-takers more accountable for their activities. If effective, each of these in turn could reduce systemic risk and the ensuing problems of moral hazard. Banks and individuals from the private sector engaged in excessively risky behaviour have often relied on bail-outs by federal and international insurance schemes to rescue them to avoid the systemic implications of their failures. These problems have become even more severe when governments, in trying to preserve financial stability, have been forced to postpone the closure and continue subsidising insolvent financial institutions for politically rather than economically desirable reasons (for example, some of the Brazilian state banks). One of the main advantages of SD is that it, along with other similarly designed mechanisms, could provide government regulators with earlier warning signals affording them more time to react. Moreover, since this information is directly linked to the market’s assessment of an institution’s risk profile, market transparency should minimise the ability of issuing banks to manipulate their yields. Finally, SD should improve the incentive mechanism as these debt holders feel an even greater need to become better monitors lest they face the possibility of dealing with the greatest losses in the event of a bank failure due to the subordinated position of their claims. Mandatory SD hopes to create an entire class of financially sophisticated creditors who realise that they will not be bailed out by the government should

Incentive v. Rule-Based Financial Regulation 69 the banking organisation fail. Among bank liabilities, SD is uninsured and would be among the first to lose value in the event of a bank failure. Moreover, with the knowledge that in case a bank becomes insolvent, the holders of SD are unlikely to be protected by implicit government guarantees, SD becomes an especially strong instrument of direct market discipline. However, it is important to note in order for market discipline to have its full effects SD must be unsecured and uninsured so that its value is unequivocally threatened when an institution takes greater risks. Proponents also argue that higher levels of SD can increase market discipline indirectly by better attuning the bank’s costs to its risk profile. In the end, it is the market’s view of a particular institution’s risk profile which will affect the SD’s yield and provide better and more timely signals to both the market and the regulator.

Advantages Although the introduction of more risk-based capital standards and risk-based deposit insurance premia is becomingly increasingly common, they are still no substitute for the discerning ability of the market to assess and price risk. Added to this already formidable task for regulators is the ever increasing need to keep pace with institutions whose technical competence becomes more sophisticated and complex on a daily basis. Most banks employ a huge amount of resources in the task of pricing risk, and it is only logical from a regulatory perspective that supervisors should have similar capabilities. Therefore, by encouraging market participants to play a greater role in monitoring and controlling bank risk through SD obligations, regulatory authorities arm themselves with similar if not equal capabilities to sustain systemic stability. It is this very ability of the market to react to even the slightest changes in risk profiles which regulatory discipline alone does not possess. Most regulatory authorities are able only to react to blatant violations of certain standards or rules but are not able to—and often choose not to in order to retain some objectivity—discern and penalise banks for marginal increases in a bank’s risk profile. Most regulatory discipline, even under risk-based capital and insurance premia standards, occurs across broad classifications of risk and is unable to adjust to minor—albeit crucial— changes in a bank’s risk profile.5 As mentioned before, the recent regulatory shift towards risk-based rules has also been accompanied by a commitment from supervisors to a certain course of action in advance such as “prompt corrective actions” and “structured early intervention approaches”. Such forms of intervention include higher capital; structured and pre-specified publicly announced responses by 5 Several examples of the failure of regulatory capital standards to adjust to increasing levels of risk can be seen during the 1997 Asian crisis when bank capital ratios in South Korea, Thailand, Malaysia, and Indonesia were not necessarily reflective of the increased level of risk undertaken by most financial institutions in these countries: see Dhumale, n. 4 above.

70 Rahul Dhumale regulators triggered by decreases in a bank’s performance below established criteria; mandatory resolution of a capital-depleted bank at a pre-specified point when capital still exists; and market value accounting and reporting of capital. One of the problems with the establishment of such pre-fixed rules is that, as mentioned earlier, governments may be tempted to re-write them during difficult times. It is hoped that the SD requirement will supplement these earlier corrective efforts by providing better incentives for regulators to take action sooner and avoid regulatory forbearance. That certain policy-makers have delayed the recognition of bank failures or financed economically unwise bail outs for politically or socially desirable reasons rather than economic prudence has not been uncommon. Such regulatory forbearance has only exacerbated the incentive problem by allowing banks with low or even negative net value to continue their operations. The best policy for supervisors to avoid such intervention often requires that rules be established ex ante which reduce the ability of policy-makers to influence decisions to delay the closing of financial institutions. Reducing regulatory forbearance and occurrences of government bailouts is one goal which an SD requirement hopes to address. Proposals to link regulatory action to signals from the SD market rather than other types of uninsured deposits is one effort in this direction. For one thing, uninsured deposits provide significantly less information to regulators so that a “silent run” by depositors may pass unnoticed whereas a comparable amount of SD dumped on the SD market would most certainly affect its price and alert regulators.

Technicalities Various technical issues still confound even the keenest proponents of the SD proposal. Proposals concerning the maturity, issue frequency, the level of required SD, the size of banks required to undertake an SD mandate, and so on, differ and are numerous. For example, most proposals call for an SD requirement of between 2 and 5 per cent of total assets. If this amount is required in addition to and not instead of a bank’s current capital requirements, it could have other negative effects, namely the creation of a regulatory burden. Whilst it is important to set a requirement large enough to make the discipline matter, it is equally important to realise that a larger capital requirement could place an unnecessarily higher burden on some well capitalised banks causing them to reduce their lending and inhibit economic growth. Similarly, the differences between the SD of “large” and “small” banks needs to be considered closely. To begin, the transaction costs of issuing SD could be too heavy for small banks so that it would impair their overall financial health; furthermore, it is less likely that the secondary market for small banks’ SD would be as liquid, if at all, as that of its larger counterparts. Consequently, there would be very little information contained in the spreads of any but the largest banks. The maturity and

Incentive v. Rule-Based Financial Regulation 71 issue frequency of the SD are also important issues and need to be considered closely. If banks are required to issue SD frequently, it might be too costly for banks giving investors less incentive to monitor as they are assured that their SD will mature before the occurrence of any bad events. Similarly, if the maturity is too long, banks could escape market discipline by being allowed to go for years without issuing any further SD. The issue of participation in this SD market also remains an important matter. Recognising that one of the main goals of the SD requirement is to create a financially sophisticated class of creditors with better incentives for monitoring, perhaps allowing only member banks to become holders of the SD is worth considering. The financial exposure created by one bank for another in this system would provide strong incentives for banks to monitor each other. One natural advantage in such decentralised monitoring arrangements is the mitigation of the free rider problem. By increasing the costs specifically for the defaulted bank as well as that bank which failed as an effective monitor, i.e., through higher yields in the SD market, holders of the SD recognise that any losses they create will have direct repercussions on their own portfolios. Such is the basic idea in Calomiris’ recent scheme for banks to police themselves by requiring every bank to finance a small proportion of its assets by selling SD to foreign banks with the stipulation that the yield on this debt cannot be more than 50 basis points higher than the rate on corresponding riskless instruments. The yield cap guarantees that banks cannot compensate these debt holders with large spreads when they participate in high risk activities.6 As the essence of Calomiris’ recommendation is to reduce these risks, investors, i.e., other banks, will buy SD only when they are sure that the bank’s activities are low risk. If in fact a bank is unable to convince other banks of its aversion to risk, it is not allowed to function. In this way, Calomiris exploits the access to greater and better information which other fellow bankers rather than supervisors are believed to have. Such direct debt holding by member banks might align the incentives of private banks and regulators alike by mandating that the economic costs of high risk activities are not borne only by the public at large.

THE ROAD AHEAD

...

The analysis in this chapter has tried to address most of the issues from the perspective of both regulators and the institutions which they regulate. However, regulators are not the only ones in government who worry about incentives. Much of government activity involves the motivation of private interests to further the public good. When government taxes, it weighs the public good from tax revenues against the incentive effects of the tax. In many 6 Although there are some difficulties in Calomiris’ argument, he suggests some solutions from the outset, e.g., to avoid “cronyism” and collusion within a specific market, buyers of SD would have to be outsiders, i.e., foreign banks.

72 Rahul Dhumale cases, for example, tobacco, the purpose of the tax is its incentive effect rather than the revenue generated. Similarly, when government seeks to limit the level of systemic risk within the financial environment, many of its actions affect the incentives of private financial institutions. This problem has been evident in the recent proposals by the Basel Committee which faces difficult challenges in the future. The Committee has recognised the possible effect via distorted incentives of some of its original requirements, the increased competition in the financial services industry, and the notable effects of market risk on bank portfolios. In finding solutions, it not only has to address each of the former issues, but it needs to account for the differences amongst its potential clients. Clearly, a need exists for a risk assessment framework which not only avoids the problems of potentially cosmetic adjustments to capital ratios but also is easily adaptable to different macroeconomic, institutional and financial conditions. By allowing financial institutions to play a greater role in setting their own capital requirements, the 1999 Basel proposals have recognised the information advantages of the banks themselves and the potential value of rating agencies. However, before these reforms can be put into practice, they require at least the setting of appropriate incentives for private agencies and some standards for internal ratings mechanisms in addition to better coordination of international regulatory standards. In this light, although a mandatory SD requirement is still plagued by several technical issues which require further work, there are some positive indications that such a requirement can allow banking regulation to take greater advantage of the signals provided by the market it governs. It capitalises on market discipline to provide better and more timely information via observable market prices and spreads, prevents regulatory forbearance, and helps to avoid costly bail outs by national insurance schemes. The aforementioned conditions exist to some extent due to the inferior quality and quantity of information received by regulators about the circumstances of any regulated firm relative to the firm’s own information resources. This is true because the firm is the source of virtually all the regulator’s information, and the firm can effectively filter much of that information. Managers are likely to have better information despite the best efforts of regulators to stay informed, and the asymmetry is often exacerbated by the choice of process for making regulatory decisions. The information provided by an active and liquid SD market can complement existing accounting-based capital rules and provide a public trigger during difficult times. By issuing this type of signal, the market not only gives regulators more time to react, but it also increases the accountability of future actions by both the bank and policy-makers. Similarly, by insisting on the subordinated position of such debt, the SD requirement provides greater incentives for a class of financially sophisticated investors to become even better monitors. The issues addressed in this chapter suggest that before designing any incentive-based regulatory mechanism, the trade-off between regulatory and agency incentives must be recognised and addressed. A better understanding of

Incentive v. Rule-Based Financial Regulation 73 these various costs and benefits should result in a more resilient regulatory structure for the future. Regulation itself is an incentive mechanism. The regulator and the firm are engaged in a strategic game in which each party tries to maximise the benefits of its reactions relative to the other party’s actions. Every aspect of regulation including accounting rules, management standards, etc., has an effect on the incentives of the firm. In many ways, it is not that regulators are ever given a choice of whether to use incentives, but rather their focus remains mainly on how to best utilise these incentives to promote the public good or systemic stability.

6

Directors’ Fiduciary Duties and the Approved Persons Regime COLIN BAMFORD

N E W S E T O F legal obligations has been introduced by the Financial Services and Markets Act 2000 (the Act). Those who apply for, and are granted, the status of “approved persons” will be subject to a detailed regime which will make requirements of them in the performance of their functions within the organisations for which they work. The entities will almost always be corporations and an “approved person” will often be a director of that company or of its parent. The question has been prompted whether the establishment of the Approved Persons Regime (sometimes called below the new Regime) might produce a conflict between the course of conduct required of an individual by the new Regime and the actions which the same individual is obliged to take under the terms of general company law. On a more general level, is there a mismatch between the nature of the obligations created by the new structure and those which already exist under company law? The argument in this chapter is that the establishment of the Approved Persons Regime does create the potential for conflict in the duties imposed on company directors, in theory at least. That is not, however, a criticism of the new Regime. Rather, the new Regime highlights the differences between the traditional approach of company law and the modern view of corporate governance. There is a tension between the two because they spring from different roots and serve different purposes. One regulates behaviour so as to safeguard the interests of the public, while the other protects private property rights. In the light of this, legislators and practitioners should be aware of the potential for practical problems to arise. Further, even though the whole subject of company law is under review by the Steering Group of the Company Law Review established by the Department of Trade and Industry (the Steering Group), the differences might point to the need to re-examine the basic approach of company law to the conduct of company managers in a much more radical way than is contemplated at present.

A

76 Colin Bamford

THE APPROVED PERSONS REGIME

The starting point in the design of the structure of the new Regime is the belief that if the Financial Services Authority (the FSA), the body designated as regulator under the Act, is to carry out its function efficiently, it must have confidence in the ability and integrity of individuals who perform certain key roles in the business of institutions which are authorised to carry on investment business. The Act does not specify the precise nature of these controlled functions. It does, however, list three conditions, one of which must be present in any function which is so designated. These conditions therefore identify three categories of activity as follows: ——where the individual deals with customers in relation to regulated business; ——where the individual deals with the property of customers; or ——where the individual is a senior manager. Although the three categories are treated together in the Act, for the purpose of the present discussion only the third category (senior managers) is relevant. The Act establishes the new Regime in Part V, sections 56–71 inclusive. The FSA is given the power to specify ‘controlled functions’. Any such controlled function must have as a constituent part one of the categories referred to above. As far as senior managers are concerned, the condition is set out in section 59(5) as follows: the function is likely to enable the person responsible for its performance to exercise a significant influence on the conduct of the authorised person’s affairs, so far as relating to the regulated activity.

The regulatory control is introduced by section 59(1) which requires that the authorised institution must take care to ensure that no-one performs that function unless the FSA has approved the individual in relation to that activity. Once within the net of the new Regime, an individual is subject to the provisions in the Act which allow the FSA to regulate and guide the conduct of approved persons and to subject approved persons to a disciplinary regime in the event of a breach of the obligations imposed on them. Section 64 of the Act authorises the FSA to issue “statements of principle with respect to the conduct expected of approved persons”. With each statement of principle the FSA must also issue a code of practice “for the purpose of helping to determine whether or not a person’s conduct complies with the statement of principle”. The Act lays out a detailed consultation and explanation procedure which the FSA must follow in drafting its statements of principle and codes of practice. The disciplinary powers and measures are set out in the Act. Section 66(2) provides that an individual who is subject to the new Regime is guilty of misconduct if he has failed to comply with a statement of principle issued by the

Directors’ Fiduciary Duties and the Approved Persons Regime 77 FSA, or been knowingly involved in a contravention of a requirement placed by the Act on the authorised institution for which he works. Action against an individual may result in the imposition by the FSA of a financial penalty “of such amount as it considers appropriate”. In addition, a statement of the misconduct may be published. Approval for the individual may be withdrawn, with the result that he or she will be unable to work within the financial services industry again with a function that requires approval. The nature of the obligations under the new Regime is not described in the Act. Nor would one expect it to be. It is quite clear, however, that the obligations are public, rather than private, in the sense that the existence of the duty does not require the existence of a correlative right on the part of another individual. Indeed, the Act is at pains to “ring-fence” the Approved Persons Regime so that the terms of it do not contaminate the private law rights and obligations of those outside that boundary. Section 64(8) provides Failure to comply with a statement of principle under this section does not of itself give rise to any right of action by persons affected or affect the validity of any transaction.

It is quite clearly the intention to avoid creating liability by imposing legal obligations on approved persons which amount to legal duties owed to outsiders. It is worth noting, however, that the attempt to prevent the new legal obligations from contaminating legal relationships between the approved person and third parties, or between the approved person’s employer and those third parties, may be incomplete. There are several circumstances in which failure to comply with a statement of principle might have the effect which section 64(8) seeks to avoid.

Misrepresentation Suppose that an approved person, while performing the relevant controlled function, makes a representation to a potential counterpart which leads to the formation of a contract. It transpires that the representation was incorrect and misleading. Further, had the maker complied with the applicable statement of principle, he or she would not have made the statement without heavy qualification, or may not have made it at all. In the circumstances, the fact that the statement had been made in breach of the duty to comply with the statement of principle might well be evidence sufficient to turn a finding of innocent misrepresentation into one of fraudulent misrepresentation. Depending on the facts, such circumstances might well “affect the validity of [the] transaction”.

78 Colin Bamford

Constructive trust liability The breach of a statement of principle by an approved person might be evidence of ‘dishonesty’ on the part of the individual concerned, or of the employer institution, if a court were applying the test in Tan,1 in order to decide whether the individual or the institution should be held liable as a constructive trustee.

Non-compliance in conjunction with other facts Sub-section (8) provides only that the failure to comply with the statement of principle does not “of itself” give rise to a right of action. This does not preclude the possibility that the failure to comply, taken in conjunction with other facts, might have the result that a liability exists that might not have come into existence in the absence of that failure.

Contracts connected with an illegality There are circumstances where the validity of a contract or other obligation is left to the discretion of the court. A recent proposal relates to contracts which, although not themselves illegal, are connected with an illegal contract. The law relating to the validity of such agreements is very complex. The Law Commission has recently, however,2 proposed that the law be changed. Its suggestion is that the court should be given a discretion to decide whether, in all the circumstances, an agreement which is connected with an illegal contract should be enforceable. In such a case, it is difficult to see how a court could ignore the fact, for example, that the ancillary contract had involved the breach by one of the parties of an obligation imposed under the new Regime. In such a case, the validity of the transaction would clearly have been affected by the failure to comply with a statement of principle, if that leads to the court declining to exercise its discretion in favour of validity of the contract. Despite these reservations, however, the nature of the legal obligations which arise under the new Regime is clear. The obligations create a duty of compliance “at large”. The need to fulfil those obligations may result in the imposition of a personal penalty on the person who was under the duty. There is, however, no organisation or individual to whom the obligations can be said to be owed.

1

Royal Brunei Airlines Sdn. Bhd v. Tan [1995] 2 AC 378. CP154, Illegal Transactions: The Effect of Illegality on Contracts and Trusts (Law Com Consultation Paper No 154). 2

Directors’ Fiduciary Duties and the Approved Persons Regime 79

THE LAW OF DIRECTORS ’ DUTIES

In contrast, the body of corporate law which deals with directors’ duties has its origins in the law of trusts. In the absence of the concept of separate identity for the corporate vehicle, the individuals to whom property was entrusted by a group, in order that they should use that property for a trading activity the fruits of which would belong to that group of investors would naturally be regarded as trustees. They would owe duties to the beneficial owners of the trading property. The contents of those duties would be found by reference to the general law of trusts. With the growth of the concept of limited liability and separate corporate identity, the link between the directors and the investors was broken. Directors were, therefore, no longer trustees of property for the benefit of the investors. Nonetheless, the idea of the trust relationship remained. The clearest exposition of this can be seen in the leading case of Regal (Hastings) Ltd. v. Gulliver and Others.3 The case concerned a claim against directors for breach of duty to the company. The directors, although acting in good faith, had made a profit for themselves by taking a business opportunity (acquiring shares in another company) which came to their attention in connection with the business of their company. In the Court of Appeal, Lord Greene MR had held that for there to be a claim against the directors it had to be shown that they were under a duty to obtain the shares concerned on behalf of the company. If they were under no such positive duty they had no liability to the company, in the absence of fraud. In the House of Lords, Lord Porter rejected this approach: To treat the problem in this way is, in my view, to look at it as involving a claim for negligence or misfeasance and to neglect the wider aspect. Directors, no doubt, are not trustees, but they occupy a fiduciary position towards the company whose board they form. Their liability in this respect does not depend upon breach of duty but upon the proposition that a director must not make a profit out of property acquired by reason of his relationship to the company of which he is a director.4

His view forms the basis of the law of directors’ duties. A director, although not a trustee, is expected to behave with scrupulous honesty and integrity towards the beneficiary of his duty—the company itself. As a general rule, no-one may seek to enforce the director’s duties, or to seek damages in respect of a breach, except for the company itself (the rule in Foss v. Harbottle5). There are, of course, a number of well-known exceptions to this rule. They do not, however, prove the rule, they illustrate it. The law erects a steel curtain between the duties of the director and the people who might be affected by his actions, by interposing the company itself as the sole beneficiary of the director’s fiduciary duties. 3 4 5

[1942] 1 All ER 378. At 395. (1843) 2 Hare 461.

80 Colin Bamford The case law has concentrated on the requirement that directors should act towards the company with a trustee-like sense of loyalty. The obligations of directors are set out very succinctly in a consultation document published by the Steering Group.6 In summary, these duties are as follows: —to comply with the constitution and to use powers under it for proper purposes; —to run the undertaking for the benefit of the company (i.e., generally speaking, for the benefit of its members as a whole) and not for any other purpose; —to maintain their independence of judgement; —to avoid profiting personally from their position and to avoid conflicts of interest without the consent of the members or the authority of the constitution; —to act fairly as between members; and —to apply reasonable care and skill in exercising all their functions. These duties are different in nature from the kind of legal obligations which are envisaged by the Approved Persons Regime under the Act. They do not prescribe what a director should do, but how he or she should carry out the function of director. The underlying reason for the reluctance of the law to prescribe particular courses of conduct for company directors lies in the origins of this area of law in the law of private property. The law is quite prepared to enforce the obligation of directors, as fiduciaries, to act with propriety when dealing with the property which belongs ultimately to the shareholders. The law will not become involved, however, in deciding how that private property should be applied. That is a matter for the property owners and those to whom they decide to entrust it.

CORPORATE GOVERNANCE

Recent years have seen a growth of interest both among company lawyers and in much wider constituencies on the subject of “corporate governance”. Although one might assume that the phrase related to the methodology employed in the governing of corporations, in practice it has a much more elastic meaning. In the business community generally, the phrase is often used to indicate the institution of management procedures which produce transparency and consistency in decision-making in certain specified areas. The clearest example of this is to be found in the Combined Code, which all listed companies are required to adopt and which is subtitled Principles of Good Governance and Code of Best Practice. 6 Modern Company Law For a Competitive Economy: Developing the Framework (London, DTI, March 2000). This report is referred to below as The Steering Group Report.

Directors’ Fiduciary Duties and the Approved Persons Regime 81 In the popular press, the phrase seems to have an even wider meaning. It is often used simply to indicate that the management of a company is conducted in a way of which the writer approves (or in the case of poor corporate governance, a manner of which the writer disapproves). Among lawyers, the phrase is used more tightly, often to refer to the specific question of directors’ duties. While the “traditional” approach of company law is that a director’s principal duty is one of loyalty, to act bona fide in the interests of the company, there is a strong feeling in some quarters that directors of companies, and in particular of large public companies, should have a legal obligation to protect or further the interests of groups of people or even of abstract concepts. Thus, it is argued, directors have a positive duty to protect the interests of customers, or of the environment. The debate is considered at length in the Steering Group Report. In the report, the wider approach to the identification of directors’ duties is called “the pluralist approach”. The idea is rejected in favour of the retention (as the Steering Group Report sees it) of the traditional view that the principal duty of a director is to: exercise his powers in the way he believes in good faith is best calculated . . . to promote the success of the company for the benefit of its members as a whole.

The Report explains why the wider approach is difficult to adopt, as far as legal principle is concerned: First, a pluralist duty would no longer be a duty of loyalty to the company in the current sense. The loyalty idea would need to be extended . . . to become loyalty to all those interests which may be regarded as legitimately competing with shareholders. The duty thus becomes one to serve a balanced economic purpose. It might be possible, but not in our view very helpful, to redefine this as the interest of the company and thus to retain the notion of loyalty.7

The idea of a fiduciary duty involves a relationship which gives rise to a duty of exclusive loyalty. Just as a man cannot serve two masters, a director cannot be loyal to two competing interest groups. On the present company law view of the nature of a director’s duty, the only escape from the dilemma is, as the Steering Group Report says, to concentrate on the idea that the duty of loyalty is owed to the company and that, in adopting the pluralist view, only the content of the duty and not its nature is altered. The Report regards this as ‘not very helpful’. One might go further. The reality of the present position is that the duty is owed by the director to the shareholders through the company—the fact that there are exceptions to the rule in Foss v. Harbottle shows this. It simply would not be practicable to inject into company law a duty of loyalty owed by directors to other interest groups, to sit alongside the duty to members. The only example of the “pluralist” idea finding its way into law is to be found in section 309 of the Companies Act 1985. This provision illustrates the 7

At para. 3.27.

82 Colin Bamford difficulty created by the imposition of new fiduciary duties and is worth considering with some care. The section is as follows: (1) The matters to which the directors of a company are to have regard in the performance of their functions include the interests of the company’s employees in general, as well as the interests of its members. (2) Accordingly, the duty imposed by this section on the directors is owed by them to the company (and to the company alone) and is enforceable in the same way as any other fiduciary duty owed to a company by its directors. (3) This section applies to shadow directors as it does to directors.

This section raises a number of questions.

Unnecessary and confusing? The generally accepted view from case law is that the primary fiduciary duty owed by directors to their company is “to run the undertaking for the benefit of the company (i.e., generally speaking, for the benefit of its members as a whole) and not for any other purpose”.8 This formulation, that the directors have a trustee-like duty to run the company “for the benefit of” the members, is rather more directed than merely to say that, in performing their functions, they should “have regard” to the interests of the members. It is, of course, perfectly possible to have regard to a factor without reaching a conclusion in which that factor has a determinative weight. If the section intends simply to state the common law, so far as the position of members is concerned, it does not seem to do it very accurately. If, on the other hand, it intends to create a quite separate duty, it appears to be unnecessary and confusing.

“Fiduciary” duty to have regard to employee interests? The obligation to have regard to the interests of the company’s employees is, by implication, described as a fiduciary duty owed by the directors to the company. It is said to be enforceable in the same way as any other fiduciary duty owed by the directors. It is very hard to see how the obligation to have regard to the interests of employees can be called a fiduciary duty. The word “fiduciary” is not an adjective which means “very strong”. Rather, it describes an obligation which arises in a particular situation or because of a particular relationship between the person who owes the duty and the person to whom it is owed. Lord Porter in Regal v. Gulliver (see above) was uneasy, even with the description of the obligation as a “duty” at all. In describing the obligation of the directors to account he said: 8

See the Steering Group’s Report, n. 6 above, para. 3.12.

Directors’ Fiduciary Duties and the Approved Persons Regime 83 Their liability in this respect does not depend upon breach of duty but upon the proposition that a director must not make a profit out of property acquired by reason of his relationship to the company of which he is a director . . . the profit which he makes is the company’s . . .9

The fiduciary nature of the obligation of the directors springs up because of the property, and the relationship of the directors to the owners of the property. It is difficult to see how a duty of the directors to take account of the interests of third parties can be a “fiduciary” duty.

Position of shadow directors The duty is said to be a duty of shadow directors, as well as of directors. Again, it is very hard to see how shadow directors could owe a fiduciary duty to have regard to the interests of the company’s employees “in the performance of their functions”. A shadow director does not have any “functions”. If he did, he would be a director. The paradigm of a shadow director is someone who controls the majority of the shares in a private company, but is not a director. Because of his or her position, the directors who manage the company will consult the majority owner on all matters of significance, and will usually comply with his or her wishes. When that person forms a view on the company’s activities, he or she will be doing so as the owner of the shares. To describe the shadow director as reaching a decision “in performance of his functions” as a shadow director is very strange. Assuming, however, that the section might apply to the dealings of such a shadow director, what is meant by the provision that the obligation of the shadow director to have regard to the interests of employees is a fiduciary duty owed by the shadow director to the company? The relationship between the shadow director (in our example) and the company is that he is the owner of it. If he does indeed owe a fiduciary duty to the company to have regard to the interests of employees, that duty must always take precedence over any inclination he may have to further the interests of the members (himself). Principles of equity dictate that, if his duty in relation to the employees is a fiduciary one, it must be placed above any duty which he owes to himself. The effect is to place the shareholder under an obligation to ensure that, if there is any conflict between the interests of the members and those of the employees, the interests of the employees should prevail. This was clearly never intended. The problem lies in failing to grasp the essential point made by Lord Porter. The duties of directors to a company are duties which spring from the fiduciary relationship and are defined by the rules of equity relating to those who stand in particular positions in relation to property which in reality belongs to others. They are not public law obligations or (as Lord Porter would say) “claim[s] for negligence or misfeasance”. 9

At 395.

84 Colin Bamford The debate on corporate governance, in which it is argued that directors should have wider obligations than are set out in current company law, is in reality about the imposition of duties of this general nature. Just as a citizen can be said to have a duty not to drive a motor vehicle negligently in such a way as to injure his neighbours,10 it is argued that the directors of a company should be under an obligation to manage the affairs of the company in such a way that they further, or at least do not damage, the interests of others. It is not the purpose of this chapter to engage in the debate on whether wider duties should be imposed on directors than exist at present. It is important, however, to understand that the wider obligations for which an argument is being made, for example, an obligation to run companies in such a way that the environment is not damaged by the activities of the company, are not amendments of the common law directors’ fiduciary duties. Rather, they should be seen as public law obligations, of the same kind as those set up by the Approved Persons Regime under the Act.

THE RELATIONSHIP BETWEEN THE APPROVED PERSONS REGIME AND COMPANY LAW

The new Regime will impact on some senior managers who are not directors of UK incorporated companies. This will not, however, usually be the case. The normal situation will be that an individual who is subject to the Approved Persons Regime will also be a director of at least one UK company. Usually, there will be no conflict in fact between the public duties imposed under the Act and the common law duties imposed by the general company law. But it would be unwise to assume that this will always be the case. The regime under the Act is designed to protect consumers and the stability of the financial system. Company law, on the other hand, is designed principally to protect the position of shareholders. It is possible to foresee circumstances where the new Regime will require that approved persons act in a way which protects the wider interest, without reference to strict legal entitlement. For example, in relation to systemic problems such as the recent difficulties with “pension mis-selling” or “endowment mortgage mis-selling” it might be felt by the regulator, quite properly, that public confidence in the system was so much at risk that companies should be required to compensate claimants, even in circumstances where there might be no legal liability, or the claimant could not discharge the burden of proof required. Compliance with that instruction might well, of course, be in the longer-term commercial interests of the company concerned. There might be circumstances, however, where the amounts were so large that the damage to 10 Defined by Lord Atkin in Donoghue v. Stevenson [1932] AC 562, 580 as “persons who are so closely and directly affected by my act that I ought reasonably to have them in contemplation as being so affected when I am directing my mind to the acts or omissions which are called in question”.

Directors’ Fiduciary Duties and the Approved Persons Regime 85 shareholders’ financial interests could not be justified by arguing that their longterm interests merited the present cost, or where the company had no longerterm interests (for example, an insurance company which had ceased writing new business and was in run-off). In those situations there would be a conflict between the general obligations imposed on directors and their fiduciary obligations to further the interests of shareholders. Of more immediate concern to an individual director is the possible conflict between the company law duties imposed on him and the regulations to which he is subject under the Act. These difficulties are, perhaps, not very difficult to reconcile when viewed in the context of an individual company. But the matter is more complex than this. Most large financial businesses have a group structure. The businesses of the individual companies within the group, however, are not self-contained. The structure in many cases has been designed for accounting, tax or regulatory convenience. The management of the business, however, may be conducted on a group basis. Thus, an individual may be a director of a number of companies within the group, but have had management responsibility defined by reference to a particular product and/or a geographical area. The obligations under the new Regime follow the matrix structure of management which will in practice be applied. Company law, however, looks at individual companies. In the case of a financial collapse, it is possible to foresee situations where the public obligations under the new Regime may point to a different course of action than would the strict application of company law principles. An illustration of the kind of dilemma which might arise can be seen in the following example: FINANCIAL HOLDINGS PLC Owes £100m to bond creditors FHUK LTD

FC BANK LTD Net liabilities of £300m Including retail depositors

FC FUTURES LTD

FC FUND MANAGERS LTD

Huge net liabilities as a result of disatrous speculation

Small net worth, but very good business

Owes £350 to FC Bank Ltd

86 Colin Bamford In the example, FC Futures Ltd has lost an enormous amount of money in speculation. That money was largely borrowed from its sister company, FC Bank Ltd. The funds which FC Bank Limited has lent were, in turn, taken by it from members of the public as part of its deposit-taking business. Although it is not suggested that the new Regime, as it is now proposed, would include any requirement of this nature, it is possible to foresee a situation in the future where the Regime might impose on the directors of FHUK Ltd and/or Financial Holdings Plc an obligation to ensure that the affairs of the group were conducted in a way that protected consumers and outside creditors. Suppose, when the facts set out above became known, the directors of FHUK Ltd were approached by a major bank, which offered to buy the valuable and self-contained business of FC Fund Managers Ltd. It might well be at that time that the public interest would be best served if the directors of FHUK Ltd were prepared to sell the shares in FC Fund Managers Ltd for a nominal amount, on condition that the purchaser also acquired the shares in FC Bank Ltd, and undertook to inject sufficient funds into the bank to enable it to repay retail depositors. Such an outcome would generally be regarded as the best solution that could be expected in the circumstances, with the least amount of pain being shared among the lowest number of people. If one applies pure company law principles to the situation, however, one gets a different result. The directors of FHUK Ltd owe their principal fiduciary duty to that company, to manage its affairs for the benefit of its members. Thus, on the collapse of the group, they might feel that their obligation was to ensure that the maximum value was extracted from the assets which they held, for the benefit of their shareholders. That would involve selling the shares in FC Fund Managers Ltd for as much as they could realise, washing their hands of the shares of FC Bank Ltd and FC Futures Ltd, and passing the sale proceeds of the FC Fund Managers Limited shares as dividend up to their shareholder, Financial Holdings plc. That company would then use the funds to pay its creditors, with any surplus going to its shareholders. If the directors of FHUK Ltd took legal advice on the nature of their fiduciary duty in that situation they might well be told that it was not open to them to look to the interests of the depositors with FC Bank Ltd. Those people were the creditors of a separate company, the worthless shares in which were simply one of the assets of FHUK Ltd. This example may seem extreme. Fortunately, major collapses do not happen in the financial services sector very often. When they do, however, they are nearly always more extreme and more lurid than the example given above. There is clearly a difference between the approach taken to directors’ duties by company law, and the approach taken to the obligations of senior managers by the Approved Persons Regime. That difference should be recognised, and the potentially detrimental effects of it removed. There are two ways in which this could be done. First, precedence could be given to the Approved Persons Regime by a provision that, in any action against a director for breach of fiduciary duty,

Directors’ Fiduciary Duties and the Approved Persons Regime 87 it would be a defence to show that the action had been taken in good faith in compliance with obligations under the Act. Or, alternatively, the basis of the law relating to directors’ duties could be readdressed, and directors placed under a public law obligation to behave in an appropriate manner, rather than the law regarding their behaviour merely as a matter of private property law. While the second of these options is the most satisfactory in intellectual terms, it involves a major rethink of the current approach to company law, and is therefore impractical. The sensible approach, therefore, might be to think of the creation of a “safe harbour” for those who comply with obligations under the Act.

7

Fiduciary Duties, Regulation of Companies and Regulation of Individuals SIR ADAM RIDLEY*

INTRODUCTION

from which this chapter results was made just after the publication in June 2000 of two important FSA documents: the Policy Statement High Level Standards of Firms and Individuals; and The Regulation of Approved Persons: Controlled Functions (Consultation Paper (CP) 53). These two documents represented a major step in the evolution of the FSA’s thinking, in the light of the outside world’s responses to the first proposals in The Regulation of Approved Persons (Consultation Paper (CP) 26, of July 1999) and Senior Management Arrangements, Systems and Controls (Consultation Paper (CP) 35 of December 1999). The regulatory regime has evolved further since my comments to the conference on 6 July 2000, in particular with the draft manuals for supervision and enforcement. In February 2001, when this presentation was finally revised, the consultation process was still far from complete. Moreover the principal issues raised then were little affected by developments since the paper was originally delivered in July 2000. It therefore seemed wisest not to attempt to update the original comments comprehensively. To have done so, paradoxically, would have produced a paper both more ephemeral and more speculative than the original. The FSA papers just referred to enshrine vividly the tensions which arise from attempts to regulate both firms and individuals simultaneously in relation to very similar matters. How should one evaluate them? The most important issues to examine are: whether the initial proposals to regulate both firms and individuals appear justified, and whether the procedures proposed meet the basic canons of good regulation.

T

HE CONFERENCE PRESENTATION

* These comments were written in a personal capacity. However they draw heavily on the work undertaken for the Financial Services and Markets Legislation City Liaison Group, particularly by my colleague Peter Beales.

90 Sir Adam Ridley

IS SIMULTANEOUS REGULATION OF FIRMS AND INDIVIDUALS JUSTIFIED ?

At this stage in the debate it is not too soon to offer fairly firm views on whether the simultaneous regulation of firms and persons has been justified by FSA, both analytically and procedurally. Consider first the analytical issue of whether, even if feasible, this double regulation is the best course to follow.

The Best Way? When LIBA members considered the Statements of Principle and Code for Approved Persons in CP26, the approach looked threatening and too prescriptive. It smacked of heavy footsteps rather than a light touch. Moreover the code on which approved people would have to rely did not appear to provide safe harbours on which the diligent and honest employee or manager could rely. Members asked themselves then, in the autumn of 1999, if there were not simpler and more certain ways to proceed, and saw that there were. We described our principal idea briefly in a submission to the FSA on CP26: We believe that the essential objective—and CP 26 reflects this in a number of places— is to have a framework in place which encourages firms to comply with FSA’s Rules. But it will be the decisions taken by individuals which will determine whether satisfactory compliance is achieved in practice. Building on the statement in paragraph 3 of the Code—“for the avoidance of doubt, the Statements of Principle do not extend the duties of individuals beyond those owed by the firm” . . .—we would suggest that a simpler way forward is for FSA to adopt a rule to clarify that individual culpability potentially arises where an Approved Person has knowingly followed a course which would put his firm in breach of a Rule or was reckless about the application of relevant FSA Rules in the area of work for which he was responsible.

In essence, and in other words, once one has carried out “approved persons” tests for a given authorised firm, there is no need for a further detailed statement of the principles applying to those persons, let alone a detailed code describing how they should behave. Something else would, of course, still be needed: a statement about the roles of the managing body. But it could be simple—perhaps on lines of management’s “duty to supervise”. In such a system, if an approved person is reckless, negligent or roguish while carrying out a controlled function and thus puts his firm in jeopardy, he is then subject to FSA discipline. This would, indeed, be an unbureaucratic and light touch approach, of the kind subsequently described so attractively and eloquently in FSA’s New Regulator for a New Millennium.1 The question why the FSA did not adopt it is intriguing.

1

FSA Policy Report (London, February 2000).

Fiduciary Duties, Regulation of Companies and of Individuals 91

Why No Cost-benefit Analysis? The issue of whether such simultaneous regulation has been procedurally justified is not just a rhetorical point. It reflects the requirement in the Financial Services and Markets Act 2000 (FSMA) that FSA policy proposals and activities should be subject to cost-benefit analysis; and that such analyses should be published. When the extremely important CP26 proposals on approved persons were published, the outside world naturally expected that the model just identified would be included in the FSA’s cost-benefit analysis. But, unaccountably, it has not been. Yet such a structure would serve FSA’s two major objectives very well. It would contribute greatly to aligning the incentives of individual managers and senior and approved persons with those of the business and with FSA’s rules applying to that business. Moreover it would also bring home to the individual the supplementary incentives which the FSA feels are needed to give an extra element of protection over and above the requirements imposed on firms themselves. That is the benefit aspect of the proposal. On the other side of the coin, the FSA now proposes a very substantial apparatus of principles and codes. Though outsiders cannot easily evaluate the costs, financial and administrative, of their proposals across the whole regulated sector, we must note they are sure to be significant, given, for example 17 pages of Rules for Firms (plus definitions) in the Policy Statement, and 21 pages of Principles for Individuals and another five pages on their fitness and propriety—both, again, in the Policy Statement. In the light of this how can one take seriously the FSA’s cynical statement in paragraphs 4.7.4–4.7.5 of its Policy Statement that the new regime for persons will lead to no or nominal extra costs when compared with the status quo? Interestingly, FSA itself said: the primary responsibility for ensuring compliance with the firms’ regulatory obligations rests with the firm itself. Normally therefore, the FSA’s main focus in considering whether disciplinary action is appropriate, will be on the firm rather than on approved persons.2

But, if so, do we really need all the extra baggage? Is it really essential, or even helpful, to have massive and complex documentation to tell individuals what their jobs are, when what is wanted is a disciplinary structure which comes into place when they break a requirement of the business in which they are working. As William of Ockham wisely said, “entities should not be multiplied beyond necessity”. Recalling the scandal-driven nature of so much financial regulation, one cannot but ask how far this system of rules and codes is driven by the unshakable 2

Policy Statement, para. 4.14.

92 Sir Adam Ridley conviction that this duplicative apparatus is there only because it is believed to be the only way to get at individual wrongdoers, whose actions so often embarrass the authorities. In sum, then, one concludes both that the overlapping regulation of persons and firms does not seem to be the best way to proceed and that, even if it were, the FSA has not even tried to meet its own cost-benefit standards for justifying what it proposes to do. If it were decided to follow the much simpler approach which LIBA has advocated and which is described above, it could perhaps be done by a very modest amendment to section 66(2)(b) of the FSMA, essentially by extending the wording to cover reckless, negligent or rogue behaviour.

DO THE FSA ’ S PROPOSALS MEET THE CANONS OF GOOD REGULATION ?

Even if we accept regretfully that such a radical simplification is not on the cards for the foreseeable future, we still have to consider whether what is proposed meets the basic canons of good regulation. Amongst other things, the priorities of good regulation will always include flexible, light touch intervention; simple rules; and certainty that conduct in breach of a rule should be foreseeable as such at the time the behaviour occurs. There has been considerable progress in that direction since the original CP26 and CP35, for example clear assurance that there will be no hindsight, and emphasis on reasonableness, objective tests etc. But has the progress gone far enough?

Do the Proposals Provide Certainty? Will the material in the Policy Statement and CP53 give management and individuals the certainty they need? Consider first the approach to standards for approved persons. Principle 3 for approved persons states that: An approved person must observe proper standards of market conduct in carrying out his controlled function.3

For an approved person the practical question is therefore whether, if you conform to the various codes, you can be confident that you are in a safe harbour and not open to disciplinary action. The FSA says in the main text of the Policy Statement, in words that appear to be directed at creating total certainty, that: to avoid any doubt, the FSA’s policy is that compliance with relevant provisions of the Inter-Professionals Code, Code of Market Conduct, or other market codes and exchange rules will tend to show compliance with the code of practice, but will not be a safe harbour in respect of disciplinary action for breach of it.4 3 4

CP 26, App. B (APER) 3. Policy Statement, para. 4.35.

Fiduciary Duties, Regulation of Companies and of Individuals 93 So the goal is to eliminate doubt; the codes and standards for persons are necessary and mandatory—but not sufficient to provide disciplinary safe harbours. Such an uncompromising self-contradiction is not calculated to create a sense of certainty. An analogous problem arises in the interpretation and application of the Inter-Professional Code (IPC). The FSA consultation paper relating to the IPC (CP 47) says that the IPC is largely by way of being guidance, in other words not obligatory.5 Yet in practice it is also being suggested that it will be seen as being obligatory. Another part of CP 47 contains the statement that the Senior Manager will need to take steps “to ensure that the IPC is observed by the firm’s employees for whom he/she is responsible” in so far as the firm’s activities are governed by the IPC.6 The Statements of Principles outlined in CP 26 require a senior manager to take reasonable steps to ensure that the business for which he is responsible complies with the relevant regulatory requirements.7 So is the IPC guidance really rules to be observed? If not, what is its real status? ARE REQUIREMENTS ON FIRMS AND INDIVIDUALS CONSISTENT ?

Another serious puzzle also arises over the relationship between the code for individuals and regulatory requirements for firms. In his chapter Colin Bamford correctly made it clear that such discrepancies must be expected to arise occasionally, for reasons of basic principle.8 To make matters worse, paragraph 4.24 of the Policy Statement says that where approved persons: act in compliance with the requirements on their firm, then that is a relevant factor which is likely to show compliance with the Statements of Principle.

Can one really be satisfied with a mere statement that something is a “relevant factor” in such circumstances? And how far can and should one accept indefinitely a detailed and worked-out regime in which an individual’s conduct is compliant with the obligations on him, and yet is not consistent with the requirements on the firm—or vice versa? If one does so, how can one best provide the certainty practitioners need? Surely the authorities need to excavate and signpost some safe harbours, rather than merely plastering the charts with vague warnings of danger everywhere? Another Freudian statement is to be found in paragraph 4.93 of the Policy Statement, which states that the principles applying to approved persons are: designed to ensure that the individual senior managers through whom the firms act will manage their areas of responsibility appropriately in the light of these obligations and the expectations of the FSA [emphasis added].

Who is to know what these expectations are? 5 6 7 8

Para. 1.21. Para. 1.34, emphasis added. CP 26, No 7. See p. 84.

94 Sir Adam Ridley

THE FSA ’ S CASE AGAINST SAFE HARBOURS : A LOGICAL HOWLER

The FSA’s draftsman’s handling of the central issue of safe harbours, or rather their denial, is not just deeply inconvenient and psychologically intriguing. It is logically exotic, as is well illustrated by the discussion of safe harbours in paragraphs 4.22–4.23 of the Policy Statement. Paragraph 4.22 says that many of those consulted wanted compliance with the Code of Practice to be a safe harbour. The FSA’s response to this was: the code of practice is not exhaustive and is not intended to be. Compliance cannot therefore be a safe harbour [emphasis added].

This is a grotesque non sequitur. A statement can be accurate and reliable without being exhaustive; and it does not have to be comprehensive to be accurate. The FSA’s claim is like saying that because a map is incomplete, it is not to be relied on even in those respects in which all features marked are clear and correct. Yet incomplete does not imply unreliable in what it does cover.

CONCLUSION

All in all, then, the FSA’s development of the overlapping regimes has left many loose ends, which could spell damaging uncertainty to firms and individuals alike if not tied up one way or another. Perhaps worst of all, their joint imposition has yet to be justified.

8

Regulatory Discipline and the European Convention on Human Rights—A Reality Check DANIEL F. WATERS AND MARTYN HOPPER

INTRODUCTION

the role of disciplinary action in financial services regulation and the impact of Article 6 of the European Convention on Human Rights (ECHR) on the disciplinary process. The public and parliamentary debate surrounding the passage of the Financial Services and Markets Act 2000 (FSMA) has rightly focused considerable attention on this issue. As with any consideration of the fundamental civil rights and freedoms enshrined in the Convention, important public policy issues are raised. Sight of these should not be lost beneath the intricacies of the large body of relevant, but sometimes conflicting, jurisprudence on Article 6. We begin with a brief review of the key elements of the new regulatory regime established by FSMA. We then go on to consider the role played by disciplinary action in the context of that regime and contrast that with the function of the criminal law. The application of Article 6 of the ECHR to such proceedings is then considered, looking in particular at whether regulatory discipline should be considered as a “criminal” or “civil” matter for Article 6 purposes. Having reviewed the main principles emerging from the Strasbourg jurisprudence, we go on to consider what guidance can be gleaned from overseas jurisdictions where similar issues have been considered. Finally, we conclude with some observations on the purposes of regulatory discipline, the need to reflect those purposes in applying Article 6 ECHR to such processes, and the need to avoid the “creeping criminalisation” of the regulatory regime.

T

HIS CHAPTER EXAMINES

96 Daniel F. Waters and Martyn Hopper

THE NEW REGULATORY REGIME FOR FINANCIAL SERVICES IN THE UK

FSMA establishes a single statutory regime for the regulation of financial services. It confers on the Financial Services Authority (“FSA”) responsibility for the regulation of all investment, banking and insurance business conducted in the UK.

Statutory Objectives The Act confers duties, powers and functions on the FSA for the purpose of pursuing four objectives. For the first time in this field, the regulator’s objectives have been explicitly enshrined in the statute. They are as follows: Market confidence Maintaining confidence in the financial system, including financial markets and exchanges and regulated activities;1 Public awareness Promoting public understanding of the financial system, including promoting awareness of the benefits and risks associated with different kinds of investment or other financial dealing; and the provision of appropriate information and advice;2 The protection of consumers Securing the appropriate degree of protection for consumers;3 and The reduction of financial crime Reducing the extent to which it is possible for regulated business to be used for a purpose connected with financial crime.4 In discharging its general functions5 the Authority must, so far as is reasonably possible, act in a way which is compatible with the regulatory objectives and which the Authority considers most appropriate for the purpose of meeting those objectives.6 It is clear from these objectives that the Government has placed considerable responsibility upon the shoulders of the FSA. A sound financial services industry 1

S. 3 (In this ch., references to sections are to sections of FSMA unless otherwise stated). S. 4. S. 5. 4 S. 6. 5 The Authority’s general functions are: (a) making rules under the Act (considered as a whole); (b) preparing and issuing codes under the Act (considered as a whole); (c) its functions in relation to the giving of general guidance (considered as a whole); and (d) its function of determining the general policy and principles by reference to which it performs particular functions. 6 S. 2. 2 3

Regulatory Discipline and the European Convention on Human Rights 97 is a very significant contributor to the national economy of the UK, and is crucial to the present and future economic well being of all of its citizens. The comprehensive scope of the FSMA demonstrates Parliament’s recognition that the financial services industry profoundly affects the public interest, and requires a specialised regulatory regime and regulatory authority to oversee it. In addition to the four objectives that drive the work of the FSA, in discharging its general functions the Authority must also have regard to the seven “principles of good regulation” set out in section 2. These are: (1) the need to use its resources in the most efficient and economic way; (2) the responsibilities of those who manage the affairs of authorised persons; (3) the principle that a burden or restriction which is imposed on a person, or on the carrying on of an activity, should be proportionate to the benefits, considered in general terms, which are expected to result from the imposition of that burden or restriction; (4) the desirability of facilitating innovation in connection with regulated activities; (5) the international character of financial services and markets and the desirability of maintaining the competitive position of the United Kingdom; (6) the need to minimise the adverse effects on competition that may arise from anything done in the discharge of those functions; (7) the desirability of facilitating competition between those who are subject to any form of regulation by the Authority. BROAD SCHEME OF FSMA

The main tools which the Act provides to the FSA in order to achieve these objectives are as follows. FSMA imposes a general prohibition on the conduct of regulated financial services business without authorisation. The FSA is given the power to enforce the general prohibition through criminal prosecution and/or civil proceedings for injunctions, restitution and/or winding up.7 The Act then gives the FSA power to grant authorisation to conduct regulated business. In granting authorisation (by giving “permission(s)” to carry out specified regulated activities), the FSA must ensure that the firm or individual satisfies (and will continue to satisfy) certain “threshold conditions”. These include adequate resources and suitability (i.e. the firm or individual must be a “fit and proper person”) to conduct regulated activities.8 The FSA is also given power to require individuals performing certain functions within an authorised firm to be subject to prior vetting and approval by the FSA (“approved persons”).9 7 8 9

Ss. 19, 380, 381 and 401 and Pt XXIV. S. 41 and sched. 6. Ss. 59 and 60.

98 Daniel F. Waters and Martyn Hopper The FSA is given power to make rules governing the carrying on of regulated activities by authorised firms. The FSA must also establish under the Act statements of principle and codes of practice in relation to the conduct of approved persons.10 The investigation powers in the Act enable the FSA to investigate suspected regulatory failings—these include powers to compel production of documents and answers to questions.11 The Authority then has a range of tools available under the Act to enable it to secure compliance with the obligations imposed on authorised firms and approved persons. These include: (1) imposition or variation of conditions on a firm’s permission requiring the firm to take action to remedy problems or protect consumers or to cease/refrain from certain activities;12 (2) administrative or civil proceedings to secure redress for those who have suffered loss as a result of breaches;13 (3) public censure and financial penalties—disciplinary action against authorised firms or approved persons for breaches of regulatory requirements or standards of conduct imposed by the Act/rules/principles;14 (4) withdrawal of a firm’s authorisation or an individual’s approval;15 (5) criminal prosecution powers in respect of certain offences (for example, breach of the Money Laundering Regulations).16 The overall scheme of FSMA is therefore familiar—a requirement to be authorised and thereby subject to prior vetting; rules governing the conduct of regulated persons; and powers to secure compliance (and discipline noncompliance) with the obligations and standards of conduct imposed on regulated persons. The underlying purpose may be summarised as follows. The nature of financial services business is such that it can present significant risks in terms of (a) risk that consumers’ interests may be unfairly disadvantaged by improper or negligent conduct; and (b) risk to public confidence in the financial system arising from poor prudential control, misconduct in the financial markets or the use of financial services for the purposes of financial crime. It is therefore in the public interest to require those engaging in such business to be authorised for that purpose and to satisfy certain minimum requirements as to their suitability and soundness. Those authorised are subject to a specialised body of regulatory rules and requirements aimed at mitigating the risks associated with financial 10 11 12 13 14 15 16

Pt X, s. 138. Pt XI, s. 165. Ss. 43–46. S. 71. Ss. 205–206. S. 33. S. 402.

Regulatory Discipline and the European Convention on Human Rights 99 services business. Compliance with those rules and requirements is monitored and enforced by a specialist regulatory body.

FSA ’ S APPROACH TO REGULATION

In keeping with the statutory objectives, the FSA’s proposed approach to the performance of its functions under the Act has a number of key features. The first of these features is openness and transparency. The FSA handbook of rules and guidance will include clear, publicly stated policies on the way in which the FSA will use its powers and clear, transparent and fair processes. Secondly, the FSA will seek to avoid overly prescriptive rules. Overprescription increases costs of compliance and inhibits innovation. The FSA proposes to use high level rules/standards (“Principles for Businesses” and “Principles for Individuals”) to guide the activities of regulated persons—supplemented by more detailed rules and guidance. The third feature relates to the promotion of an open and co-operative relationship between firms and their regulator that facilitates compliance and mitigates regulatory risks. This feature is grounded in the principle that prevention is better than cure. Fourthly, the FSA will seek to make proportionate, targeted and cost-effective use of the range of regulatory tools available under FSMA to address those issues which present the greatest risk to achievement of the statutory objectives. Fifthly, practitioner and consumer/public interest representation—in terms of both consultation and decision-making—are intended to enhance the specialist expertise and public interests which inform the FSA’s performance of its functions. The proposed FSA Regulatory Decisions Committee, which will be responsible for decisions to exercise disciplinary powers and other formal statutory powers, will include practitioner and public interest representation. Crucially, and indeed as required by the FSMA, the design of this new regulatory regime is consultative and consensual. The FSA has thus far published more than 60 consultation papers describing in detail not only proposed regulatory requirements, but also the FSA’s policy in respect of operating the regulatory regime in practice. There are a good many more on the way. This process of consultation is key to the ultimate success of the new regulatory regime. Regulation in the UK will stand or fall on its ability to gain the understanding and support of its stakeholders, including consumers and the regulated community in particular.

THE ROLE OF DISCIPLINE

The purpose of the disciplinary powers conferred on the FSA is to promote compliance with the regulatory requirements and standards to which authorised

100 Daniel F. Waters and Martyn Hopper firms and approved persons are subject. Formal disciplinary powers are only one of the regulatory tools available to the FSA. It will be possible and desirable to address many instances of non-compliance without resort to formal disciplinary action. The FSA will publicly set out, in its “Enforcement Manual”, its policies on the use of all of its enforcement powers. However, effective and proportionate use of disciplinary powers will play an important role in buttressing the FSA’s pursuit of the objectives set for it by Parliament. Public censure or the imposition of financial penalties provides a powerful incentive to comply with regulatory requirements. Public discipline ensures that non-compliance is not profitable and that firms that invest in compliance are not at a disadvantage to those who do not. Under FSMA the proceeds of any financial penalties are therefore distributed to the authorised firms which are required to fund the FSA. Disciplinary action assists in maintaining public confidence in the regulated industry by demonstrating that regulatory standards are being upheld and in promoting public awareness of regulatory standards through transparent communication of the nature and relative seriousness of failings. Disciplinary powers provide an important intermediate tool between negotiation, informal guidance or warnings and the very serious step of withdrawing a firm’s authorisation or an individual’s approval. The purpose of this range of regulatory tools and responses is to assist the FSA in delivering its statutory objectives—selecting appropriate tools for the particular circumstances.

REGULATORY DISCIPLINE AND CRIMINAL LAW IN THE UK

The use of criminal offences to regulate private business activities has a long and chequered history. Distinguishing features of the role of the criminal justice system in this context may be described as follows. Criminal offences generally embody basic minimum standards of conduct with which all persons are expected to comply. Disciplinary matters concern the regulation of the conduct of a defined group which has a special status in that it is permitted to undertake regulated activities which unauthorised persons are not. Criminal offences of significance generally involve some form of criminal intent or knowledge on the part of the wrongdoer. Regulatory rules and requirements generally impose higher standards of conduct on regulated firms. Criminal convictions therefore signal a greater degree of moral culpability. The liberty of the defendant may be at stake—perhaps the single most important factor that drives the need for demanding standards of due process in criminal proceedings. The criminal justice system provides for the investigation and prosecution of past offences, but not for the on-going, pro-active monitoring and surveillance of private activities. Indeed, in criminal law enforcement, proactive monitoring and surveillance by public authorities would be considered a serious intrusion into citizens’ dayto-day private lives. However, in a regulatory regime such proactive monitoring

Regulatory Discipline and the European Convention on Human Rights 101 is considered necessary and proportionate to effective control of the risks which certain defined business activities present to the public interest. These important differences reflect the underlying public policy reasons for having a specialist regulatory regime: the need to subject the conduct of regulated activities to additional safeguards in order to address the particular risks presented to consumers and to the financial system—risks which would not adequately be addressed by reliance on the criminal law. These differences are also reflected in differences in enforcement processes. For example, regulatory discipline is administered by a specialist tribunal including practitioners, or others with relevant professional expertise. The strict rules of evidence applicable in criminal proceedings do not apply in regulatory proceedings. The standard of proof may be lower than the standard applied in criminal proceedings. Historically, disciplinary proceedings have frequently taken place in private—protection of the commercial and professional interests of the regulated firm or individual until the allegations are proved being valued above the exposure of the proceedings to public scrutiny. Provision for legal aid is generally more generous in criminal proceedings than in civil or disciplinary proceedings. The regulated firm or individual may be required to answer the factual allegations made in disciplinary proceedings in order to enable the regulator or tribunal to reach a conclusion on whether regulatory standards have been met. Generally, in criminal proceedings and investigations the accused has the right to remain silent. However, in a regulatory context, a requirement to answer goes hand-in-hand with the requirement to demonstrate compliance with regulatory standards on an ongoing basis. These differences in process do not mean that disciplinary proceedings are less “fair” than criminal proceedings. The rules of natural justice are not engraved on tablets of stone.17 English law on procedural fairness has long recognised that what fairness requires in practice depends in part on the nature of the decision being taken and the seriousness of the consequences. The different processes adopted in disciplinary matters reflect the fact that the proceedings are concerned with enforcing a specialist set of standards required of regulated entities, in order to provide to consumers and the financial system protection which the criminal law does not provide.

REGULATORY DISCIPLINE AND ARTICLE 6 OF THE ECHR

The differing purposes of criminal proceedings and other legal proceedings are recognised in Article 6 ECHR. Over and above the basic right to a fair trial in Article 6(1), Article 6(2) and 6(3) provides additional due process protections for proceedings which involve the determination of a “criminal charge” including: the presumption of innocence; the defendant’s right to be informed promptly of 17

Lloyd v. McMahon [1987] AC 625, 702, per Lord Bridge.

102 Daniel F. Waters and Martyn Hopper the case against him; the right to legal assistance of the defendant’s own choosing, or if he has not sufficient means to pay, the right to free legal assistance when the interests of justice so require; and the right to examine witnesses. The privilege against self-incrimination has also been held to form part of the right to a fair trial in criminal proceedings. In Saunders v. United Kingdom the Strasbourg Court held that statements obtained from the defendant by compulsion should not be used against him in criminal proceedings—although the precise nature and extent of this principle have not been tested to any great extent in Strasbourg.18 These basic rights are familiar characteristics of the criminal process in most democratic legal systems. They reflect the nature and purpose of criminal proceedings that we identified above. Proceedings involving the determination of a “criminal charge” is a concept “autonomous” to the Convention19—the fact that domestic law does not classify a matter as “criminal” is not conclusive. This principle prevents the state from circumventing the additional rights guaranteed by Article 6 in criminal proceedings simply by re-labelling the “offence” as a non-criminal matter. In determining whether proceedings involve the determination of a criminal charge, the European Court of Human Rights has held that three main criteria apply: first, the classification of the offence under the law of the defendant state, secondly, the nature of the offence and, thirdly, the severity of the possible punishment.20 Where a regulator has power to impose substantial financial penalties and other sanctions in relation to acts of misconduct, the question arises whether the exercise of such powers may involve the determination of a “criminal charge” for the purposes of Article 6. The guidance to be gleaned from the Strasbourg jurisprudence is limited and sometimes appears contradictory. There are a number of cases in which the European Court has held that the imposition of financial penalties, although classified as civil or administrative sanctions under domestic law, is nevertheless “criminal” for the purposes of the Convention. In Bendenoun v. France,21 for example, administrative proceedings conducted by the French tax authorities for the imposition of large financial penalties for tax evasion involved the determination of a criminal charge, even though French law treated the proceedings as non-criminal.22 18 Note Lord Mustill’s caution in R. v. Serious Fraud Office, ex parte Smith [1993] AC 1, 30–1 where he noted that a number of separate immunities are clustered together under the label of the “right to silence”, thereby leading to the misconception that they are all different ways of expressing the same principle, whereas in fact they are not: “it is necessary to keep distinct the motives which have caused them to become embedded in English law; otherwise objections to the curtailment of one immunity may draw a spurious reinforcement from association with other, different, immunities”. 19 Engel v. Netherlands (1976) 1 EHRR 647. 20 Ibid., and see Ravensborg v. Sweden (1994) 18 EHRR 38 for a recent reaffirmation of these criteria. 21 (1994) 18 EHRR 54. 22 See also Weber v. Switzerland (1990) 12 EHRR 508; Öztürk v. Germany (1984) 5 EHRR 409; Lauko v. Switzerland, 4/1998/907/1119; Societe Stenuit v. France (1994) 18 EHRR 38.

Regulatory Discipline and the European Convention on Human Rights 103 However, under the general headings of “the nature of the offence” and “severity of punishment” a number of factors may be relevant in deciding whether regulatory proceedings involve the determination of a criminal charge for the purposes of Article 6, including: (1) whether the offence or breach concerned is one which applies to the population as a whole, rather than one which is concerned with regulating the conduct of a particular group;23 (2) the “colouring” of the offence—whether it is considered “especially grave” or whether it involves conduct of an “anti-social” nature rather than being “purely disciplinary” in nature;24 (3) whether the available sanctions include a substantial term of imprisonment;25 (4) the scale of any monetary penalty which may be imposed and whether there is a possibility of it being converted into a term of imprisonment in the event of default;26 and (5) where a monetary order is to be imposed, whether its purpose is punitive or deterrent in nature or, rather, preventative.27 It should not therefore be assumed that the mere fact that the regulator has administrative power to impose financial penalties means that the regulator’s decision to impose such a sanction involves the determination of a “criminal charge”. A careful examination of the purpose of the regulatory regime, the nature of the conduct that it regulates and the nature and purpose of the sanction will be required in order to form a view on whether the additional protections for criminal proceedings must be afforded, in order to secure a fair trial under Article 6. It is impossible properly to assess such questions using a mechanical, check-list approach. Regard must be had to the underlying policy objectives behind the regime under consideration (as compared with those of the criminal law), and the general principles, explicit and implicit, in Article 6. There are examples of disciplinary proceedings involving the punishment of misconduct which do not attract the protections of Article 6 in its criminal aspect. While the punitive effect which a financial penalty may have is clearly an important factor, it is not conclusive. In Irving Brown v. United Kingdom,28 for example, the European Court declared inadmissible a complaint by a solicitor that a fine of £10,000 imposed by the Solicitors’ Complaints Tribunal for 23 See Öztürk v. Germany (1984) 5 EHRR 409; Weber v. Switzerland (1990) 12 EHRR 508; Ravensborg v. Sweden (1994) 18 EHRR 38. 24 See Campbell & Fell v. United Kingdom (1984) 7 EHRR 165. 25 See ibid.; but cf. Engel v. Netherlands where the Court took the view that the possibility of being detained for 2 days was not, of itself, sufficient to render the proceedings “criminal” for the purposes of Art 6. 26 See Ravensborg v. Sweden, above n 20. 27 See Air Canada v. United Kingdom (1995) 20 EHRR 150; Bendenoun v. France; Raimondo v. Italy (1994) 18 EHRR 237; Welch v. United Kingdom (1995) 20 EHRR 247; Lauko v. Slovakia, 4/1998/907/1119. 28 Application No. 38644/97, admissibility decision of the European Court, 24 November 1998.

104 Daniel F. Waters and Martyn Hopper professional misconduct involved “criminal charges”. The European Court found that the charges related to matters of professional behaviour and organisation within a specific professional group, rather than the conduct of members of the general public. The Tribunal had no power to imprison. Although the size of the fine shows that it did have a punitive effect: the Court observes that the fine was imposed in respect of three serious disciplinary offences and that the level of the fine equalled the amount for which the applicant sold the practice after his brief involvement in it. Nor was there any investigation into the means of the applicant prior to the imposition of the penalty, which is a pre-requisite of any criminal fine in domestic proceedings. There was not involvement of the police or prosecuting authorities in these proceedings. In these circumstances, having regard in particular to the essential disciplinary context of the charges, the Court finds that the severity of the penalty was not, of itself, such as to render the charges “criminal” in nature.

In Air Canada v. United Kingdom,29 seizure of an airliner, unknowingly used for the carriage of prohibited drugs, pending payment of £50,000 to Customs and Excise was found to be a civil sanction. In Ravensborg v. Sweden,30 penalties imposed on a party to civil proceedings in relation to his conduct before the civil courts were held civil—the Strasbourg authorities apparently taking the view that those who are party to court proceedings could be viewed as a limited special status group. In Pierre Bloch v. France,31 an election candidate was required to pay to the French Treasury an amount equal to that by which he had exceeded statutory limits on election expenditure. The candidate could have been prosecuted in the ordinary criminal courts for precisely the same conduct. The European Court held the administrative sanction was not criminal. This was partly on the grounds that it was: in the nature of a payment to the community of the sum of which the candidate in question improperly took advantage to seek the votes of his fellow citizens and . . . forms part of the measures designed to ensure the proper conduct of parliamentary elections and, in particular, equality of candidates.

As these cases demonstrate, it would be naïve for lawyers approaching Article 6 ECHR to assume that there is a bright line to be drawn between criminal and civil processes, or to seek such a bright line in the jurisprudence of the Strasbourg court. Defining the nature of criminal law is a task that has occupied a considerable amount of academic thought—to no simple satisfactory conclusion.32 It has long been recognised that the traditional notion that the punishment of public wrongs is the province of the criminal law, while the civil justice system is concerned with redressing private wrongs, does not withstand scrutiny 29

(1995) 20 EHRR 150. (1994) 18 EHRR 38. 31 (1998) 26 EHRR 202. 32 See L. Farmer, “The Obsession with Definition: The Nature of Crime and Critical Legal Theory” (1996) 5 Social and Legal Studies 57. 30

Regulatory Discipline and the European Convention on Human Rights 105 in the context of the modern state. There has been a move away from the “night-watchman state” of classical liberal theory (whose concern was limited to protecting citizens from violence, fraud or theft and defining the law of contract) to a regulatory state which adopts a wide array of different strategies for regulating private institutions (through licensing, compliance systems, codes of practice etc.). At the same time, ideas of “restorative justice” traditionally associated with the civil justice system are introduced into the criminal justice system.33 As a result, it is increasingly difficult to be certain where the boundaries between criminal and non-criminal enforcement can be said to lie.34 As Farmer observes, criminal law can then be defined only according to the positive, and circular, criterion of whether an act is tried under criminal proceedings: “there is no single, simple moral or other purpose that is capable of holding the whole together”.

GUIDANCE FROM OTHER JURISDICTIONS

In applying the ECHR in the UK, it is helpful and important to have regard to approaches taken not only in Strasbourg but also in other jurisdictions where similar basic standards of civil liberties are upheld. Financial services business is increasingly global and increasingly mobile in nature. If the balance struck in the UK between the rights of firms and individuals conducting such business and the need for effective regulation is significantly different from that in other developed jurisdictions, the consequences for the UK economy may be significant. In this section we review a number of cases from other jurisdictions which may be instructive as to the way in which these issues should be addressed following the coming into force of the Human Rights Act 1998. In Canada the nature of administrative proceedings brought by securities regulators has been considered in Johnson v. British Columbia Securities Commission and Others.35 The court considered the BCSC’s administrative power to order the payment of up to $100,000 in respect of contraventions of the Securities Act. Two brokers registered under the Act were alleged to have breached duties owed to their clients, contravened the rules of the Vancouver Stock Exchange and engaged in conduct that jeopardised the integrity of the capital markets. The underlying facts concerned the distribution of shares in the knowledge that the offering memorandum was defective. The sanctions sought by the BCSC included the imposition of financial penalties. Johnson sought to argue that to compel him to testify was contrary to his right to silence and privilege against self-incrimination in breach of section 11 of the Canadian Charter of Rights. 33 See J. Braithwaite, “The New Regulatory State and the Transformation of Criminology” (2000) 40 British Journal of Criminology 222. 34 See N. Lacey, “Contingency and Criminalisation” in I. Loveland (ed.), The Frontiers of Criminality (London, Sweet & Maxwell, 1995), 1. 35 (1999) 64 CRR 275.

106 Daniel F. Waters and Martyn Hopper The rights guaranteed by section 11 of the Charter are available to persons prosecuted by the State for public offences involving punitive sanctions, i.e. criminal, quasi-criminal and regulatory offences, either federally or provincially enacted. In contrast, private domestic or disciplinary matters which are to regulate conduct within a limited private sphere of activity fall outside section 11. Those matters are subject to the more flexible criteria of “fundamental justice” in section 7 of the Charter. However, where there are potential “true penal consequences”, section 11 will be engaged regardless of the type of provision or proceeding. The potential for a fine may be construed as penal depending on its purpose. A fine levied “for the purpose of redressing the harm done to society at large” is penal, while one imposed to achieve the purpose of the statute will be consonant with the limited private sphere of the activity and thus will not engage section 11. The court held that the fines imposed by the BCSC are properly classified as administrative. The penalty is ordered only after a hearing where the Commission has determined that there has been a breach of the legislation and it is in the public interest to make such an order. Monies paid as an administrative penalty may be expended only “for the purpose of educating market participants with respect to legal, regulatory and ethical standards that govern the operation of the securities market in BC”. The potential for administrative fines did not convert the statute from a regulatory act to a penal statute. The fact that the impugned conduct may also constitute a quasi-criminal act does not affect the characterisation of the proceedings. A similar approach was adopted in Branch and Levitt v. British Columbia Securities Commission.36 There the court held that the purpose of the Securities Act, which is to protect the economy and the public from unscrupulous trading practices, justifies inquiries which legitimately compel testimony because the Act is concerned with the furtherance of a goal which is of substantial public importance—namely, obtaining evidence to regulate the securities industry. In the United States the nature of administrative penalties imposed by Federal regulatory commissions has been considered in the context of the double jeopardy clause of the Fifth Amendment to the US Constitution, which applies to criminal penalties. In Hudson v. United States37 the US Supreme Court held that the Fifth Amendment was not a bar to a federal criminal prosecution of three individuals for offences where the individuals had already paid monetary assessments of between $12,500 and $16,500 before the Office of the Comptroller of Currency (OCC). They had also agreed not to participate in the affairs of any banking institution without agency authorisation. This was notwithstanding that the violations charged rested on the same transactions that formed the basis for the prior administrative action by the OCC. The Supreme Court started from the proposition that Congress intended that the OCC money penalties and occupational debarment sanctions should be civil in nature. The sanctions were 36 37

(1995) 2 RCS 3. (1997) 522 US 93.

Regulatory Discipline and the European Convention on Human Rights 107 not so punitive in form and effect as to render them criminal, despite the intention of Congress. They had not been viewed historically as punishment; they did not involve an “affirmative disability or restraint”; neither sanction came into play only on a finding of scienter; the fact that the conduct might also be criminal was insufficient to render the sanctions criminally punitive; and deterrence might well serve civil as well as criminal goals. Then the Supreme Court, following an analysis clearly resonant of the principles applied by the European Court of Human Rights, concluded: The sanctions at issue here, while intended to deter future wrongdoing, also serve to promote the stability of the banking industry. To hold that the mere presence of a deterrent purpose renders such sanctions “criminal” for double jeopardy purposes would severely undermine the Government’s ability to engage in effective regulation of institutions such as banks.

The Court reversed as “ill considered” a previous decision in Halper v. United States 38 which had held that imposition of “punishment” of any kind was subject to double jeopardy constraints. This need to balance the public interest in effective regulation of a special status group against the procedural rights normally afforded to defendants in criminal proceedings is an issue of public policy which is evident from at least a century of US constitutional law. In the context of companies regulation, as long ago as 1906 the US Supreme Court, whilst acknowledging the general principle that no person can be compelled to give evidence which may expose that person to prosecution for crime, held that a corporation is a creature of the state, presumed to be incorporated for the benefit of the public, and that, being vested with special privileges and protection, it cannot “refuse to show its hand when charged with an abuse of such privileges”.39 More generally, the long-standing “required records” doctrine illustrates the need to balance the policy that underlies the privilege against self-incrimination with the public interest in effective regulation. This doctrine precludes a person invoking the privilege against selfincrimination in relation to: records required by law to be kept in order that there may be suitable information of transactions which are the appropriate subjects of governmental regulation and the enforcement of restrictions validly established.40

Guidance from the other European states which are signatories to the ECHR is much more limited. The French Commission Operations de Bourse has recently faced a number of challenges to the fairness of its proceedings, based in part on the application of Article 6 of the Convention. In the Oury case,41 and more recently an appeal by KPMG,42 the French courts attacked the internal 38 39 40 41 42

(1989) 490 US 435. Hale v. Henkel (1906) 201 US 43. Shapiro v. United States (1948) 335 US 1. Cour de Cassation, Commercial Chamber, 5 February 1999. Court of Appeal, Paris, 7 March 2000.

108 Daniel F. Waters and Martyn Hopper processes of the COB, mainly on the grounds that the Commission, when exercising its powers to impose administrative penalties, had allowed those involved in the investigation of the case to participate in the decision that led to the imposition of the sanction. The cases appear more concerned with whether the requirements of Article 6 apply at all. However, the Paris Court of Appeal has stated that the COB’s powers to impose penalties, in relation to misleading or inaccurate information disclosed to the public regarding public securities, while administrative in nature are, by virtue of the high tariff (10 million FFr or disgorgement of profits) and the publicity given to them, designed to punish general norms laid down by the Commission, and to deter others from similar practices. As a result the Court has said that those principles fundamental to the trial of criminal matters enshrined in Article 6 apply—in particular, the right to an independent and impartial tribunal and the presumption of innocence. However, the privilege against self-incrimination was not an issue in these cases. Further, the Court made it clear that even when it takes action which may give rise to such sanctions, the COB is not required to comply, in all aspects, with the formal requirements of Article 6, since its decisions may afterwards be reviewed by a judicial body offering all of the protections of Article 6. It was even accepted that combining within a single administrative authority the functions of investigation, prosecution and adjudication is not, of itself, contrary to the requirements of Article 6. What must be considered is the way in which these functions are structured. Hong Kong has, since 1991, had a civil tribunal for inquiring into and imposing penalties for insider dealing. In 1993, shortly after the introduction of the Bill of Rights, the Insider Dealing Tribunal’s (IDT) powers to rely on records of compelled interviews were challenged in the case of Lee Kwok-hung.43 Both the then Hong Kong High Court and Hong Kong Court of Appeal held that proceedings before the IDT were not criminal. These decisions rested on a formalistic examination of proceedings before the IDT and concluded that, as there was no criminal charge and the punishment was civil in terms of Hong Kong law, the IDT’s proceedings did not breach the Bill of Rights. However, the relevant ECHR jurisprudence was not considered. Although Australia does not have an entrenched Bill of Rights, as a Commonwealth jurisdiction, its jurisprudence may well be instructive where the same underlying public policy issues are in play. Environment Protection Authority v. Catlex Refining Co,44 for example, includes a comprehensive historical and comparative analysis of the privilege against self-incrimination. This demonstrates that the underlying policy rationale for the privilege is complex and is directed at protecting the privacy and human dignity of the individual, discouraging abuse of investigative power by public authorities and the obtaining of unreliable confessions as well as buttressing the principle that 43 44

Hong Kong Court of Appeal No 7 1993 (Civil). (1993) 178 CLR 477.

Regulatory Discipline and the European Convention on Human Rights 109 the prosecution must prove a criminal charge beyond reasonable doubt without the accused being compelled to admit his guilt. In EPA v. Catlex the High Court of Australia concluded that the privilege could not be invoked by corporate entities on the basis that the historical and modern rationales for the privilege did not demand its extension to corporate entities and such an extension would not strike the correct balance between the power of the state and the rights of corporations.

ARTICLE 6 AND THE MARKET ABUSE REGIME

FSMA establishes a new regime for the regulation of misconduct on the UK’s financial markets—applicable to all those who have dealings in relation to designated organised investment markets, as well as those authorised or approved under the Act. Under the new regime, the FSA will have power to impose financial penalties on persons who have engaged in “market abuse”,45 as well as the power to prosecute the existing criminal offences of insider dealing and market manipulation. Market abuse is defined in section 118. Further guidance will be contained in the Code of Market Conduct to be issued by the FSA,46 which will have evidential weight in proceedings for the imposition of a penalty.47 Broadly speaking, market abuse covers: misuse of non-public information which a person has on a privileged basis; false or misleading impressions about the price, or value or market in investments traded on designated markets; and distortion of the market in such investments. There is a significant overlap with conduct regulated by the criminal offences of insider dealing and misleading statements and practices. But “market abuse” extends to a wider class of behaviours which damage the integrity of organised investment markets. In particular, it applies an objective test of behaviour that the hypothetical “reasonable regular user” of the market would consider unacceptable, rather than being confined to conduct involving criminal intent, knowledge or recklessness. Proceedings for the imposition of a penalty for market abuse will be subject to the right of referral to the Financial Services and Markets Tribunal—the same basic process as for FSA disciplinary proceedings in the regulated community. However, although the sanctions and basic procedures are similar to those for the FSA’s disciplinary powers, there are important differences. First, the market abuse regime is intended to address market misconduct on the part of any person—it is not confined to the regulated community. Secondly, the new regime deals with serious misconduct which is similar in nature to the criminal 45 46 47

S. 123. S. 119. S. 122.

110 Daniel F. Waters and Martyn Hopper offences of insider dealing and misleading statements and practices, which the FSA will also have power to prosecute. These considerations are not conclusive. The market abuse regime is aimed at regulating the conduct of those who choose to participate in the UK’s organised investment markets so as to ensure the integrity of market mechanisms. It imposes standards of conduct different from and higher than the general norms imposed by the criminal law. Financial penalties imposed under the regime are paid back to the financial services industry, thus compensating (albeit indirectly) those who suffer the increased costs imposed on market participants by market abuse. Market abuse proceedings do not result in a criminal record, or the moral opprobrium that attaches to criminal convictions. The liberty of the defendant is not at stake. Nevertheless, while not accepting that the regime is criminal in nature, the Government and Parliament have taken the view that the protections provided in Article 6 in its criminal aspect should be adopted in proceedings for the imposition of a penalty for market abuse. Statements obtained under the FSA’s compulsory investigation powers may not be used against the individual from whom they have been obtained.48 Further, the Lord Chancellor is charged with establishing a scheme for the provision of free legal assistance in proceedings before the Financial Services and Markets Tribunal.49 The scheme will be funded by authorised firms.

ARTICLE 6 AND THE DISCIPLINARY REGIME FOR AUTHORISED FIRMS AND APPROVED PERSONS

However, it has not been considered necessary or desirable to extend these provisions to ordinary disciplinary proceedings in relation to authorised firms or approved persons. This rightly reflects the different purposes served by disciplinary action within the regulated community and the additional responsibilities to which authorised firms and approved persons are subject in order to enable them to carry on regulated activities in a manner which affords adequate protection against the risks inherent in such business. During Parliamentary debate on the Bill, the Economic Secretary to the Treasury put the Government’s position as follows: Authorisation is not solely a privilege that allows a person to carry out financial services business; it also involves obligations, one of the most important of which is to be frank with the FSA about how an authorised person’s business has been conducted, including cases involving misconduct. It would be quite mistaken to allow authorised persons who have committed serious misconduct, which would justify a financial penalty, to escape the consequences simply because the evidence took the form of a statement that they had made to investigators.50 48

S. 174. Ss. 134–136. 50 Debate in Standing Committee A (23 November 1999) on the Opposition amendment to extend what is now s. 174 to disciplinary proceedings. 49

Regulatory Discipline and the European Convention on Human Rights 111 In other words, the nature of the misconduct at which disciplinary sanctions are directed is fundamentally different from that addressed by the criminal law. As much as we may deplore the failures of regulated firms or approved persons, it would be difficult to brigade such failures under the rubric of antisocial conduct. Disciplinary action is directed at failure to comply with specific obligations imposed on the regulated community in relation to the conduct of financial services business—not at enforcing general norms of behaviour of the kind with which the criminal law is normally concerned. As regards the question of the severity of the regulatory sanctions that may be imposed and the purpose for which they are imposed, FSMA gives power to the FSA to impose disciplinary fines upon regulated persons and financial institutions. No limit is set in respect of these fines. On its face this could mean that a fine in any particular case might be very large. However, this unlimited ceiling for the FSA’s fining power cannot be considered simply in the abstract. It must be analysed against the FSA’s stated policy and practice in setting the level of fines. When this analysis is undertaken, it becomes clear that the principal purpose of disciplinary sanctions, as noted above, is to assist the FSA in achieving its statutory objectives by incentivising compliance with regulatory standards. The key factors that will guide the FSA in deciding to impose a fine are: the nature and seriousness of the breach; the conduct of the firm after the breach; the previous regulatory record of the firm in breach; and the relevance of any guidance issued by the FSA on the matter. It is no accident that three of these factors refer to specific aspects of the ongoing relationship of the firm to the FSA. From this it is clear that the choice of disciplinary penalties is heavily dependent upon the FSA’s overall assessment of the regulatory relationship with, and conduct of, the firm rather than purely on an abstract scale of inherent seriousness. The decision to impose a financial penalty on an authorised firm or approved person involves the exercise of judgment by the FSA on the soundness of the firm or individual’s approach to its regulatory responsibilities. As such, it includes a strong element of remediation. The factors that the FSA will consider in setting the level of penalty are equally instructive. These include the nature and seriousness of the breach as mentioned above, as well as the action of the firm in remedying the situation after failure. But another key factor in this calculus is whether the firm brought the matter to the FSA’s attention, and whether it did so in a timely and complete manner. Taken together, these aspects of the FSA’s fining policy make clear the desire of the FSA to incentivise the correction of regulatory failings, and to put the regulatory relationship with the firm or approved person back on a sound footing. Although there is no pre-set limit on the amount of a financial penalty, the policy and practice of the UK regulators to date, which the FSA may be expected to carry forward in broad terms, have been quite restrained in the actual levels of fines imposed. The largest fine imposed by the SROs thus far is £2,000,000, against a fund management group that was part of one of the largest financial institutions in the world. It is not at all uncommon for fines against

112 Daniel F. Waters and Martyn Hopper major UK financial institutions to amount to tens or occasionally hundreds of thousands of pounds. Set against the economic power of the institutions concerned, these levels of fine cannot be characterised as severe. Indeed the existing regulators are not infrequently ridiculed for the level of fine as compared to the balance sheet of some of the financial institutions involved. Such ridicule misses the point of regulatory financial penalties in the UK. The UK regulators have not sought to use financial penalties to inflict real economic pain upon financial institutions. The practice and policy have been to set levels of fines on a comparative scale, whose purpose is primarily to communicate the relative seriousness of the conduct, not to inflict financial pain. Even very large financial institutions will debate a variation in the level of fine of a few thousand pounds, if that amount makes a material difference in where the firm will appear on the “league table” of seriousness. There may be cases, of course, in which a firm profits enormously from its wrongdoing. This is one reason why there is no limit on the FSA’s ability to fine. One could imagine in such circumstances the setting of a fine calculated to ensure that the misconduct is not profitable. But this is in essence a disgorgement of unlawful profit, putting the firm in breach back in the position it would have been in if it had not engaged in the misconduct. A fine that disgorges profit cannot be said to be primarily punitive in purpose.

CONCLUSIONS

Securing a fair trial in regulatory proceedings is vital to securing public confidence in the FSMA regime. However, the introduction of an entrenched Bill of Rights in the UK should not be occasion to adopt a simplistic or mechanistic approach to the question of what constitutes a “fair trial” in the context of a specialist system of commercial regulation. As we have seen, domestic, Strasbourg and overseas jurisprudence all point towards the need carefully to examine the underlying purposes and nature of regulatory proceedings in considering the nature of the procedural protections that should apply. As one commentator has observed in relation to the application of the privilege against self-incrimination, there must be an examination of a scale of potential abuses of power, rather than a “blanket application” of a human right. That examination must respect regulatory imperatives. It should be recognised that processes of commercial regulation are more complex than processes for the investigation of ordinary crime. Regulation must be seen as qualitatively different from traditional criminal controls in numerous respects: while relatively high levels of objective information tend to be available to the regulator, there may be extensive reliance on evidence produced by selfmonitoring and self-policing. Ongoing relationships exist between regulated parties and the regulator. These reflect the regulated party’s knowledge and ability to defend its interests, as compared with the arguably more vulnerable

Regulatory Discipline and the European Convention on Human Rights 113 suspect at the police station. The relationship also reflects the high degree of reliance upon compliance strategies and negotiation as part of the regulatory process.51 FSMA is founded on the concern that the protection of consumers and our financial markets requires those engaging in financial services business to be subject to, and able to demonstrate their compliance with, a scheme of regulatory obligations, duties and requirements. The public interest in effective regulation of the financial services industry is sufficiently important to warrant the imposition of regulatory obligations over and above the general norms imposed under the criminal law. The legitimate and proportionate use of disciplinary sanctions to secure compliance with those obligations is an important tool in ensuring the effectiveness of that regime. These additional obligations that flow with the benefits of authorisation/approval need to be reflected in the nature of the enforcement process. Some of the elements of the right to a fair trial in criminal proceedings may clearly be relevant to civil or disciplinary proceedings as well. The right to examine witnesses, for example, may well be required, particularly where issues of disputed fact arise. A party’s right to advance notice of the case against him is a principle of procedural fairness that the common law has long since applied outside the realm of criminal proceedings. However, other protections afforded in criminal proceedings reflect the nature of such proceedings. The privilege against self-incrimination, for example, is founded, in part, on the important principle that citizens are not generally required to demonstrate their continuing compliance with general norms of behaviour in the criminal law. The application of that privilege, or the “right to silence”, is not consistent with a regulatory regime which legitimately requires those undertaking authorised business to demonstrate their continuing compliance with regulatory standards. The procedural rights afforded by the right to a fair trial in criminal proceedings reflect the nature of such proceedings and the behavioural norms being enforced and the importance of what is at stake for the defendant. To bring regulatory discipline within this realm would raise fundamental issues regarding the purpose of having a regulatory regime—why, in such a world, should regulatory breaches not attract the same consequences as other offences, as well as the same procedures? In other words, public trial, criminal record and imprisonment for serious wrongdoing. The underlying issue is at least as much a policy question as it is a legal one. What does fairness require in this context? Consideration must be given to the important principles of public policy that underlie Article 6, in order to ensure the sensible application of the right to a fair trial in the context of modern systems of commercial regulation. To adopt a simplistic approach that, merely 51 Stallworthy, “The Regulation and Investigation of Commercial Activities in the United Kingdom and the Privilege Against Self-incrimination” (2000) 11(5) International Company and Commercial Law Review 167.

114 Daniel F. Waters and Martyn Hopper because certain sanctions may be punitive in effect, the procedure for exercising such disciplinary powers should adopt the same procedures as are required in criminal proceedings pays inadequate regard to the underlying purpose of these statutory powers and the important public policy objectives enshrined in FSMA.

9

Holding the Balance—Effective Enforcement, Procedural Fairness and Human Rights THOMAS A.G. BEAZLEY

INTRODUCTION : THE HUMAN RIGHTS ACT 1998 H E F I N A N C I A L S E R V I C E S and Markets Act 2000 (FSMA) will dramatically alter the enforcement of law and standards relating to the provision of financial services. One of the major concerns regarding the FSMA has been the extent to which its provisions are compatible with the rights and fundamental freedoms set out in Articles 2 to 12 and 14 of the European Convention on Human Rights (ECHR), Articles 1 to 3 of the First Protocol to the ECHR, and Articles 1 and 2 of the Sixth Protocol to the ECHR (as read with Articles 16 to 18 of the ECHR) (the Convention Rights). Under the Human Rights Act 1998 (HRA) legislation must so far as possible be read and given effect to in a way which is compatible with the Convention Rights.1 If a higher court2 is satisfied that a provision of primary, or in some circumstances secondary, legislation is incompatible with a Convention Right it may make a declaration of that incompatibility.3 That declaration does not affect the validity, continuing operation or enforcement of the provision, or bind the parties to the action in which it is made,4 but such a declaration is likely to lead to amendments to the relevant legislation and other remedial orders.5 It is unlawful for a public authority to act in a way which is incompatible with a Convention Right unless, broadly, as a result of existing legislation it could not have acted differently or it was giving effect to or enforcing existing legislative provisions which cannot be read or given effect to in a way which is compatible with the Convention Rights. A public authority includes a court or tribunal and any person certain of whose functions are functions of a public

T

1 2 3 4 5

HRA, s. 3(1). HRA, s. 4(5). HRA, s. 4. HRA, s. 4(6). HRA, s. 10.

116 Thomas A.G. Beazley nature (other than Parliament).6 A person who is a victim of such an unlawful act by a public authority may bring proceedings under the HRA in the appropriate court or tribunal and rely on the Convention Rights in any legal proceedings, including proceedings brought by or at the instigation of the public authority.7 Subject to various restrictions as regards damages, the Court may grant any relief within its powers which it considers just and appropriate.8 A Minister of the Crown in charge of a Bill in either House of Parliament must, before Second Reading of the Bill, make a statement either to the effect that in his view the provisions of the Bill are compatible with the Convention Rights (a statement of compatibility) or that although he is unable to make a statement of compatibility the Government nevertheless wishes to proceed with the Bill.9

THE FINANCIAL SERVICES AND MARKETS ACT 2000 AND HUMAN RIGHTS

Many people raised concerns about the compatibility with the Convention Rights of the FSMA as originally drafted. Certain of these concerns were investigated in some detail by the Joint Committee on Financial Services and Markets chaired by Lord Burns. The Burns Committee raised specific concerns in its First Report.10 Despite improvements, the Committee continued to raise compatibility issues for consideration in its Second Report.11 The views of lawyers who gave evidence to the Committee have differed on some of these issues, but the Government has felt able to make a statement of compatibility in respect of the FSMA as revised. The principal debate has been as to whether the following were compatible with the Convention Rights: (a) The FSA’s powers of control, discipline and enforcement12 over authorised persons (broadly people or entities who have been authorised to carry on a regulated activity13) and approved persons (broadly people who carry out significant functions for an authorised person);14 (b) The FSA’s power to control and impose penalties in relation to market abuse under Part VIII; (c) The role of the FSA in adjudicating on enforcement and the role and constitution of the Financial Services and Markets Tribunal (the Tribunal).15 6 7 8 9 10 11 12 13 14 15

HRA, s. 6. HRA, s. 7. HRA, s. 8. HRA, s. 19. HL Paper 50, HC 328. HL Paper 66, HC 465. E.g., FSMA, Pts IV, V, XI and XIV. E.g., FSMA, s. 31. FSMA, s. 59. FSMA, Pt IX and sched. 13.

Holding the Balance 117

ARTICLE 6 OF THE HRA

The most critical Article of the ECHR for these purposes is Article 6 which provides as follows: Right to a fair trial In the determination of his civil rights and obligations or of any criminal charge against him, everyone is entitled to a fair and public hearing within a reasonable time by an independent and impartial tribunal established by law. Judgment shall be pronounced publicly but the press and public may be excluded from all or part of the trial in the interest of morals, public order or national security in a democratic society, where the interests of juveniles or the protection of the private life of the parties so require, or to the extent strictly necessary in the opinion of the court in special circumstances where publicity would prejudice the interests of justice. Everyone charged with a criminal offence shall be presumed innocent until proved guilty according to law. Everyone charged with a criminal offence has the following minimum rights: (a) to be informed promptly, in a language which he understands and in detail, of the nature and cause of the accusation against him (b) to have adequate time and facilities for the preparation of his defence (c) to defend himself in person or through legal assistance of his own choosing or, if he has not sufficient means to pay for legal assistance, to be given it free when the interests of justice so require (d) to examine or have examined witnesses against him and to obtain the attendance and examination of witnesses on his behalf under the same conditions as witnesses against him (e) to have the free assistance of an interpreter if he cannot understand or speak the language used in court.

ARTICLE 6 AND THE FSMA

Initial objections that the role of the FSA and the Tribunal in proceedings did not result in determination by “an independent and impartial tribunal” appear to have been, or been largely, overcome in the FSMA and this chapter will not cover any residual areas of challenge there may be in that area. The requirement of a fair hearing contained in Article 6(1) is paramount. It enshrines “the fundamental principle of the rule of law”.16 The Article is not to be restrictively interpreted.17 Article 6(1) applies to all determinations, whether of civil rights and obligations or of criminal charges, but Article 6(2) and (3) provides further express protections for people “charged with a criminal offence”. 16

Salabiaku v. Belgium (1988) 13 EHRR 379, para. 28. “[T]he right to a fair administration of justice holds such a prominent place that a restrictive interpretation of Article 6(1) would not correspond to the aim and purpose of that provision”: Delcourt v. Belgium, 1 EHRR 355 (1970), para. 25. 17

118 Thomas A.G. Beazley This is not to say that the protections in Article 6(2) and (3) are necessarily irrelevant in proceedings where a person is not charged with a criminal offence, but simply that they are mandatory where the person is so charged. Even in a noncriminal case some of those protections may form part of the notion of a “fair” trial under Article 6(1).18 A number of commentators on the FSMA advanced the argument that people charged under the discipline and enforcement regime or the market abuse regime would, at least in some cases, be treated by the courts as people charged with a criminal offence for the purposes of Article 6 of the ECHR. The Government has adopted the following views19: Disciplinary and enforcement charges against approved and authorised persons (other than for market abuse) would be classified by the Courts as involving the determination of civil rights and obligations, for the purposes of the ECHR. This paper seeks to explore this argument a little further, and to consider whether, if there is a risk of classification of the charges as criminal, the impact of that can be reduced; That although there are reasonable arguments that the market abuse regime would be classed as civil proceedings for the purposes of the ECHR, there is a real possibility that market abuse charges might be classified as criminal, and that it would therefore be prudent to ensure that the protections prescribed by Article 6(2) and (3) are put in place in the FSMA for the market abuse regime.

In particular, the following further protections are being put in place for the market abuse regime. To try and fulfil the requirement in Article 6(3)(c) of the ECHR, provision is to be made for legal assistance;20 but this will apply only to individuals who have referred a matter to the Tribunal under section 122(4) (the market abuse regime).21 To try and comply with the European Court’s jurisprudence under Article 6(2), particularly Saunders v. United Kingdom,22 a statement made to an investigator by a person in compliance with an information requirement may be admissible in evidence generally, but no evidence relating to the statement may be adduced and no question relating to it may be asked by the prosecutor or the FSA in certain criminal proceedings “or proceedings in relation to action to be taken against a person under section 123 [which is the market abuse regime]”.23 18 See, e.g., Albert and Le Compte v. Belgium (1983) 5 EHRR 533, para. 30. One area which might need further consideration is legal aid in non-criminal proceedings. It is clear that Art. 6(1) does not require legal aid in all non-criminal proceedings, but if the case is too complex to be dealt with without legal assistance and that assistance is not available due to absence of funds, it might be argued that without funding there was a real impairment of the right of access to a tribunal: cf Airey v. Ireland, 2 EHRR 305 (1979), para. 26; Aerts v. Belgium (2000) 29 EHRR 50, para. 60; and Perks v. United Kingdom (2000) 30 EHRR 33, para. 76. 19 Memorandum from HM Treasury (14 May 1999). 20 FSMA, ss. 129–130. 21 FSMA, s. 129(3). 22 It must be stressed that Saunders does not prevent enforcement of an information requirement or any use of information so acquired; it only prevents use of information compulsorily acquired during a regulatory investigation against the provider of that information in criminal proceedings: see (1996) 23 EHRR 313, paras. 67–81. 23 FSMA, s. 174(2).

Holding the Balance 119

ARTICLE 7

The significance of classification of a charge as “criminal” goes further than Article 6, for Article 7 also provides protection for people charged with or found guilty of a criminal offence. Article 7 provides as follows: No punishment without law No one shall be held guilty of any criminal offence on account of any act or omission which did not constitute a criminal offence under national or international law at the time when it was committed. Nor shall a heavier penalty be imposed than the one that was applicable at the time the criminal offence was committed. This Article shall not prejudice the trial and punishment of any person for any act or omission which, at the time when it was committed, was criminal according to the general principles of law recognised by civilised nations.

ARTICLE 7 AND THE FSMA

Article 7 imposes a requirement of certainty for criminal charges. It has been suggested that fundamental statement of principles for approved persons (the Principles)24 and the definition of market abuse25 are not sufficiently certain to satisfy this requirement. The Government does not regard a charge for breach of the Principles as criminal, and thus does not consider that Article 7 applies to such charges. The Government has stated its view that the provisions for market abuse fully meet the Article 7 requirement for certainty.26 These matters are considered shortly below.

MAY A DISCIPLINARY CHARGE BE CLASSIFIED AS CRIMINAL FOR THE PURPOSES OF THE ECHR ? IF SO , CAN THE IMPACT OF THAT BE REDUCED ?

The Approach to Classification There are a number of decisions regarding classification of a charge as “criminal” (which is an autonomous concept under the ECHR), but it is reasonably well established27 that the following three criteria must be considered. First, as an autonomous concept, it is not, or not simply, a matter for the domestic law concerned how the charge is to be classified for the purposes of the ECHR. However, regard will be had to the classification under domestic law. If the charge is domestically classified as criminal that will or will probably be conclusive. On 24

FSMA, s. 64. FSMA, Pt VIII. 26 Memorandum from HM Treasury (14 May 1999), para. 15. 27 See, e.g., Engels and others v. The Netherlands (No 1), 1 EHRR 647 (1976), para. 82; Campbell & Fell v. United Kingdom (1984) 7 EHRR 165; Lauko v. Slovakia, ECtHR 2 September 1998. 25

120 Thomas A.G. Beazley the other hand a domestic classification as “civil” carries less weight. In the interpretation of any autonomous concept, there may be much to be learned from consideration of the classification adopted in other relevant jurisdictions. For example careless driving which was classified domestically in Germany as a “regulatory” offence was held to be “criminal” for the purposes of the ECHR partly because other contracting states regard such traffic offences as criminal.28 The second consideration is the nature of the offence itself. What is the content of the charge and the conduct concerned? Is the conduct concerned the sort of conduct which is properly classified as “criminal”? If the conduct complained of is generally regarded as criminal (for example careless driving), there is an increased likelihood that the charge will be treated as criminal even if it is domestically classified as civil. One factor in determining whether a matter is criminal is the scope of the rule: a rule whose scope is limited to a particular group as opposed to the general public is more likely to be classified as “civil”: for example, Brown v. United Kingdom.29 The third factor relates to the nature and degree of severity of the penalty. This is frequently an important factor which may bring the charge into the criminal sphere notwithstanding “the non-criminal character of the proscribed misconduct”.30 For example, a penalty involving deprivation of liberty will militate strongly in favour of a criminal classification.31 This may be so even if the risk of deprivation of liberty only follows a failure to comply with the penalty (for example, imprisonment for non-payment of a fine, at least if it is without further “fair” consideration).32 The conclusion can be driven by a single criterion, but the second and third criteria are of greater weight,33 and: [a] cumulative approach may be adopted where the separate analysis of each criterion does not make it possible to reach a clear conclusion as to the existence of a

“criminal charge”.34

Classification of FSA Disciplinary Proceedings For purely domestic law purposes FSA disciplinary proceedings would presumably be classified as civil rather than criminal,35 but that is not conclusive for 28

Öztürk v.Germany (1984) 6 EHRR 409, paras. 46–47. App No. 38644/97, 24 November 1998. 30 Brown v. United Kingdom, n. 29 above. 31 See, e.g., Campbell & Fell v. United Kingdom (1984) 7 EHRR 165, para. 72. 32 Cf Garyfallou Aebe v. Greece, ECtHR, 24 September 1997; Ravensborg v. Sweden (1994) 18 EHRR 38, para. 62. 33 Öztürk v. Germany (1984) 6 EHRR 409, para. 52. 34 Lauko v. Slovakia, n. 27 above, para. 57. 35 See, e.g. Wickramsinghe v. The United Kingdom, App No. 31503/96, 9 December 1997; APB Ltd v. United Kingdom, App No. 30552/96, 15 January 1998; X v. United Kingdom, App No. 28530/95, 19 January 1998. Although the regimes were not exactly analogous and issues were not fully argued. 29

Holding the Balance 121 ECHR purposes. It may well be that other jurisdictions have also classified at least certain financial services disciplinary charges as civil, although I am not aware of a clear statement of the outcome of any comparative analysis (if one has been carried out). In evidence to the Joint Committee on 19 May 1999, the Economic Secretary to the Treasury and the lawyers instructed by the Government were asked about the experience in other countries with regard to ECHR matters. No comparative analysis was provided on that occasion. In relation to solicitors’ disciplinary charges for conduct unbefitting a solicitor the charges were recently described by the European Court of Human Rights as being in an “essentially disciplinary context”.36 Disciplinary measures will be imposed for a wide range of contraventions under FSMA. The contravention may be a relatively unimportant breach of a rather minor technical rule or it may be a serious, deliberate and knowing breach of a fundamental statement of principle issued under section 64 (a Principle) or of a vital Rule made under Part X. At one end of the scale is conduct that no-one would be really likely to classify as criminal. At the other end, the conduct concerned might amount also to criminal conduct. For example, conduct amounting to market abuse by an authorised or approved person or insider dealing by such a person would also constitute a breach of Principle.37 Under the current regime SFA has disciplined people for conduct constituting breaches of the SIB Principles when such conduct might have been treated as insider dealing or other criminal conduct and been charged as such in the criminal courts. However it has been said that the possibility of parallel criminal proceedings does not make the nature of the offence inherently criminal.38 Lawyers acting for the Government have identified as of the utmost importance to classification that the disciplinary regime does not apply to the public at large, but only to members of a particular occupation.39 Certainly in some cases the fact that the regulation concerned applies to a limited profession has been regarded as indicating that a disciplinary charge was not “criminal”. However, defendants may argue that there are material differences between the internal regulation of a traditional profession which might be regarded as partly consensual and the full statutory regime of the FSMA, which applies compulsorily to a substantial industry. It may also be argued that limited scope is not of itself determinative. Certain criminal offences can be committed only by those who engage in a particular activity or are restricted to people in a particular category. For example, prison regulations can be classified for ECHR purposes as criminal (for

36 Brown v. United Kingdom, n. 29 above. In Albert & Le Compte (1983) 5 EHRR 533, the Court did not expressly exclude the possibility of a finding that a disciplinary charge could be a criminal charge. See also Köenig v. Germany, 2 EHRR 170 (1978). 37 See, e.g., FSA, Enforcing the New Regime, (CP 17) and Enforcing the New Perimeter (CP 25) and FSA Response, December 1999. 38 E.g., Wickramsinghe v. United Kingdom, n. 35 above. 39 Joint Committee on Financial Services and Markets Second Report (HL 66, HC 465, May 1999) paras. 9–12.

122 Thomas A.G. Beazley example, Campbell and Fell v. UK40), but prison discipline applies only to prisoners. On the other hand, there are sound reasons to distinguish between a rule applying to a limited group such as prisoners, and a rule applying to a limited group such as authorised people, who are given in effect a licence to practise. The disciplinary measures involved also vary widely.41 They range from public censure42 to a financial penalty.43 The size of the financial penalty is unlimited, although the FSA must issue a policy with respect to the imposition and amount of penalties.44 In addition, whether or not identified as “disciplinary”, misconduct may lead to a person’s authority or approval being withdrawn.45 In the argument that a disciplinary charge may be classified as criminal for the purposes of the ECHR, the possibility of unlimited fines has played a distinctive and substantial role. The fine is, after all, a common penalty for a criminal offence. Many commentators emphasise that unlimited substantial fines may be treated as a powerful indicator of a criminal charge. Whilst stress on fines (of a significant amount) may well be understandable for this purpose as a matter of legal analysis, many regulated people regard the sanction of de-authorisation as of far more concern and as far more damaging than even a very large fine. Indeed in negotiation and argument it is usual to find the regulated person arguing for a substantial fine rather than expulsion without a fine. It is a peculiarity that such people would consider that added protection against a fine would be of no or small comfort if there were no such protection against expulsion. Regulatory tribunals have tended to treat expulsion cases as the most grave and as requiring the most cogent proof. Further, whilst the deprivation of the opportunity to make a living in the way a person is accustomed to do is not, as such, an existing criminal penalty, at least in modern England; if it were, it would be regarded as a penalty of some gravity. The fact that a particular criminal penalty would have the effect of depriving a person of his livelihood is treated as highly material in sentencing in the criminal courts. Is it right to treat the “penalty” of expulsion as indicative of a civil offence, when, if the penalty were available in criminal proceedings, it would be a harsh one? At least part of the answer to these sorts of questions is to consider the purpose of the measure concerned.46 When a person is de-authorised the consequences are punitive for the person concerned47 but, in general, the purpose of the de-authorisation ought, perhaps exclusively, to be the protection of the 40

(1984) 7 EHRR 165. E.g., FSMA, s. 66. 42 FSMA, s. 205. 43 FSMA, s. 206. 44 E.g., FSMA, ss. 69 and 210. 45 E.g., FSMA, Pts IV and V. 46 See, e.g., Wickramsinghe v. United Kingdom, n. 35 above. 47 The power to expel (and suspend) has been described domestically as “penal”: John v. Rees [1970] Ch 345, 397, per Megarry J. In Lewis v. Heffer [1978] 1 WLR 1061, 1073, Lord Denning identified Megarry J’s words as applying to suspensions “which are inflicted by way of punishment” and distinguished suspension for “good administration”. 41

Holding the Balance 123 investing public.48 Here again the distinction is not absolute because criminal penalties also have a protective effect, but the primacy of the protective purpose in de-authorisation and the relative absence of punitive purpose will count against a classification as criminal. The distinction between de-authorisation and disciplinary punishment is also vital. There is a significant difference between the decision whether to permit a person to continue as authorised, that is to continue to license him as fit and proper, and the decision whether a person who is and remains fit and proper should be fined or otherwise punished for an infraction. It has recently been said that if the penalty is “punitive and deterrent rather than compensatory” that “may suggest that the matter is ‘criminal’ in nature if the penalty is sufficiently substantial”.49 However, the element of deterrence should not of itself lead to a classification as “criminal”. De-authorisation for disciplinary offences may well have a deterrent effect, but it is not of itself indicative of “crime”. The fact of publicity for a penalty is sometimes mentioned as indicative of the charge being criminal. This factor would, if it were really a factor at all, surely be of little weight. Publicity may indeed be damaging, but publicity of an adjudication of all sorts of civil rights disputes can be damaging. A sufficiently substantial fine for a disciplinary offence is properly to be regarded as punitive and deterrent rather than compensatory. This is only a factor. It does not follow that the charge which led to the fine will be treated as criminal for the purposes of the ECHR. It can be argued that the FSA fines cannot lead to deprivation of liberty. Even where a fine can eventually lead to such deprivation the charge is not necessarily criminal. In Brown v. United Kingdom the fine of £10,000 could, via a finding of contempt, have led to imprisonment, but the charge was held to be non-criminal. It must be noticed that the size of the fine in isolation does not define whether the charge is criminal. Criminal charges frequently involve small fines as is clear from Öztürk.50 Another factor in the decision in Brown v. United Kingdom appears, rather surprisingly, to have been that there was no investigation of the means of the defendant prior to the imposition of the penalty, which investigation is “a prerequisite of any criminal fine in domestic proceedings”. In disciplinary proceedings such investigation has not been routine, but if a defendant has raised the point it has usually followed. This must continue. It is hard to see how such an investigation could really suggest a criminal charge. Attention has been drawn by some commentators to the classification by the French courts of a securities regulation offence as criminal.51 It is difficult to judge the real significance of a single case in isolation in unfamiliar jurisprudence, but 48 See, e.g., Bolton v. The Law Society [1994] 1 WLR 512, 518–19, where the Court of Appeal distinguished orders primarily directed to punishment and those directed to the maintenance of a well-founded confidence in the trustworthiness of all members of the legal profession. 49 Brown v. United Kingdom, n. 29 above. See also Bendenoun v. France (1994) 18 EHRR 54, para. 47. 50 (1984) 6 EHRR 409. 51 Oury, Court of Appeal, December 1998; Cour de Cassation, 25 January 1999.

124 Thomas A.G. Beazley the French courts stressed the level of the penalty, the fact that it was intended to be punitive and deterrent, and the publicity attached to it.

Can FSA Minimise the Potential for Disruption? No one can be absolutely certain of the final outcome of this debate. There will probably come a case which is sufficiently near the line and important for a party to pursue the argument through the courts.52 Although the fairness protections built into the FSMA (see, for example, the extensive protections regarding notices, representations, publicity and disclosure of potentially adverse material in Part XXVI) may result in few cases being fought out. In the meantime there is a degree of uncertainty, but the regulators may well feel in many cases that the issue can be largely avoided. Take the Saunders prohibition on the use of compelled answers at trial: although it may be necessary to use his own compelled answers against a person in some cases, in many (perhaps most) it is not. Careful gathering of evidence in other ways must become a priority. The issue of “certainty” is considered further below, but in most cases there should be no need to pursue a disciplinary charge which is not sufficiently certain to satisfy the criminal test. Whether financial assistance will ever be provided is another matter, but in most cases the regulated person can afford a defence. These are matters which the FSA will have to judge in each case, but they will have to be judged fairly and in accordance with the ECHR. The FSA cannot and must not risk prejudicing effective enforcement because of these concerns (which the Government has not accepted), but it may reach pragmatic decisions on a fair and equal basis to minimise the risk of serious disruption to the regulatory process.

MIGHT DISCIPLINARY OR MARKET ABUSE CHARGES BE REGARDED AS UNCERTAIN IF ARTICLE 7 APPLIES ?

The FSMA has been criticised during its passage through Parliament on the ground that in various respects it would result in charges being brought which did not satisfy the requirement of certainty that has been derived by the European Court of Human Rights from Article 7 of the ECHR. It will be recalled that Article 7 applies only to criminal offences, so that this problem will as such arise only if a charge is classified as criminal. There are probably two principal areas of potential challenge on the basis of lack of certainty. The first is a disciplinary charge based solely on breach of a Principle. The second is the definition of what constitutes market abuse.

52

The decision ought to be case by case, but guidelines may emerge.

Holding the Balance 125

The Requirement of Certainty The relevant principles are that: only the law can define a crime . . . the criminal law must not be extensively construed to the accused’s detriment . . . an offence must be clearly defined in law. This condition is satisfied where the individual can know from the wording of the relevant provision and, if need be, with the assistance of the courts’ interpretation of it what acts and omissions will make him liable.53

Plainly, conduct which was not previously punishable should not be made so by court decision against a person in a particular case. This does not mean that there cannot be “gradual clarification of the rules of criminal liability from case to case, provided that the resultant development is consistent with the essence of the offence and could reasonably be foreseen”.54 The Principles It may be that at the margins there could be problems of certainty with particular charges for breaches of the Principles, but it is not a valid objection of itself that a requirement is widely drawn.55 There already is substantial guidance on the sort of conduct which fell foul of the SIB Principles, and will or is likely to fall foul of the Principles. Such guidance will continue both from the Tribunal and the FSA. Further, in most cases where breach of the Principles rather than a particular rule has to be relied on, the issue is whether the defendant did or did not do something or did or did not have a particular state of knowledge, not whether, if he did do it or know it, it was wrong. For example, it is generally clear whether someone has acted without integrity once the facts and his state of knowledge at the time are known. In any event, if it is not clear, he is not very likely to be convicted. There is no realistic alternative to high level principles if regulation in this field is to be effective. In the area of financial services regulation it is impractical to define in precise rules all conduct which is prohibited. There are judicial comments criticising assertions of this sort in different contexts,56 but the complexity of financial services, the speed of change and the ingenuity of the participants all combine to justify the assertion in this context. The rationale and need for high level principles as a tool for enforcement is clear. The more, and the more up to date, guidance there is the better, but FSA will have to take as firm a line 53

Kokkinakis v. Greece (1993) 17 EHRR 397, para. 52. SW v. United Kingdom (1995) 21 EHRR 363, para. 36. 55 Muller v. Switzerland (1988) 13 EHRR 212, para. 29. 56 E.g., Westminster City Council v. Blenheim Leisure (Restaurants) Ltd., The Times, 24 February 1999 (QBD). This case concerned prosecution of a licensee for permitting acts of prostitution to take place on its premises on the grounds that it amounted to a failure to “maintain good order” in the premises. Brooke LJ strongly criticised the use of the vague concept of the maintenance of good order to prohibit prostitution and commented that criminal offences “must be clearly defined in law”. 54

126 Thomas A.G. Beazley as it can against undermining of use of the Principles for discipline if regulation is to be as effective as possible.

Innovation There is an argument that without certainty innovation is stifled by market participants acting unduly cautiously. There are a number of practical answers to this, such as efficient provision for consultation, and the weight of the argument may be exaggerated by the profession. For example, if a market participant wants to act in an innovative manner, he has a variety of ways of showing at least his integrity. Particularly vital is the decision whether or not to consult in advance internally, in a full and frank manner, with knowledgeable and competent other practitioners, with compliance and in-house lawyers (if any), and outside lawyers if appropriate. If he does so consult in an open and full manner he goes a long way to rebutting the allegation that he is acting without regard to the regulatory requirements.57 If he does not, he will need to explain why not, and inferences may be drawn against him, at least if the explanation is unconvincing. Of course it is then said that compliance and legal advisers tend to be too cautious at the margins. That may be so in some cases, but the assistance of the regulator can sometimes be available and it can always be sought.

Market Abuse In the field of market abuse the Government has gone some way to meet the criticisms of lack of certainty. For example, the likely view of the conduct in question of “a regular user of the [that] market” has been included as a condition of guilt.58 This will require evidence and may give rise to difficulties of proof in a borderline case, but it does provide a degree of certainty protection. The conduct will at least be judged by the understanding of other market participants, not simply by the view of the tribunal. The ultimate content of the Code will be all-important. There can be no real objection on grounds of certainty to clarification of the general prohibition by a Code. Clarification by judicial decision is already accepted as satisfying Article 7. Whether the Code is itself sufficiently clear in any particular case is another matter, but there is plenty of opportunity for outside representation. The Government has now reacted to criticism by providing59 that if a person does that which is said by the Code not to amount to market abuse, he is not guilty of market abuse. Market participants are thus safe to act in ways approved by the Code. 57 See, e.g., FSMA, s. 118(2)(b) which expressly refers to such material in the context of market abuse. 58 FSMA, s. 114 (1)(c) and (2)(e). 59 FSMA, s. 117.

10

Regulating the Regulator—A Lawyer’s Perspective on Accountability and Control ALAN PAGE

INTRODUCTION H E U K A P P R O A C H to regulation has been widely criticised. Critics argue that regulators possess excessive powers while being subject to few effective constraints. For Majone, “[t]he American experience shows that a highly complex and specialised activity like regulation can be monitored and kept politically accountable only by a combination of control instruments: legislative and executive oversight, strict procedural requirements, public participation and, most importantly, substantive judicial review. Measured against these standards, regulation in Europe is seen to be highly discretionary, suffering from weak accountability to Parliament, weak judicial review, absence of procedural safeguards, and insufficient public participation”.1 Majone’s criticisms are echoed by Harlow and Rawlings for whom “the design of ‘regulation UK style’ exhibits serious deficiencies in the arrangements for accountability and participation”. These deficiencies, they suggest, put in issue the legitimacy of agency action.2 The FSA has not been immune from such criticisms. The parliamentary proceedings on the Financial Services and Markets Bill were punctuated by criticisms of the FSA as “ legislator, investigator, prosecutor, judge, jury and executioner”.3 Criticisms that regulators are insufficiently accountable may of course disguise disagreements over the scope or substance of regulation.4 One thing which the arguments about regulatory accountability underline however is the lack of an alternative theory or practice of accountability to that provided by the doctrine

T

1 2

G. Majone, “The Rise of the Regulatory State in Europe” (1994) 17 West European Politics 93. C. Harlow and R. Rawlings, Law and Administration (2nd edn., London, Butterworths, 1997)

351. 3 Tyrie, “Forging a regulation sledgehammer”, Financial Times, 10 April 2000; Centre for Policy Studies, Leviathan at Large (London, 2000). 4 C. Graham, “Is there a Crisis in Regulatory Accountability?” in R. Baldwin, C. Scott and C. Hood (eds.), A Reader in Regulation (Oxford, OUP, 1998) 484–5.

128 Alan Page of ministerial responsibility.5 The conventional answer to concerns about regulatory accountability is to assert that regulators are accountable via ministers to Parliament. In the case of the FSA, this is indeed the claim that has been made. The “prime line” of accountability is thus said to run through ministers to Parliament.6 The difficulty with this claim is that it carries very little conviction. Sir Christopher Foster in a recent lecture describes the claim that ministers are accountable to Parliament for what their departments and agencies do as a “fiction”, a fiction moreover which is “profoundly misleading, often absurd, frequently inconvenient and sometimes damaging in that it prevents genuine instruments of accountability from being developed”.7 If the claim that the FSA is accountable is to be sustained, it seems clear that the roots of its accountability must be sought elsewhere. The literature on regulatory legitimacy8 identifies five models of regulatory legitimacy, three of which are directly relevant to an enquiry into regulatory accountability and control. The three are the legislative mandate, oversight and due process models.9 For ease of exposition I have found it convenient to draw a distinction between those mechanisms of oversight which are of general application and those which are primarily concerned with the redress of individual grievances. The argument of this chapter in summary is that in the arrangements that have emerged one can discern the outlines of an alternative model or theory of regulatory accountability, one that is not over-reliant on fictions about ministerial responsibility. Key elements of that model include the FSA’s statutory objectives, which provide the basis for a ‘positive’ system of accountability, due process and oversight. The question, as always, is whether that model has been taken far enough, or whether Treasury fears that the FSA’s effectiveness may be compromised have meant that it is subject to insufficient control. Sight must also not be lost of the alternative possibility that control has been taken too far, with the result that the FSA’s regulatory effectiveness may be impaired.

5 C. Foster, “Two Concepts of Accountability: Is a Bridge Possible Between Them”, lecture to the Public Policy and Management Association, 10 November 1999, 18. 6 First Report from the Joint Committee on Financial Services and Markets, HL (1998–99) 50, HC (1998–99) 328, Evidence q 2, Howard Davies. 7 Foster, n. 5 above, 19, “The official line that these bodies are still accountable, via Ministers, to Parliament is an unconvincing and inadequate description of the real position”: P. Riddell, Parliament under Pressure (London, Gollancz, 1998), 32. 8 Harlow and Rawlings, n. 2 above, 309–12; R. Baldwin and C. McCrudden, Regulation and Public Law (London, Weidenfeld & Nicolson, 1987), chap. 3; R. Baldwin, Rules and Government (Oxford, OUP, 1995), chap. 3; Jones, “Administrative Law, Regulation, and Legitimacy” (1989) 16 Journal of Law and Society, 410. 9 The others are (a) the expertise and (b) the efficiency and effectiveness models.

Regulating the Regulator—A Lawyer’s Perspective 129

LEGISLATIVE MANDATE

The legislative mandate model asserts that agency action is deserving of support when it is authorised by the legislature.10 This is a potentially powerful claim, but one which commentators have tended to discount. Regulators typically possess a large measure of discretion, the argument runs, and the more discretion there is the less a statutory mandate can be used to justify actions and policies.11 The FSA is no exception in possessing wide discretionary powers. In contrast to the Financial Services Act 1986, however, the Financial Services and Markets Act 2000 establishes a framework of objectives and principles within which the FSA is to carry out its general functions. The four regulatory objectives are: • • • •

maintaining confidence in the financial system, promoting public understanding of the financial system, securing the appropriate degree of protection for consumers, and reducing the extent to which it is possible for business falling within the scope of the legislation to be used for a purpose connected with financial crime.12

In carrying out its general functions the FSA is required, “so far as is reasonably possible”, to act in a way which is compatible with and which it considers most appropriate for the purpose of meeting those objectives.13 The general functions to which this obligation applies embrace rule-making, the preparation and issue of codes, the giving of general guidance and the determination of the general policy and principles by reference to which particular functions such as the grant and withdrawal of authorisation are carried out.14 The four regulatory objectives are supplemented by seven regulatory ‘principles’, which the Act requires the FSA to have regard to in carrying out its general functions.15 The seven principles, or “relevant considerations” in the language of administrative law, cover the efficient and economic use of resources; the responsibilities of those who manage the affairs of authorised persons; the principle of “proportionality”; the desirability of facilitating innovation in connection with regulated activities; the desirability of maintaining the competitive position of the United Kingdom; the need to minimise the adverse effects on competition that may arise from anything done in the discharge of its general functions; and the desirability of facilitating competition between those who are subject to any form of regulation by the FSA.16 A failure to have regard 10

Baldwin, n. 8 above, 43. Ibid. 12 Financial Services and Markets Act 2000, ss 2(2), 3–6. Subsequent references to ss., etc. are to ss., etc. of the FSMA unless otherwise stated. 13 S. 2(1). 14 S. 2(4). 15 S. 2(3). 16 Ibid. 11

130 Alan Page to these principles could potentially form the basis for a claim that the FSA had acted ultra vires (but see below). The device of statutory objectives is not new: “fanfare” provisions setting out the general scope of a body’s duties were once routinely included in statutes setting up public bodies.17 The combination of objectives and principles however represents the most ambitious attempt yet made to define the public interest in financial services regulation. The lack of any equivalent statement of objectives in the Financial Services Act 1986 was widely regarded as one of its major weaknesses, affording ample scope for disagreement about the purposes the Act was intended to serve.18 In A New Regulator for the New Millennium, the FSA describes how it proposes to translate the statutory objectives and principles of good regulation into regulatory activities. As well as an “effective discipline” on the work of the FSA,19 the objectives and principles are also seen as having an important role to play in securing its accountability. By defining the public interest in financial services regulation the objectives and principles offer a benchmark or set of binding standards against which the FSA can be called to account for its performance.20 In its annual report the FSA is thus expected to report on the extent to which in its opinion the regulatory objectives have been met and, following an amendment to the Bill, its consideration of the principles.21 One question which is raised by this shift towards what has been termed a positive system of accountability in which what regulators are to do, and are accountable for, is prescribed in some detail, is whether effective means exist to scrutinise FSA’s performance against its objectives.22 I come back to this question below. The imposition of general duties on the FSA also opens up the possibility of judicial review proceedings in the event that those duties are breached, but the scope for judicial enforcement is limited by the fact that the obligations apply to FSA’s rule-making, code issuing and general guidance functions “considered as a whole”.23 Individual acts of rule-making, code issuing or general guidance will therefore not be open to challenge on the grounds that they are contrary to the objectives and principles. The procedural requirements (below) that attend FSA decision-making make it unlikely, however, that the question of their compatibility with the objectives and principles will not be thoroughly ventilated before decisions are taken. Individual decisions, on the other hand, will be open to

17

See, e.g., Ministry of Health Act 1919, s. 2. A. Large, Financial Services Regulation: Making the Two Tier System Work (London, Securities and Invesments Board, 1993), paras. 1.3.i and 1.6–1.9. 19 Joint Committee, n. 6 above, Evidence, q 22, Howard Davies. 20 In other contexts the lack of such standards has been recognised as impairing the effectiveness of accountability: E. Roll, Independent and Accountable: A New Mandate for the Bank of England (London, Centre for Economic Policy Research, 1993), 48. 21 Sched. 1, para. 10(1). 22 Foster, n. 5 above, 24–5. 23 S. 2(4). 18

Regulating the Regulator—A Lawyer’s Perspective 131 challenge on the grounds that the policy on which they are based is in breach of the objectives and principles.

OVERSIGHT

The oversight or checks and balances model represents the terms in which we are accustomed to thinking about regulatory accountability. In this model regulatory legitimacy is a function of the subjection of the regulator to adequate checks and balances; it “expresses the idea that the exercise of broad agency discretion is rendered more acceptable by the presence of effective channels of accountability and external control”.24 Such controls include judicial controls, which I deal with separately below.

INTERNAL CONTROLS

The FSA is governed by a board which must have a majority of non-executive members;25 in addition to an executive chairman, the board currently comprises 11 non-executive members and two executive members. The Act follows the example of the Bank of England Act 1998, which reformed the Bank’s governance in line with current best practice, in entrusting certain functions of the FSA to a committee made up of its non-executive members.26 The non-executive committee, whose chairman is appointed by HM Treasury,27 is responsible for keeping under review the economy and efficiency with which the FSA uses its resources and the sufficiency of its internal financial controls in securing the proper conduct of its financial affairs, and for determining the chairman’s and executive members’ remuneration.28 The committee is required to prepare a report on the discharge of its functions for inclusion in the FSA’s annual report.29 These arrangements are designed to provide “significant additional assurance that the FSA is performing its functions efficiently and with due propriety”.30 Having followed the example of the Bank of England Act, the government must have been taken aback to find itself accused of failing to follow best practice in corporate governance by allowing the roles of FSA chairman and chief executive to be combined in a single individual. A major attraction of splitting the roles of chairman and chief executive for its proponents was that it would 24

Harlow and Rawlings, n. 2 above, 311. Sched. 1, para. 3. 26 Sched. 1, para. 3(1); Bank of England Act 1998, s. 3. 27 Sched. 1, para. 3(3). 28 Sched. 1, para. 4(3). 29 Sched. 1, para. 4(6). 30 HM Treasury, Financial Services and Markets Bill: a Consultation Document (London, HMSO, July 1998), para. 1.8. 25

132 Alan Page provide a means of ventilating concerns about the functioning of the FSA. “Under our proposals, the City—those regulated by it and those outside it— would have in the chairman someone whom it could approach with its anxieties, someone who, if not instantly responsible for the issues, could take them up with the chief executive, enabling the whole system to be seen to work better.”31 The government argued in response that there was no need for such a split given the other checks and balances to which the FSA would be subject. Having failed to persuade the Bill’s opponents of its arguments, however, it brought forward an amendment to the Bill requiring the FSA in managing its affairs to “have regard to such generally accepted principles of good corporate governance as it is reasonable to regard as applicable to it”.32 Among the generally accepted principles of the Combined Code on Corporate Governance it is reasonable to regard as applicable to it is provision A.2.1, which states: “[a] decision to combine the posts of chairman and chief executive officer in one person should be publicly justified. Whether the posts are held by different people or by the same person, there should be a strong and independent element of the board, with a recognised senior member other than the chairman to whom concerns can be conveyed.” Whether this means that the roles will be split, however, will not be known until the next chairman and chief executive of the FSA are appointed.33

MINISTERIAL CONTROLS

In the scheme of the Act the “prime line” of accountability is seen as running through ministers to Parliament.34 One reason no doubt for the emphasis placed on FSA’s accountability to ministers is to underline the intended break with the investment business regime under the Financial Services Act; as Hopper puts it, the proposed reform of financial services regulation “signalled the government’s rejection of the traditional deference to self-regulation in financial markets”.35 It also reflects the fact that the FSA’s powers are statutory. In truth, however, the scope for ministerial control (and hence parliamentary control) of the FSA is limited. Ministers’ powers under the Act are restricted to appointing and removing the members of its governing body;36 to defining the coverage of its annual report;37 and to requiring it to alter its rules, but only where they have “a significantly adverse effect on competition”,38 or in order to comply with the 31

HL Debs., col. 300, 13 April 2000. S. 7. 33 HL Debs., cols. 379–380, 18 May 2000. 34 Joint Committee, n. 6 above, Evidence q 2, Howard Davies. 35 M. Hopper, “Financial Services Regulation and Judicial Review” in J. Black, P. Muchlinski and P. Walker, Commercial Regulation and Judicial Review (Oxford, Hart Publishing, 1998), 67. 36 Sched. 1, para. 2(3). 37 Sched. 1, para. 10(1). 38 S. 163. 32

Regulating the Regulator—A Lawyer’s Perspective 133 United Kingdom’s Community or international obligations.39 Ministers also have powers to commission value-for-money audits40 and to arrange independent inquiries into regulatory matters of serious concern.41 Nor should the lack of ministerial controls cause surprise when we recall that the Act’s conception is of the FSA as an independent regulatory body, i.e. a body which enjoys a substantial measure of autonomy in the exercise of the functions entrusted to it—as the Financial Times put it, a regulator which is “robustly independent of those it regulates and of wider public pressures to be overintrusive”.42 The more extensive the controls exercisable over the FSA, the less its independence in the exercise of those functions, and the less the case for entrusting them to a separate body as opposed to ministers.43 Attempts were made at the pre-legislative stage to persuade ministers to take a reserve power of direction over the board, but these were resisted. Were such a power to be taken, it was argued, any aggrieved consumer or regulated body could then turn to Treasury ministers as an appeal body against the FSA “and we are back in the situation we wanted to avoid by having an independent regulator in the first place”.44 But if ministers were unwilling to assume control themselves for fear of finding themselves being dragged into the regulatory arena, they emerged as even more unwilling to cede control to anyone else for fear that FSA’s regulatory effectiveness might be compromised. This left open the possibility of FSA being subject to less control than it ought to be, a possibility I come back to below. The limited powers possessed by ministers mean however that the claim that regulatory accountability is secured through ministers cannot be regarded as an especially powerful one.

PARLIAMENTARY CONTROLS

The FSA is accountable through ministers to Parliament. Its annual report will thus be laid before Parliament.45 Following discussions between the Government and the FSA an agreed list of matters to be covered in its annual report was published.46 It is also subject to select committee scrutiny, with 39

S. 410. S. 12. 41 S. 14. 42 Financial Times, 29 October,1997. “Under the new statutory regulation, the regulator must be, and be seen to be, an independent representative of the public interest”: J. Herbst and D. Scott, “The Financial Services and Markets Bill—Regulation for the 21st Century” (1998) 1 Journal of International Financial Markets Law and Regulation 36. 43 Cabinet Office, Non-Departmental Public Bodies: A Guide for Departments (London, Cabinet Office, 2000), ch. 2, para. 33. 44 Third Report from the Treasury Committee, HC (1998–99) 73, Evidence, q 316, Patricia Hewitt; Joint Committee, n. 6 above, Evidence, q 424, David Roe. 45 Sched. 1, para. 10(3). 46 In a press release of 6 July 1999, the FSA committed itself to providing substantial information in its future annual reports. 40

134 Alan Page attempts being made in the House of Lords to establish a role for the House in its scrutiny through the mechanism of a joint committee, following what has been generally regarded as the successful precedent of the joint committee which examined the draft Bill.47 The Treasury Committee took evidence from the FSA on 2 November 1999, “the first accountability occasion”, and again on 14 March 2000. There have also been proposals for confirmation hearings, but these were resisted by the government on the grounds that appointments were a matter for which ministers were properly responsible to Parliament;48 in other words, their powers should remain unfettered, an attitude underlined in the Treasury’s response to the report of the Treasury Committee on the appointment of Christopher Allsop as a member of the Monetary Policy Committee. Its rules, on the other hand, will not be subject to any form of direct parliamentary scrutiny or control. Nor will it be subject to National Audit Office/Public Accounts Committee scrutiny, despite a concerted effort by the NAO and the Comptroller and Auditor General to establish a role in its oversight.49 The weaknesses of parliamentary oversight are well known.50 I am not aware of any attempt to evaluate the work of the Treasury Committee in relation to the regulation of financial services, but select committee scrutiny, the most important instrument of parliamentary accountability, is widely regarded as ineffective; “whatever their other merits, [select committees] have rarely been effective instruments of accountability”.51 Parliamentary control is potentially stronger where it is backed by effective support. The outstanding example is the Public Accounts Committee, which takes the work of the National Audit Office as its starting point. The same may be said of the Select Committee on the Parliamentary Commissioner for Administration in the 1992–7 Parliament. What is striking in the case of the FSA, however, is that Parliament is effectively cut off from these potential sources of support; in the case of the NAO because of fears that the FSA’s regulatory effectiveness would be compromised were it to be subject to investigation at the initiative of the NAO. It will be subject to value for money scrutiny, but the initiative will rest with the Treasury, not the NAO or Parliament. Its exclusion is indicative of a deep-seated distrust on the part of government of modes of control other than ministerial control, which as we have seen is limited because ministers do not want to find themselves in the position of second-guessing the FSA.52 Given this lack of support the prospects for effective parliamentary scrutiny must be regarded as slight. What is essential if a reality is to be made of the 47

HL Debs., col. 322, 13 April 2000. HL Debs., col. 1719, 16 March 2000. 49 Joint Committee, n. 6 above, paras. 108–11. 50 In relation to utilities regulation, see Graham, n. 4 above, 500–1. 51 Foster, n. 5 above, 14, n. 79. 52 The picture in relation to the PCA is harder to fathom but the upshot is the same. The FSA will be subject to a complaints investigator, but unlike the Parliamentary Ombudsman the investigator will not be a servant of Parliament. x 48

Regulating the Regulator—A Lawyer’s Perspective 135 system of positive accountability foreshadowed by the statutory objectives is the means to check on FSA’s performance against those objectives. As things stand, however, Parliament lacks the means to do so. There must be doubt therefore about whether, unaided, it has the capacity effectively to scrutinise FSA’s performance against its objectives. One way in which this shortcoming may conceivably be overcome is through action on the part of the FSA itself, in whose interests it is to be seen to be properly accountable, and through action on the part of the industry and consumers. If there is to be progress towards an improved system of accountability, Foster argues, it must come from those who are accountable and those who control them. They must provide information of “a quality and substance which would empower better instruments of accountability if they were to be constructed”.53 There is also a role for the industry and consumers in analysing this information. “Before information reaches ministers and parliament, it should have gone through processes of verification and inspection, analysis and comment to make effective discussion easier in public and before parliament”.54 Action along these lines might go some way towards compensating for the shortcomings of parliamentary scrutiny.

STAKEHOLDER CONTROL

A “second” line of accountability runs to the industry and consumers. The accountability framework established by the Act is intended to ensure “that the FSA is properly accountable to Ministers and Parliament, and to practitioners and consumers”.55 Although the Act represents “a complete move away from the philosophy of self-regulation under which the regulator was directly accountable to the industry”,56 a complete rejection of the notion of accountability to the industry would be difficult to reconcile with modern notions of accountability, which stress accountability to users alongside traditional notions of political accountability. Considerations of regulatory effectiveness provide an additional justification for involving representatives of affected interests in the FSA’s deliberations. The emphasis on the FSA’s accountability to ministers and Parliament is therefore combined in practice with an emphasis on its accountability to the industry and to consumers. “As part of its commitment to accountability and to maintaining an open dialogue with industry practitioners and consumer representatives”, the FSA established a practitioner forum and a consumer panel in 1998. Following the consultation on the draft bill the government decided that the panel and the forum should be placed on a statutory footing. The Act therefore requires 53 54 55 56

N. 5 above, 22. Ibid., 30. Patricia Hewitt, quoted in Joint Committee, n. 6 above, para. 106. Herbst and Scott, n. 42 above, 36.

136 Alan Page the FSA to make and maintain effective arrangements for consulting practitioners and consumers on the extent to which its general policies and practices are consistent with its general duties under section 2.57 These arrangements must include the establishment of practitioner and consumer panels to represent the interests of practitioners and consumers respectively.58 The membership of both panels is appointed by the FSA, with the appointment and removal of their chairman being subject to Treasury confirmation. The consumer panel, which is funded by the FSA, was established to provide advice on the interests and concerns of consumers and to assess the FSA’s effectiveness in its objectives to protect consumers’ interests and promote public awareness of the financial system. The practitioner panel has been invited to comment publicly on the extent to which the FSA is meeting its statutory objectives and, in doing so, is having due regard to the regulatory principles set out in the Act.59 It sees itself as achieving most, however, through “a low profile exercise of influence at a senior level”.60 Under the Bill as originally introduced the FSA would simply have been obliged to “have regard to” any representation made to it by the panels.61 At third reading in the House of Lords however the Bill was amended to require the FSA also to “consider” representations made to it by either panel and, should it disagree with representations made, to give the panel a written statement of its reasons for disagreeing.62 This creates a strong incentive for the FSA not to disagree with either panel. It will also highlight any differences of opinion that may arise. Whether statements are published is a matter ultimately for the panels.63 Both panels publish annual reports; and the FSA has undertaken to include in its annual report a statement from the chairmen of the panels.64 Separately from the requirement to make and maintain effective arrangements for consulting practitioners and consumers, the FSA is required to convene an annual public meeting for the purposes of enabling its annual report to be considered.65 This requirement, with its echoes of the Athenian idea of accountability as direct answerability to the people,66 met with some initial scepticism, but the government defended it as providing a valuable opportunity for interchange between the FSA, the regulated community and consumers at large. The FSA is required to publish a report of the meeting.67

57 58 59 60 61 62 63 64 65 66 67

S. 8. Ss. 9–10. FSA website. Annual Report (1999), 4. Ss. 9(4), 10(4). S. 11. HC Debs., cols. 45–46, 5 June 2000. HL Debs., col. 320, 13 April 2000. Sched. 1, para. 11. P. Day and R. Klein, Accountabilities (London, Tavistock, 1987), 6–7. Sched. 1, para. 12.

Regulating the Regulator—A Lawyer’s Perspective 137

OVERSIGHT : CONCLUSIONS

Commentators have viewed with some scepticism the claim that post-legislative accountability to Parliament, to the executive or to the public provides a secure foundation for legitimacy.68 On the face of it there is no reason to dissent from this view in relation to the FSA. The major difference from the pattern in other contexts is the panels, but it is too early to attempt an assessment of their contribution to the FSA’s oversight.

DUE PROCESS

A regulator’s claim to legitimacy may also be based on the adoption of “fair administrative procedures, maximising consistency, and equality of treatment, transparency and participation of outside interests”.69 Ogus uses the term “procedural accountability” to describe procedures which provide “an appropriate framework for making rules and decisions which serve the public interest and for resisting the undue influence of private interests”.70 The strong desire of government not to follow the US model of due process for fear of legalism has been well documented.71 In utilities regulation, “a formal due process model has been officially regarded as something actively to be avoided, liable to enmesh the regulators in legal complications, as well as generating substantial costs and delays”.72 Something of that same unwillingness is evident in financial services regulation. What we find, however, is regulation being driven in this direction in an effort to bolster FSA’s claim to legitimacy. We can see this if we look first at rule-making.

RULE - MAKING

Under the Act the FSA will enjoy extensive rule-making powers. Its powers include a general rule-making power,73 as well as power to make various other kinds of rules, for example financial promotion rules.74 It will also have power to issue statements of principle and codes of practice in respect of approved

68

Baldwin and McCrudden, n. 8 above, 39; Harlow and Rawlings, n. 2 above, 330. Ibid., 311. 70 A. Ogus, Regulation: Legal Form and Economic Theory (Oxford, Clarendon Press, 1994), 111. 71 C. D. Foster, Privatisation, Public Ownership and the Regulation of Natural Monopoly (Oxford, Blackwell, 1992), 267–85. 72 Harlow and Rawlings, n. 2 above, 334; A. Prosser, Law and the Regulators (Oxford, Clarendon Press, 1997), 50–1. 73 S. 138. 74 S. 145. 69

138 Alan Page persons,75 to issue a code of market conduct,76 to publish statements of policy77 and to issue guidance.78 Although rules made by the FSA in the exercise of the powers conferred by the Act will be a species of subordinate legislation, they will not be subject to any form of direct parliamentary control, despite the fact that, in the view of the House of Lords Delegated Powers Committee, they are of far greater practical importance than the statutory instruments which ministers are empowered to make under the Act and which are rightly subject to parliamentary control. “If powers of this kind were to be vested in Ministers, we would undoubtedly advise that there should be a measure of Parliamentary control.”79 Under the draft Bill published for consultation the safeguards attending the exercise of these powers were relatively limited. Rules were to be published in draft, accompanied by a cost benefit analysis and an invitation to make representations within a specified period.80 The FSA was to be required to have regard to any representations made before making the proposed rules.81 These requirements could be dispensed with where the delay in complying with them would be prejudicial to the interests of consumers.82 Following the consultation on the draft Bill, and in the course of the parliamentary passage of the legislation, these requirements were strengthened to include a requirement that draft rules be reasoned, i.e. that they be accompanied by an explanation of their purpose and a statement of the FSA’s reasons for believing that their making is compatible with its general duties under section 2 of the Act.83 Where the FSA decides to make the proposed rules, it is also required to publish an account, in general terms, of the representations made to it and its response to them.84 And where the rules made differ significantly from the draft rules, it must publish a statement of the difference accompanied by a cost benefit analysis.85 The requirements are in summary: • rules must be published in draft and accompanied by a cost benefit analysis and an explanation of why in the Authority’s view they are compatible with its general duties under section 2 (section 155(2)(a)–(c)). • an opportunity for representations must be afforded and regard had to any representations before the proposed rules are made (section 155(4)).86 75 76 77 78 79 80 81 82 83 84 85 86

S. 64. S. 119. SS. 69, 124 and 210. S. 157. Joint Committee, n. 6 above, Annex B, para. 8. Cl. 85(1), now s. 155(2)(a). Cl. 85(3), now s. 155(4). Cl. 85(5), now s. 155(7). S. 155(2)(b)–(c). S. 155(5). S. 155(6). For the FSA’s approach to consultation, see The Open Approach to Regulation (July 1998).

Regulating the Regulator—A Lawyer’s Perspective 139 • where the FSA decides to make the proposed rules, it must publish an account, in general terms, of the representations made to it and its response to them (section 155(5)). • where the rules made differ significantly from the draft rules, it must publish a statement of the difference accompanied by a cost benefit analysis (section 155(6)). These requirements may be dispensed with where the delay in complying with them would be prejudicial to the interests of consumers (section 155(7)). The requirement of a cost benefit analysis may also be dispensed with if no significant increase in costs would be involved in complying with the proposed rules (section 155(8)). Equivalent safeguards exist for statements of principle and codes of practice in respect of approved persons (section 65), the code of market conduct (section 121), statements of policy (sections 70, 125, 211), and standing guidance of general application (section 157(3)). These requirements may be contrasted with the general absence of any formal requirements in respect of departmental law-making. Attempts were made during the parliamentary passage of the Bill to apply the same disciples to the exercise of the Treasury’s delegated law-making powers under the Act, but these were successfully resisted; because the Treasury was directly accountable to Parliament, it was argued, there was no necessity for it to be subject to formal requirements.87 They may also be contrasted with the more limited requirements which applied to SIB under the Financial Services Act: it was simply obliged to consult publicly on its proposed rules,88 and to have satisfactory arrangements for taking into account the costs of complying with its rules.89 In place of the highly attenuated vision of the legislative process offered by the draft legislation therefore, what we have seen is a clear shift in the direction of an “inclusive rule-making procedure, policed by the courts, akin to an American-style ‘interest representation’ model of administrative law”.90 The FSA is also subject to a special regime for the scrutiny of its impact on competition. Under the Act its “regulating provisions and practices”, which include its rules, must not have “a significantly adverse effect on competition”.91 The FSA’s compliance with this requirement is monitored by the Director General of Fair Trading. Should the Competition Commission, on receipt of a report from the DGFT, conclude that the FSA is in breach of this requirement, and that the adverse effect on competition is not justified, the Treasury must require the FSA to take appropriate remedial action.92

87 88 89 90 91 92

HL Debs., cols. 1555–1557, 9 May 2000. Sched. 8, para. 12. Sched. 7, para. 2A, inserted by the Companies Act 1989, s. 204(4). Harlow and Rawlings, n. 2 above, 332. S. 159(2). S. 163(2).

140 Alan Page While these additional safeguards have been welcomed, increased formalisation carries with it dangers. One danger is that of ossification so that it is “impossible for agencies to develop rules due to complex procedural requirements and far-reaching judicial review”.93 It seems clear, however, that ossification in the United States is less a consequence of the accretion of procedural requirements than of the intensity of judicial review, in particular of the judicial rewriting of the requirement that rules must be reasoned, an intensity which on present trends is unlikely to be matched in the United Kingdom.94 A second, potentially more serious, danger is that the regulator’s attention is deflected from its task. “The closer the rule-making procedures are to an adjudication model, the more likely it is that that the decision-makers will strive for outcomes which constitute a compromise between competing special interests that are represented in the proceedings; and this may force them to lose sight of a broader conception of the public interest.”95 Participation may thus lead to “the dilution of the regulatory process rather than the protection of persons from arbitrary action”.96

DISCIPLINARY AND ENFORCEMENT POWERS

A second area where there has been a marked increase in due process is discipline and enforcement. Under the Act the FSA possesses significant disciplinary and enforcement powers, including power take disciplinary action against authorised persons (Part XIV) and approved persons (Part V). It will also have powers to impose penalties for market abuse (Part VIII). In response to the perception that the FSA’s internal procedures “may lack fairness and transparency . . . and that the FSA will be able to act as ‘prosecutor, judge and jury’”,97 the government made a number of changes to the draft Bill published for consultation. Central to the changes made was a clear separation in the FSA’s procedures between those responsible for investigating or recommending the institution of disciplinary proceedings and those responsible for deciding whether action should be taken.98 Under the FSA’s proposals, decisions on the exercise of disciplinary powers will be taken by a separate Enforcement Committee, with a chairman and other members appointed by the FSA, none of whose members, 93 Prosser, n. 72 above, 279; McGarity, “Some Thoughts on ‘Deossifying’ the Rulemaking Process” (1992) 41 Duke Law Journal 1385; Pierce, “Seven Ways to Deossify Agency Rulemaking” (1995) 47 Administrative Law Review 59. 94 Pierce describes the judicially enforced duty to engage in reasoned decision making as “the single largest source of judicial ossification of the rule making process”: n. 93 above, 67. 95 Ogus, n. 70 above, 115; an unexceptional result, as Ogus points out, for those who see regulation as a surrogate political process. 96 Hamilton, quoted in Harlow and Rawlings, n. 2 above, 205–6. 97 HM Treasury, Financial Services and Markets Bill: Progress Report (March 1999), para. 6.2. 98 S. 395(2).

Regulating the Regulator—A Lawyer’s Perspective 141 apart from the chairman, will be employed by the FSA or will be involved in establishing the evidence on which the Committee bases its decisions.99 Following the issue of a warning notice, which marks the start of formal disciplinary proceedings, the respondent firm will have the right to obtain access to the evidence on which the FSA relies, and to make representations to the Enforcement Committee. It will also have the opportunity to enter into settlement discussions with the FSA, on a “without prejudice” basis and, if these reach deadlock, to enter into mediation. The FSA envisages that in a majority of cases a settlement will be reached, but should a case not be settled, the Enforcement Committee will then decide what action should be taken in the light of any representations made. The changes made, coupled with the “clarification” of the Tribunal’s role (below), have entailed a restriction of the FSA’s powers to impose sanctions unilaterally. Under the Bill as originally drafted the FSA would have made a decision, after giving the firm an opportunity to make representations, against which an appeal would then lie to the Tribunal. Under the Act it will still make a decision, via the Enforcement Committee, but its decision will take effect only if the firm does not exercise its right to have the matter referred to the Tribunal. If the firm exercises its right, the FSA’s “decision” will form the basis of the case put before the Tribunal, which will hear the matter afresh. The FSA will thus have power to impose sanctions only with the agreement of firms. This creates an incentive for the FSA to pitch disciplinary action at a level at which firms are likely to agree rather than refer the matter to the Tribunal. At the same time there is an incentive for firms to submit to disciplinary action rather than incur the costs of referring the matter to the Tribunal. The provision to be made in the FSA’s enforcement procedures for independent mediation is intended to reduce the scope for oppressive plea-bargaining.100 The requirements are in summary • where the FSA proposes to take disciplinary action it must give the person concerned a warning notice (for example, section 207(1)). The warning notice must be in writing and must set out the reasons for the proposed action (section 387(1)). • a person to whom a warning notice is given must be given an opportunity to make representations (section 387(2)); he or she must also be given access to the material on which the FSA relied in taking the decision which gave rise to the obligation to give the notice and any secondary material which might undermine that decision, unless the material is excluded or access would not be “in the public interest” or “fair” (section 394). • where the FSA decides to take disciplinary action it must give the person concerned a decision notice (for example, section 208(1)). The decision notice must be in writing and must set out the reasons for the action (section 388(1)). 99 100

FSA, Response to Consultation Paper 17 (July 1999), para. 18. Joint Committee, n. 6 above, Evidence, q 448, Andrew Whitaker.

142 Alan Page • a person to whom a decision notice is given must be informed of his/her right to have the matter referred to the Financial Services and Markets Tribunal (section 388(1)); he or she must also be given access to the material on which the FSA relied in taking the decision which gave rise to the obligation to give the notice and any secondary material which might undermine that decision, unless the material is excluded or access would not be “in the public interest” or “fair” (section 394). In framing its procedures the FSA has sought to avoid the “full judicialisation” of the decision to initiate disciplinary action. There will thus be a right to make oral representations, but not a right to cross-examination. Whether it has succeeded in this aim however remains to be seen. Also open to question is whether the procedure will command public confidence. The Joint Committee considered that the procedure “must lead as transparently as possible to a fair and just decision in the public interest; it must avoid any impression of secretive and collusive plea-bargaining”.101 All that the Act requires, however, is that the FSA must publish such information about the matter to which a final notice relates as it considers appropriate.102

DUE PROCESS : CONCLUSIONS

Prosser suggests that if regulators are really “government in miniature” but potentially lack democratic legitimacy, “the alternative of procedural participation would seem to offer an alternative form of such legitimacy”.103 This is indeed the direction in which financial services regulation has been moving. There are dangers however attendant on that process—of the regulator’s attention being deflected from its objectives, of ossification, and of the regulator becoming enmeshed in legalism.

REDRESS

The existence of opportunities to check decisions through appeal or judicial review constitutes an important element of accountability.104 Account must also be taken of the scope for administrative redress.

101

Joint Committee, n. 6 above, Evidence, para. 200. S. 391(4). 103 Prosser, n. 72 above, 279. 104 A. Prosser, “Regulation, Markets and Legitimacy” in J. Jowell and D. Oliver (eds.), The Changing Constitution (3rd edn., Oxford, Clarendon 1994), 256. 102

Regulating the Regulator—A Lawyer’s Perspective 143

APPEALS

The principal means of redress under the Act is by way of appeal to the Financial Services and Markets Tribunal. A right of appeal or, in the language of the Act, a right to refer the matter to a tribunal lies against the exercise of the FSA’s more important powers,105 with the possibility of a further appeal on a point of law to the courts.106 The Tribunal was originally conceived as an appellate body, but its role was later “clarified” to be that of a tribunal of first instance, fully able to consider the merits and facts of each case, and with the authority to substitute its own conclusions for those of the FSA.107 Under the Act its task is to determine “what (if any) is the appropriate action for the Authority to take in relation to the matter referred to it”.108 This may be contrasted with the much less generous provision made by the Banking Act 1987, for example, under which the tribunal was confined to determining whether “for the reasons adduced by the appellant, the decision was unlawful or not justified by the evidence on which it was based”.109 The conversion of the Tribunal to one of first instance was seen as an important step towards meeting the charge that the FSA was “judge, jury, and prosecutor” in its own cause.110 In response to the consultation on the draft Bill, the government also dropped the proposed power to exclude from the Tribunal’s deliberations evidence not available to the FSA. The availability of a right of appeal to the Tribunal underlines the remarkable change that has taken place in attitudes towards redress over the last 30 or so years. 30 years ago the proposal that there should be a right of appeal against a finding that a person was not fit to be director, controller or manager of an insurance company was rejected on the ground that it would prejudice the central purpose of the insurance companies legislation, which was the protection of the public against “the charlatan and the rogue”; the question of fitness, it was suggested by the Lord Chancellor, was not “a justiciable issue of any kind”, but rather “a subjective judgement made by an instructed person upon a question of experience”.111 Among the factors which have led to this change in attitudes has been the recognition that, in the absence of any provision for appeal, aggrieved firms are likely to have recourse to alternative means of redress, including judicial review of administrative action and recourse to the European Court of Human Rights, with consequences for the attainment of regulatory objectives 105

E.g., s. 208(4). S. 137. 107 Progress Report, n. 97 above, para. 6.4. 108 S. 133(4). 109 Banking Act 1987 s. 29(1), A. C. Page and R. B. Ferguson, Investor Protection (London, Weidenfeld & Nicolson, 1992), 102. 110 Joint Committee, n. 6 above, Evidence, q 47 Phillip Thorpe. It allowed the government and the FSA to recast disciplinary proceedings as administrative rather than judicial. 111 Page and Ferguson, n. 109 above, 101. 106

144 Alan Page that are no less serious than those of a successful appeal. Rather than incur this risk, the architects of regulatory systems have preferred to establish special machinery for the settlement of disputes arising out of the powers conferred. In accordance with general principles of administrative law this machinery must first be exhausted before recourse will be permitted to the supervisory jurisdiction of the superior courts.112

JUDICIAL REVIEW

Appeal is backed by the possibility of judicial review. Although the courts have been famously prepared to extend the scope of judicial review to cover the activities of the various non-governmental authorities involved in financial regulation,113 they have at the same time adopted an essentially cautious approach to the review of regulatory decision-making.114 In R. v. SFA, ex parte Panton, Sir Thomas Bingham MR said that regulatory bodies under the Financial Services Act were amenable to judicial review “but are, in anything other than very clear circumstances, to be left to get on with it”.115 In favour of a cautious approach it has been argued that it diminishes the risk of tactical litigation, something which the courts have shown themselves to be acutely concerned to discourage, and that the courts do not possess the expertise normally associated with regulators.116 Walker describes Sir Thomas Bingham’s assertion that the regulators are to be left to get on with it as “no more than a reiteration in relation to financial regulation of the more general principle that the views of those who exercise decision-making power are entitled to respect”.117 The contrary danger is that the courts are too cautious, denying individuals—the tactical litigant and the genuinely aggrieved alike—the measure of protection against the abuse of power they are entitled to expect.118 Whether the Human Rights Act 1998 will lead to a change in the approach of the courts remains of course to be seen, but it is widely expected to lead to the subjection of regulatory action to more intense scrutiny where Convention rights are in issue.

112

Page and Ferguson, n. 109 above, 101. R. v. Panel on Takeovers and Mergers, ex parte Datafin [1987] QB 815. 114 Hopper, n. 35 above; P. Walker, “Irrationality and Commercial Regulators” in J. Black, P. Muchlinski and P. Walker, Commercial Regulation and Judicial Review (Oxford, Hart Publishing, 1998), 159. 115 Unreported, 20 June 1994 (CA). 116 Ogus, n. 70 above, 117; Walker, n. 114 above, 172. 117 Ibid., 167. 118 Page and Ferguson, n. 109 above, 104. 113

Regulating the Regulator—A Lawyer’s Perspective 145

STATUTORY IMMUNITY

The scope for legal redress is restricted on the other hand by the fact that the Act confers an almost complete immunity from liability in damages on the FSA; only where it acts in bad faith or in breach of Convention rights will the question of liability in damages arise.119 Immunity is premised on the proposition that the FSA should not be inhibited in the performance of its functions by fear of liability; the quality and effectiveness of supervision will suffer, it is argued, if regulators have the threat of actions for damages hanging over their heads when taking difficult decisions. “Financial supervision requires a lot of difficult judgements and if everything the regulator does is to be subject to threats of legal action, over-regulation and excessive caution will ensue”.120 To “red light” theorists who see the courts as central to the protection of the individual, immunity is of course anathema; a regulator that “is not statecontrolled and cannot be sued in the courts is, in the last resort, irresponsible”.121 The courts, however, have shown themselves no more willing that the legislature to accept that regulators owe investors a duty of care in negligence. In Yuen Kun Yeu v. Attorney General of Hong Kong122 the Privy Council held that the Hong Kong banking supervisor did not owe the depositors of a failed institution a duty to take reasonable care to prevent them suffering financial loss by reason of the fraudulent or improvident conduct of the institution’s affairs. And in Davis v. Radcliffe,123 which arose out of the collapse of the Isle of Man Savings and Investment Bank, the Privy Council followed its earlier decision in holding that the relationship between the depositors and the supervisor was not such that it would be “just and reasonable” to impose a liability in negligence on the supervisor for the loss suffered by the depositors. This consensus between the legislature and the courts that no liability should attach to regulators in negligence has been called into question recently by the decision of the European Court of Human Rights in Osman v. United Kingdom,124 in which the Court held that the striking out of a claim on the ground that the police had no general liability in negligence arising out of their activities in the investigation and suppression of crimes constituted a disproportionate interference with the applicants’ right of access to a court under Article 6(1) of the European Convention on Human Rights. The case arose out of the killing of a father and the wounding of his son by a teacher who had become obsessed with the son. The deceased’s widow and the son brought an action against the police, alleging that they had been negligent 119 120 121 122 123 124

Sched. 1, para. 19; on bad faith see Melton Medes Ltd v. SIB [1995] Ch. 137. HL Debs., col. 1186, 16 March 2000, Lord Burns. HC Debs., vol. 99, col. 412, 11 June 1986, Nicholas Budgen. [1988] AC 175. [1990] 1 WLR 821. (2000) 29 EHRR 245.

146 Alan Page in failing to prevent the attack, but their statement of claim was struck out by the Court of Appeal as disclosing no reasonable cause of action.125 The Court of Appeal held that the case was indistinguishable from Hill v. Chief Constable of West Yorkshire126 in which the House of Lords held that it would be contrary to public policy were the police to be open to claims in negligence arising out of their activities in the investigation and suppression of crimes. The European Court of Human Rights, however, held that the application of the rule laid down in Hill constituted a disproportionate interference with the applicants’ right of access to a court under Article 6(1). It accepted that the rule served a legitimate purpose in terms of the Convention, being directed to the maintenance of the effectiveness of the police force and hence to the prevention of disorder or crime. But it appeared to the Court that the Court of Appeal had proceeded on the basis that it provided a watertight defence to the police.127 In the Court’s view, its application in this manner, without further enquiry into the existence of other public interest considerations, conferred a blanket immunity on the police for their acts and omissions during the investigation and suppression of crime, and amounted to an unjustifiable restriction on an applicant’s right to have a determination of the merits of his or her case against the police in deserving cases.128 In its view it had to be open to the domestic court to have regard to the presence of other public interest considerations which pull in the opposite direction to the application of the rule.129 It was not persuaded by the government’s argument that the rule as interpreted by the Court of Appeal did not provide an automatic immunity to the police.130 The FSA’s immunity is of course statutory, in contrast to the common law immunity successfully challenged in the Osman case. In Lord Hoffmann’s view this is immaterial: “it must follow from the decision of the Strasbourg court that even if the rule in Hill . . . had formed part of the Police Act 1996, it would have been held to contravene the right in Article 6.1 to a hearing before a tribunal”.131 Reading the Osman case, however, it is difficult to avoid the conclusion that the relative uncertainty of the common law afforded the European Court of Human Rights more room for manœuvre than would have been the case had it been faced with an unambiguous statutory rule. Given that the courts are not bound by the decisions of the European Court of Human Rights, but only obliged to take them into account,132 it may also be significant that the Osman decision has attracted considerable judicial criticism.133 The burden of the criticism is that 125

Osman v. Ferguson [1993] 4 All ER 344. [1989] AC 53. 127 Para. 150. 128 Para. 151. 129 Ibid. 130 Para. 152. 131 “Human Rights and the House of Lords” (1999) 62 Modern Law Review 164. 132 Human Rights Act 1998, s. 2. 133 In Barrett v. Enfield LBC [1999] 3 WLR 79 Lord Browne-Wilkinson confessed that he found the decision of the Strasbourg court “extremely difficult to understand”: at 84. 126

Regulating the Regulator—A Lawyer’s Perspective 147 the European Court of Human Rights has decided that there should be a right to compensation, or at least a right to go to court to argue that there should be such a right, in circumstances in which the domestic courts have decided that there is no such right—this against the background that the content of the rights safeguarded by Article 6 has hitherto been regarded as a matter for the states parties to the Convention. Given this criticism, and the fact that the Act poses squarely the question of the freedom of states to decide that there should be no right to compensation in a way in which the rule laid down in Hill did not, it cannot be readily assumed that the courts would regard statutory immunity as incompatible with Article 6(1).134

ADMINISTRATIVE REDRESS

The Joint Committee saw statutory immunity as conditional upon a “robust complaints procedure”.135 Schedule 1 requires the FSA to make arrangements for the investigation of complaints arising out of the exercise or non-exercise of its functions, other than its legislative functions, and to appoint an independent complaints investigator to be responsible for the conduct of investigations in accordance with the complaints scheme.136 Under the arrangements made the investigator will be able to investigate complaints on his own initiative or on a reference from the FSA.137 The question whether the investigator should have the power to recommend the award of financial compensation for administrative shortcomings was the subject of long running argument. The government’s and FSA’s concern was that the complaints procedure should not become a backdoor means of putting pressure on the FSA through the threat of claims for compensation.138 “We cannot set up a system that encourages [people] to take constant pot shots at the FSA”.139 An additional factor in the Treasury’s thinking, no doubt, was that it should not find itself picking up the bill for regulatory failure, as happened in the Barlow Clowes case. The argument was finally resolved when an amendment was carried against the government during the Bill’s report stage in the House of Lords empowering the investigator to recommend the making of compensatory payments to those wrongly damaged by FSA action.140 134 Since the Osman case was decided, there have been two further cases, both child protection cases, in which the European Commission of Human Rights has decided that the striking out of claims as disclosing no reasonable cause of action on the basis of the analogous rule in the Bedfordshire case constitutes a disproportionate interference with the applicants’ right of access to a court (Z v. the United Kingdom (the Bedfordshire case), TP and KM v. United Kingdom (the Newham case)). In neither case did the Commission see any basis on which to reach a different conclusion from that reached by the Court in the Osman case. 135 Joint Committee, n. 6 above, para. 139. 136 Sched. 1, para. 7. 137 Sched. 1, para. 8(2). 138 Ibid., Appendix 61. 139 Standing Committee A, 13 July 1999. 140 Sched. 1, para. 8(5).

148 Alan Page The FSA will not however be subject to the jurisdiction of the PCA, so that following an investigation by the investigator there will not be the possibility of a further complaint to the PCA as the final rung in the public services complaints ladder.141 The Government sought to justify this restriction on the less than compelling argument that the FSA is not the sort of body which is subject to the PCA’s jurisdiction.142 The impression fostered was of financial regulation as an enclave in which the FSA should be allowed to get on with its job untrammelled by the normal mechanisms of accountability. For the FSA not to be subject to the jurisdiction of the PCA however leaves a question mark against the independence of the complaints procedure, which is not removed by making the investigator’s appointment and dismissal subject to Treasury approval.143 It also has the undesirable consequence of cutting the FSA off from one of the principal sources of thinking about standards of good administration.

REDRESS : CONCLUSIONS

How serious a limitation statutory immunity is depends on the view one takes of the sufficiency of the other means of redress. For defenders the combination of judicial review and the complaints procedure offering administrative compensation is sufficient; for its opponents it is not. As regards FSA’s exclusion from the jurisdiction of the PCA, it is difficult to dissent from the view that it should be subject to the jurisdiction of the PCA. The aim, as the London Investment Banking Association put it, should be to ensure independent scrutiny at least as extensive as that applied to government.144 That aim is not satisfied by merely having a complaints procedure.

GENERAL CONCLUSION

There is no gainsaying the importance of accountability for regulatory bodies.145 Subject a regulator to too many controls and its effectiveness may be impaired; subject it to too few controls and its legitimacy may be impaired, with consequences no less serious for its effectiveness. What we have seen during the parliamentary passage of the legislation is the government and the regulator ‘muddling through’ to a solution to the problem of regulatory accountability. In the solution they have arrived at it is possible to discern the outlines of an alternative model of accountability to that offered by the doctrine of ministerial 141 T. Daintith and A. Page, The Executive in the Constitution: Structure, Autonomy and Internal Control (Oxford, OUP, 1999), 367. 142 Joint Committee, n. 6 above, Evidence, q 424, David Roe. 143 Sched. 1, para. 7(3). 144 Joint Committee, n. 6 above, Evidence, Appendix 6, para. B5. 145 Hopper, n. 35 above, 66.

Regulating the Regulator—A Lawyer’s Perspective 149 responsibility. Key elements of that model include the FSA’s statutory objectives, which provide the basis for a ‘positive’ system of accountability, and the requirements of due process written into the legislation, as well as the more familiar elements of oversight and redress. What remains to be seen is whether that model has been taken far enough; or whether it has been taken too far, as the Treasury initially feared, with the result that the FSA’s regulatory effectiveness is impaired.

11

Regulating the Regulator—An Economist’s Perspective on Accountability and Control CHARLES A.E. GOODHART

CAN ONE MEASURE SUCCESS / FAILURE ? THE CONTRAST BETWEEN THE MONETARY POLICY COMMITTEE AND THE FINANCIAL SERVICES AUTHORITY

Monetary Policy Committee is as a monetary economist who has served on the Monetary Policy Committee (MPC). Here attainment of transparency and accountability was relatively straightforward. The MPC has had a specified numerical target. This was set for it by the Chancellor in May 1997, requiring the maintenance of a 21⁄2 per cent per annum rate of change in a particular index of the Retail Price Index (RPIX) until further notice, i.e. for an indefinite period. So the MPC has been set a publicly known quantified target, and is accountable for hitting that. Of course, errors and unforeseen shocks will prevent anybody from ever achieving such a target perfectly. But some variance around the target has been catered for by setting a 1 per cent band around the target, beyond which the MPC has to explain what has happened, and outline what steps it will take to rectify the situation, in letters to the Chancellor; though no letter has yet had to be written. In addition, it is known exactly how each member individually voted; and the Minutes are now produced within three weeks of the meeting, setting out the arguments presented, and recording individual votes. Since monetary policy acts only with a rather long transmission lag, interest rate decisions now have to be taken with an eye to future forecast inflation, rather than the current level of inflation. In order to explain and account more closely for the rationale for changing interest rates, an Inflation Forecast is completed within the Bank of England four times per year, and is then published and explained in the quarterly Inflation Forecast. Besides all that, there are regular meetings before the HM Treasury Sub-committee of the House of Commons, and also irregular meetings before a similar Committee established by the House of Lords.

M

Y OWN BACKGROUND

152 Charles A.E. Goodhart So, transparency of target, and of the reasoning and steps towards meeting that target are crystal-clear, and accountability is strong.1

Financial Services Authority Compare, and contrast, the transparency and accountability of the MPC, with that of the Financial Services Authority (FSA). The FSA has four main objectives.2 These are: (a) (b) (c) (d)

to maintain confidence in the financial system; to promote public understanding of the financial system; to secure the appropriate degree of consumer protection; to reduce financial crime, (for example, money laundering).

But how could you measure these? Let us start with (d), the final objective. The measurement of crime, including financial crime, is notoriously difficult, if not impossible. There are no data whatsoever, as far as I know, on the extent of financial crime being perpetrated. The only data that exist are for the number of cases brought to trial, together with the outcomes of such trials. If the number of cases falls, is this because the amount of financial crime has gone down, so policy has been successful? Alternatively, could it be because less financial crime has been detected, and brought to justice? Thus, any change in the number of cases can be described either as a success for policy, or a failure for policy. How then is it ever possible to give any kind of assessment of whether the FSA is meeting the final objective? Next let us turn to the penultimate objective. What is the “appropriate degree” of consumer protection? Who decides on that? On what criteria should one judge what is “appropriate”? Would such criteria, if they could be set, be capable of quantification and of ex post assessment for purposes of accountability? In any case, as far as I am aware, there has not been any authoritative attempt to present criteria, either quantitative or qualitative, on what exactly is appropriate. Unless such external criteria are presented, and in such form as they are capable of measurement and assessment, then it seems that judgment about what was “appropriate” is left entirely in the hands of the FSA. The FSA will, therefore, be its own judge about whether it has acted appropriately in the light of this objective. Most judges rule in their own favour. 1 I have myself also been an advocate of giving members of the MPC a pecuniary incentive to achieve the target, in the shape of a graduated bonus which increases the nearer they manage to get to the exact target, and falls off to nothing if they miss by too much. This is very much in accord with a theoretical argument presented by Walsh *C. Walsh, “Optimal Contracts for Central Bankers” (1995) 85 American Economic Review 150. For a variety of reasons, this suggestion has never found favour, though it was nearly adopted in New Zealand; but I shall go on arguing for its adoption. 2 See C. Briault, The Rationale for a Single National Financial Service Regulator, FSA, Occasional Paper Series No 2 (May 1999).

Regulating the Regulator—An Economist’s Perspective 153 The first two objectives concern the state of mind, and thinking, of the individual members of society. How, exactly, are we to measure these? Is it, for example, to be suggested that a random selection of members of society should be given an examination to assess whether their public understanding of the financial system is satisfactory? But if there should not be such regular quizzes, or examinations, then how exactly does the FSA intend, or indeed any outside body try to assess, exactly what the state of public understanding of the financial system at any time may be? As far as I know, there are no plans afoot to undertake regular testing of public understanding of the financial system. Given this objective, I look forward with interest for plans for setting up such regular exams. Whereas “understanding” can, at any rate in principle, be measured by examinations, the extent of “confidence” is an even more subjective issue. This can, perhaps, be quantified, though somewhat insecurely if at all, by a survey asking randomly chosen members of the public exactly how confident they may be in the financial system. This is probably worth doing, but would you base decisions, for example on reappointment or salaries, on such surveys? What is the population to be surveyed? The majority are almost certainly relatively uninformed, while the informed members of the population, i.e. those working themselves in the financial sector, may be biased. Moreover, the opinion of the majority is likely to depend crucially on whether there has recently been “news” in the Press of some juicy financial scandal, or not. The majority are more likely to respond to recent public news, rather than to the underlying efficiency and true operational success of the FSA. Having outlined and examined the main objectives of the FSA, it is difficult to come to any other conclusion except that the achievement of the objectives which have been set for the FSA are non-operational in the sense that no measurement of success can be achieved. If no measurement of success, or failure, can be undertaken, then these objectives, for all practical purposes, are nonoperational. Accountability in terms of these objectives is effectively impossible. While there may be transparency of process, there will certainly be no transparency with respect to the underlying achievement of the supposed objectives. Perhaps the expert body best able to assess whether the FSA lives up to its objectives, and meets the best, international, standards, would be its peer group of supervisors from other countries. Later in this chapter I propose the formation of the equivalent of an international ratings agency for regulators made up of members of supervisory agencies from other countries, which is required to issue public gradings and reports.

ECONOMIC OBJECTIVES

If we turn from the objectives that actually have been set for the FSA to the objectives that an economist would suggest for financial supervisors, economists

154 Charles A.E. Goodhart would outline three main objectives from an economic viewpoint. Each of these represents the prevention of some potential loss, rather than a positive objective to be attained. These are to prevent: (a) a systemic failure of financial institutions, and/or financial markets; (b) a loss of competitiveness and efficiency, especially vis-à-vis foreign competitors; and (c) consumer protection, i.e. to prevent ill-informed (retail) customers from being exploited. These have been set out in order in terms of their likely importance for the aggregate income, or wealth, of the UK. But in terms of their apparent relative importance in the Financial Services and Markets Act 2000, and in the use of resources at the FSA, and very likely in the culture of the FSA, the ordering may well be reversed. Much more emphasis has been placed in the course of the foundation and establishment of the FSA on consumer protection, than on either competitiveness or the prevention of systemic failure. Indeed Don Cruickshank has complained3 that insufficient emphasis had been placed on the maintenance on competitiveness, and this also is one of the themes in Colin Mayer’s paper which appears as chapter 3 in this book. Is this a problem? In particular may the FSA spend too much of its time and energies in consumer protection, without paying enough regard to the ultimately more important issues of systemic stability and the maintenance of competition? Is this a problem, and, if it should be so, can it be rectified? Apart from competitiveness, which can, with some considerable difficulty, be measured, (for example, by the size of spreads, by the assessment of international comparative costs, and by the net migration of financial businesses), success is measured by an absence of unwanted events, for example, (multiple) financial failures and by customer losses and complaints. But are these outcomes, whether success in the form of absence of failure and complaints, or failures, due to luck and conjuncture or to the efforts of supervisors? It is rarely, possibly never, clear which is which; though it must be noted that it is equally true that nobody can measure exactly whether the outcomes for the MPC have been due to luck or good management by the MPC. To some extent that same problem occurs in all types of activity, that it is rarely possible to distinguish luck from ability. To that extent, one should reward success, whichever is the cause of the outcome. Indeed some believe that it is better to be lucky than to be good! Because the measure of success of regulators is the prevention of disasters, there is a natural tendency for a regulator/supervisor to try to insure against bad outcomes, particularly when he/she is responsible, by over-regulation and over-supervision, and, if something then does go wrong, by trying to prevent 3 D. Cruickshank, Competition and Regulation in Financial Services: Striking the Right Balance, www.bankingreview.org (July 1999).

Regulating the Regulator—An Economist’s Perspective 155 that outcome being recognised as a failure. This can be done, for example, through forbearance, whereby the regulator and regulated agree not to invoke the required public penalty for an infringement of some regulation, in the hope that such an infringement can be rectified by more successful future measures by the regulated. Indeed, such forbearance does, from time to time, have a satisfactory outcome; an example is the ability of the money-centre banks in the United States to work their way out of the capital losses imposed on them by the Latin American failures in 1982. But, in many other cases, such forbearance has adverse effects with larger systemic losses arising. Again, an example is the slowness and unwillingness in the United States to recognise and resolve the losses caused to the Savings and Loans institutions in the course of the 1980s; another is the delays in recognising and responding to the banking crisis in Japan after the asset “bubble” burst there in 1991–2. This raises the question of how the regulators should try to achieve the “optimal” extent of financial losses. Note that the optimal will always be greater than zero, since the cost in intrusive supervision, restrictive regulation and constraints on competition and innovation of trying to bring losses absolutely to zero will always outweigh in costs to the financial system the benefits that might be achieved by preventing all possible losses. If those involved in enterprise are going to innovate, and to be allowed to take risks, which is in large part the essence of financial intermediation, then there must be some losses. In addition, financial losses are frequently the result of fraud. While it is desirable to construct incentives to maximise monitoring that can reduce the likelihood of fraud, it is doubtful whether such fraud can ever be entirely eliminated from the system. How then can one set down processes which will prevent over-regulation, and help the FSA to achieve the best balance between the possibility of loss on the one hand and the cost of regulation on the other? There are a variety of mechanisms that can help in this respect. I shall now consider three such mechanisms. These are: (a) cost/benefit analysis; (b) rules of conduct for the supervisors/regulators (rather than discretion); and (c) transparency and market discipline. But this latter, i.e. transparency and market discipline, is usually applied to the regulated, and not commonly applied to the supervisor/regulator. I shall consider later whether such transparency and discipline can also be applied to the regulator.

156 Charles A.E. Goodhart

COST / BENEFIT ANALYSIS

Let us turn first to the issue of cost/benefit analysis, which the FSA is now required under section 3 of the Financial Services and Markets Act 2000, as part of its Principles4 to undertake.5 Cost/benefit analysis is a nice idea, about which economists were extremely enthusiastic several decades ago. But, alas, it turned out to be generally impractical in operation. There simply were too many intangibles, which had an important bearing on most decisions, but whose quantification was almost impossible. One particular example is what value should you put on human life, an issue which occurs quite regularly, for example, in issues about transport investment? As we shall see, exactly the same problems arise in applying cost/benefit analysis to financial regulation. The costs involved in financial regulation are, however, frequently quite easy to measure with some accuracy. These include the direct costs of additional compliance officers on the regulated, the staff of the regulators, the use of buildings and equipment for such regulation, and so on. There is, however, a problem in ascertaining just how much of such costs the commercial institutions would have undertaken on their own accord in any case, so there is some tendency for such direct costs to be exaggerated. In addition, of course, regulation is making the regulated undertake activities, and choose portfolios, which they would not otherwise have done for themselves. Otherwise regulation would be otiose. Forcing the regulated to adopt a less preferred portfolio, and other activities, must have some effect in raising costs and lessening competitive and innovative abilities. Such higher costs will be passed on to customers in the form of higher charges and spreads and, of course, to shareholders in the form of lower profits. Such additional costs will naturally tend to lower the competitiveness of the regulated. The adverse effect of such worsening competitiveness is, however, probably non-linear. Financial intermediaries generally have some natural advantage in their current activities and location, and gain rents from these. For a time such rents can be compressed without much apparent affect on relative competitiveness, and on locational and functional advantage. Then after a time, when such rents have become exhausted, there may well be a non-linear sudden shift to another financial centre, or alternatively a non-regulated body may come to take over much of the functions of the more heavily regulated institution. Again such, non-linear, costs are difficult to assess, but not impossible, since it is possible to measure spreads, charges and also the migration of institutions between locations. 4

FSA, A New Regulator for the New Millennium (London, FSA, January 2000). FSA, Designing the FSA Handbook of Rules and Guidance, Consultation Paper 8 (London, FSA, April 1998); FSA, Meeting our Responsibilities (London, FSA, August 1998); I. Alton and P. Andrews, Cost-Benefit Analysis in Financial Regulation, FSA Occasional Paper 3 (London, FSA, September 1999). 5

Regulating the Regulator—An Economist’s Perspective 157 Thus, taken all in all, the costs of regulation are reasonably measurable. The same cannot be said of the benefits. As noted earlier, the economic benefits of regulation lie in the prevention of disaster. But how do you measure this? Without the assistance of such regulation, what is the increase in the probability of disaster, and what would be the cost of disaster if such befell? These latter questions are almost impossible to quantify. Again, another potential benefit is the enhanced reputation of financial markets as clean and honest. But exactly how do you measure reputation? By some kind of survey? One idea that is sometimes floated is that the benefit of regulation might be addressed by asking (those who would be affected) how much they would be prepared to pay in order to have such regulation. But this immediately runs into the “free rider” problem. Moreover, the assessment of the probability of disaster by those who might benefit from regulation is almost certainly inaccurate, and a function of how recently a disaster has actually occurred. Thus the public tends to see large, probably excessively large, benefits from regulation in the immediate aftermath of a disaster, which is indeed why politicians tend to legislate after some financial crisis has occurred. Then, with no disaster arising, the enthusiasm of the public for paying for additional regulation tends to wane quite rapidly, as memories dim. All in all I have great sympathy for those within the FSA who are charged with the responsibility of trying to undertake such cost/benefit analysis. The benefits are, for most practical purposes, simply not measurable. So it will be remarkably difficult to undertake any meaningful cost/benefit analysis, even though it is now required. Exactly how they will try to handle this impossible remit will be fascinating to see.

RULES OF CONDUCT

Let me turn next to another approach, that of trying to tie the hands of the regulators so that they behave in a way that benefits society, rather than themselves. This is to mandate them to follow certain rules of conduct, so they are committed to following a particular path, rather than using their own discretion. This line of approach has been used most frequently in trying to prevent regulators offering forbearance, i.e. not taking immediate steps to realise and dissolve cases of financial fragility, out of concern with the bad reputation that such recognition of adverse realised effects would cause them. The main example comes from the United States. As is well known, the main tool for banking regulation, in order to try to prevent excess losses, is the required maintenance of capital adequacy among banks. In this respect, Congress passed, under the FDIC Improvement Act, or FDICIA, a requirement for Structured Early Intervention and Resolution (SEIR), under which the American banking authorities had to undertake a mandated ladder of responses

158 Charles A.E. Goodhart as the capital of individual banks became increasingly impaired. The idea was that, as capital fell increasingly below the level that was deemed to be fully satisfactory, the freedom of banks to undertake potentially risky activities, and to transfer funds out of themselves, because increasingly constrained; the idea also was that any bank should be closed before its capital was totally exhausted, so that there should be, under normal circumstances, no loss absorbed by taxpayers.6 In order to be effective, such an approach depends on an accurate, and generally accepted, approach to accounting, so that bank capital can be measured in a common and agreed fashion. So the desire to have rules of conduct for regulators in banking leads on generally to a desire to have Generally Accepted Accounting Procedures (GAAP) for banks, both within countries and internationally between countries. One of the main tests of the true efficiency and value of a country’s regulators is whether they introduce within that country generally accepted accounting principles for banks, and are keen to enforce such accounting principles. We will return to this same point again in the next section. There are other proposals that tell in the same direction. For example there is the argument, advanced by Calomiris,7 and now supported by the US Shadow Financial Regulatory Committee,8 that all large-size banks should be required to issue, and to have outstanding, holdings of subordinated debt. The idea is that the debt-holders, who are not protected by deposit insurance and might be expected to lose the value of their bonds should a bank become bankrupt, would spend time and effort in monitoring the solvency of their own bank. If they felt that their bank was becoming riskier, the value of the outstanding bonds would fall. The idea would be that the regulator would monitor the spread of the price of bank bonds, relative to some benchmark bond, and when the spread rose over a certain level, the regulator would be required to intervene in certain ways to ensure that he (the regulator) understood the nature of the greater riskiness seen by the market, and was prepared, except in such cases where he could specify in public good reasons to the contrary, to take actions to reduce the level of such perceived risk. No doubt there may be other ways in which intelligent observers may be able to use market discipline in some automatic fashion, in order to require the regulators to undertake intervention, which market tests and signals suggest might be necessary. 6 See G. Kaufman (ed.), Reforming Financial Institutions and Markets in the United States (Amsterdam, Kluwer Academic Publishers, 1994). 7 C. Calomiris and C. Kahn, “The Role of Demandable Debt in Structuring Optimal Banking Arrangements” (1991) American Economic Review 81, 497; C. Calomiris, “Building an IncentiveCompatible Safety Net” (1999) 23 Journal of Banking and Finance 1499. 8 US Shadow Financial Regulatory Committee, Reforming Bank Capital Regulation: A Proposal by the U.S. Shadow Financial Regulatory Committee, Statement No. 160, 2 March 2000; see also H. Benink and R. Schmidt, “Towards a Regulatory Agenda for Banking in Europe” in G. Kaufman (ed.), Research in Financial Services—Bank Crises: Causes, Analysis and Prevention (JAI Press/Elsevier Science, 2000), xii.

Regulating the Regulator—An Economist’s Perspective 159

TRANSPARENCY AND MARKET DISCIPLINE

Let us now turn to the question of the utilisation of transparency and market discipline more widely. Market discipline depends on transparency, and transparency depends on accurate and informative data. So, market discipline depends ultimately on the quality and enforcement of good accountancy and audit processes. If there is to be a level playing field, then the same accounting practices need to be applied across different institutions, and across the same kind of institutions in differing countries; this requires the acceptance of Generally Accepted Auditing and Accounting Procedures (or GAAP). This is made particularly difficult in banking because so many of the loans do not have any very effective second-hand market, so the current evaluation of the loan book is inevitably a somewhat subjective matter. Nevertheless the continuing development of securitisation of a growing proportion of the loan book, whereby loans of a particular kind can be grouped together and on-sold, with or without recourse to the originator, to a second party, together with the development of an increasing market in credit derivatives, may make it more easily possible to give a reasonable and acceptable market evaluation to the greater majority of banks’ loans book. This will enable it to become increasingly possible to value the balance sheet of a bank on a “mark-to-market” basis, instead of at historic cost. The continuing improvement of accounting procedures, and, even more important, their widespread acceptance and utilisation across the world as a whole, is required as an essential precursor of reliance for regulatory purposes on a greater extent of market discipline. The reliance on market discipline has reached its high point so far in New Zealand.9 Here, the Reserve Bank of New Zealand (RBNZ) has forsworn the idea of receiving private information from the commercial banks, regarding that information as being either more useful in the public arena to help inform investors, and/or insufficient to enable it to give an implicit safety-net guarantee to commercial banks, believing that the assumption of such an implicit safetynet was taking their own responsibilities beyond a level that was helpful or desirable either to the general public, or to the commercial banks, or to the Central Bank itself. Consequently, the RBNZ has required the commercial banks to provide even fuller information than formerly, with a full quarterly statement, of which an abridged and simplified form has to be posted in all bank branches, together with a requirement that such banks get a rating from a rating agency. Most important, perhaps, all directors, including non-executives, now have to write, at least annually, a letter of attestation that they have checked the internal control and 9 See e.g. D. Mayes, “Incentives for Bank Directors and Management: The New Zealand Approach”, paper presented at the Conference on Regulatory Incentives, held at the Bank of England (13–14 November 1997).

160 Charles A.E. Goodhart security arrangements of their own banks and found them to be satisfactory. Having written and signed such a letter, they then face severe potential legal penalties if the internal control mechanism is found wanting, and they cannot demonstrate that they undertook proper checking of such mechanisms. This puts greater pressures and incentives on bank directors to take responsibility for their own control mechanism. This additional risk would make a director’s job less attractive, unless matched by a higher salary. But if the directors of a bank are not to take formal responsibility for their own control mechanisms, then who else could, or even be in as good a position to, do so? I have already touched on the possibility of requiring large banks to issue subordinated debt (the Calomiris suggestion), and the requirement for Structured Early Intervention and Resolution (SEIR).10 Another proposal along these general lines, which was introduced by two economists, Kupiec and O’Brien,11 was to require banks to precommit themselves to their regulators not to make losses greater than matched by their capital in their trading books, i.e. where they were active for their own account in markets. Whilst in many ways a good idea in theory, the problem was that the form of sanction, should the bank fail to live up to its precommitment, that was considered at some length was financial fines. This had the difficulty of appearing to hit a bank financially just when it had done relatively badly, perhaps by bad luck, on financial markets. It also meant that if the combination of fine and financial loss should drive capital down to low levels, this would actually be likely to make a bank assume even greater risks, because with limited liability, the managers and shareholders had relatively little left to lose should their impaired capital go down even further, whereas assuming greater risks would give them the benefit of the potential upside. Although the precommitment idea was technically rather neat, and could be worked out analytically in an elegant fashion, the difficulties with devising the appropriate (financial) sanction has meant that the idea appears to have floundered. Although it was given a trial in the USA on a simulated basis, it seems unlikely, as at present, ever to be put into practice. The multinational operations of the major financial intermediaries means that supervisors and regulators in any one country have a concern with the standards and competence of such supervisors/regulation in other countries, especially where such intermediaries may have their headquarters. Such concern can be met (minimally) by the agreement of codes, or principles, of good conduct in these fields.12 Such codes have proliferated in recent years, multiplying at an almost exponential rate. Beyond codes, there can be agreements on minimum standards,

10 See G. Benston and G. Kaufman, “The Intellectual History of the Federal Deposit Insurance Corporation Improvement Act of 1991” in Kaufman (ed.), n. 6 above, chap. 1. 11 See e.g. P. Kupiec and J. O’Brien, “A Pre-Commitment Approach to Capital Requirements for Market Risk”, Division of Research and Statistics, Board of Governors of the Federal Reserve System, mimeograph (April 1995). 12 See the IMF’s Web page on Standards and Codes, www.imf.org.

Regulating the Regulator—An Economist’s Perspective 161 either at a regional level, as in the European Community Directives, or globally as in the Basel Accords on Capital Adequacy. It is relatively simple to agree on codes, on what represents good behaviour. It is much more difficult to monitor and to apply sanctions for infringement. But international sanctions do exist. Publicity, or “naming and shaming”, is an important instrument, for example as used by the Financial Stability Forum to grade the relative status of supervision among offshore centres.13 Beyond publicity, the possibility of excluding intermediaries in the offending countries from financial markets elsewhere would represent a strong, and quite credible, potential punishment. Perhaps as difficult and important as sanctions is the problem of how to monitor (bank) supervision and regulation elsewhere, an issue of importance in so far as a financial crisis in one country may have contagious spill-over effects on other countries. Suggestions have been made that such international monitoring could be done by one, or other, or a combination of, international financial agencies, for example, BIS, IBRD, IMF, or, perhaps, by a “college” of national regulators, i.e. self-regulation for the regulators. But, at the time of writing, not much real practical advance had been made, and the question, Quis custodiet ipsos custodes? remained largely unanswered. There are a number of general problems with such naming and shaming procedures. First, they are often based on an insecure subjective judgement, as some of the offshore centres argued and complained about the listing, in the summer of 2000, from the Financial Stability Forum. Within a country those who have been unfairly named could, presumably, seek redress in the courts for their loss of reputation. It is not so clear what might happen in an international context. Secondly, if one is at risk of being held to up to obloquy, this may reduce the cooperation from the regulated, and either lessen or distort the flow of future information from the regulated to the regulators. No ordinary person is likely voluntarily to provide information to someone outside in cases where they feel that such information may be used in ways that they cannot predict, and possibly unfairly so, against themselves. So, “naming and shaming” may provide incentives for the regulated to hide information. Again, such public naming may enhance fragility, and the possibility of contagion, by publicising where weaknesses are to be found. This may be perceived as providing an incentive for the public to shift their funds out of those being named as less secure. Whereas this acts as yet another incentive for those potentially at risk of being named to clean up their act, nevertheless it raises, at least in the short run, the potential for greater contagion and financial fragility. So the optimal level of transparency is rarely clear. 13 Financial Stability Forum, Release on Offshore Financial Centres, www.fsforum.org (May 2000). Such gradings provoked much concern, in some cases fury, amongst the authorities in some centres which felt that they had been judged without due process, without being able to give evidence in rebuttal, and without the possibility of redress. Perhaps, but they could always choose to invite outside observers to attest to their good offices. Moreover the strength of reaction was testimony to the efficacy of the instrument.

162 Charles A.E. Goodhart What, however, needs to be emphasised is that the possibility of publicity, of “naming and shaming”, is potentially as usable as an incentive mechanism to stimulate and to improve the regulators, as for the regulated. There is a great deal to be said for introducing some mechanism that will provide ratings and gradings for the various regulators themselves. The question remains how to set this in place; what the mechanisms should be. What might happen is that all countries, and not just emerging and transitional countries, should voluntarily submit to regulator inspections by a “college” of supervisors/regulators from other countries, say once every three years. The external “college” would be required to submit a grading and give its explanations publicly. Individuals of known expertise and reputation could be nominated to serve in such a “college”, and chosen, perhaps randomly, to serve in each case; possibly the BIS or IMF/World Bank could provide the secretariat. Some of the present arrangements being introduced by the IMF and World Bank, i.e. the Financial System Stability Assessments and Financial Stability Assessment Programmes (FSAPs), tend in this direction, but they need to be generalised, and applied to all countries. Whether countries such as the USA, Germany or the UK would be willing to countenance external rating/grading for their own supervisory/regulatory systems is uncertain. But it is worth a try.

ACCOUNTABILITY

Since “success” can only really be measured by the absence of financial failures, consumer losses or the competitive failure and migration of financial intermediaries, supervisors tend to get taken for granted, until such failures occur. Outcomes can only be easily observed when they are bad, i.e. “failing”, especially if the transparency of their own (i.e. regulators’) relative grading and rating is not apparent, perhaps because no such mechanism may have been put in place. How should one then respond in order to try to assess the success of regulators, when accountability is so difficult? There are a number of possible responses. Perhaps the most common, usual, response, and one which is often adopted by the financial regulators themselves, is to measure their own activities by the process that has been undertaken, and not the outcome. By process I mean the number of visits to regulated firms, the number and amount of fines imposed, the number of court cases, the workload of the staff, etc., etc., etc. Measurement by process, and not by outcome and value added, is unfortunately quite common. It is not recommended, in large part because the relationship between “process” and “outcome” is not necessarily closely correlated. The worst supervisors may well expend an enormous amount of, even damaging, energy intruding in ways that reduce value into the operations of the financial system. Energy and activity, while being generally desirable, do not in themselves guarantee that the exercise is being directed in the appropriate way.

Regulating the Regulator—An Economist’s Perspective 163 One of the major problems in holding supervisors accountable is that much of their operations is necessarily cloaked with commercial confidentiality. If such confidentiality is to be forcibly removed, then the free flow of information between the regulated and the regulators is likely to be impaired. This causes problems for accountability. For example, if the supervisors were required to give full and complete details of all their activities to a parliamentary subcommittee, it is dubious whether the testimony of the regulators would necessarily remain private. One of the consequential responses has been to set up some confidential group of insiders, not a public body, to act as an overseeing board on the operations and success of the supervisors. An example in this respect is the Board of Banking Supervision that was set up by the Bank of England to provide both general guidance and an oversight to the supervisory work of the banking supervisors when that function was undertaken within the Bank itself. But there remains a dilemma. The confidential nature of the supervisors’ work means either accountability is undertaken in private, which means that such accountability can never be full and public, or that the accountability has to be limited, or that commercial confidentiality is frequently breached, which will reduce the flow of information.14

CONCLUSIONS

Perhaps the only proper conclusion is that providing accountability and transparency for supervisors, especially for the supervisors of commercial banks, is particularly difficult. The information which they get is frequently commercially confidential. Such confidentiality will impede transparency and also accountability. Moreover, the supervisors are trying to prevent disasters, whether of systemic stability or of abuse of consumer ignorance. Failures are clear and manifest, but the absence of disaster is not, in itself, much of an indication of good management; it could be pure good luck. Moreover, the optimal number of failures, either of consumer protection or of financial failure, is not zero. A zero outcome of failures would, of itself, mark excessive intrusion, overregulation, and undue restriction of innovation and risk-taking. 14 It was, perhaps, partly for such reasons that the Reserve Bank of New Zealand felt that it was sensible for it to get out of the business of being responsible for banking supervision almost altogether, leaving the exercise up to market discipline more generally. The problem with that approach, as undertaken in New Zealand, was that all the banks in New Zealand, except for one very small one, were subsidiaries (or branches) of larger banks which were headquartered elsewhere. Such larger banks must naturally have received supervision and regulation on a consolidated basis in the country in which they were headquartered. So it is perfectly possible to argue that the RBNZ could withdraw from supervision, because it was free riding, or piggybacking on the supervisory efforts of its larger neighbours. Those who take this line argue that the New Zealand experiment will, as a result, prove nothing whatsoever about the appropriate form and nature of supervision.

164 Charles A.E. Goodhart So, it is difficult to assess the adequacy of supervisors by outcome; though if failure is too prevalent, it will provide a reasonable indication that all is not well. Measurement of process, though easy, is not recommended, since energy and activity can be badly directed. Perhaps the best suggestion which has been reviewed in recent years, and discussed earlier in this chapter, is that the regulators and supervisors in any country should themselves be monitored by some outside international body, which could rate the agencies and publish the gradings of such ratings, and the reasoning behind such gradings in a public fashion. It is generally agreed that rating the creditworthiness of commercial financial institutions is a beneficial form of self- and market discipline. By the same token, the public rating of the regulators themselves may be even more valuable to society. I would like to think that such a good idea would be put into practice, but I have my doubts.

12

Public Accountability in the Financial Sector ROSA M. LASTRA AND HEBA SHAMS*

ACCOUNTABILITY AND GOVERNANCE

defines governance as “the manner in which power is exercised in the management of a country’s economic and social resources for development”.1 The definition refers specifically to state power. This is obvious from the Bank’s interpretation of the definition as including “building the capacity of public sector management [and] encouraging the formation of the rules and institutions which provide a predictable and transparent framework for the conduct of public and private business and to promoting accountability for economic and financial performance”.2 Both public sector management and rule-making are tools of state power in the performance of its governance function. By contrast, the Commission on Global Governance3 adopts a broader definition of governance as “the sum of the many ways individuals and institutions, public and private, manage their common affairs. It is a continuing process through which conflicting or diverse interests may be accommodated and action may be taken. It includes formal institutions and regimes empowered to enforce compliance, as well as informal arrangements that people and institutions either have agreed to or perceive to be in their interest”.4 In the last decades the role of the state and the function of governance have been refined and redefined. For instance, enforcing law and order and resolving

T

HE WORLD BANK

* This chapter was first presented at a conference jointly organised by the Financial Markets Group of the London School of Economics and the Centre for Commercial Law Studies of Queen Mary and Westfield College on Rules, Incentives and Sanctions. Enforcement in Financial Regulation, May 2000. 1 World Bank, Governance and Development (Washington, DC, World Bank, 1992), 3. 2 Ibid., 3. 3 The Commission on Global Governance is an independent commission which was established by its members in 1991 to look into the changes in the world since 1945 and especially after the collapse of the Berlin Wall and the end of the Cold War. Its task was to observe this change and to discuss its implications for world governance. For more details see The Commission on Global Governance, Our Global Neighbourhood (Oxford, OUP, 1995), pp. xi–xx. 4 Ibid., 2.

166 Rosa M. Lastra and Heba Shams conflicts of interests through the police and judicial system have been traditionally considered a primary governance function, which has been reserved to the state even in the most minimalist approach to its role. However, in the current process of increasing globalisation, the state is finding it increasingly difficult to enforce its laws against global actors such as multinational corporations and criminal organisations; tax laws are a case in point.5 Resolving conflicts is diverging from the state’s judicial machinery to private bodies through the crescent popularity of arbitration as an alternative dispute resolution mechanism. Even in the area of policing, the state is enlisting the private sector in the fight against crime. Money-laundering control systems and the reporting duties they impose on financial institutions are an obvious example of this shift towards private policing. Today, the state is neither the sole nor the sufficient holder of the governance function in the society. As Marc Williams puts it, “[i]nstead we should visualise a range of loci of decision-making, legitimacy and authority in contemporary society”.6 Power is now diffused. It is exercised by a variety of actors including international organisations, such as the WTO secretariat, the IMF and the World Bank, multinational corporations and the civil society. So if we understand governance as the exercise of power in the management of resources, this function becomes centralised or fragmented inasmuch as the decisions of production, distribution or redistribution are taken by central power or by diffused loci of power. Following the end of the cold war and the spread of neo-liberal economic thinking, the market has become the primary mechanism for the allocation of resources. As a result, the participants in the market have become holders of power and agents of governance. Financial markets’ share in this power cannot be exaggerated in view of their role in the allocation of the most versatile, mobile and indispensable element of production; namely, capital. The question of accountability emerges whenever the question of good governance is examined. With respect to financial markets as holders of power, three loci of accountability may be identified: the regulators, the market participants and the auditors.7 In this chapter we focus mainly on the accountability of the regulators.

DEFINITION OF ACCOUNTABILITY

Accountability is a pervasive concept. One encounters it in political, legal, religious, philosophical and other contexts. Each context casts a different shade on 5 P. G. Cerny, “What Next for the State”, in E. Kofman and G. Youngs (ed.), Globalization: Theory and Practice (London: Pinter, 1996), 126. 6 M. Williams, “Rethinking Sovereignty” in ibid., 119. 7 C. A. E. Goodhart, “An Incentive Structure of Financial Regulation” in C. A. E. Goodhart (ed.), The Emerging Framework of Financial Regulation (London, Central Banking Publications 1998), sect. 1, 96.

Public Accountability in the Financial Sector 167 the meaning of accountability. However, a general definition incorporating basic elements remains recognisable. Accountability can be defined as an obligation owed by one person (the accountable) to another (the accountee8) according to which the former must give account of, explain and justify his actions or decisions against criteria of some kind,9 and take responsibility for any fault or damage. Four elements are at the core of any understanding of accountability.

The Accountable The accountable is a holder of power. Accountability presupposes that a person is in a position to make decisions that are likely to have an impact on others and to implement those decisions. This definition is broad enough to encompass private decision-making as long as it can affect the fortunes of others. For instance, the decision of a driver regarding the speed of his driving in a busy street might result in an accident that affects the life, property or physical integrity of another person. However, when the person is holding power that is public in nature, in that it can affect the collective wellbeing of the society, the question of accountability becomes more crucial. A clear-cut example of public power is the decision-making authority invested in central and local government as well as civil servants. The sine qua non requirement of power in any analysis of accountability is emphasised by analysts in various contexts. One commentator discussing the principle of accountability in tort said: Thus, the principle of accountability . . . concerns itself with power. . . . The fundamental norm is that power cannot be divorced from responsibility. The greater the dependency of one person on another, the greater the law’s temptation to impose liability on the person in a position to determine the actual distribution of harms.10

Another commentator discussing accountability in the context of constitutional theory said: “[r]esponsibility should, indeed, be commensurate with the extent of the power possessed”.11 Accountability is often categorised with reference to “the accountable”. So, for instance, we speak of individual accountability, ministerial accountability, central bank accountability, corporate accountability and market accountability.

8 This usage is borrowed from D. Oliver, “Law, Politics and Public Accountability: The Search for a New Equilibrium” [1994] Public Law 228. 9 Cf. ibid., 246. 10 S. B. Young, “Reconceptualising Accountability in the Early Nineteenth Century: How The Tort of Negligence Appeared” (1989) 21 Connecticut Law Review 202. 11 C. Turpin, “Ministerial Responsibility”, in J. Jowell and D. Oliver (eds.), The Changing Constitution (2nd edn., Oxford, Clarendon, 1994), 111.

168 Rosa M. Lastra and Heba Shams

The Accountee The accountee describes an authority to whom accountability is owed. Who guards the guardians? Accountability as an obligation must be owed to another party. The latter becomes by virtue of this obligation in a position of authority vis-à-vis the accountable. There are various types of accountability according to the authority that exacts it. We speak of judicial accountability (or accountability to the judiciary) when courts are the authority that enforce accountability. An obvious example is the judicial review of administrative actions or decisions. When Parliament is the accountee we speak of parliamentary accountability (or accountability to Parliament). We speak of accountability to the public, to refer to the general public as the accountee. The Content of the Obligation The accountable holder of power is under an obligation to give an account of his decisions or actions, to explain and justify the decision or the course of action taken and, where error is proved or harm inflicted, to own the responsibility and take appropriate measures of amendment or redress. While there is no accountability without a duty to give account and explain,12 the forms of amends or redress vary from one type of accountability to another. Where accountability is imposed by the law and enforced by courts, redress often involves the imposition of sanctions or compensation. On the other hand, political accountability that is enforced by Parliament often stands at the prevention of future recurrence and is short of actual redress.13 With regard to the content of the obligation, some authors distinguish between ‘explanatory accountability’ where the obligation is to answer questions, to give account of action, and ‘amendatory accountability’ where there is an obligation to make amends and grant redress.14 Furthermore, reference is sometimes made to criminal, civil or administrative accountability according to the type of sanction that is likely to be imposed for the established fault or harm. Criteria of Assessment Any form of accountability presupposes that there are objectives or standards according to which an action or decision may be assessed.15 In other words, 12 C. Turpin, “Ministerial Responsibility”, in J. Jowell and D. Oliver (eds.), The Changing Constitution (2nd edn., Oxford, Clarendon, 1994), 112 (“[a]n obligation to answer, to give an account of action taken, has been described as the ‘central core’ of the concept of responsibility”). 13 On the comparison between judicial and political accountability in terms of redress and in other terms see Oliver, n. 8 above, 246–52. 14 Turpin, n. 11 above, at 109. 15 Ibid., 111.

Public Accountability in the Financial Sector 169 accountability implies an obligation to comply with certain standards in the exercise of power or to achieve specific goals.16 The more complex the activity, the more difficult it is to establish clear standards of conduct and specific outcomes. In which case accountability becomes ever more evasive. In the case of government accountability, goals are often specified in the electoral manifesto or in the framework documents describing the policy of a certain department. Standards, on the other hand, depend on the political values as expressed in constitutional principles and customary practice in political life. The more specific the goals and standards the more effective the accountability. This might induce the “accountees” to resort to economic or other measurable criteria of performance (hence the term “performance accountability”). Some commentators on government accountability in the UK have criticised this approach, labelling it as “new managerialism”.17 Indeed, a recurring theme in some UK Government proposals for reform of the civil service is the need to improve its managerial effectiveness by adopting principles and practices of the private sector; an example of this trend is the introduction of performance management systems, according to which civil servants are to be made individually accountable for delivering specific targets.18

Ex Ante and Ex Post Accountability A further twist to understanding the notion of accountability is the distinction between ex ante and ex post accountability. Accountability can be exercised either before/during the process of taking the decision/action, or after the decision/action has been taken. It is with reference to this fact, the fact of concluding a decision or action, that we define accountability as either a priori (ex ante) or a posteriori (ex post). An example of ex ante accountability is where the “accountee” interferes in the process of choosing the holders of power, or where the consent of “the accountee” is required for the decision of “the accountable” to be final. For instance, the appointment procedures of central bank officials, when such procedures require parliamentary approval, and the parliamentary debate of inflation targets (if such a parliamentary debate is required) can be regarded as ways of exercising accountability ex ante or through scrutiny. The reporting requirements and the appearances of the central bank chairman or governor in front of parliamentary committees are ways of exercising accountability through control or ex post. 16

Ibid., 112. I. Loh reviewing R. Pyper (ed.), Aspects of Accountability in the British System of Government (Eastham, Tudor Business, 1996), [1997] Public Law 736 wrote: “Indeed the conservative administration from 1979–1997 unashamedly extolled the virtues of the managerial acronyms such as the Three Es (economy, efficiency, and effectiveness) which have latter metamorphosed into the Five Es (incorporating ethics and empowerment) and bolder still, the Big A (accountability)”. 18 See e.g. V. Bogdanor, “Sharing Responsibility for Reform”, Financial Times, 29 March 2000. 17

170 Rosa M. Lastra and Heba Shams

THE PLACE OF TRANSPARENCY IN THE FRAMEWORK OF ACCOUNTABILITY

In this section we first define the notion of transparency, then analyse the relationship between the concept of transparency and the concept of accountability.

Understanding “Transparency” Prior to the 1980s, transparency was hardly discussed in academic and policy literature. The 1980s witnessed growing attention to the concept, which was reflected in academic discussions across the disciplines of economics, political economy, information theory and law. In the 1990s this trend was confirmed. Studies of the concept proliferated, especially in the literature of international organisations, and “transparency” was established as a term of art in the relevant disciplines.19 This inevitably begs the question why the current concern with transparency. Transparency is an essential feature of governance in a market economy. The emergence of the current concern with transparency coincided with the retreat of the welfare state following the oil crisis in 1974. This eventually resulted in a wave of privatisation in the 1980s; a practice that confirmed the commitment to a market economy and reinforced the role of markets in the allocation and management of resources. This link between transparency and the market is further illustrated by the increased emphasis on transparency in the 1990s following the collapse of the Soviet Union and the global trend towards a market economy. One commentator, discussing governance structures in a market economy pointed out that: a market system pre-ordains the rule of law by ensuring three basic conditions: free entry to markets, access to information, and the objective sanctity of contracts 20 [Emphasis added].

A cursory review of the literature reveals that the question of transparency is present in any discussion about the need for good governance. The transparency of government and bureaucratic machinery of the state remains a popular concern. In this context transparency is defined as “a measure of the degree to which information about official activity is made available to an interested party”.21 The current concern for transparent political and economic structures22 suggests 19 W. Mock, “The Centrality of Information Law: A Rational Choice Discussion of Information Law and Transparency” (1999) 17 Marshall J. Computer & Info. L n. 29. 20 P. Dhonte and I. Kapur, Towards a Market Economy: Structures of Governance, IMF Working Paper No.11 (Washington, IMF, 1997), 6. 21 Mock, n. 19 above, 1082. 22 See e.g. L. Lowenstein, “Financial Transparency and Corporate Governance: You Manage what You Measure”(1996) 96 Colum. L. Rev. 1335; C. A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency” (1999) 112 Harv. L. Rev. 1197. (discussing corporate

Public Accountability in the Financial Sector 171 the need to reach a common understanding of transparency. In this context, we have identified five elements: (1) An organisation or an institution with sufficient power to influence the management of resources in the society, i.e., with a role in governance. The government is an obvious example and the market is another one. (2) Information. In general terms information can be defined as the “processed data which bears a reasonable possibility of altering the world perception of someone receiving the data”.23 However, for information to qualify as an element in transparency it must also possess an extra quality. Namely, it must be capable not just of “altering the world perception” of the recipient but also of doing so in a way that influences its political, economic, or social choices. For example, laws can be regarded as pieces of information in the sense that they change the “world perception” of the person about what is right and what is wrong. In doing so, they influence the person’s choices, because a rational person would organise its conduct in accordance with the law to avoid liability. Thus, laws qualify as information for the purposes of transparency. (3) A recipient is an essential component in the definition of both information and transparency.24 While discussions of transparency often refer to the “general public” as the recipient of the information, this element can sometimes be narrowed down to a specific group of interested recipients. (4) The availability of the information. Several mechanisms are employed for this purpose, such as: disclosure procedures, reporting requirements, granting the recipient investigative powers or a general right of access to information. For information to be available, some codes of transparency ought to impose on the given organisation certain duties regarding the quality of the information and its presentation. According to such codes the information must be accurate, clear, understandable and complete.25 (5) The time element. Transparency implies constant visibility of information. It is not sufficient that the information be provided periodically or in response to information requests. Instead, for the concerned institution to be sufficiently transparent, the collective mechanisms of making the information available must be such that timely information is constantly available.

transparency). See also e.g. R. Gester, “Accountability of Executive Directors in the Bretton Woods Institutions” (1993) 27 J W T 99–104; IMF, Report of the Acting Managing Director of the International Monetary and Financial Committee on Progress in Reforming the IMF and Strengthening the Architecture of the International Financial System (Washington, DC, 12 April 2000), ¶¶ 13–16 (discussing the transparency of international organisations). 23 Mock, n. 19 above, 1075. 24 Not all definitions of information incorporate the recipient as an element. Some theorists view information as an inherent quality in the data itself. See ibid., 1073–4. 25 Ibid., 1081.

172 Rosa M. Lastra and Heba Shams On the basis of this analysis and the broad definition of governance we have advocated, we can define transparency as the degree to which the rules governing a certain agent of governance and its activities, actions, processes or practices are constantly ascertainable and understandable by a party who is interested in the relevant information.26

TRANSPARENCY IN THE FRAMEWORK OF ACCOUNTABILITY

Any recent discussion of accountability has often included a reference to transparency and vice versa. This poses the question of the relationship between the two concepts. As we have indicated before, accountability is an obligation to give account of, explain and justify one’s actions, while transparency is the degree to which information on such actions is available. The provision of information is clearly an element of accountability. As the Scott Report puts it: The importance, if ministerial accountability is to be effective, of the provision of full and adequate information is, in my opinion, self evident, whether in answering parliamentary questions or in debate or to a select committee. Withholding information on the matter under review, it is not a full account, and the obligation to account for what has happened or for what is being done has prima facie not been discharged. Without the provision of full information it is not possible for parliament, or for that matter the public, to hold the executive fully to account.27

However, accountability is not merely about giving information. It must involve defending the action, policy or decision for which the accountable is being held to account.28 Transparency, in turn, is about the provision of information. The two concepts are, however, not identical. Transparency is the degree to which information is available. Full transparency is a condition or environment that exists when clear and adequate information is constantly available. The provision of information is hardly ever a neutral account of what happened or of what is happening; hence, the need for an explanation or justification of the agency’s actions or decisions (i.e., accountability). The provision of information in the context of accountability, whether in an ex ante investigation or an ex post requirement of disclosure, facilitates transparency. On the other hand, a transparent economic and political environment enhances the effectiveness of accountability. The two concepts are therefore mutually enforcing, and they both share the provision of information as a common requirement. 26 Cf. ibid., 1082. Our definition draws on the author’s definition but expands it beyond the scope of government rules and activities to those of any agent of governance such as markets, international organisations, the professions and non-governmental organisations. 27 Inquiry into exports of defence related equipment and dual use of goods to Iraq and Related Prosecution (HC 115 I, 1995–96) cited in H. Fenwick and G. Philipson, Sourcebook on Public Law (London, Cavendish, 1997), ¶ D4.58. 28 Ibid., 554–5.

Public Accountability in the Financial Sector 173

INDEPENDENCE AND ACCOUNTABILITY

Over the last two decades the establishment around the world of independent regulatory agencies has ignited a debate on how to reconcile technocratic independent institutions with the demands of democratic legitimacy. How can giving freedom (i.e., independence) to unelected officials be reconciled with a society remaining democratic? The answer is: through accountability. To begin, it is important to point out that authority is not given away, but “delegated”. A clearly specified mandate is given by Parliament, and the agency to whom the mandate is given, be it the central bank or another agency, is then left to get on with carrying it out. Accountability then requires, at the very least, that the agency explain and justify its actions and decisions and give account of the decisions made in the execution of its responsibilities. However, lawyers and economists tend to give emphasis to different issues when they try to articulate the accountability of independent agencies. Lawyers emphasise the institutional dimension, i.e., the placing of the institution (for example, the independent central bank) within the existing system of checks and balances, in relation to the three branches of the state—legislative, executive and judiciary (the question of who regulates the regulators or who guards the guardians). Accountability—from a legal perspective—should be “diversified” to include parliamentary accountability as well as judicial review of the agency’s acts and decisions, and a degree of co-operation with the executive to ensure consistent overall policy-making. In a national context, Parliament remains sovereign in its legislative decisions, and one statute proclaiming the independence of an agency can always be removed by another one revoking it. Parliamentary accountability should be exercised through a variety of procedures and mechanisms, including annual reports and appearances in front of Parliament or of public officials on a regular basis, and also in the case of an emergency situation. Judicial review of the agency’s actions and decisions (conducted by an independent and depolitisised judiciary) is essential to prevent and control the arbitrary and unreasonable exercise of discretionary powers. This is a fundamental element of the rule of law. The discretion of public officials should never be unfettered but subject to legal control. Economists, while accepting this “institutional” articulation of accountability, in particular parliamentary accountability, tend to put the emphasis on performance accountability on the one hand29 and on disclosure on the other. Disclosure or transparency in this context is viewed as a “market-based” form of accountability, typically favoured in Anglo-Saxon countries, such as the USA and the United Kingdom, where competition and transparency are considered to be the two main pillars of a market economy. For instance, with 29 See e.g., S. Fisher, Modern Central Banking, paper presented at a conference celebrating the third centenary of the establishment of the Bank of England in 1994.

174 Rosa M. Lastra and Heba Shams regard to the transparency required in the monetary policy decisions taken by an independent central bank, it is worth noticing that the minutes of the Federal Open Market Committee (in the USA) or of the Monetary Policy Committee of the Bank of England must be published. Performance control (the question of how accountability is to be achieved), on the other hand, is conditional upon the objectives and targets imposed upon the agency (for example, upon the central bank). Performance control is facilitated first by the existence of one rather than multiple goals or by their unambiguous ranking and, secondly, by the existence of a clearly stated and narrowly defined goal. Finally, the support of public opinion is another form of de facto accountability. Independence and accountability can be seen as opposite ends of a continuum. While too much independence may lead to the creation of a democratically unacceptable “state within the state”, too much accountability threatens the effectiveness of independence, and in some instances (particularly in the case of the exercise of a government override) may actually nullify independence. The debate about independence and accountability resembles the philosophical debate about freedom and responsibility: independence without accountability would be like freedom without responsibility.

THE ACCOUNTABILITY OF INDEPENDENT CENTRAL BANKS : THE EXAMPLE OF THE BANK OF ENGLAND

Since 1989, central banks around the world have grown more independent, i.e., less subordinate to the dictates of the political authorities in the conduct of monetary policy. In the European Community, the Treaty on Monetary Union, signed in Maastricht on 7 February 1992 made legal central bank independence a conditio sine qua non to participating in European Monetary Union, in addition to the four criteria of economic convergence. In other parts of the world, governments have also been compelled internally or externally (for example, via a recommendation of the International Monetary Fund) to grant independence to their central banks. In the United Kingdom, the Bank of England Act 1998 granted operational independence to the Bank of England. The case for independence is supported by economic theory and empirical evidence. However, in a democratic community, independence—as we have already pointed out in the previous section—is only one side of the coin, for accountability is also necessary. Interestingly, the consensus that surrounds the case for central bank independence and its legal articulation does not extend to the articulation of accountability. Both the measurement of accountability and the extent to which independent central banks are held accountable for their actions remain a matter of controversy and vary considerably from country to country.

Public Accountability in the Financial Sector 175 In a recent book on the theoretical foundations of the “democratic accountability” of central banks, the author, Fabian Amtenbrink, develops eight criteria to measure such accountability30: (1) the legal basis of the central bank (typically an Act of Parliament, but also a constitutional or treaty provision in some instances), (2) the monetary policy objectives (whether price stability is broadly or narrowly defined and whether this goal coexists with others, such as growth and employment), (3) the relationship with the executive branch of the government (from informal discussions to formal consultations), (4) the appointment and dismissal procedures (which are also a test of independence), (5) the override mechanism (which, if exercised, effectively nullifies independence), (6) the relationship with Parliament (the real test of accountability as Parliament should represent the will of the people), (7) transparency (i.e., disclosure), and (8) budgetary accountability (the counterpart of financial autonomy). In some of these categories, it becomes evident that—as we pointed out in the preceding section of this chapter—independence and accountability can be seen as opposite ends of a continuum. While too much accountability may threaten the effectiveness of independence, too much independence risks damaging appropriate accountability. A clear illustration of this tension is the liaisons or relations between an independent central bank and the Treasury or Minister of Finance. While too much liaison lessens independence, too little liaison comes at the expense of accountability. The optimal trade-off between independence and accountability varies from country to country, depending upon the political structure of government, the existing system of checks and balances in a society and the centralised or decentralised (both geographically and functionally) structure of the state. The design of the pre-1999 German Bundesbank and of the European System of Central Banks tilts on the side of independence, with weak parliamentary accountability. The Reserve Bank of New Zealand tilts on the side of accountability, because of ministerial control and the possibility of government override. The US model provides a good balance between independence and accountability. In the USA, the seven members of the Federal Reserve System Board of Governors are appointed by the President, with the advice and consent of the Senate. The President designates two members to be chairman and vicechairman and these designations must also receive the Senate’s approval. The Board of Governors is required to submit an annual report of its operations to 30 See F. Amtenbrink, The Democratic Accountability of Central Banks: A Comparative Study of the European Central Bank (Oxford, Hart Publishing, 1999), ch. 2. See also the book review written by Lastra [2000] Public Law 151.

176 Rosa M. Lastra and Heba Shams the Speaker of the House of Representatives, “who shall cause the same to be printed for the information of the Congress”, and special reports twice each year on the state of the economy and the system’s objectives for the growth of money and credit. The chairman—representing the Board—is responsible for reporting bi-annually to both houses of Congress on the goals and conduct of monetary policy. These are the so-called “Humphrey-Hawkings” hearings, under the Full Employment and Balanced Growth Act of 1978. The chairman of the Fed testifies in front of the Senate Committee on Banking, Housing and Urban Affairs; and the House Committee of Banking, Finance and Urban Affairs. Furthermore, the chairman and other Board members often testify before the Joint Economic Committee of Congress and other congressional committees. The Bank of England—according to the Bank of England Act 1998—provides an interesting balance between independence and accountability, though with a lower degree of parliamentary accountability31 and a higher degree of ministerial control than in the case of the US Federal Reserve System. The Bank of England lacks goal independence, because the objective (inflation target) to be pursued by the Monetary Policy Committee is precisely specified by the Chancellor of the Exchequer in terms of a particular index and quantified, with an obligation imposed on the MPC to report back to the Chancellor if it deviates from the target by exceeding the bands imposed upon it. The Bank of England Act 1998 imposes a high degree of transparency with regard to the actions and decisions of the MPC, with the obligation to publish the minutes of the meetings of the Monetary Policy Committee.32 The Bank also needs to produce an annual report of its activities to the Chancellor of the Exchequer, who must lay copies of every report before Parliament.33 Other reporting requirements are spelt out in section 31 In 1997 the Treasury Committee asked one of the authors of this ch. (Lastra) to submit to the House of Commons some written evidence with regard to its inquiry into the parliamentary accountability of the Bank of England. The memorandum written by Lastra was published as an appendix in the report on The Accountability of the Bank of England ordered by the House of Commons to be printed, 23 October 1997, House of Commons, Session 1997–98, HC 282, 28–30. Lastra advocated that the Treasury Committee should have appointed a sub-committee with the specific task of monitoring the Bank of England. (Under Standing Order No 152, the Treasury Committee has power to appoint one sub-committee.) Such sub-committee should have been independent of the Treasury on the one hand, and of the Bank of England on the other. To ensure its independence and depoliticisation, such sub-committee (which might have been called “The Bank of England Sub-Committee”) could have been chaired by an Opposition MP. All the members of this sub-committee (three or five) should have had the technical expertise required to deal with monetary matters. In summary, the sub-committee should have been multi-partisan and highly specialised. Amongst the procedures or mechanisms to facilitate parliamentary accountability, Lastra’s written evidence recommended inter alia that the advice of this Committee (or sub-committee) ought to be requested for the appointment of the Governor and the other members of the Monetary Policy Committee. Whether the Treasury Committee (or sub- committee) should also have been given a role to ‘consent’ to appointments would have depended on the political composition of the Committee (if dominated by the ruling party, such consent would be unnecessary). Approval or ratification of the appointments by the House of Commons would not have been necessary, because: first, Parliament in the UK is typically dominated by the executive party and, secondly, because a debate on the floor of the House on the merits of a candidate might be personalised and unedifying. 32 Bank of England Act 1998, s. 15. 33 Bank of England Act 1998, s. 4.

Public Accountability in the Financial Sector 177 18 of the Act (including the publication of the inflation report). The Act also contains a section on ‘reserve powers’34 that the Treasury can exercise in “extreme economic circumstances”. If this provision were to be applied, it would effectively nullify the independence of the MPC. Indeed, this “reserve provision” illustrates the trade-off between independence and accountability. One problem in the design of an “accountable independence”35 lies in the possible reversal of the intended objective of “depoliticising” the conduct of monetary policy. Indeed, if too much independence may lead to the creation of a democratically unacceptable “state within the state”, too much accountability threatens the effectiveness of independence.

THE ACCOUNTABILITY OF THE FSA

In this section we shall discuss the accountability of the Financial Services Authority (FSA) for its responsibilities under the Financial Services and Markets Act 2000 (hereinafter, the Act) following the four elements that we have identified in the definition of accountability above, i.e., the accountable, the accountee, the content of the obligation and the criteria of assessment. 36

The FSA (The Accountable) On 20 May 1997 the Labour Government announced a radical overhaul of the UK financial regulatory structure, whereby responsibility for banking supervision would be transferred from the Bank of England to a reformed and enlarged Securities and Investment Board (SIB), which would also subsume the selfregulatory organisations.37 On 28 October 1997 the Chancellor of the Exchequer baptised the new single regulator as the Financial Services Authority (FSA), born out of a change of name for the Securities and Investment Board. The FSA inherited the SIB’s legal structure as a private company limited by guarantee.38 As was the case with respect to the SIB under the Financial Services Act of 1986, the rationale for this particular legal status remains that such structure would allow it “to relate more effectively to the market place”39 within 34

Bank of England Act 1998, s. 19. See R. Lastra, Central Banking and Banking Regulation (London, Financial Markets Group, 1996), 49– 59. 36 This part shall not be concerned with the current interim arrangements for the FSA powers and accountability. 37 See the statement of the Chancellor of the Exchequer to Parliament of 20 May 1997. See also (1998) 5(3) Parliamentary Brief 28. 38 The Financial Services and Markets Act 2000 (hereafter FSMA) s. 1(1). 39 Statement by Mr Howard Davies, Chairman of the FSA cited in Joint Committee on Financial Services and Markets, First Report on the Financial Services and Markets Bill (HL Paper 50-1, AC 328–I, 1999) para. 104. 35

178 Rosa M. Lastra and Heba Shams which it was embedded and by which it was funded. It also allows the Authority sufficient “managerial flexibility and independence”40 from government. The status of the FSA as a private company has raised some fundamental concerns regarding its accountability. These were particularly aggravated by the expansive regulatory scope and powers of the new body and the fact that it received its mandate and functions directly from the statute. Under the Financial Services Act 1986, the regulatory functions were conferred on HM Treasury which then delegated them to the SIB. This arrangement meant, at least in principle, a degree of parliamentary accountability and the possibility for government to revoke the transfer of power and to resume the regulatory function should the “designated agency” fail to perform. Under the model envisaged by the Act the functions are directly conferred on the FSA by the statute, thus removing the degree of parliamentary accountability possible under the delegation model, as well as the power of government to interfere and take over the regulatory function. Commentators on this point, while maintaining that the accountability of the FSA is a crucial point of concern, dismissed the argument that the private company structure of the agency was specifically prejudicial to accountability. Mr Christopher Bates of Clifford Chance, testifying to the Joint Committee,41 indicated that what matters for the purposes of the accountability is the role that the agency performs and the powers that it has rather than its legal structure.42 Another commentator addressing this issue indicated that parliamentary accountability under the delegation model of the Financial Services Act 1986 was more theoretical than real. In practice, the government did distance itself from the day-to-day operation of the regulatory system and the responsibility for regulatory failures resided in the self-regulatory organisations supervised by the SIB rather than in the SIB itself or in the government.43 The Authority is governed by a chairman and a governing body of which the chairman is a member. Members of the Governing Body are appointed according to the principles of the Nolan Report, i.e., on basis of their individual integrity and experience. The Act provides that the governing body must include a majority of non-executive members.44 This provision provides an element of internal accountability within the structure of the Authority. The nonexecutive members shall form a committee with the responsibility of: (1) reviewing the performance of the Authority in terms of its compliance with the 40 Statement by Mr Howard Davies, Chairman of the FSA cited in Joint Committee on Financial Services and Markets, First Report on the Financial Services and Markets Bill (HL Paper 50-1, AC 328–I, 1999), para. 105. 41 It was an ad hoc Joint Committee of both Houses of Parliament, which was set up on 2 March 1999 for the purpose of scrutinising the draft Financial Services and Markets Bill. It is interesting to note that this was the first occasion in which a Joint Committee of both Houses was charged with exercising pre- legislative scrutiny. 42 N. 39 above, para. 105. 43 E. Lomnicka, “Making the Financial Services Authority Accountable” [2000] JBL 67. 44 The constitution of the governing body is stipulated in FSMA, sched. 1, para. 2.

Public Accountability in the Financial Sector 179 decisions of the governing body and the efficiency and economy with which it uses its resources; (2) reviewing the Authority’s internal financial controls; and (3) determining the remuneration of the executive members of the governing body.45 The implications of this arrangement for accountability are further strengthened by the requirement that the non-executive committee’s report must be disclosed as part of the Authority’s annual report. As we have indicated in the definition of accountability above, in any system of good governance the more significant the powers exercised by a certain agency the stricter its accountability should be. The Financial Services and Markets Act 2000 vests in the FSA a wide range of powers and responsibilities. The Authority combines both prudential and conduct of business regulations in an unprecedented manner. In the prudential aspect of its activity, it replaces nine different regulatory agencies: the Building Societies Commission (BSC), the Friendly Societies Commission (FSC), the Insurance Directorate of the Department of Trade and Industry, the Investment Management Regulatory Organisation (IMRO), the Personal Investment Authority (PIA), the Registry of Friendly Societies (RFS), the Securities and Futures Authority (SFA), the Securities and Investment Board (SIB) and the Supervision and Surveillance Division of the Bank of England. Accordingly, the regulatory scope of the FSA extends to cover the majority of the financial services industry. Additionally, this regulatory reach is extended under the market abuse powers of the Authority to non-authorised participants in the market who would not otherwise be subject to the regulatory remit of the FSA. The FSA also exercises very extensive powers. The Authority determines the entry into the market through its functions of authorisation of firms and approval of individuals. It sets standards for the conduct of regulated activities in the industry and investigates any suspected breach of such rules. For the purpose of investigating any breaches, the Authority is vested with broad powers for collecting evidence and enforcing disclosure. Where a breach has been proved, the Authority has the power to impose a variety of sanctions ranging from censure to withdrawal of authorisation and imposition of unlimited fines. Each of the powers conferred raises concerns for the accountability of the Authority, in response to which various mechanisms were incorporated in the Act. However, certain powers were more problematic than others. In the following few paragraphs we would like to turn our attention to the rule-making and the enforcement powers as two of the categories that seem to raise more concerns in terms of their impact on the industry and sometimes even on individual rights.

45

FSMA, sched. I, paras. 3 and 4.

180 Rosa M. Lastra and Heba Shams Rule-making Power46 Section 138 of the Act vests in the FSA a general power to make rules if it is deemed to be necessary or expedient for the purpose of protecting the interests of the consumers. In addition to this general power, the Act also incorporates in different parts thereof a variety of specific rule-making powers. Examples of such specific powers are the power to issue statements of principle and a code of practice with respect to the conduct of approved persons,47 and the power to issue a code of conduct on what amounts to market abuse.48 The FSA’s rules will not be incorporated in statutory instruments and therefore will not be subject to direct parliamentary control. The Delegated Powers and Deregulation Committee in its report to the Joint Committee on the Financial Services and Markets Bill criticised this point, indicating that “[i]f powers of this kind were to be vested in Ministers, we would undoubtedly advise that there should be a measure of parliamentary control”.49 The Delegated Powers Committee, however, accepted that in view of the close contact between the FSA and the market, and the technical nature of the issues addressed by regulation, “there is probably no sensible alternative to the approach set out in the draft bill”.50 This approach is further justified by the rapidly changing nature of the financial market and the need for regulatory flexibility to accommodate innovation and respond to change. Enforcement Powers The Act gives the FSA a wide range of enforcement powers that are thought necessary to enable it to carry out its statutory objectives. These powers are exercisable where the regulated firms fail to meet their prudential or conduct of business regulatory obligations. The enforcement powers are exercised against both the authorised firms and approved individuals. They include withdrawal of authorisation or restriction thereof, withdrawal of approval, intervention, imposition of disciplinary sanctions such as public censure or financial penalties and granting redress for aggrieved individuals. The FSA also has powers to prosecute for money-laundering, insider dealing and a myriad of other regulatory and financial offences. The Act gives the Authority additional power to prohibit certain individuals from being employed in the financial services industry. This power is not confined to individuals who are subject to approval procedures under the Act; instead it extends to any individual whom the FSA considers not fit and proper for the industry.51 46 For a discussion of this power and comparison to the system under the 1986 Act see e.g. I. MacNeil, “The Future for Financial Regulation: The Financial Services and Markets Bill” (1999) 62 MLR 731. 47 FSMA, s. 64(1) and (2). 48 FSMA, s. 119. 49 Delegated Powers and Deregulation Committee, First Report, n. 39 above, annex B, para. 8. 50 Ibid., para. 13. 51 FSMA, s. 56.

Public Accountability in the Financial Sector 181 Apart from the powers of the FSA with regard to market abuse, which are newly introduced under the Act, the Authority’s enforcement powers are to a great degree a restatement of powers granted to regulators under the regulatory system of the 1986 Act. However, those powers raised a lot of concern within the industry during the consultation process. According to the government’s report on the process: The main focus of comment on the draft Bill has been on the disciplinary process. There has been a perception that the FSA internal procedure may lack fairness and transparency, or be unduly costly and burdensome, and that the FSA will be able to act as a prosecutor, judge and jury.52

One of the powers that raised substantial concern was the power to impose fines for violations. The main concern was the fact that the Act does not set a maximum fine and leaves it up to the FSA to determine the size of the fine according to the circumstances of each case subject to certain guidelines regarding the seriousness of the offence.53

The Accountees and the Content of the FSA’s Obligation The FSA is accountable to a number of authorities: the government, Parliament, the judiciary, practitioners and consumers. In the following paragraphs we will outline those five different routes of accountability, the content of the FSA’s obligation towards its ‘accountees’ and the mechanisms of accountability incorporated in the Act. Accountability to Government The FSA is accountable to the Treasury. This accountability is achieved through a number of mechanisms: first, the Treasury has the power to appoint and remove the chairman and the members of the FSA’s governing body as well as the chairman of the non-executive committee of its governing body, which is invested with powers of checks and controls. Secondly, the FSA is under an obligation to submit to the Treasury an annual report regarding its operation. The content of this report has been outlined in schedule 1 to the Act on the basis of consultations between the Treasury and the FSA on the matter. The report must include the discharge of its functions with reference to its statutory objectives and principles of good regulation as set in the Act. The Treasury may also direct the FSA to include other points in the report. The report of the nonexecutive committee must be annexed to the report along with the reports of any other persons that the Treasury may deem relevant. Thirdly, the Treasury may 52

HM Treasury, Progress Report (March 1999), para. 6.2 cited in First Report, n. 39 above, para.

147. 53

FSMA, s. 210.

182 Rosa M. Lastra and Heba Shams commission independent financial reviews of the FSA operation as well as independent enquiries in cases of regulatory failures. Fourthly, the Treasury has limited power to intervene in the functions of the FSA by directing it to comply with the recommendations of the Director General of Fair Trading on issues of competition or with the UK international obligations. Accountability to Parliament Given the broad range of powers of the FSA, there have been concerns regarding the insufficiency of its parliamentary accountability. As we have already pointed out, the Delegated Powers and Deregulation Committee has expressed such concerns with regard to the rule-making powers of the FSA.54 There have also been suggestions to grant the National Audit Office the power to review the FSA’s operation and report to the Public Accounts Committee.55 Along the same line of strengthening the parliamentary accountability of the FSA, some participants in the consultation process proposed that the appointment of the governing body, or at least its executive members, should be subject to parliamentary confirmation hearing.56 All the above proposals were rejected in favour of an indirect parliamentary accountability of the FSA through the Treasury.57 The Treasury is under a duty to submit to Parliament the FSA’s annual report for consideration. Parliament is expected to consider the report through one of its committees (mainly the Treasury Select Committee) and to receive evidence from the Treasury and the FSA board and staff. Concerns have also been raised with regard to the fact that in view of the excessive workload of the Treasury Select Committee it may lack the resources necessary to exercise effective review of the FSA’s functions.58 Generally, the parliamentary accountability of the FSA is thought to be insufficient. This is especially in view of the non-involvement of the Treasury in the operational aspects and the individual decisions of the FSA. According to the MoU between the Treasury, the Bank of England and the FSA: The Treasury is responsible for the overall institutional structure of regulation, and the legislation which governs it. It has no operational responsibility for the activities of the FSA and the Bank, and will not be involved in them.59

54

See n. 49 above, and accompanying text. First Report, n. 39 above, paras. 108–111. See also Page [cross ref to his chapter]. Ibid., para. 122. 57 Ibid., para. 120. 58 Ibid., para. 121. 59 Memorandum of Understanding between HM Treasury, the Bank of England and the FSA, annexed to Financial Services Authority, Financial Services Authority: an Outline (London, 1997). 55 56

Public Accountability in the Financial Sector 183 Judicial Accountability The FSA, as an agency performing a public role, is subject to judicial review according to the general principles of administrative law. In addition to this general form of judicial accountability, the Act also provides for the establishment of the Financial Services and Markets Tribunal as an independent adjudicator over all the FSA decisions to authorise, to revoke authorisation, to intervene or to discipline. Accountability to Practitioners and Consumers The aggregate impact of accountability to practitioners and consumers is a form of public accountability in the general sense, i.e., accountability to the public as a whole. Public accountability in this sense is deeply rooted in the Act, and manifests itself in various requirements of consultation and public disclosure. The Act requires the FSA to hold an annual public meeting within three months of the production of its annual report to facilitate public consideration of the report. The FSA is required to organise the meeting in a way that makes discussion and public questions possible. It is also required to publish the minutes of this meeting within one month of its occurrence. The Act places a general duty on the FSA to maintain effective arrangements for the consultation of both consumers and practitioners.60 For this purpose, the Act requires the FSA to establish and maintain a consumers’ panel and a practitioners’ panel to consult with the Authority on practitioners’ and consumers’ issues as they relate to the fulfilment of its statutory functions. This statutory requirement is an endorsement of what was initially proposed and implemented voluntarily by the FSA. Turning the FSA’s initiative into a statutory requirement was however welcome as enhancing the independence and the effectiveness of the panels.61 While the appointment of the panels and their chairmen is the prerogative of the FSA, approval by the Treasury is required for the appointment of the chairmen and their dismissal. The FSA is required to take the panels’ views into consideration in the performance of its functions and, if it disagrees with a panel’s views or proposals, the Authority must explain to the panel the reasons for its disagreement in writing.62 There is nothing in the Act to prevent the panels from publishing their assessment of the FSA and its relationship to them. The Treasury may also require the FSA to annex such reports to its annual report. The effectiveness of the panels will depend on such mechanisms of consultation and disclosure.63

60 61 62 63

FSMA, s. 8. First Report, n. 39 above, para. 125. FSMA, s. 11. E. Lomnicka, “Making the Financial Services Authority Accountable” [2000] JBL 67, 75.

184 Rosa M. Lastra and Heba Shams The Act expresses an overall commitment to public consultation. Especially with respect to its rule-making powers, the FSA is repeatedly required to conduct formal consultation and to respond to its outcome. Attempts during the consultation period to secure the representation of consumers on the governing body by a reserved number of seats were rejected in favour of the application of the Nolan principles of public appointment. The Joint Committee did however stress that in selecting amongst candidates balance should be maintained between consumer and practitioner experience.64 In view of these multiple forms of accountability, there have been some concerns regarding the possibility of conflict between the priorities of the various accountees and the impact that such possible conflict could have upon the effectiveness of the FSA’s regulatory system. Mr Howard Davies in his statements to the Joint Committee accepted the difficulties inherent in this multiplicity of commitments and indicated that “the prime accountability route [is] through Ministers to parliament but we have to take account of the views of the consumers and of financial institutions themselves”.65 The accountability of the FSA is mostly an “explanatory accountability” in the sense that it involves a duty to account and explain. However, the “amendatory accountability” of the FSA has also been questioned at length in view of the statutory immunity granted by the Act.66 According to the Act, the FSA is immune from liability in damages for anything done or omitted in the discharge or purported discharge of its functions.67 This immunity is cast very broadly to leave outside its ambit only acts performed in bad faith or in breach of the Human Rights Act 1998. It was however justified by the need for effective regulation and the concern that the removal of the immunity or the restriction thereof might result in hampering the discharge of the FSA of its statutory functions.68 The immunity was therefore maintained and counter-balanced by imposing a duty on the FSA to establish and maintain a complaint scheme involving the appointment of an independent investigator who is empowered to investigate complaints against the Authority.

CRITERIA OF ASSESSMENT

In analysing the definition of accountability we indicated that it implies an obligation to comply with certain standards or to achieve certain goals. The more complex the activity the more difficult it is to identify specific goals and standards and the more evasive accountability becomes. One of the most

64 65 66 67 68

First Report, n. 39 above, para. 118. Minutes of Evidence, Q2. See on “explanatory” and “amendatory” accountability n. 14 above and accompanying text. FSMA, sched. 1, para. 19. First Report, n. 39 above, para. 136. See also Lomnicka, n. 66 above, 77–9.

Public Accountability in the Financial Sector 185 innovative aspects of the Act is its introduction of statutory objectives and principles for the financial regulatory system. Section 2(2) of the Act stipulates four regulatory objectives: first, maintaining confidence in the market; secondly, promoting public awareness; thirdly, protecting the consumer; and, fourthly, reducing financial crime. The four objectives are meant to be pursued simultaneously and in a complementary manner. Attempts to prioritise amongst them were rejected by the Government and the Joint Committee as unnecessary. However, Mr Andrew Whitaker, General Council of the FSA, indicated in a public lecture that “maintaining confidence in the financial system . . . is, in one sense, an overarching objective, under which all others can be subsumed”.69 Concern has been expressed regarding the absence of any reference to the reduction of systemic risk in the regulatory objectives of the FSA. Mr Howard Davies commenting on this point in his evidence to the Joint Committee indicated that this goal is embedded in the four statutory objectives set by what was then the Bill and sufficiently covered by the MoU between the Treasury, FSA and the Bank of England. In his view adding this as an additional objective would have been redundant. The stipulation of regulatory objectives in the Act was hailed as enhancing the accountability of the FSA at all levels. According to the Delegated Powers and Deregulation Committee: These [objectives] provide a valuable framework and discipline for the exercise of secondary legislative powers and open the way to judicial review proceedings if it is considered that such powers are not being exercised properly.70

The FSA also indicated that: The existence of such a set of objectives, and the benchmark they set against which others may judge our performance, will act as crucial discipline on the Authority.71

This celebration of the impact of statutory objectives on accountability could be exaggerated in view of the fact that these objectives apply only to the performance of the FSA at a very high level of generality.72 The statutory objectives apply to the assessment of the FSA’s discharge of its general functions of making rules, issuing codes and giving general guidance; they also apply to the assessment of the FSA’s general policy and principles. By contrast, the statutory objectives do not apply to the assessment of the individual decisions or acts of the FSA. This approach was specifically adopted to allow the FSA the flexibility necessary to respond to the circumstances of individual cases. It means, however, that while the statutory objectives could offer a helpful benchmark for the discharge of general political or public accountability, 69 A. Whitaker, Architecture for the New Single Regulator, Public lecture delivered at the Institute of Advanced Legal Studies (1999). 70 Delegated Powers and Deregulation Committee, n. 49 above, ¶11. 71 Financial Services Authority, Meeting our Responsibilities (London, August 1998) , para. 21. 72 Lomnicka, n. 43 above, 69–70.

186 Rosa M. Lastra and Heba Shams they will not be very useful for the enforcement of judicial accountability or public accountability for specific decisions and actions. In the pursuit of its statutory objectives, the FSA is constrained by deference to a number of principles. Section 2(3) stipulates seven considerations that the FSA must bear in mind in the discharge of its general functions; first, the need to use its resources in the most efficient and economic way; secondly, the need to have regard to senior management responsibility for the performance and compliance of the regulated firms; thirdly, the need to ensure that the benefits of regulation are proportionate to the costs of compliance; fourthly, the need to facilitate financial innovation; fifthly, the desirability of maintaining the competitive position of the UK in the international financial services and markets; sixthly, the need to minimise the adverse effects on competition from anything done in the discharge of its functions; and seventhly, the desirability of facilitating competition between those who are subject to regulation. The considerations stipulated in section 2(3) are not homogeneous in nature. While some of them are regulatory values, others are concerned with adverse outcomes of regulation that the Authority must avoid. The principles of efficiency, economy and proportionality are regulatory values that the regulator must observe in the discharge of its functions. The considerations of innovation and competition are, on the other hand, concerned with the vulnerability of those practices to regulatory intervention. Both innovation and competition can be undermined by excessive or unsound regulation. The Act imposes a duty on the FSA to bear in mind the adverse impact of its activities in the discharge of its functions on innovation and competition. The place of competition in the Act has been subject to extensive debate. Some argued that promoting the competitiveness of the UK financial markets should be elevated to a regulatory objective. This was, however, rejected as inconsistent with the other regulatory objectives. Inclusion of competition as a regulatory objective may also undermine the relationship between the UK financial regulator and financial regulators in other countries. Competition remains relevant as a condition which the FSA must not undermine in discharging its functions. To strike the balance between regulation and competition, the Act provides for the involvement of both the Office of Fair Trade and the Competition Commission in preventing any unjustified detriment to competition in financial markets that results from the regulatory activities. It is worth remembering in this context that risk to competition is one of the two cases where the Treasury can intervene and give directions to the FSA in the discharge of its functions.73 Imposing multiple regulatory objectives and a set of regulatory principles that must be taken into account in the discharge of the regulatory function implies an approach to regulation that is based on cost-benefit analysis. The Act makes this approach explicit by imposing on the FSA an obligation to conduct such 73

FSMA, s 163.

Public Accountability in the Financial Sector 187 analysis and to disclose its outcome whenever it proposes new rules, issues general guidance about rules or introduces changes to proposals following consultation. The basic rationale for this method is the potential powerful impact of regulation on the market and the complexity of its both intended and unintended consequences.74 It is believed that this new obligation will enhance the accountability of the FSA.75 But this cost-benefit analysis is not without difficulties, and assessing its success will depend on its application over time.76 Section 2(3) is a partial statement of the standards that the FSA must observe in discharging its functions. Its short list of principles could be justified on the basis of its focus on the general functions of the FSA rather than on all its functions. By the general functions the Act means the overall functions of rulemaking, issuing codes and giving general guidance as well as determining the general policy and principles. However, in addition to these general functions the Authority performs a myriad of other roles. It acts as an administrative authority in the implementation of financial regulation, as an investigator in cases of suspected breaches of regulation, as a prosecutor where there is a case to answer for such breaches and as an adjudicator in the imposition of penalties where infringements are proved. In performing each of these roles the FSA is bound by a variety of values and standards, thus diffusing the ‘criteria of assessment’ and making accountability more evasive. Section 7 of the Act also states that: In managing its affairs, the Authority must have regard to such generally accepted principles of corporate governance as it is reasonable to regard as applicable to it.

Article 6 of the European Convention on Human Rights (ECHR) establishes fairness and certainty as two standards that are binding on the Authority in the discharge of its adjudicative function in the context of disciplining those who breach financial regulations. According to the Convention, every one is entitled to a fair and public hearing in any proceedings, whether civil or criminal, with additional safeguards in the case of the latter. The Convention also requires that criminal offences should be clearly defined. With the extensive disciplinary powers that are vested in the FSA and the implementation of the ECHR in the UK by the Human Rights Act 1998, there has been great concern that the Act might fall short of satisfying the requirements of fairness and certainty in this regard. Despite consultations on this matter, the issue remains unresolved. Whether the disciplinary mechanisms of the FSA are consistent with the values of fairness and consistency as enshrined in the Human Rights Act 1998 and the ECHR will depend on the decisions of the European Court of Human Rights, should future conflicts be brought within its jurisdiction.

74 I. Alfon and P. Andrews, Cost-Benefit Analysis in Financial Regulation: How to Do it and How it Adds Value (1999) 7 JFR & C 341. 75 Ibid., 341. 76 Ibid., 342–3.

188 Rosa M. Lastra and Heba Shams

EVALUATION OF THE ACCOUNTABILITY OF THE FSA

If one approaches the question of accountability with a nineteenth-century framework in mind, one can conclude that the new FSA appears to be the “sole master of its own destiny”. Parliamentary accountability is minimal, independence from the Treasury is rather extensive and “unreasonableness” for the purposes of judicial review would be hard, if not impossible, to prove with such an intricate web of statutory objectives and regulatory principles. This conventional approach to accountability (the “old paradigm”) was obvious in the consultation process, where concern was repeatedly expressed regarding the absence of adequate parliamentary accountability. However, given the expanding and changing notion of the function of public governance (which has led to a diffusion in the exercise of power) and the complexity of the financial activities, conventional forms of accountability have given way to another paradigm that is based on participation and transparency. Both mechanisms of accountability are enshrined in the Act through its explicit obligations of consultation and public disclosure. This is not to say that executive, judicial and parliamentary accountability have become redundant, but, rather, that these forms of accountability are no longer considered to be sufficient to hold financial regulators responsible for their actions or decisions. Whether the “new paradigm” based on participation and transparency will secure effective accountability remains to be seen.

CONCLUDING REMARKS

This chapter has presented an introductory theoretical framework for understanding the notion of public accountability in the financial sector. We have identified a number of elements that ought to be included in any definition of accountability (the accountable, the accountee, the content of the obligation and the criteria of assessment). We have also examined the interrelationship between accountability and transparency and have provided a definition of the latter. We have paid special attention to the debate about independence and accountability, and illustrated this discussion with a reference to the accountability of independent central banks. The greater the freedom or discretion granted to an agency (financial or otherwise), the greater the need for adequate accountability. We have also examined in some depth the accountability of the new single financial regulator in the UK, the Financial Services Authority, for its responsibilities under the Financial Services and Markets Act 2000.

13

Regulating European Markets: The Harmonisation of Securities Regulation in Europe in the New Trading Environment EDDY WYMEERSCH*

THE PRESENT STATE OF THE REGULATION OF SECURITIES MARKETS IN THE EU

Short Historical Background the harmonisation efforts in the field of securities regulation in the European Union can best be started with a short overview putting developments in a historical perspective. Looking back on the developments over the last 30 years, taking as a starting point the publication of Segré Report1 in November 1966, one cannot but admit that considerable progress has been made: capital markets have been fully liberalised, and access entirely freed, regulations in all of the 15 European states are more or less harmonised, investment products and services circulate freely all over Europe under the European passport, all that resulting in a truly European capital market carried on in a single currency, at least in the core EU states. The movement has involved more than liberalisation and integration. Most jurisdictions have considerably upgraded their regulations and practices: it is often forgotten that even in the mid-1970s many jurisdictions did not provide for organised supervision of prospectuses, while I still remember the days when even leading market representatives denied the existence of any insider trading, and therefore the need for any regulation. This longer historical view is needed to put recent dissatisfaction with the present stage of regulation and development in its right historical perspective: what

A

N ANALYSIS OF

* This paper was written in the summer of 2000. Since then, major changes have intervened in the markets: exchanges have merged, a new regulatory framework is being put into place, the markets have declined significantly. These changes have not been incorporated. 1 CEE-Commission, Le développement d’un marché européen des capitaux (Brussels, November 1966) 400.

190 Eddy Wymeersch has been achieved is far from negligible, but it could have been more and certainly it should have been better. Dissatisfaction presently stems mainly from the poor state of integration of the markets themselves, resulting in an equally deficient state of regulatory harmonisation. One must admit that over the last seven years, i.e. after the Investment Services Directive (ISD),2 leaving aside the Takeover Directive, nothing substantial has been achieved. 3 The main cause of discontent lies at the level of the poor integration of the securities markets, especially of the stock exchanges. Here also some historical perspective is useful. The first attempts to improve the organisation of the markets date back to the mid-1980s: one of the earliest of these long defunct projects was one to which the European Commission contributed financially, but that finally ran ashore on the unwillingness of the existing exchanges to wake up to the challenges of the new times. Schemes for linking the existing markets or opening access to traders from the other states were circulated but fell on deaf ears.4 Competition was kept low and profitable. Protected behind the high walls of monetary division, markets could more or less live at their own pace. This state of affairs has changed. New competitors, especially the American and Japanese traders, have entered the scene, while the stock exchanges—of which there still are something like 23 in Europe—have been challenged by the presence of new trading systems, such as Nasdaq, Easdaq, Tradepoint, Instinet and the like. Also competition between the exchanges has considerably increased, leading to vast changes in trading patterns. The winners of yesterday are not necessarily those topping the league table today, and even less tomorrow. Against the background of these developments, regulation has also come under increasing pressure: deregulation, liberalisation, globalisation are the buzz words; less so are investor protection, prudential regulation, curbing market manipulation and insider dealing. With the new affluence, have investors become less risk averse? The Present State of Regulation The regulation of the securities business in Europe presents a highly scattered picture. Each of the 15 jurisdictions has its own regulations. Although a large part of these regulations has been based on the same EU rules, and use a common core of definitions, concepts and ideas (among which is the central concept of “mutual recognition”), the implementation of the Community rules in the national legal systems presents considerable differences, some of which have an undeniable influence on business decisions. 2

Directive 93/22/EEC [1993] OJ L141/27. In 1999, the Commission disclosed its new action programme. 4 See among the early proposals E. Wymeersch, “Quelques réflexions sur l’interconnection des marchés européens de valeurs mobilières” [1982] Rivista delle Società 1214; also: E. Wymeersch, “From Harmonization to Integration in the European Securities Markets” (1981) 3 Journal of Comparative Corporate Law and Securities Regulation 1. 3

Regulating European Markets 191 The overall picture of securities regulation at the EU level is of a partial body of common concepts and regulatory patterns, while a large part of the field remains uncovered. Considerable differences subsist in the rules ultimately applicable, each state having translated the European rules more or less according to its own fancy. This rather depressing view is brightened by the “mutual recognition principle”: although the overall system continues to show a lack of a central policy and direction, the regulators are no longer standing in each other’s way. At least in theory: in practice the possibility for national regulators to broaden the scope of the “general interest clause” constitutes in certain fields a pretext for restricting and sometimes barring cross-border transactions.5 Mutual recognition essentially aims at avoiding double regulation and supervision, the situation that existed in the 1970s and which was so heavily criticised in the Segré report. In the early directives, the leading idea was to enact similar regulation, which would necessarily be very detailed so that double vetting of the prospectus and other disclosure documents would become unnecessary. This proved unworkable. Therefore mutual recognition was introduced: the first directive in which it was used was the 1985 Undertakings for Collective Investment in Transferable Securities (UCITS) Directive.6 Apart from reducing interstate barriers, mutual recognition has another definite advantage: it creates some competition between regulations and between regulators. The threat of losing their supervisory business, from which often they receive a large part of their income, prevents overly cautious regulators from enacting excessive regulation. The success of some market centres is partly based on differences in regulatory burdens: if it stays within limits of overall prudence, this is not necessarily a bad feature. As an increasing number of issues become cross-border, mere mutual recognition is proving insufficient. Especially in the fields of prudential supervision on financial conglomerates, supervisors are co-ordinating their actions by entering into Memoranda of Understanding. Specific agreements between supervisors deal with organising multi-state and multi-subject supervision to be exercised over groups containing banks, insurance companies, investment advisers, brokers and so on, most of these operating in numerous jurisdictions. Multiplicity of supervision therefore co-exists with certain forms of co-ordination. A whole body of rules and practices has sprung from this approach leading to new forms of “contractually” organised supervision that clearly go beyond the minimum norms laid down in the directives and in the regulations of the states involved. No similar developments have been witnessed in the core fields of securities regulation, especially the regulation and supervision of the stock exchanges. In addition, there is a need for further streamlining of the existing regulations, probably through a more strictly enforced system of “mutual recognition”. 5 6

See also the contribution by G. Thieffry ch. 14, below. Directive 85/611/EEC [1985] OJ L375/3.

192 Eddy Wymeersch

Towards a European SEC? It cannot be denied that the present state of regulation and supervision in Europe presents certain flaws and undeniable drawbacks. But one should also view the advantages of this pattern of regulation. It is a clear expression of subsidiarity, a notion that has become dear to many citizens in our, in all respects, very diverse but culturally very rich part of the world. Furthermore, it stimulates competition between regulations which is a considerable protection7 against being burdened by unnecessary, over-restrictive rules. It allows firms to innovate, to launch new financial products or to create new trading mechanisms. Competition between the markets and their participants avoids costly outlays, both in regulation and supervision. But the consequence inevitably is that regulations present greater diversity, causing costs in terms of compliance and oversight. The major difficulty in actual practice derives precisely from this diversity of regulation: cross-border transactions have to take account of the numerous regulatory systems which they could possibly affect. More harmonisation is called for. Several solutions can be imagined: some prefer more flexibility in the regulatory system, others a de facto co-ordination while the maximalists plead for a fully fledged European SEC. These issues have been on the table for a long time. With recent developments in the market structure they may be calling for a new analysis.8 The present regulatory process at the EU level is too slow and too cumbersome. The average time for adopting a directive is closer to 10 than to five years. Once adopted, a directive cannot be changed, except with considerable effort and after lengthy negotiations: some rules are obsolete, others that were not so well justified from the outset were adopted as a political compromise. These rules cannot be revised, removed or updated. The EU Commission has started a simplification exercise called SLIM (Simpler Legislation for the Internal Market): however, the securities field has not benefited from the blessings of SLIM. There always has been a need for a monitoring body supervising the implementation and interpretation of the directives: this body, known as the Contact Committee, was provided for in the Admission Directive of 1979.9 But being a mere advisory body, its rulings are not binding until laid down in a directive. There are good arguments for further reinforcing the functioning of this committee, for example by rendering its recommendations and opinions public, and giving some binding force to its interpretations of the existing rules (for example, on a comply or explain basis). 7

In some respects comparable to some sort of habeas corpus. See the Lamfalussy group’s assignment: “Création du comité de sages pour les marchés boursiers, blocage à propos de la lutte contre le blanchissement de capitaux”, Agence Europe, 18 July 2000. 9 Art. 20 of Directive 79/279/EEC [1979] OJ L66/21. 8

Regulating European Markets 193 But more should be done: the Contract Committee or another body yet to be set up should have the power to initiate new regulations, or at least to set policy guidelines which Member States are bound to implement. This would at least render the system more vigorous and facilitate integration, especially in fields not covered by the present directives. But it will not render regulation more harmonised: the deep differences in the legal traditions of the Member States will result in even more regulation, leading to even greater differences in the national rules. Also as these European policy guidelines—as at present the directives— would be regarded as minimum standards to which Members States could freely add, at the end of the day one could expect a new round of regulations. Therefore and understandably, the cry for an all-powerful European SEC has been formulated by several writers in the past and in this volume.10 Much depends on what would be the exact meaning one wants to give to this “European SEC”: if it is the all-powerful, highly centralised body, with extensive powers of investigation and enforcement as we known it from the American experience, the reaction in many parts of the EU will certainly be negative. However, a pattern comparable to the one found in the Maastricht Treaty, empowering the European Central Bank (ECB) to set policy guidelines with respect to prudential supervision11and to have certain powers of verification of the implementation of its guidelines, seems a more workable approach which more closely follows the spirit of the European Union. To extend the power to direct investigations in the Member States or even to engage in enforcement actions would go beyond the limits of the workable integration patterns in Europe. This does not mean that no further co-ordination measures can be taken, for example in organising mutual information on supervision methods or common training, and in reinforcing the exchange of information in other areas.12

REGULATION OF THE MARKETS UNDER THE MODIFIED TRADING LANDSCAPE

The major challenge for the regulation of the securities markets in Europe lies in the adaptation to the new trading environment which will be the consequence of the merger of the exchanges. A couple of months, or even days, before more precise details on the structure of the new trading environment become clear, dealing with this subject is like looking into a black crystal ball. Therefore, the following analysis will be based on theoretical hypotheses which later may appear to be realistic, or not. Two items will be dealt with: the first one deals with a trading scheme as may be introduced in some Member States. The second will more specifically deal with the application of the existing regulations to some of the possible schemes. 10

See G. Thieffry ch. 14, below. See Art. 105(6) of the EU Treaty. 12 The subject has been extensively dealt with by K. Lannoo, Does Europe need an SEC? Securities Market Regulation in the EU (European Capital Markets Institute, November 1999). 11

194 Eddy Wymeersch

The New Trading Schemes At present there is only sketchy information available about the two new trading schemes. Under the originally proposed iX scheme, there would have been at least two trading platforms, one for seasoned stock, to be linked to the London regulatory sphere, and the other for securities of more junior high growth and technology companies, reportedly to be linked to the Frankfurt regulation. The Euronext scheme contains a comparable subdivision of matters: Paris will be the trading place for the most important stocks, Brussels for the small caps, while Amsterdam will house the derivatives market. The legal structure of Euronext will be based on a Dutch holding company, subject to the Dutch codetermination system, with 100 per cent subsidiaries in Paris, Brussels and Amsterdam, the latter being the operational units born out of the former stock exchanges. Shares in the former exchanges will be exchanged for shares in the holding company. Reference to these schemes will be made only by way of example: the issues remain comparable under both schemes. Previously, exchanges were regarded as public interest organisations aimed at securing the smooth functioning of the secondary market. This was judged mainly in light of the interest of the issuers, among which the Treasury counted as the first and most important. On the continent, this function was visible in the regulation up to a few years ago, as was indicated by some features that went back to Napoleonic times and Napoleon’s continuous search for funds to finance the war effort. Starting from the mid-1990s, under the pressure of international competition, but also as a consequence of new, more efficient trading alternatives, exchanges gradually moved away from their public function to become essentially commercial firms competing with other trading systems (ECNs or PTSs) aimed at maximising profits. As most exchanges combined organisational, regulatory, supervisory and enforcement tasks, it became increasingly apparent that the combination of these tasks with their essentially commercial private business objectives would be incompatible. Several exchanges chose to convert into commercial companies,13 sometimes after difficult demutualisation14 exercises, while others still retain some of their previous supervisory functions. Exchanges have become “market organisers” and compete on a commercial basis, although not necessarily, with other order execution systems. The main drivers of change are well known: international competition, globalisation of the markets and the formidable facilities offered by the electronic linking of the markets. The stock exchanges as commercial providers of financial services no longer have a monopoly position: the same services can be 13 14

E.g. in Sweden, France, Italy. See in the UK and in the Netherlands.

Regulating European Markets 195 provided on a competitive basis by any firm that meets certain requirements, and especially by computer driven electronic networks or ECNs. Competition has replaced the public interest function that previously dominated the market organisation. Regulation should be adapted to secure access to this market of “securities trading services” to any provider of financial services that meets pre-established criteria. Therefore a regulatory framework for the registration of stock exchanges and other market organisers should be introduced. The role of the market supervisor should consist of registering the candidates on the basis of the criteria set by the legislature, and thereafter supervising whether the criteria are being correctly applied. In this scheme there would be no difference between a stock exchange and any other ECN. The supervisory function of the stock exchange would be limited to reviewing whether its own rules relating to trading on the market have been complied with, while the market supervisor, an external public agency, would be in charge of evaluating this limited form of supervision by the exchange. The next question relates to the extent to which this liberalised market for “securities trading services” should be subject to the normal rules of competition, and whether the European competition authorities in charge of competition matters should not oblige Member States to provide equal access to this market. Under the Treaty rules on freedom of establishment and of services, exchanges as bodies active in the competitive sector should be allowed to establish themselves in all Member States. The competition issue has not directly been addressed in the directives: it was approached, in the ISD, in terms of remote access to markets. That directive formulated a weak response which resulted in states being able de facto to restrict access to foreign markets.15 Under the changed market conditions which are now being framed, this question can no longer be avoided: there should be free access to all markets for those that meet the conditions in their state of establishment,16 while Member States should not be able to deny non-resident exchanges access their markets, for example by refusing to install trading screens or to give local brokers access to the foreign trading systems. Only on the basis of the “general good” reservation could Member States restrict access. Review on the basis of the well known four-pronged criteria will almost invariably lead to free access.17 The role of the public regulatory body would become much clearer within the scheme which has just been outlined. Supervision and enforcement of all regulations established by or pursuant to an act of the legislature would be within the competence of an independent public agency. 15 The ISD contains no rules on the recognition of markets within the EU. Only rules on recognition of market participants have been harmonised. 16 To be appreciated on the basis of the criteria formulated in Art. 48 of the Treaty. 17 Several ECJ judgments have allowed national restrictive regulations to be upheld provided these have the following conditions: (a) non-discriminatory application; (b) justified by imperative requirements in the general interest; (c) suitable for securing the attainment of the objective pursued and (d) not going beyond what is necessary to attain that objective (“proportionality”).

196 Eddy Wymeersch In some of the regulations today, the stock exchange is in charge of certain supervisory matters, such as the admission of securities to the market, the tracing of insider transactions or the review of company financial disclosures. There is an evident conflict of interest between the stock exchange which is in charge of promoting its trading system and attracting new listings and at the same time exercising control over its clients. A recent example in the Netherlands has shown the extent of this dilemma.18 Conceptually, this is the major objection to self-regulation. Therefore it is not striking that self-regulation will increasingly be abandoned: in the UK matters relating to listing are now the responsibility of the FSA rather than the London Stock Exchange, while in the Netherlands the role of the Exchange as a regulator was increasingly criticised even before the Euronext decision was taken. Although one may regret that this flexible alternative to hard law has to be abandoned, at least for the regulation of the modern, internationalised and highly competitive markets, the time for old forms of selfregulation is gone. Redefining the tasks of the public supervisory body and of the market organisers invites reflection on their respective roles. The public regulatory body would be in charge of the overall regulation of the market and of registering those securities market organisers that meet the criteria laid down by the regulator pursuant to the law. The conditions for recognition as “market organiser” could be described as the minimal safeguards for the proper functioning of the markets. They are as follows: • transparent, open and fair systems of price fixing, the methods of price determination being determined by the market (order or quote driven); • open, objective and non-discriminatory procedures for admitting securities to the market; issuers of securities should previously file with the supervisory agency, for approval, company financial disclosure documents; • open and objective procedures for admitting traders to the markets that meet the prudential conditions set in the bylaws of the “market organiser”; • rules and procedures ensuring transparency and interconnection, including equal access to all other market participants with respect to price and quotations; to maximise competition and avoid excessive segmentation, rules would have to be provided for safeguarding the interconnection of market organisers; • rules on clearing of transactions, and appropriate and safe delivery-versuspayment (DVP) requirements for settlement, including central counterparty systems. Candidates meeting these requirements would be allowed to offer their services to the public. No discrimination should be allowed, as competition between systems should be guaranteed. Market fragmentation would be 18 One refers to the case of WorldOnLine, in which the Exchange reportedly was persuaded not to postpone a public issue and listing, in circumstances where the issuer was threatening to seek a listing abroad.

Regulating European Markets 197 avoided by mandating appropriate interconnection at the level of trading and price formation and dissemination. In their redefined role of market organisers, exchanges would have limited regulatory and supervisory powers: these would be restricted to the transactions taking place on their “floor”, in order to ensure the market develops in a fair and orderly way. So, for example, it would have to intervene to suspend trading in securities which it lists when significant developments have been notified, whether by the issuer, by the supervisory agency, or even by its own observation. For certain matters the exchange would be the starting point for further supervisory action, for example, with respect to detecting insider trading or market manipulation. A certain stock watching function would remain useful, along with the primary surveillance exercised by the agency. At the same time, the exchange would not be in charge of admission of securities, disclosure, prudential supervision of or enforcement against market participants, issuers, or any other parties. Although there certainly are a number of subjects for which appropriate allocation of supervisory competence should be further investigated, the general framework should be clear: exchanges and other market organisers, as commercial enterprises, offer their services to the public. They exercise monitoring and surveillance tasks but only within the limits of the efficient organisation of their markets, not as aides to the public administration function. As providers of financial services, several rules of European Community law would be applicable. As mentioned before, competition law would be fully applicable, leading to spontaneous consolidation over time, without freezing out new initiatives. The merger of the Paris, Brussels and Amsterdam exchanges is subject to review by the European Commission, in which review general considerations of market efficiency and of avoiding segmentation should play a important role. Freedom of establishment and of rendering services would allow these service providers to spread all over Europe without national states being able to reserve their market to national competitors. Branches could be opened in other states, while access to the trading system would be opened to all professionals willing to abide to the rules set by the new organisation. The mutual recognition principle would apply: although it is not yet clear which state will supervise which part of the new organisations, there can be no doubt that host states would be restricted in their review procedures for branches or for services to those aspects that are strictly related to the domestic “general good”. All these ideas point to the conclusion that there are good arguments for drafting a directive fixing the minimum criteria for establishing and operating a “securities market service provider”. States should be obliged to provide for a registration procedure in which certain minimum criteria are established. There should be a provision that allows the applicant to be denied registration or be struck off the list if its organisation does not—or can no longer—meet certain minimum criteria, while the identity of the owners or shareholders should be open for review to avoid infiltration by criminal organisations. Organised

198 Eddy Wymeersch according to the rule of private business, these market organisers could enter into alliances, conclude mergers or take-overs, and generally take all initiatives that they deem useful for the development of their markets. Finally, arrangements would have to be agreed with respect to the supervision exerted over these service providers and to ensure co-operation between national supervisors. Most of these proposals could probably be realised within a reform of the ISD, adding a special class of investment firms.

THE NEW REGULATORY PATTERN

The development that calls for our attention consists of the formation of crossborder, fully integrated securities trading schemes, whereby two or more traditional stock exchanges reorganise themselves in such a way that the markets will be fully integrated and that trading in shares listed on both exchanges will essentially take place on the trading platform organised and maintained by one of them. Without analysing the notion of “market”,19 the issue to be dealt with here is the regulatory one: what rules and regulations will be applicable to securities that originally were subject to the jurisdiction of state A and are now exclusively traded in state B? Several answers could be given. In fact there is a longstanding tradition of cross-border listing: many major securities have been listed for many years on several European stock exchanges. These are secondary listings, most of the time also of secondary importance, the original market continuing to attract the main trading. The securities remain subject to their original legal status: company law rules, disclosure rules etc. remain those of their “home market”. Trading rules are those of the market where the securities are effectively traded, with some exceptions. So, for example, foreign shares in most exchanges are traded in the currency of the exchange, allowing for easier access to local investors. Only Amsterdam had a fairly developed market in US denominated shares traded in US dollars. The Community sustained this policy of “dual listing” in the—mistaken—belief that it would lead to the creation of an integrated European securities market.20 “Foreign listing”, whereby issuers from state A list exclusively in state B, is a more recent phenomenon and it has developed especially in the high-tech sector. Originally, the rules of the company’s home state also remained applicable. However, an increasing number of market rules dictate the obligations of the company: so, for example, in the Easdaq system, the system itself imposes its own requirements in terms of disclosure, annual reports, and even corporate governance rules. In case of conflict between the home state rules and those of 19 See R. Lee, What is an Exchange: the Automation, Management and Regulation of Financial Markets (Oxford, Oxford University Press, 1998) 405. 20 See the amendments introduced by Directive 94/18 (Eurolist) [1994] OJ L135/1.

Regulating European Markets 199 Easdaq, the market authority may consider granting an exemption from the latter rules.21 At present we are confronted with a further stage of development, in which all securities of the participant exchanges will be traded in one market, according to the rules of that market, and with as little link as possible to their market of origin. It should be observed that at the moment of writing no definite decision have been made about the future market structure. The following analysis is made on assumptions that should first be detailed.

Privileged Access Hypothesis In the first, minor hypothesis, the linkage of the market would be limited to offering privileged access to each other’s trading floors. Investment firms active in one market would obtain direct access to the market without having to pass through a local broker. Transaction costs would be reduced by avoiding fees for the correspondent broker. In general, the market structure would not be changed and would remain subject to the regulation of the different exchanges involved. As the exchanges merge institutionally, this scheme may be the first stepping stone towards further integration. From the regulatory point of view, it changes very little: co-operation between supervisors should be strengthened to ensure that foreign brokers abide by the rules applicable on the market of execution.

Common Trading Platform Hypothesis In the second hypothesis, the merger of the stock exchanges would lead to the creation of a common trading platform, on which the major securities of each of the participant exchanges are listed and traded. A single trading list would be drafted, composed of the major securities of each of the constituent exchanges. Notwithstanding the differences in legal regime, there might be a case for indicating the nationality to which the issuers belong. All members of each of the affiliated exchanges would have access to this common platform on the same conditions and according to the same trading rules, i.e., those of the state responsible for the single trading list. In fact trading rules should be unified over the constituent exchanges: order and quote driven systems might eventually have to be integrated. Clearing and settlement would be integrated, so that sales originating in one market could be matched against purchases from the other. The question arises which part of the regulatory framework would be governed by the state of trading and which part by the state to which the issuer is 21

See § 4200 of the Easdaq Regulation.

200 Eddy Wymeersch subject. The first set of rules could be designated as “market rules” while the second are “company law rules”. At least in an intermediate stage, it seems inevitable that the rules involving the legal status of the company would be governed by the law applicable to the company, whatever techniques are used to define that law.22 How far this field extends should than be further discussed: company structure including corporate governance, the legal position of shareholders, the rules relating to distributions, legal capital, voting rights, and so on, would remain governed by the home state of the company. But disclosure, perhaps also accounting, insider rules, part of takeover regulation are rather subject to “market law”. The rules of trading on the market, including the rules applicable to IPOs would also exclusively belong to the “market rules”. This approach is comparable to the dual listing technique mentioned above, but extends the ambit of market rules to a large part of the factors that have a direct impact on the market, such as disclosure. There is a significant difference however, and that is that the price list would be fully integrated: the adoption of the Euro as the trading currency on most of the continental markets would facilitate this presentation. But what if they belong to different currency zones, as would have been the case with the London-Frankfurt merger: would there have been two parts in the single price list, one in Euro, one in sterling? From the supervisory angle, the question arises whether supervision should be concentrated in the hands of the supervisor in charge of the market where the securities are listed, or should in part remain under the supervision of the “home state” of the company. The idea has been put forward that in each case there should remain a “local window” so that issuers and investors alike can address themselves to a local supervisor. That supervisor would then be acting in a double capacity, as the ultimate company law supervisor but simultaneously a local representative of the market supervisor. Would it apply only “home state rules” or also “market rules”? Logically in market matters, the local supervisor could act as the branch of the market supervisor. 22 See Case C–212/97 Centros [1999] ECR. Among the very numerous comments see W. Ebke, “Das Centros-Urteil des EuGH und seine Relevanz für das deutsche internationale Gesellschaftsrecht. Das Schiksal der Sitztheorie nach dem Centros-Urteil des EuGH” [1999] JZ 646 and 656; M. Göttsche, “Das Centros-Urteil des EuGH und seine Auswirkungen” [1999] DStR, n° 34; P. Kindler, “Niederlassungsfreiheit für Scheinauslandgesellschaften?” [1999] NJW 1993; K. W. Lange, “Eintragung der inländischen Zweigniederlassung einer ausländischen Gesellschaft” [1999] DNotZ 658; O. Sandrock, “Centros: ein Etappensieg für die Überlagerungstheorie” [1999] Betriebsberater 1337; J. J. Sonnenberger and H. Großerichter, “Konfliktlinien zwischen internationalen Gesellschaftsrecht und Niederlassungsfreiheit. Die Centros-Entscheidung des EuGH als gesetzgeberische Herausforderung” [1999] RIW, n° 10; S. Stieb, “Sitz-oder Gründungstheorie: der Gesetzgeber muß endlich Farbe bekennen” (1999) 15 GmbHR 257; P. Ulmer, “Schutzinstrumente gegen die Gefahren aus der Geschäftstätigkeit inländischer Zweigniederlassungen von Kapitalgesellschaften mit fiktivem Auslandssitz” [1999] JZ 662; S. Van den Braak, “Het Centrosarrest en het Nederlandse internationaal privaatrecht betreffende vennootschappen” [2000] WPNR 347; E. Werlauff, “Centros aus dänischer Sicht” [1999] ZIP 867; J. C. Casacante, note in [1999] RIW 450; E. Wymeersch, “Centros: A Landmark Decision in European Company Law” in T. H. Baums, K. J. Hopt and N. Horn, Corporations, Capital Markets and Business in the Law: Festschrift for Richard Buxbaum (Amsterdam, Kluwer Law International, 2000); H. De Wulf, “Centros: Vrijheid van vestiging zonder race to the bottom” (1999) 12 Ondernemingsrecht 318.

Regulating European Markets 201

Stronger Intergration The third hypothesis would be based on a scheme of stronger integration. Here too the partners would have divided the securities to be traded on the trading “floors” of each of the exchanges: the major securities going to A, the intermediate ones to B, and the small caps to C. A would be fully responsible for all aspects relating to the securities traded on the A market: in principle the same rules should be applicable to all the A securities, whatever the legal regime applicable to their issuers. These would be entirely subject to A’s authority. Trading would take place in one currency. Uniform rules would deal with matters such as: trading techniques, company disclosures, ad hoc disclosures, market manipulation, but also with insider trading and corporate control changes, take-over rules, reporting by major shareholders, corporate governance, and so on. Ultimately, within the limits set by the domestic law of the company, company structure issues would increasingly become governed by the rules of market A. From the supervisory angle, most of the competencies of the “home state” supervisor would be exercised by the market supervisor, while efforts are made to “harmonise” company law on a single mould. As far as trading rules are concerned, both in the second and third hypotheses, the members of the participating exchanges would have to adapt and familiarise themselves with a common set of rules, fixed or approved by the supervisor in charge of the market. One could see agreements on trading hours, on quotation in full currency or in percentage points, rather than in fractions (1/8th), on cash payments and DVP rules, which should tend to real time DVP anyway. Integrating an order driven system with a quote driven system may raise more difficult questions: a combination of the two has already been practised in some of the continental markets, and sufficient levels of liquidity seem to have been maintained. If there is a subdivision of markets segments as outlined above, an effort could be made to integrate the market rules, although specific characteristics would be determined by the concrete functional needs of each of the segments. The question to be analysed mainly concerns the borderline between matters that should be subject to market rules and matters of company law that should be governed by the laws of issuers’ home states. The basic concept would be that investors should know that they are buying financial instruments that are governed by legal systems that are not necessarily those of the state where the market is being organised. This idea results in the need to differentiate between “domestic” and “foreign” securities, a distinction that markets are not likely to make. At present, there is no clear answer to this hurdle. A further distinction can be introduced: some matters have a direct influence on the functioning of the markets and on price formation, while other matters, although far from neutral, have only an indirect, remote influence. One could

202 Eddy Wymeersch imagine that the former type of items will be more readily within the competence of the market regulator and supervisor, while the latter inevitably belongs to the realm of the company law. The dividing line, as here proposed, is also found in the proposal for a thirteenth Company Law Directive. This proposal contains an elaborate set of rules on conflicts of laws issues raised in cases of cross-border takeovers. The proposal draws a distinction between the competencies of the supervisory bodies and the laws on which these bodies will have to base their decisions. It is especially the latter subject that deserves to be further analysed. According to the proposed Takeover Directive, Article 4, the following matters are market related matters and hence are of the competence of the state of trading: —consideration offered in the case of a bid; —the procedure of the bid; —the information on the offeror’s decision to make an offer; —the contents of the offer document; and —the disclosure of the offer. The following belong to the realm of company related matters and hence will be supervised by the “supervisor in charge of the company law”: —the information for employees of the offeree company; —matters related to company law; —the percentage of voting rights which confers control; —any derogation from the obligation to launch a bid; and —the conditions under which the board of the offeree company may undertake any action which might result in the frustration of the offer. It should be added that the applicable company law will be designated by applying the rules of Article 48 of the Treaty, that is that of “the registered office, central administration or principal place of business”. The proposed directive refers to the “registered office” in the English text, and to the “siège social” in the French version. These are meant to be equivalent. Attention should be drawn to the practice, existing in several EU states, according to which stock exchanges and market supervisors impose additional requirements when listing the issuer’s securities or on the basis of their general oversight over financial disclosure. These requirements are directly related to company law matters, and deal with issues such as preferential subscription rights, share buy-backs, relationships with dominant shareholders and, more recently, recommendations on corporate governance. The interest shown by market regulators in these topics originates not only in genuine investor protection motives, but also, if not mainly, as a promotion device for the product offered on the “trading floor”. An example is provided by the London Listing Rules which contain provisions designed to neutralise the dominating influence of a controlling shareholder in its listed subsidiary, an interesting example of

Regulating European Markets 203 informal law on company groups. The most recent wave of regulation relates to corporate governance rules, which were strongly supported by the exchanges involved. There is therefore nothing new in market supervisors entering the field of company law, although this action is not based on any formal authority. On the other hand it is clear that these recommendations or guidelines, or rules of best practice cannot run against formal provisions of the company law to which the issuer is subject. An attempt to identify the rules which would be classified as market rules and which would be more readily viewed as company law rules can be undertaken by analysing the main sets of rules.

Disclosure Company disclosures have, on the one hand, been harmonised by different EU directives but, on the other, these directives have introduced only minimum standards which several regulators have supplemented. Disclosure obligations could be placed under the guidance of the market supervisor. This would apply to prospectus disclosure: this type of disclosure is part of the conditions for access to the market, and therefore could be governed by the market of listing, to the extent that its disclosure requirements go beyond the ones applicable in the home state of the issuer. Accounting rules would also be governed by the same principle: as most internationally active companies follow the IAS, there cannot remain much objection against urging all listed companies to follow IAS. But whether the same could apply to companies listed on the segments for small caps is debatable, especially as divergence from domestic accounting regulations may be more significant. Indeed, several of these companies are subject to less sophisticated accounting rules or may be located in third countries. The same approach could be followed in relation to other forms of disclosure, such as interim disclosure. There might be difficulties for ad hoc disclosure, as some Member States23 have introduced a catalogue of items about which disclosure should be made, while other states have merely adopted the general formulation that was followed in the directive creating differences in the ambit of the “ad hoc” disclosure duty. Ironically, in the fields of disclosure and accounting, there is a good chance that under the unifying influence of the securities markets, voluntary harmonisation will soon reach a higher level than in the case of legally mandated harmonisation. Undoubtedly there will be tensions between legal systems. Differences in national sensibilities may become apparent: disclosure of remuneration of individual directors is a good example of constantly advancing de facto harmonisation. Now that this type of disclosure has also been advocated in France, one can 23 E.g. Germany see H.-D. Assmann and U. H. Schneider, Wertpapierhandelsgesetz: Kommentar (Cologne, Schmidt, 1999) 1047.

204 Eddy Wymeersch expect several other states to follow. In some states objections will be raised in the name of privacy. The disclosure of significant shareholdings has been refused in some jurisdictions out of fear of criminal actions against their owners. Disclosure of major holdings cannot be classified without more under the heading of disclosure: the subject is more closely related to the position of the shareholders in the company, and hence company law should prevail. Additional disclosures are already imposed in some states, for example, with respect to the relationship between major shareholders (for example on concerted action). Exemptions are more touchy: here the market discipline should prevail.

Listing Procedure The procedure for listing on the market will be a key point, especially for new entrants. Will companies applying for listing be entitled to file the applications in their home states and according to the rules applicable there, or should they necessarily have to address themselves to the offices in the location where the market is legally situated? Proximity, better knowledge of local traditions, language differences and other similar sensibilities may turn out to be barriers that plead for a decentralised approach. This might result in each of the participant exchanges maintaining its present listing window for new listings and for maintaining contact with issuers whose shares have previously been listed. Differences in listing practices—but not in conditions—might result but should be kept to a minimum. Here a first difference between the three hypotheses appears: in the first and maybe also in the second hypotheses, listed shares would essentially maintain their national status and rules may be different depending on the state in which they were originally listed. Insider Rules What insider trading rules should be applied, those of the home state or those applicable to the market of listing? The question cannot be reduced to the application of the legal rules, even harmonised according to the Directive.24 Many exchanges have developed additional rules and restrictions relating to trading in sensitive periods. One can expect companies listed on participating exchanges to be bound by these additional requirements, whether these have been imposed by the exchange or by the supervisor in charge of the market where the exchange is located. 24 Directive 89/592 [1989] OJ L334/31. Notwithstanding the Directive, some Members States have maintained exemptions e.g. Art. 181 of the Belgian law of 4 December 1990 contains an exemption for holding companies trading on the basis of the information that the holding company has obtained as a shareholder, and provided the information is not liable to be disclosed under the ad hoc disclosure rules. The exemption has been challenged in a reference to the ECJ.

Regulating European Markets 205 Notwithstanding harmonisation, the definitions of insider trading are far from identical in each of the EU Member States. Article 5 of the Directive gives some relief as far as cross-border insider transactions are concerned: any action which is defined in the Directive as falling under the insider trading prohibition may give rise to prosecution in any state where action was undertaken, and not only where the insider transaction was executed on the market. But the latter can in any case prosecute, although it may find it difficult to find the right data on which to base its prosecution.25 Insider cases originate most of the time from market observations through the so-called stock watch programmes. These programmes are activated in the state of trading, and hence the rules applicable there would initially apply. The supervisor in the state of trading will request additional information from the state where the company is located: this request for information will normally be addressed to the supervisor in the company’s home state. The competent public prosecutor should be entitled to act on the basis of that information, which is not necessarily the case today, as treaties on mutual assistance and exchange of information relate to criminal information, not to administrative information. The question may become more difficult if the criteria used in the state where the market is located are much broader than in the state in which the company is located. This seems to be the case with the broad definition of “market abuse” as is now adopted under the new UK Financial Services and Markets Act 2000.26 The state in which the company is located may be unwilling to transmit information as the action involved is not a criminal act according to its law. There will be a new need to adapt existing regulations, bilaterally or according to the rules of an EU-wide harmonisation. In the meantime bilateral co-operation will be restricted. To summarise: the insider trading issue should not be a major stumbling block as long as the original definitions and criteria of the directive are followed. Extending the ambit of violations of market rules gives rise to new and difficult issues.

General Company Law The subject becomes more sensitive once one enters into fields that are more directly related to company law matters. There can be no argument that companies listed in a non-domestic market will not have to adapt their legal status to the company law of that market: on all of the EU markets today, there are securities that have been issued by companies that are established under the jurisdiction of foreign states. There has never been any claim that these companies should organise themselves according to the rules 25 See for an analysis K. Hopt in K. Hopt and E. Wymeersch, Insider Dealing (London, Butterworths, 1991), 146. 26 S. 118.

206 Eddy Wymeersch of the state where their securities are trading. The French Cour de Cassation decided that the status and rules applicable to the securities are those applicable by the lex societatis, not by the place of trading.27 Therefore, German companies functioning under the co-determination system would not have to abandon codetermination in order to be traded, for example, in London. This applies to all other features of mandatory company law. One can presume that continental company law is generally more mandatory than UK law.28 As a consequence, by acquiring shares of companies originating in different jurisdictions, investors necessarily buy “products” that are fundamentally different. This should not be a major problem, as the same already happens today. It is however important that investors should be clearly informed. The problems arise out of the additional rules that have been developed by the stock exchanges or by other bodies and that have an impact on company law and practice. A few topics immediately spring to mind. Some use the example of the proposed but since abandoned London-Frankfurt merger to illustrate the issues that may arise. As part of this illustration it is assumed that the London Stock Exchange remains the competent authority for matters relating to listing although, in fact, that function was transferred to the Financial Services Authority with effect from May 2000. Corporate Governance The London Stock Exchange rules on corporate governance, which were annexed to The Listing Rules, are recommended to UK companies.29 They could not possibly be applied to German two-tier boards. Independent directors are unknown and CEOs have a different function in the German company structure. Generally, one can presume that it would not be attempted to apply UK governance principles to non-UK companies, so that German governance rules can be further developed. Even the development of “substantially similar” rules would not be feasible. The London Stock Exchanges’s Listing Rules contained a provision limiting the influence of important shareholders: according to this document a listed company with a controlling shareholder, i.e., a shareholder with a stake of 30 per cent or more, had to be capable at all times of acting independently of that shareholder. It is clear that this rule could not be applied to continental companies, most of which are firmly controlled by one or a few shareholders. Also, to neutralise the influence of a controlling or significant shareholder would not necessarily be in conformity with the legal system applicable to the company. Generally it seems inappropriate to introduce a system of group law by stock 27

Cass. comm. fr., 17 October 1972 [1974] Rev. S. 127. See for a comparative analysis M. Lutter and Wiedemann (eds.), “Gestaltungsfreiheit im Gesellschaftsrecht” [1998] ZGR, Sonderheft 13, 329. 29 These are contained in the Combined Code on Corporate Governance. 28

Regulating European Markets 207 exchange regulation, even if the final outcome—at least in comparison with the German law on de facto groups—would come very close to the UK rule. Enforcement of company law rules would remain subject to the home state rules of the company: generally, market supervisors do not intervene to seek redress in respect of company law violations. This is left to the initiative of the shareholders, or other organs of the company. Takeover Regulations Would UK takeover rules be applicable? At present the City Code applies to “public companies30 considered to be resident in the UK, the Channel Islands or the Isle of Man”. A company is considered to be resident only if it is “incorporated in the mentioned territory and has its place of central management in one of those jurisdictions”.31 But the Code further calls attention to the need for “early consultation” in the case of dual jurisdiction. It seems highly improbable that a takeover of a German company whose primary listing is in London will be dealt with according to—future—German law, and that the UK authorities—in this case the Takeover Panel—would apply German rules. On the other hand, the German supervisor will not be able to scrutinise transactions that are taking place in the market of the company’s principal or even exclusive listing. Therefore an appropriate solution has to be worked out. The proposed Takeover Directive states two sets of rules in this respect. The first addresses the issue of who is competent to supervise the transactions. The second designates the substantive regulation of one of the jurisdictions involved, and distinguishes between company law matters, and market-related matters. On the first point, the competent authority will be the authority of the state in which the company has its registered office provided the company’s securities are admitted to trading in that state.32 If the securities are listed on several markets, the company’s “home state” will be competent provided it is at least listed in its home state, whatever the volume of trading in these other states. This rules creates a parallel between market rule and company law rule. Under present market conditions, at least 95 per cent of EU companies will qualify under this rule. Only where there is no listing in the “home state” will the state of trading prevail.33 Several hypotheses are further distinguished: if the home state and the state of trading are different, the state of trading will be competent; in case of 30

Whether listed or unlisted, see for details the City Code, Introduction 4. See ibid., pt 4(a). This double criterion obviously relies on elements that are also essential in the “siège réel” theory. The Panel normally considers a company to be so resident if it is incorporated in the UK etc., and if the place of central management is in one of these jurisdictions. If central management moves abroad the company will cease to be protected by the Code: S. Marchant in A Practitioner’s Guide to the City Code on Takeovers and Mergers (Old Woking, City and Financial Publishing, 1999–2000), 19. 32 Art. 4(2)(a) of the 13th Directive, 22 June 2000. 33 Ibid., Art. 4 (2)(b). 31

208 Eddy Wymeersch multiple listing, the state where the first listing took place will be competent. If simultaneous multiple listing took place, the issuer will determine which authority will be competent. By way of transitory measure, the supervisory bodies involved will have to decide, and if not, the company will designate the competent authority.34 Under merged market structures the question will arise whether trading on a market organised by a stock exchange located in another state will be considered trading on the market of “another state” even if the securities were originally listed in the home state. In clear terms: under the previously announced scheme, would trading in London be considered trading in London, although the admission took place in Frankfurt? But what if the listing took place from the outset only in London, although the company is not a UK company? A similar issue springs up under the Euronext scheme. Apart from designating who will exercise supervision, and hence will be in charge of applying the rules relating to takeovers, the proposed Directive contains a further provision as to which rules will be within the competence of the market supervisor, and which will remain under the guidance of the national company law system, including implementation by a supervisor in charge in the home state of the company.35 This list of subjects was already cited above at p. 202. This division of competencies does not necessarily render the application of divergent takeover rules easier. The subjects that were explicitly mentioned in the Directive may be reviewed as follows, it being understood that the reverse cases could be construed where “small” UK companies would be made subject to German supervision: • “the percentage of voting rights which confers control”: if German takeover law fixes a 50 per cent threshold for mandatory bids there may be control acquisitions on the London market that are not governed by the general rule of the City Code. The market may get confused by this differential treatment. Also the Panel would have to decide in what circumstances control is acquired under German law; • “any derogation from the obligation to launch a bid”: derogation to launch a bid may be more sensitive, as this relates to cases where the threshold has been crossed without control being permanently acquired. These cases have to be construed under German law. Here the Panel would have to make difficult assessments involving matters of German company, banking and contract law. 34

Art. 4(2) b and c and the transitory provision of 2(2) 2nd §. The identity and function of this home state supervisor is not clear: would it mean that the German supervisor the “Bundesaufsichtsamt für das Wertpapierwesen” would be called upon to enforce German company law? This would be outside its present statutory ambit and contrary to Germany’s legal system. The same applies to the UK Takeover Panel, which is not in charge of applying company law in the UK. 35

Regulating European Markets 209 • “the information for employees of the offeree company”: this item is to be construed under the law applicable to the company: as this condition does not touch upon substantive issues, it would be logical that there would be no objection to the Panel enforcing this condition. • “the conditions under which the board of the offeree company may undertake any action which might result in the frustration of the offer”: the City Code is very strict on the point of frustrating action by the board. The Directive takes an equally strict attitude but cases may show up where the board undertakes action opposing a bid which would not be forbidden under German regulation, although falling under the extended prohibition as applied by the Takeover Panel (for example, strict rules on press campaigns). Here a clash between the two jurisdictions might appear. To summarise: the rules relating to the attribution of jurisdiction as laid down in the proposed Thirteenth Company Law Directive may have to be put on the agenda again in light of the proposed reorganisation of the markets. Matters that are more directly related to the correct functioning of the market should in any case be subject to the jurisdiction which is competent according to where trading takes place, even if the listing originally took place in another market centre. Better co-ordination has to be provided for with respect to the application of company law-related matters in general, and more particularly in the field of takeovers. Other Potential Tensions There certainly will be other rules or restrictions in company law that might render it difficult, if not impossible, for foreign companies to abide by UK stock exchange regulations: one could think about the differences in waiving preemptive subscription rights, the more liberal attitude towards share buybacks, the differences in dividend distribution practices (three monthly versus annual). Differences in the forms of the shares have been bridged: the German legislator has adopted a law rendering nominative shares more market friendly, making sure that these can easily be transferred according to today’s electronic settlement techniques. Whether these differences would constitute significant handicaps for integrating the two markets, should be analysed on a case by case basis.

General Perspective This all ends up in the following general perspective. By having the markets integrate into one large trading system under the guidance of one supervisor, the supervisor will necessarily have to take account of differences flowing from the company law status of the companies whose securities are listed. This applies first to the mandatory rules of company law that have been laid down by Act of

210 Eddy Wymeersch Parliament. Conversely, this also will apply to additional regulations the authorities would like to impose on these companies which cannot run counter the mandatory—or even enabling?—rules under which they are functioning according to their lex societatis. Within these limits however the market regulators can impose additional requirements. This applies especially to disclosure rules. If no agreement between regulators can be reached, directives should act as the bridge. A further issue relates to the extent to which an agreement between stock exchanges or other similar bodies could result in imposing new or additional rules that have not been imposed at the moment of the original listing. This question is the more pressing as the rules applicable in some jurisdictions have been rendered applicable by public Act, and may now be changed by an agreement between exchanges governed by private law. The help of the governments will be needed here, allowing for some changes in the applicable regulations.

CONCLUSION

The regulation of the securities markets in the EU is at a turning point: for the first time the issue of the reorganisation of the market structure is on the regulatory table. Mergers between exchanges will raise a number of new questions, calling for new patterns of regulation. Imagination will be necessary to negotiate workable solutions.

14

The Case For a European Securities Commission (ESC) GILLES THIEFFRY*

INTRODUCTION

Union (EMU), the cornerstone of European economic integration, was implemented by the Maastricht Treaty in 1992.1 Four or five years ago, the debate centred on the consequences of EMU and many predicted a disastrous “legal meltdown”, although some of us expressed a greater degree of optimism and confidence.2 That debate is clearly now over and EMU is now a reality with the successful introduction of the Euro from 1 January 1999.3 Irrespective of the fluctuation of the external value of the Euro and its adoption or not by additional Member States in addition to the original 11 countries, the effect of the introduction of the Euro has been to create a massive market of Euro-denominated securities (second only to the US$). For example, EMU resulted in the conversion of the international debt market into a “dual currency” market. In 1999, there was US$1.4 trillion equivalent of new issues in the international bond market, of which 43.1 per cent was denominated in the Euro.4 The enormous impact thus far of EMU is undeniable. The focus now shifts towards greater harmonisation and integration of the European securities regulatory environment to “mirror” the effect of monetary union on the Euro zone securities markets. In addition, there are the pressures of fierce competition

E

CONOMIC AND MONETARY

* Head of Capital Markets, Partner, Andersen Legal. The author is a solicitor, a member of the New York bar and an Avocat au barreau de Paris. The opinions raised in this chapter are personal and do not necessarily represent those of Andersen Legal and/or Arthur Andersen. 1 Treaty establishing the EU, [1992] OJ C224/1. 2 C. Proctor and G. Thieffry, “EMU—Business as Usual in Financial Markets: A Legal Analysis of the Impact of EMU on Financial Obligations”, Norton Rose Briefing, September 1996; G. Thieffry and C. Proctor, “European and Monetary Union: Progress and Opportunities”, Norton Rose Briefing, September 1997. 3 This marked the third and final stage of EMU for 11 Member States. Euro banknotes will begin to be issued in Member States from 1 January 2002. 4 The International Capital Market, IPMA Report (March 2000). Based on current growth rates, the figures for 2000 will reach at least US$1.7 trillion equivalent. It was noted that the market share of Euro-denominated securities was only marginally lower than that of US$ (45.5%).

212 Gilles Thieffry between the different national regulators, the explosion in cross-border financial activities now made more viable as a result of speedy technological innovations and advances (such as trading via electronic crossing networks (ECNs)) which in turn improves market efficiency, as well as the increasing internationalisation and consolidation of market players. Initiatives towards the consolidation of European stock exchanges have developed rapidly and such acceleration, unprecedented in the history of Europe’s capital markets, should be viewed in the context of the growing trend towards the globalisation of the world’s financial markets. The formation of entities such as Euronext and the tumultuous potential mergers and/or takeovers of the London Stock Exchange this year have been well documented in the financial press,5 and no doubt there will be further news of rival entities emerging to challenge for a greater market share in Europe (if not globally). The question now is not whether the regulatory regime in Europe can cope with these market innovations (one might suggest “no” for an answer) but instead when will the regime change in view of these market developments. The author has advocated in earlier articles for a change in EU regulatory approach and indeed opined on a movement towards the formation of an ESC.6 The purpose of this chapter is to re-assess (and reassert) that position, especially in the light of recent market developments and the growth of the Euro zone market. Instead of a central body through which key policies can be devised and uniformly implemented there are 15 different EU regulatory regimes, each requiring different levels of disclosure co-operation. Demand for access to capital markets by issuers and investors alike on a borderless basis is rendering the concept of national exchanges increasingly redundant. Moreover, a single currency deserves a single capital market but the present fragmented regulation is impeding progress towards the aim of a unified financial services market in Europe. The chapter will be set out as follows: first, a brief look at the motivations for pan-European harmonisation; secondly, an assessment of the present (and unsatisfactory) EU position on securities regulation, including a discussion on recent market developments; thirdly, setting out the case for an ESC, postulating the possible forms of such a body (by considering both European and US models); and finally, the author’s concluding remarks. It should be noted that this chapter was finalised in October 2000. The pace at which events take place in the capital markets is quite high. When the 3CL conference on The Challenges Facing Financial Regulation took place in July 2000, the merger of the Deutsche Börse with the London Stock Exchange under the name “iX” 5 See, e.g., “Werner uber alles”, The Economist, 6 May 2000; “Deutsche Börse backs merger with London”, Financial Times, 23 May 2000; “Euronext plans to compete with iX”, Financial News, 29 May 2000; “Euronext stock exchange deal may be sealed by October”, Wall Street Journal Europe, 4 July 2000; “Stock markets eye Nasdaq deal”, Financial Times, 18 July 2000. 6 G. Thieffry, “Regulation of the Securities Markets and the Euro”, European Single Financial Market, September 1998, 6; G. Thieffry, “Regulation and the Euro”, London Financial News, 23 June 1997, 7; G. Thieffry, “Towards a European Securities Commission” (1999) 18(9) International Financial Law Review 14.

The Case For a European Securities Commission (ESC) 213 looked a certainty. It seems that this venture has been, for the time being, postponed. Whatever the short-term movements of history, the trend is set firmly in the direction of a further integration of the European markets. WHY HARMONISE ?

The aim of integrating the European securities markets is enshrined in the Treaty of Rome 1957 as amended (the “Treaty”).7 Under the Treaty, the principle of free movement of capital and services (as well as the free movement of goods and persons) was formulated. The reasons for harmonisation and integration are manifold. These have been espoused on numerous occasions and they may be briefly summarised as follows. First and foremost, harmonisation of securities laws aims to create a “level playing field” for investors throughout the European Union. Secondly, a truly Community harmonised policy will provide the safeguard for the proper functioning of markets and enhance the transparency which the newly unified markets lack. Improved efficiency of the capital markets through common high levels of disclosure and transparency would also optimise the allocation of capital and improve liquidity. Furthermore, it has been argued that if the securities markets are not uniformly regulated, it may give rise to regulatory arbitrage and “forum shopping”. In such circumstances, regulators would be in direct competition and this would affect the quality of the national stock exchanges since Member States, so as to attract market participants, would adopt a relaxation of the rules in a “race to the bottom”. In turn, market participants would be able to choose between Member States and inevitably opt for the regime which was the cheapest and least onerous. Finally, harmonised co-ordination of the regulatory rules would remove obstacles for issuers, equalise conditions of competition and, more significantly, reduce the cost of cross-border capital raising. EMU has eliminated the exchange risk for issuers and investors alike. However, as will become apparent from the discussion below, the sound economic reasons set out above have not led to the harmonisation of European securities regulation. It should be remembered that the “Single Market” for financial services was due in 1993. It is fair to say that this deadline was, by and large, missed. The call for a unified regulatory regime has become an obvious necessity to all those waiting to capitalise fully on the use of the Internet in the Euro zone. It is presently virtually impossible to emulate the US market in Europe, an unacceptable situation for the financial industry, and a loss of opportunity for the economy at large. As Stephen Kingsley suggests: Europe needs a cheap and efficient market for securities and their derivatives. Until it gets one, we will all continue to pay the price through unnecessarily high transaction costs and therefore reduced investment performance.8 7

Treaty establishing the European Economic Community, Rome, 25 March 1957, as amended. “A blueprint for the new exchange—Stephen Kingsley suggests the principles Europe’s bourses must follow to keep up with technological innovation”, Financial Times, 18 September 2000. 8

214 Gilles Thieffry It is impossible to imagine an efficient Euro denominated securities market without, if not totally integrated regulations, a very high degree of harmonisation which does not exist yet. Any person who doubts the attractiveness of the US model of an integrated securities market, providing a deep and liquid source of finance for issuers, and a wide array of financial products for investors, must have been deaf to a large section of the European financing community (corporate and sovereign issuers, investors and investment bankers). For example the total inability of effecting pan-European retail IPOs limits the ability of many issuers to raise funds efficiently. Equally, the lack of common standards for the use of the Internet on a cross-border basis deprives the European securities industry of one of the most efficient cost-cutting tools used by the US domestic market. This is caused solely by the incompatibility of the securities regulatory regimes in the various Member States.

THE CURRENT POSITION IN THE EUROPEAN UNION

Attempts at Harmonisation Presently, attempts at harmonisation of European financial markets have been achieved, in theory, by implementing EC directives,9 notably the Second Banking Directive (indirectly), the Admissions Directive, the Listing Particulars Directive, the Public Offers of Securities Directive and the Investment Services Directive. The Second Banking Directive established the notion of the European banking “passport” under home country rule in relation to the authorisation and supervision of certain financial institutions. The Admissions Directive established minimum conditions for the listing of both debt and equity securities on stock exchanges situated or operating in Member States. The Listing Particulars Directive deals with the publication of sufficient information about the applicant for listing to satisfy and protect investors. This Directive was amended in 1987 to provide for a system of mutual recognition where listing was requested in more than one Member State. Likewise, the Public Offer of Securities Directive imposes an obligation on companies to provide a prospectus for all public offerings (onor off-exchanges) that conforms to certain minimum requirements, in the interest of investor protection. The Investment Services Directive, the most significant Directive thus far in achieving harmonisation of securities regulation, establishes the “single passport” in investment services for specialised securities firms, i.e. it enables investment firms authorised in one Member State to provide investment services in other Member States on the basis of their “home” state authorisation. The standards (defined in these Directives) establish a minimum regulatory foundation necessary for the correct operation of the markets and for the protection of investors. They leave it up the national regulatory authorities to apply 9

The Directives are based on Art. 54(3)(g) of the Treaty.

The Case For a European Securities Commission (ESC) 215 these Directives and to co-operate with one another to ensure the best functioning of the whole market. In theory, the concept of mutual recognition ought to mean that it is possible for securities offerings to be extended to other Member States. However, those familiar with market realities and legal practicalities know this is not the case. For example, there are many obstacles which make it hard for issuers to make use of the mutual recognition of listing particulars. There is no harmonised definition of what constitutes a public offer in Europe, and conditions for admission to a regulated market are still very different across Member States. Continuing obligations to listing of issues have not been fully harmonised and in certain countries the language in which the disclosure documents are written still remains an obstacle. In certain countries, consumer protection legislation is sometimes a bar to the use of a directive. Finally, certain regulations do not necessarily display a great deal of zeal in implementing the spirit of these Directives. Directives are often the result of political compromises following protracted negotiations and bargaining. They end up being rather inflexible, almost impossible to alter once they are adopted and thus are rarely implemented into national laws uniformly and promptly. For example, the Public Offers of Securities Directive’s stated objective of creating a level playing field in the information provided to investors throughout Europe has not been achieved.10 Despite these efforts to regulate and harmonise EU capital markets, different rules and practices have developed in accordance with the history and the characteristics of each national market, in part due to national regulators’ competition to develop the most attractive market environment and partly due to their unwillingness to assess the consequences of non-co-operation. The terms and conditions under which enterprises finance investment and the role of intermediaries still vary considerably from country to country in the EU. This is due to deeply rooted structural differences in legal systems, development of markets and institutions, and the role of the state.11 Each market’s characteristics are the result of distinctive historical, political and cultural developments. The enactment of EU Directives means that Member States now have, broadly speaking, a mixed system of public/private regulation. However, the implementation of these Directives has not been consistent nor timely as these different philosophies continue to apply and influence political decisions. The development of a pan-European securities market is also hindered by differences in laws and practices, notably taxation and accounting standards.

10 R. Lee, “Should There be a European Securities Commission? A Framework for Analysis” (1992) 2 European Business Law Review 102. 11 K. Lannoo, “The First Weeks in Euroland: A More Market-based System to Emerge?” (1999) 14 (3) Journal of International Banking and Financial Law 81.

216 Gilles Thieffry

Movement towards Integration of the European Stock Exchanges and Clearing Systems The past couple of years have seen an increased awareness amongst European stock exchanges of the need to co-operate more closely and to consolidate. In spite of announcements last year of closer alliances between the leading eight European stock exchanges12 (and with little significant progress), it is only this year that we have witnessed a flurry of “demutualisation” and consolidation activities by the exchanges.13 By outlining these recent proposals and difficulties, one hopes to identify potential obstacles to overcome, which would reinforce the author’s argument for a more centralised regulatory body. Euronext On 21 March 2000, the French, Dutch and Belgians announced that they planned to merge their respective stock exchanges into Euronext, thereby representing the first full merger between stock exchanges of different countries, which would result in the creation of Europe’s second largest exchange behind the London Stock Exchange. Euronext was successfully launched on 18 September 2000, and other exchanges have announced their intention to join.14 “Blue chip” stocks will be traded on the Paris Stock Exchange, whereas small and medium company listings will take place in Brussels. Amsterdam will be responsible for the derivatives and futures markets. In addition, Euronext will have a common trading platform, common settlement (Euroclear15) and clearance (Clearnet), a central counterparty and a common rule book.16 Less than a year from now, there will be a new pan-European market with 1,400 companies representing half the capitalisation of the Euro zone.17 Virt-X Virt-X, an Anglo-Swiss enterprise, will be a pan-European “blue chip” exchange based in London (and, therefore, regulated by the UK’s Financial Services Authority (FSA)), consisting of shares currently trading on Tradepoint, the UK exchange, and SWX Swiss Exchange (which has a current daily trading volume of SFr 3.4 billion). It will operate in direct competition with Euronext for 12 The Amsterdam, Brussels, Madrid, Milan, Paris and Zurich stock exchanges signed a Memorandum of Understanding with London and Frankfurt to form the European Alliance. 13 “End of the stock exchange as a national institution”, Financial News, 29 May 2000. 14 “Euronext launches rival to London Stock Exchange”, Financial Times, 22 September, 2000. 15 The new entity, Euroclear Clearance System—see 25 below. 16 C. Shrimpton, “Euronext: the Birth of Europe’s Largest Stock Exchange” (2000) 11(3) Practical Law for Companies 7. 17 “Euronext merger set for October”, Financial Times, 3 July 2000, quoting Jean-François Theodore, Chairman of the Paris Stock Exchange and Chairman designate of Euronext.

The Case For a European Securities Commission (ESC) 217 increased market position. Unlike the failed iX proposal, Virt-X seems to have reassured market players on key issues such as the clearing, settlement and trading systems to be adopted and the identity of a central counterparty.18 iX More interesting for the purpose of this chapter is the current apparent collapse of iX, which should have seen the merger of the London Stock Exchange and the Deutsche Börse. This “merger of equals” was to represent the coming together of the London Stock Exchange (LSE) and the Deutsche Börse (50 per cent of share capital going to Deutsche Börse and 50 to LSE shareholders), creating what would have been the leading European exchange in terms of volume and value of equity trading.19 Under the proposals, the “blue chip” market would have been based in London whilst the European “growth” technology and derivatives markets would have been located in Frankfurt. The “blue chip” market was supposed to be in London and subject to the UK’s FSA, while the Bundesaufsichtamt für den Wertpapierhandel (BaWe) would have overseen the “growth” and high technology stock markets. However, it is unclear how this dual regulation would have worked in practice (as indeed was the role of the US Nasdaq vis-à-vis the growth market and whether a full merger would subsequently have meant a surrender of iX’s dominant position in Europe for little return).20 The proposed merger collapsed as a result of a hostile take-over bid by OM of Sweden 21 and the scepticism of several important market players. One of the reasons for this scepticism was set out in a report issued by Merrill Lynch (advisers to the London Stock Exchange). It was reported: UK regulators believe Anglo-German attempts to harmonise share trading rules will be ‘a nightmare’ if the London Stock Exchange and Deutsche Börse merge to create iX. This emerged on Thursday as further details came to light from a report commissioned by Merrill Lynch, the investment bank advising the LSE. The report says senior staff at the Financial Services Authority have said privately that it will be difficult to achieve ‘any practical level of harmonisation’ of UK and German stock market regulations.22

18 SIS, Crest, EBS and London Clearing House respectively. “Tradepoint and SWX launch panEuropean market”, Financial Times, 10 July 2000; “Tradepoint steal Exchange’s glory”, Daily Telegraph, 11 July 2000. 19 The exchanges accounted for over 50% of European equity traded volume in the 12 months up to 31 March 2000. In addition, 41% of Europe’s top 300 companies have their primary listing on either the LSE or the Deutsche Börse. 20 iX are in talks with NASDAQ “to explore the possibility of a complete merger of the markets”, Financial Times, 18 July 2000. 21 “OM posts bid for London Stock Exchange”, Financial Times, 11 September 2000. 22 “FSA staff brand iX bourse a regulation ‘nightmare’ ”, Financial Times, 7 September 2000.

218 Gilles Thieffry Consolidation of Europe’s Settlement and Clearing Systems We expect there to be pressure on the different settlement systems to merge. This has already started but we expect a new wave of consolidations following today’s [iX] merger. There will not be room for the multitude of settlement systems we have now.23

That is indeed stating a logical consequence now that the process of merging Europe’s numerous stock exchanges is well under way. The consolidation efforts of the national stock exchanges are forcing the various European settlement and clearing systems into similar pacts. At the start of the year, Clearstream International (Clearstream) was formed,24 with currently g7 trillion worth of assets in custody and over 80 million transactions made each year, only to be followed by the emergence of Euroclear Clearance System (Euroclear)25 resulting in the world’s largest settlement system for internationally traded securities. Its combined annual turnover value of transactions settled will exceed g80 trillion and its aggregate annual pre-netted transaction volumes will reach g100 million. Further consolidation is evidenced by the Settlement Alliance between London’s CrestCo and the Swiss SIS (SegaInterSettle). CrestCo and Clearstream have also made discussions regarding linking up their systems by virtue of the iX proposals a top priority. Talk of big cost savings to result from increased trading efficiency through combined exchanges will be futile unless we see a coming together of the different settlement and clearing systems in Europe. Whilst the issues surrounding the stock exchange mergers impinge on national sensibilities and therefore are overtly politically sensitive, the significance of unity among the clearing and settlement systems cannot be underestimated. Integration in this respect is the real prize, and where the big cost-savings will be found.26 At present, settlement costs in Europe can be as much as 10 times higher than in the USA. Not only from a costs perspective, market players also want to see a real drive to create a centralised counterparty, enabling trades to be netted and thereby reducing counterparty risk. Influential market players, notably senior bankers at the US major investment banks, view this as an integral aspect of a flexible and liquid pan-European securities market.27 23 Quoting Werner Seifert, the present Deutsche Börse chief executive, at the iX merger press conference on 3 May 2000. 24 This represents the merger between Luxembourg-based Cedel International and Germany’s Deutsche Börse Clearing (DBC) which was formalised on 10 January 2000. 25 The merger of Euroclear, based in Brussels, and Paris’ SICOVAM announced on 24 March 2000. 26 80% of potential savings will come from making the “back office” process more efficient whilst only 20% will be attributable to trading efficiency. 27 See, e.g., the views of Pen Kent, Chairman of the European Securities Forum, and Sir David Walker, European Chairman of Morgan Stanley, the latter suggesting that if the big settlement organisations do not start to merge, then the big investment banks could break away and set up a NewCo running the system they want.

The Case For a European Securities Commission (ESC) 219 As Euronext continues to progress and the iX story further unfolds through to next year, there will be further pressure for the rationalising of the European settlement infrastructure, not least a push for a merger between the heavyweights, Euroclear and Clearstream, though one would hardly doubt that the agencies themselves will resist such a move.28 The author contends that this is a necessary move as such organisations lie at the very heart of an efficient and vibrant securities market.

Where to from Here? There is a certain degree of inevitability about the creation of some form of central regulator. The on-going consolidation may be regarded as inevitable in the face of competition, and indeed these mergers are sensible at least in principle, and will hopefully serve “as a catalyst for new thinking”,29 one which ideally would lead to a consideration of a unified European regulator for a panEuropean securities market. Mr Seifert has even boldly stated that “as a final objective, a European goal is not far-reaching enough and that is why [iX] is talking with Nasdaq”.30 In light of the recent consolidation of European stock exchanges, politicians are urgently pushing for the harmonisation of European securities regulations. For example, Laurent Fabius, the French Finance Minister, proposed a Working Group to take a comprehensive look at how to achieve a single market in financial services and the co-ordination of regulation at an EU level.31 The Group of “wise men” is chaired by Alexandre Lamfalussy (the former head of the European Monetary Institute32). Whilst some have noted that the creation of an ESC might be a very long term prospect, it is quite interesting to note that even those who said it was impossible to create such an ESC are now rejecting the idea into the far distant future, but do not rule it out. Another initiative drive in Europe comes from the Forum of European Securities Commissions (FESCO), an organisation formed by the national supervisors of the European Economic Area (EEA),33 which strives towards closer co-operation in regulatory work, information exchange and joint research in order to boost transparency, harmonisation and integrity of the

28

See “Merger questions in need of answers”, Financial News, 10 July 2000. Editorial comment in the Financial Times, 18 July 2000. 30 Quoted in the Financial Times, 18 July 2000. 31 W. Wright “Fabius in push to harmonise rules”, Financial News, 29 May 2000; “Europe’s regulatory muddles”, The Economist, 10 June 2000. 32 “Wise men to review single market”, Financial Times, 16 June 2000; “Brussels aims to quicken financial services harmonisation”, Financial Times, 4 July 2000. 33 It came into being when the 17 securities commissions of the European Economic Area (EEA) signed a Charter in December 1997. The European Commission attends FESCO meetings as an observer. FESCOPOL was established in January 1999 to facilitate effective, efficient and pro-active sharing of information to enhance co-operation and co-ordination of surveillance between FESCO Members. 29

220 Gilles Thieffry European markets in the aftermath of the introduction of the Euro. Last December, European regulators took a major step towards a more unified approach within the EEA when FESCO adopted common standards for regulated markets.34 These standards are intended to supplement the requirements of the Investment Services Directive, and they will be introduced into each FESCO Member’s regulatory objectives and ideally and where possible, in their respective rules. FESCO is also pushing for a “European passport” for issuers, enabling an EU-wide offering of securities by reducing regulatory hurdles without compromising investor protection. Whilst FESCO’s work is commended as a major step in reducing cross-border inconsistencies and thereby improving investor protection, FESCO is still in its infancy and has yet to prove that informal co-operation will be adequate for proper and effective regulation of Europe’s financial markets. Almost certainly, in the longer term, as markets become more integrated, there will be pressure for a more co-ordinated and formal approach to rule-making and enforcement in a common institutional framework for a truly integrated market.35 We could wait until necessity forces some Community action, but it would be better to take anticipatory action to support the financial markets. In essence, relying on the sum of the parts of the European regulatory jigsaw to create a unified European regulatory structure might overlook the fact that national regulators may have diverging, rather than converging, interests and agendas. If EMU and the resulting creation of the European Central Bank (ECB) and the European System of Central Banks (ESCB) are anything to go by, it is clear that the impetus had to be, first and foremost, imposed by political will before being successfully implemented and supported by the national central banks (NCBs) and other relevant domestic regulators.

THE CASE FOR AN ESC

There is a great deal of support for the need to update the regulation of the Euro securities market, not least from the European Commission itself. In its Financial Services Action Plan issued last year, the Commission acknowledged that the current ad hoc organisation cannot keep up with the rapid market integration and that more changes to the current system are needed before Europe has a single, homogenous, capital market. Furthermore, the paper called for “any remaining capital market fragmentation [to be] eliminated”36

34 Standards for Regulated Markets under the ISD, 99–FESCO–C, 22 December 1999. In finalising the paper, FESCO consulted the Federation of European Stock Exchanges (FESE) and the European Community Option and Futures Exchanges (ECOFEX). 35 M. Taylor, “A European SEC?”, FRR, September 1998, 1. 36 European Commission, Implementing the Framework for Financial Markets: Action Plan (May 1999) 1.

The Case For a European Securities Commission (ESC) 221 and suggested that a “more wide-ranging rethink of the way in which policy for financial markets is processed is required”.37 The fragmented regulatory structure is such that competition between national governments to satisfy their domestic constituents naturally encourages protection of their own interests. Indeed it is difficult to justify why market participants should deal with such varying complexities and the cost of compliance with several quite different national laws when they are dealing, or would want to deal, with only one Euro-denominated securities market. It will be impossible to stimulate full cross-border competition in the financial services industry unless a single, expert, flexible and forward-thinking regulatory body is established, one which is able to enforce its policies uniformly throughout the EU. Otherwise with the (relatively) weak regulatory framework which applies in the Euro zone, we run the serious risk of undermining the entire EMU. One should note that the ECB, the only pan-European regulator for the euro zone, does not have any jurisdiction over the securities markets38 although its example might provide a starting point for a radical re-think. There is consensus that the status quo needs improvement as evidenced by the various on-going initiatives across Europe. The question then becomes one which considers the need and scope for an ESC. Opponents of an ESC have doubted the viability of such a body on constitutional grounds and also fear the enormous costs involved in setting up and operating it. ESC-sceptics have furthermore argued that the notion of a supra-national supervisor is not a pragmatic solution.39 It is argued that given the fragmented nature of Europe’s securities markets, it is untenable since such an idea presupposes that Member States are willing to make political concessions as well as complete harmonised regulations, technologies and infrastructure. There is an immediate need first for more harmonisation of securities market regulation. Thus at this stage it is more important to strengthen co-operation between Member States through international movements like IOSCO and FESCO rather than opt for a “wholesale” change. Many have strongly doubted the feasibility of the single currency and, likewise have been negative about an ESC. However, often the same opponents see the benefits of a single national regulator, as it offers “one-stop shopping” for market participants with improved economies of scale as a result of pooled resources and management, lower supervisory costs and more transparency to consumers than with a fragmented system. Already this rationale has 37

Ibid., 14. The ECB role is limited to monetary matters. For further information on the ECB’s jurisdiction, see the ECB’s website: http://www.ecb.int. Also see E. Nierop, “A New Corpus Iuris Monetae for Europe” (2000) 15(5) Butterworths Journal of International Banking and Financial Law 157. 39 See, e.g., K. Lannoo, “A European SEC? (Part II)”, FRR, March 2000, 1; J. W. F. Watson, “International Co-operation in the Field of Financial Regulatory Enforcement, Part 2—the EU approach” (2000) 15(1) Journal of International Banking and Financial Law 13; C. Briault, The Rationale for a Single National Financial Services Regulator, FSA Occasional Paper Series No 2 (May 1999). 38

222 Gilles Thieffry been entrenched in various European countries (for example UK, Sweden, Denmark, Norway, Iceland, Finland) as well as further afield such as Japan and South Korea more recently.40 If this reasoning is correct at a national level, it should logically apply at the European level, in the context of a single currency, a single market, free capital flows and an increasingly global marketplace. Debating the desirability of an ESC is putting off the inevitable. If the US precedent is anything to learn from (as discussed below) the initial reluctance to adopt federal regulation fell away in the face of the Wall Street Crash of 1929. In response, the author would counter such arguments by submitting that an ESC is entirely plausible in the present institutional EU framework and that such a body would assist in the furtherance of the harmonisation and integration of securities regulations. First, let us turn to constitutional matters.

Constitutional Issues Some commentators have objected to the creation of the ESC on the grounds of a lack of a constitutional basis. Their objection rests on the theory that the European Community is based on the principle of limited or conferred powers, i.e. Community institutions possess only those powers conferred on them. It has been suggested that creating such a body would involve amending the Treaty; that the Treaty is silent on how and by whom any centralised policies on financial services should be implemented;41 and that the EU authorities have no power under present Treaty provisions to establish new organisations entrusted with rule- or policy-making powers.42 A detailed analysis of these issues, the interpretation of relevant Treaty provisions and European precedent and practice have been outlined by the author in a previous article.43 It suffices to say in summary that the practical significance of the concept of conferred powers is diminished mainly by Article 308 (better known under its old number of Article 235 used by many EC regulations) of the Treaty, upon which the formation of a body such as the proposed ESC can be legitimately based. Article 308, in essence, grants power to the European Council to take any steps to take whatever measures are necessary to attain the objectives of the Community. Whilst the scope of Article 308 is

40 Ibid., 11–12. In addition, very recently, Luxembourg introduced its Financial Sector Surveillance Commission. 41 Howard Davies, Chairman of the Financial Services Authority (FSA), in his speech on “EuroRegulation” at the European Financial Forum Lecture in Brussels, 8 April 1999. 42 E. Wymeersch, “From Harmonisation to Integration in the European Securities Markets” (1981) 3 Journal of Comparative Corporate Law and Securities Regulation 1. 43 G. Thieffry, “Towards a European Securities Commission” (1999) 18(9) International Financial Law Review 14.

The Case For a European Securities Commission (ESC) 223 not without limitations,44 it is argued that the formation of an ESC falls within its scope on the basis that such a body is required to foster greater economic cohesion. A review of the practical application of Article 308 in EU jurisprudence will illustrate that this Article has been interpreted in such a wide and radical manner,45 that “it would become virtually impossible to find an activity which could not be brought within the objectives of the Treaty”.46 There are two schools of thought in the debate on the institutional form the European supervisor should take. The first suggestion is closer co-operation between Member States’ existing regulators at national and EU levels. We have already visited this point and we concluded that the measures being discussed and implemented remain crucial in the harmonisation exercise but also questioned the efficacy of such informal co-operation continuing in the long term. Thus, we turn to the alternative school of thought, which suggests the notion of a supra-national body, akin to the ECB in the banking industry, but one with powers broadly similar to those of the United States’ Securities Exchange Commission (SEC).47

The US Securities and Exchange Commission Precedent Proponents have often cited the American SEC as the only real precedent in this field.48 The history behind the SEC will demonstrate the relevance of that parallel, and how much it may help us shape future European regulation. The SEC, created in July 1934 under the Securities Exchange Act 1934, is an independent, quasi-judicial body empowered to regulate and primarily supervise the US securities markets. 44 For a judicial commentary on the limitations of Art. 308 see Opinion 2/94 (Re the Accession of the Community to the ECHR [1996] ECR I–1759, 2 CMLR 265) which concerned the legality of using Art. 308 (or Art. 235 as it then was) to accede to the European Convention of Human Rights (ECHR). The Court stated that accession to the ECHR would result in a substantial change in the present Community system [author’s emphasis added] for the protection of human rights, as it would involve the Community entering into a distinct international institutional system as one of integration of all the provisions of the Convention into the Community legal order. As this was of constitutional significance, it would be such as to go beyond the scope of Art. 235. See also P. Beaumont, “The European Community cannot accede to the ECHR” (1977) 1 European Law Review 235. It is submitted that the formation of an ESC is not a substantial change in the Community system; the single currency and single market already exist and it is simply contended that the securities markets be regulated at a European level, in order to protect the integrity of the single currency and the single market, or to adopt the wording of Art. 2 of the Treaty, to “strengthen economic . . . cohesion”. 45 Art. 235 has been applied in the context of the European Monetary Co-operation Fund; harmonisation of certain aspects of company law; the granting of emergency food aid to developing countries; and the establishment of European Economic Interest Groupings (EEIGs). It was also used to implement certain regulatory provisions applicable to the introduction of the Euro. 46 J. Weiler, “The Transformation of Europe” (1991) 100 Yale LJ 2403 at 2445–6. 47 K. Lannoo, Financial Supervision in EMU (Brussels, Centre for European Policy Studies, 1999), 5. 48 The SEC has long placed consumer protection in a level-playing field as its primary goal. “We are the investor’s advocate” is the often cited motto of William O. Douglas, SEC Chairman (1937–9), which features prominently on the SEC website: http://www.sec.gov.

224 Gilles Thieffry A Potted History The origins of the SEC date back to an era that was ripe for reform at a time when the United States was in deep depression following the Crash of 1929. Prior to the 1929 Crash, there were problems of non-disclosure, questionable promotional practices and the marketing of fraudulently valued securities resulting in spiralling market speculation and the huge increase in trading on margin. At that time also, politically, economically and between regulators, there was fragmentation, ineffective delegation and non-co-operation. It was a case of everybody “co-operating”, but without a unified market perspective and without the power to act swiftly before the crisis hit. Responsibility for market regulation fell to several different authorities. No one took action either because they simply did not want to assume responsibility for the crash or because another authority disagreed. For example, bodies such as the Investment Bankers Association (IBA) resisted “undesired regulation” and advocated the application of generic fraud laws, which did not include the demand for full financial disclosure.49 The lack of central regulation therefore gave rise to the opportunity for widespread market manipulation by market players and private organisations. Between 1910 and 1933, most states had enacted their “blue sky laws”50 to prevent the growing fraudulent securities dealing and trading on margin. Each state had a bureau and a commission to implement the laws and their administrative functions were mainly to investigate dealings and to require the disclosure of certain information (not unlike the powers of the SEC today, one might say) before determining whether such securities could be sold within the state. Yet the inadequacy of state legislation soon became apparent. First, some state legislatures chose not to adopt the legislation. Others followed the precedent of those states with legislation in place, but they would “tinker” here and there in trying to improve the legislation in places. In many cases, there was a reluctance on the part of state legislatures to provide for effective enforcement. Consequently, as with the varying regulatory levels between Member States in modern-day Europe, it quickly became apparent that “there [was] . . . a lamentable lack of uniformity in [the state securities laws]”.51 This enabled fraudulent dealers to “forum shop”, i.e. choose the state with the least or no regulation to 49 W. E. Bealing, M. W. Dirsmith and T. Fogarty, “Early Regulatory Actions by the SEC: An Institutional Theory Perspective on the Dramaturgy of Political Exchanges” (1996) 21(4) Accounting Organisations and Society 317. 50 Kansas is credited for the first “blue sky law” in 1911 when it introduced the first comprehensive licensing system. There are numerous explanations for the derivation of the term “blue sky”, the most common of which is that the purpose of the Kansas statute was to protect Kansas farmers against the industrialists selling them to “building lots in the blue sky in fee simple”: T. L. Hazen, Treatise on the Law of Securities (3rd edn., West Group, 1995), i. 51 Statement of Hon. Edward E Denison, Representative of Congress from the State of Illinois, Subcommittee of the Committee on Interstate Commerce, 6 December 1922, at 2.

The Case For a European Securities Commission (ESC) 225 evade liability (once again, a concern outlined for today’s European regulators). With increasing inter-state business in the “boom years”, it became extremely difficult for a state to attempt to protect its citizens against mail-order selling campaigns. The state could not prosecute the promoters because they were not committing their offences within the state borders, but their acts had the effect of nullifying the state laws. [T]he most effective and widely used method for evading the provisions of State blue sky laws consists in operating across State lines

was the conclusion reached in a Department of Commerce Report in 1933.52 Even at this stage a single regulatory system was called for, on the basis that: unless the Federal Government takes action to control interstate commerce in fraudulent securities the laws of the several States will in a large measure become ineffective.53

The Case for Federal Regulation The concept of federal regulation of exchanges was strongly resisted in the USA before the 1930s, some doubting the constitutional ability of Congress to legislate for what were essentially voluntary organisations, just as in Europe today.54 Yet in 1923 a Supreme Court decision confirmed that the enactment by Congress of federal legislation (on any subject-matter including the regulation of securities) in reliance on the “commerce power” would be held constitutional and perfectly acceptable.55 The case for federal regulation and an SEC-styled organisation was not without momentum in the late 1920s. For example, such a body was recommended as early as 1909 by Charles E. Hughes in relation to insurance companies.56 The Hughes Report of 1909 highlighted the need to “adopt methods to compel the filing of the financial condition of the companies who are listed” and various other requirements similar to those eventually imposed in 1934. It recognised 52 “A Study of the Economic and Legal Aspects of the Proposed Federal Securities Act” by the Department of Commerce, submitted for hearings before the House Committee on Interstate and Foreign Commerce, HR 4314, 73rd Cong., 1st Sess. 87,100 (1933). 53 Ibid., 3, n. 59. 54 A series of cases in the early 1920s regarding federal legislation in various areas such as the federal taxing power and the Child Labor Tax e.g. in The Bailey Case 259 US 20 42 Sup Ct 449, had held that federal legislation that intended to do merely what state legislation could and should do was unconstitutional. The Future Trading Act of 1923 was held to be invalid in Hill v. Wallace 259 US 44, 42 S Ct. 453. This was on the basis that it was a device to regulate the boards of trade, and that Congress lacked the power to do so because when enacted it had not had the commerce power in mind. 55 In 1923 the Future Trading Act 1923 was re-enacted as the Grain Futures Act. Essentially there are no real differences between the two Acts other than the fact that the latter was correctly based upon the commerce power and not described as a tax measure. This made it valid, as held in Board of Trade of the City of Chicago v. Olsen 262 US 1, 37, 43 S Ct. 470. This mere technicality of a proper legal basis mirrors the current debate concerning the suitability of Art. 235 as a foundation for the ESC. 56 Congressional Records—House 1934 at 7927.

226 Gilles Thieffry the need for some sort of a “planned economy” in the monetary field, to prevent the excessive flow of credit into the New York money market from being destructive to legitimate business throughout the country. On another occasion, the Pujo Report in 1913 also recommended similar action.57 In 1922, Congressman Denison proposed Bill 11. R. 10508, which sought to introduce federal regulation for securities.58 It is clear then that the Americans “recognised that this required federal legislation, that it was beyond the power of a single State”.59 Following the enactment of these early state securities laws and the posturing over proposals for a SEC-type body, the straw that finally broke the camel’s back came when the stock markets crashed in 1929.60 In 1932, while depression continued throughout the US economy, commentators realised that dismissing the concept of federal regulation was possible only if one were convinced that the numerous separate exchanges were enforcing the highest practicable standard of business ethics. If there was even the slight likelihood that central governmental intervention could better the situation, then this required action from Congress.61 In March 1932, Senate Resolution No. 84 was agreed to, which authorised the Committee on Banking and Currency to investigate the practices of buying and selling securities and devise some appropriate legislation. In particular, the Report of the Committee commented that attempts by individual state exchanges “far from precluding the necessity for [federal] legislative action, emphasise its need”.62 President Roosevelt, in 1934, spoke of how: the unregulated speculation in securities and commodities was one of the most important contributing factors in the artificial and unwarranted boom which had so much to do with the terrible conditions of the years following 1929

and identified the need for “legislation with teeth in it”, under which the Government could itself correct future abuses should they arise.63 The case for a federal regulator was clearly defined in the Fletcher Report of 1934: 57

Congressional Records—House 1934 at 7927. This was on the basis that “the Federal Government alone can stop such commerce, and the Federal Government ought to co-operate with the several States”. It was felt that for the welfare of the Nation all powers to control or regulate interstate commerce ought to be surrendered to the Federal Government. Although the bill was approved by the executive committee of the National Association of State Securities Commissioners, the Investment Bankers’ Association refused to accept the more stringent approach and due to its size and strength in the market the bill was not passed. 59 Congressional Records—House 1934 at 7927. 60 The aggregate value of all stocks listed on the New York Stock Exchange fell from US$89 billion (in September 1929) to US$15 billion (in 1932). Bond losses increased the total depreciation to US$93 billion. 61 J. Hanna, “The Federal Regulation of Stock Exchanges” (1931–32) 5 Southern California Law Review 9. 62 Senate Report No 792 of 73D Congress 2d Session on the Federal Securities Exchange Act of 1934. Senator Fletcher, at 4. 63 Letter from President F. D. Roosevelt to the Chairman of the Committee on Banking and Currency, 26 March 1934. 58

The Case For a European Securities Commission (ESC) 227 The contention of stock exchange authorities that internal regulation obviates the need for governmental control seems unsound for several reasons. In the first place, however zealously exchange authorities may supervise the business conduct of their members, the interests with which they are connected frequently conflict with the public interest. Secondly, the securities exchanges have broadened the scope of their activities to the point where they are no longer isolated institutions, but have become an important element in the credit structure of the country that regulation, to be effective, must be integrated with the protection of our entire financial system and the national economy. Thirdly, the control exercised by stock exchange authorities is admittedly limited to their own members, and they are unable to cope with those practices of those non-members which they deplore but cannot prevent. Fourthly, the attitude of exchange authorities toward the nature and scope of the regulation required appears to be sharply at variance with the modern conception of the extent to which the public welfare must be guarded in financial matters. Their adherence to the view that manipulation, pool activities, and the creation of illusory “price mirages” are proper and legitimate, except where certain technical violations of their rules are involved, is inconsistent with the type of regulation the public interest demands”64 [emphasis added].

Today, the SEC has transformed into a highly successful “super” federal agency, its framework much admired and imitated around the world. Its extensive legislative powers derived from various provisions of the federal securities laws (including the ability to issue interpretative rules) have resulted in a flexible regulatory environment that upholds Congress’ primary objective in 1934— investor confidence—whilst allowing the market to develop on its own and the SEC adapting its rules to accommodate any new developments. Crucial to the SEC’s effectiveness as regulator is its Division of Enforcement, which investigates all potential violations of each Act that the SEC administers, such as insider dealing, accounting fraud and the publication of false or misleading information about companies. Finally, through its Divisions and Offices, the SEC maintains close communication with other federal agencies, the selfregulatory organisations (for example, stock exchanges) and the state securities regulators.

The European Central Bank as a Model?65 If one is not persuaded by the American SEC precedent, then one could look closer to home to the ECB, “guardian of the European currency constitution”, as a plausible working model for a pan-European securities regulator. Clearly the analogy between the ECB and ESC is valid only from an institution standpoint 64 Federal Securities Act of 1934, Fletcher Report from Committee of Banking and Currency, 17 April 1934, 73D Congress, 2D session, 2. 65 For background reading, see the ECB Monthly Bulletin, July 1999, 55 and the ECB Annual Report (1999). See also E. Nierop, “A New Corpus Iuris Monetae for Europe” (2000) 15(5) Butterworths Journal of International Banking and Financial Law 157.

228 Gilles Thieffry and not from a purely regulatory viewpoint. The ECB is in charge of the monetary policy of the Euro zone and banking regulation has been left with the central banks. However, an analysis of the institutional structure of the ECB66 will hopefully provide some clues to how a proposed ESC might operate, albeit with a very different jurisdiction. Perhaps one should include a minor caveat in that the ECB has been in existence for only a relatively short space of time and, therefore, its success cannot yet be fully assessed. The Treaty and the Statute of the European System of Central Banks and of the European Central Bank (the Statute), which is annexed to the Treaty as a Protocol,67 establish the ESCB. The ESCB consists of the ECB and the national central banks (NCBs) of the 15 EU Member States. When the Euro was finally introduced on 1 January 1999, these 11 NCBs submitted their competence with regard to monetary policy to the ECB. As there are (presently) four Member States not participating in the single currency,68 the term “Eurosystem” has been coined to refer to the ECB and the 11 NCBs which have adopted the Euro, as distinguished from the ESCB. The Eurosystem’s primary objective is price stability, and in keeping with this objective, the Treaty and the Statute impose certain tasks upon the Eurosystem, inter alia, to define and implement monetary policy of Euro land; to conduct foreign exchange operations; to manage the official reserves of Member States; and to issue Euro banknotes.69 The ECB, recognised as a legal personality70 under public international law, is able to participate in matters relating to its field of competence (i.e. monetary policy). Although the ECB has overall responsibility for its mandate, it adheres to the principle of decentralisation (or “subsidiarity”), meaning: to the extent deemed possible and appropriate . . ., the ECB shall have recourse to the NCBs to carry out operations which form part of the tasks of the ESCB.71

Policy-making ability In order to carry out these tasks (those are clearly limited to the monetary field), the ECB has been given regulatory powers through which it may adopt a variety of legal acts.72 The types of legal acts range from Regulations to Guidelines. Regulations, in accordance with normal EU law principles, are directly applicable in all Member States, although in the context of EMU they are binding only on the Eurosystem. These have been effected in areas such as minimum 66 For a more detailed discussion, see J. A. Usher, The Law of Money and Financial Services in the European Community (2nd edn., Oxford, OUP, 2000). 67 Protocol No 18 to the Treaty, [1992] OJ C191/29. 68 The four Member States are Denmark, Greece, Sweden and the UK. 69 Arts. 2 and 3 of the Statute. 70 Art. 9.1 of the Statute. 71 Art. 12.1 of the Statute 72 Art. 34.1 and 34.2 of the Statute.

The Case For a European Securities Commission (ESC) 229 reserves,73 the collation of statistical data74 and, more importantly, sanctions.75 At the other end of the scale are Recommendations and Opinions, which are regarded as authoritative statements from the ECB albeit without binding effect. The ECB, more commonly, issues Guidelines addressed to the NCBs, and these will normally require implementation through the adoption or adjustment of national legislation and regulatory rules. The ESCB and the Eurosystem are governed by the decisions made by the various ECB decision-making bodies: the Governing Council, the Executive Board (and for as long as there are Member States who have not yet adopted the Euro, the General Council).76 The Governing Council, which consists of members of the Executive Board and the Governors of the NCBs within the Eurosystem, is the supreme decision-making body. On the other hand, the Executive Board is there to implement monetary policy in accordance with the guidelines and decisions laid down by the Governing Council by instructing the NCBs accordingly.77 Independence and Accountability Another important facet of the institutional framework of the ECB, which lends it credibility as a centralised European regulator, is its independence—both from a financial and an institutional perspective. The ECB has its own budget, independent of that of the EU, thereby avoiding any interference with its administration from any Community institutions. In addition to having personal independence for members of the ECB’s decision-making bodies and for the ECB’s personnel, its accounts are audited by independent external auditors.78 Balancing this high degree of independence are the requirements of accountability on the part of the ECB (by way of weekly financial statements and Annual Reports and the requirement that the President of the ECB appears before the European Parliament to report on various issues79) and judicial scrutiny of its “acts and omissions”, including those vis-à-vis NCBs, which are subject to review and interpretation by the European Court of Justice.80

73

Regulation (EC) No 2818/98 of the EBB, 1 December 1998. Regulation (EC) No 2819/98 of the ECB, 1 December 1998. 75 Regulation (EC) No 2157/99 of the ECB, 23 September 1999. 76 The General Council, comprising the members of the Executive Board and the Governors of all 15 NCBs, takes over the matters from the European Monetary Institute by virtue of the fact that some Member States have yet to adopt the Euro and, thus, the ECB is still charged with implementing the final stage of EMU. This primarily involves reporting on the progress made towards convergence by the non-participating Member States and advising on the necessary preparations for irrevocably fixing currency exchange rates of these Member States. 77 Arts. 10–12 of the Statute. 78 Art. 27.1 of the Statute. 79 Art. 15 of the Statute. 80 Art. 35.1 of the Statute. 74

230 Gilles Thieffry

Powers of Enforcement The ECB’s role as a regulator is further strengthened by its ability to impose sanctions relating to “infringements” (defined as any failure by an undertaking to fulfil an obligation arising from ECB regulations or decisions81). To this end, the ECB is entitled to impose fines or periodic payments following an investigation82 by the Executive Board or the “competent NCB”83 concluded by its decision, which may be published in the Official Journal. These fines and periodic payments are subject to upper limits ( 500,000 and 10,000 per day in respect of a maximum period of six months respectively) and are arguably not sufficiently onerous. It is clear that the ECB, an independent body entrusted with Communitywide monetary policy for EMU, could usefully provide lessons for a new ESC. In overseeing EMU, the ECB is able to issue legal acts which impact directly on Member States. Furthermore, the concession of sovereignty in respect of monetary matters by the 11 NCBs suggests that this political issue is not entirely insurmountable (but not without difficulties). This is evidenced by the close cooperation of the NCBs in the Governing Council. Finally, its ability to impose sanctions for infringements lends great credence to the ECB as a pan-European regulator. The ECB/ESCB Model for an ESC It is certainly feasible to imagine the creation of an ESC, setting pan-European rules and principles which would then be implemented, under ESC supervision, by each existing national regulator.

CONCLUSION

The analysis above reveals a need to bring regulation into line with contemporary market reality, as the information technology revolution and market integration continue to blur the boundaries of national jurisdictions. These effects place further pressure on the EU’s slow and cumbersome legislative process—in reality, Member States take on average more than five years to adopt directives. It has been argued in this chapter that the complacency demonstrated by the Americans in their pre-1934 fragmented regulatory system led to catastrophic financial consequences and, as such, it should be a salutary lesson to Member 81 Art. 1.4 of Council Regulation (EC) No 2532/98 of 23 November 1998 [1998] OJ L318/4. In this context, “undertakings” is widely defined in Art. 1.3. 82 Here, the ECB also has relatively extensive investigatory powers in the conduct of its inquiry— see Arts. 3–9 of the ECB Regulation. 83 Defined as the NCB of the Member State in whose jurisdiction the alleged infringement has occurred: Art. 1 of the ECB Regulation (EC) No 2157/1999.

The Case For a European Securities Commission (ESC) 231 States and the market participants involved in the European securities markets. Far from fearing the impact of a sole regulator one must understand that the ESC, like the SEC, would still resort to consultation from across the industry when it comes to proposing rules and amendments. With the ESC in charge of overall policy and surveillance, the exchanges and national regulators would still operate their own surveillance and compliance departments whilst also implementing ESC policies. Critics, who warn against a hasty knee-jerk reaction to recent market developments, instead seek to sow the seeds of closer co-operation within the EU.84 Granted that a considered response is always preferable—after all, Rome was not built in a day—but a dialogue between Member States on the creation of an ESC must commence urgently. It has to a large extent started with the Lamfalussy committee of “wise men”. The author has cited the ECB as a working and pragmatic institutional model within the EU institutional framework which may usefully be transposed into the context of European securities regulation. It has also been suggested that the process of moving to an ESC may be facilitated by putting FESCO on a more formal footing, thereby endorsing an organisation that is both able to draft harmonised rules which are more flexible than the directives, and to co-ordinate the implementation of these policies on a day-to-day level.85 It might be practically difficult to establish a Securities Commission for the Euro zone with political and national sensitivities to contend with, but what role a regulator like the ESC should have in underpinning investor confidence in the unified, stable European and global financial markets is of pertinent concern. The world is progressing towards a global securities market which will offer 24-hour trading, and a debate on the virtues of a global financial regulator is not far off the horizon.86 One can continue to hypothesise, but in any case, Europe must now demonstrate the political will and urgency to succeed in seeing her ambition of a single financial services market come to fruition. In any event, the author believes that the consolidation of exchanges and clearing systems in Europe87 will lead to an acute political question to which the ESC is the only answer and solution. Once Europe is left with one or two exchanges and one or

84 J. W. F. Watson, “International Co-operation in the Field of Financial Regulatory Enforcement, Part 2—the EU Approach” (2000) 15(1) Journal of International Banking and Financial Law 13 . 85 F. Demarigny, “Disentangling the Single Market” (2000) 4(4) FR 32. 86 See, e.g., the proposal of a World Financial Authority (WFA) in J. Eatwell and L. Taylor, Global Finance at Risk: The Case for International Regulation” (Cambridge, Polity Press, 2000). Eatwell and Taylor contend that the significance of the WFA will be in its role of harmonising standards and procedures and defining the global scope and relevance of decision-making. Its functions in the dissemination of information, authorisation, surveillance, guidance and enforcement will inevitably be carried out by national authorities acting in conjunction with and as agents of the WFA. 87 See 86 above.

232 Gilles Thieffry two clearing securities systems, these massive organisations will have to be monitored and regulated by someone. It would be naïve, and ignorant of European history, to entertain the idea that the Member States whose regulatory authorities will not have jurisdiction over such (mega) European exchanges and clearing systems will accept that a foreign regulatory authority, accountable only to one sovereign, will be responsible for the sanctity of the Euro zone capital markets, which is the by-product of EMU, built upon the condition of a sharing of powers at the level of the ECB. It would have been inconceivable for one particular NCB, says the Bundesbank, to be solely in charge of the Euro, the single currency of 10 other sovereign nations. Equally, believing that we are about to see the UK FSA, the French COB or the Luxembourg Government solely in charge of the central elements of a modern economy, which the securities markets are, without any power-sharing arrangements with other Member States is an illusion. As happened in the case of the ECB, a supra-national political will and momentum are required if a single regulator is to become a reality. Market participants must make the case to governments; and governments must recognise the need for an ESC. Only then can national reservations (of a purely domestic character) be overridden.

POSTSCRIPT BY THE AUTHOR

Since the finalisation of this chapter, the Group of Wise Men chaired by Baron Alexandre Lamfalussy has issued its Final Report on the Regulation of the European Securities Markets (the “Lamfalussy Report”). The Lamfalussy Report would in itself deserve detailed study and no doubt many articles will be written about it, as it will undoubtedly be remembered as the Werner Report of the European securities markets. The Lamfalussy Report does not recommend the creation of a single EU regulatory authority nor does it rule it out. The Lamfalussy Report sets out the reasons for integrating the European markets and the gross inefficiencies of the current European regulatory framework. From that standpoint, the analysis set out in the second section of this chapter is echoed and vindicated by it. The Lamfalussy Report puts forward the immediate steps to be taken to move towards the integration of the European securities markets. The Report recommends the creation of an EU Securities Committee which, after consultation with the European Parliament and an EU Securities Regulators Committee, would recommend the adoption of regulations and/or directives to be implemented by the Member States. This procedure would aim to bring together the various EU securities regulatory regimes. The EU Securities Committee will monitor the progress towards the integration of the European securities markets. The Lamfalussy Report falls short of recommending the creation of a single European regulator, and relies on a harmonisation procedure and on the co-operation of the

The Case For a European Securities Commission (ESC) 233 national regulators—largely the same methodology that has been underlying the attempts at harmonisation for the last 20 years. To a large extent this paradigm has failed to deliver the single market for financial services (though it was due in 1993) and it is difficult to see why a method that has failed in the past should be successful now. However those who believe that an ESC—a single EU regulator—is the only viable solution can take comfort from the three important and immediate actions that the Committee of Wise Men recommends: 1. the creation of an EU Securities Regulators Committee, potentially an ideal precursor to a proper ESC (as was the EMI prior to the ECB); 2. the creation of EU Securities Regulators Committee (an ideal forum to pave the way to the equivalent of an ESCB); and 3. the allocation of proper and sufficient resources to monitor progress to support both committees (a potential basis for reliable and expert resources for a real ESC). We should then remember that the Initial Lamfalussy Report states: The functioning of this approach [summarised above] should be fully reviewed around 2004, though if, in the light of the half-yearly reports, it were manifestly failing to secure sufficient progress, there would be a case for a full review earlier. It is clearly impossible to foresee the substance of a review of developments that have yet to take place. Various scenarios are conceivable however. At one extreme, the approach sketched out above might be succeeding in developing the single market in securities. In that case, its essentials could be maintained or strengthened if that seemed necessary. At the other extreme, if the approach did not appear to have any prospect of success, it might be appropriate to consider a Treaty change, including the creation of a single EU regulatory authority for financial services generally in the Community [emphasis added].

It will therefore be up to those who do not support the creation of a “European SEC” to ensure that a system that has failed us so far—harmonisation and co-operation of national regulators—has delivered the necessary level of integration by 2004. In the meantime, the creation of the Committees mentioned above with appropriate resources, enables saving of valuable time should it be decided that an EU single regulator should be created. 2004 coincides with the date of the next Intergovernmental Conference, an ideal opportunity to launch the creation of an ESC.

15

New Issues in International Financial Regulation JOHN EATWELL

H E F I N A N C I A L C R I S I S that overwhelmed many of the Asian economies in 1997, and spread to Russia in 1998, was the first crisis in emerging market economies to threaten seriously the financial stability of the West. The Mexican crises of 1982 and 1994 had placed considerable strains on western banks. But 1998 was of a different order. The most dramatic event was the near failure of the hedge fund, Long Term Capital Management. More than any of the other problems in the autumn of 1998, the threats that LTCM’s difficulties posed to financial stability throughout the world illustrated beyond all reasonable doubt that the international financial system had entered a new era.1 This was not a problem of sovereign debt, or macroeconomic imbalance, or a foreign exchange crisis. Instead it was the manifestation of the systemic risk created by the market decisions of a private firm. The potential economy-wide inefficiency of competitive financial markets was indisputable. In August 1998, in one of those remarkable coincidences that in retrospect look like good judgment, Lance Taylor and I had delivered a report to the Ford Foundation that dealt directly with the problem of systemic risk in liberal international financial markets. We had been drawn to this particular topic by a shared irritation with the overblown claims for the efficiency of financial liberalisation—claims that did not stand up to empirical scrutiny. In our 1998 report we recommended the establishment of a World Financial Authority.2 We argued that for efficient regulation the domain of the regulator should be the same as the domain of the market that is regulated. None of the standard tasks of a financial regulator—authorisation, the provision of information, surveillance, enforcement, and the development of policy—are currently performed in a coherent manner in international markets. Indeed, in many cases they are not performed at all. In the absence of a World Financial Authority

T

1 Alan Greenspan commented that he had never seen anything in his lifetime that compared with the panic of August–September 1998. 2 J. Eatwell and L. Taylor, “International Capital Markets and the Future of Economic Policy”, paper prepared for the Ford Foundation project International Capital Markets and the Future of Economic Policy (New York, Center for Economic Policy Analysis; London, IPPR, 1998).

236 John Eatwell (WFA) the liberalisation of international markets has resulted in a significant increase in systemic risk, i.e. it has been inefficient.3 Our prime objective in proposing the creation of a WFA was to test the regulatory needs of today’s liberal financial markets. Whether a single regulator is created or not, the tasks that the model WFA should perform must be performed by someone if international financial markets are to operate efficiently. The goal of this chapter is to take the argument further by identifying the challenges facing international financial regulation today, using the template of a model World Financial Authority to identify exactly what the key regulatory tasks may be and thereby to develop proposals on how they may best be performed. In moving from our initial proposal to this more concrete analysis, consideration must be given not only to the practical developments that have taken place up to now, but also to the international legal and institutional implications of our initial proposals. It is particularly striking that much of the criticism of the idea of a WFA has suggested that the required international co-operation will be impossible to achieve—even when a number of the necessary cooperative mechanisms are already in place!4 There already exists a body of international legal practice, and a cohort of institutions that would support the further development of the regime of international financial regulation. But that body of legal and institutional practice needs to be assembled and codified in a manner appropriate to today’s regulatory needs. Whilst the emphasis in this chapter will be on the development of policy, a not insubstantial part of the argument will be devoted to analysis. This is because the theoretical framework within which a new structure of international financial regulation might be formulated is lacking. Without such a framework, policy has inevitably been ad hoc, essentially responsive to pressing need, and deprived of overall coherence. In Global Finance at Risk5 Lance Taylor and I set out the skeleton of the requisite theoretical framework. In what follows I hope to put more flesh on the bones. I will first consider briefly the development of 3 Liberalisation has coincided with a worldwide slowdown in the rate of growth. Whether there is a causal link between liberalisation and that slowdown is, of course, a complex question. But the argument that liberalisation has resulted in a higher growth rate than might otherwise be the case is even more difficult to sustain: J. Eatwell, “International Financial Liberalisation: the Impact on World Development”, ODS Discussion Paper Series, No. 12 (New York, UNDP, 1996). 4 For example, W. Hutton, “America’s Global Hand”, The American Prospect, December 1999, in a preview of J. Eatwell and L. Taylor, Global Finance at Risk: the Case for International Regulation (Cambridge, Polity Press, 2000) argued that the authors’ “logic is impeccable, but it faces one insuperable obstacle. The United States at present has no intention of ceding any regulatory sovereignty to such an authority”. Hutton does not take into account the degree of authority already vested in the consensual decision-making processes of the Basel G-10 committees. The capital adequacy requirements of banks in Iowa are determined by a committee sitting in Basel that is not accountable to the US Congress. This approach has not so much involved “ceding regulatory authority” as the recognition of the advantages of collaborative decision-making. However, Will Hutton’s point may become more important as the demands for accountability in international regulation become more strident (particularly from developing countries who have, up to now, had only minor roles, if any, in development of regulatory rules and practices). 5 N. 4 above.

New Issues in International Regulation 237 international regulation to date, and then turn to the challenges, analytical, legal and institutional, that face the attempt to construct an efficient international regulatory regime for financial markets.

THE DEVELOPMENT OF INTERNATIONAL FINANCIAL REGULATION

The development of international financial regulation since 1974 has been essentially reactive. The first major reaction was to the fact of liberalisation itself. The three decades following the end of World War II had seen the refinement of the tools for managing systemic risk in domestic monetary and financial systems. Allied with the international commitment to the management of financial flows that was a key component of the Bretton Woods system, these domestic arrangements had resulted in 25 years of reasonable financial stability in most OECD countries. This is not to say that there were not financial crises; there were. But they were predominantly of macro-economic origin, disrupting the microeconomy: high inflation rates undermining confidence in monetary policy, or persistent current account deficits undermining confidence in the exchange rate. The bad old days of micro-economic instability spreading as contagion through the financial sector and destabilising the macro-economy belonged to the prewar era of economic disaster, from which important lessons had been learned.6 Those lessons were now embodied in appropriate policies and institutions. Important amongst these institutions were powerful regulatory structures and interventionist central banks dedicated to the management of (indeed the minimisation of) systemic risk. There had, of course, been a partial relaxation of wartime and immediate post-war regulation throughout the 1950s and 1960s. But even at the end of the 1960s the regulatory regime was powerful and national. In the United States domestic money markets were particularly tightly regulated, and President Johnson’s interest equalisation tax was used to manage international capital flows. Throughout the OECD the public authorities’ international role was 6 The distinction between crises emanating from the micro-economy and those that are macroeconomically induced is worth further consideration. Though the second phase of the Great Depression was marked by a failure at the micro level, that of the Austrian bank, Credit Anstalt, much of the responsibility for the depression rests at the door of inappropriate macroeconomic policy—particularly adherence to the Gold Standard and domestic monetary policies associated with the Gold Standard: P.Temin, Lessons from the Great Depression (Cambridge, Mass., MIT Press, 1989). Similarly, the recent Korean crisis derived substantially from the decision of the Korean government to join the OECD and to accept the required liberalisation of financial markets. This led to private sector firms increasing their foreign exchange exposure to excessive levels: H.-J. Chang, H.-J. Park and C. G. Yoo, “Interpreting the Korean Crisis: Financial Liberalisation, Industrial Policy and Corporate Governance” [1998] Cambridge Journal of Economics. In both the 1930s and the 1990s, an inappropriate macroeconomic environment resulted in excessive risk taking by firms. In the 1950s and 1960s macroeconomic crises were not associated with excessive private sector risk taking (which was constrained by strict regulation) but by major macroeconomic imbalances.

238 John Eatwell dedicated to the maintenance of the fixed exchange rate system. The collapse of the Bretton Woods system of fixed exchange rates in 1971 resulted in the privatisation of foreign exchange risk. If the private sector was to carry this risk it needed to be able to diversify its financial assets amongst a variety of monetary instruments and currencies. So it was necessary to dismantle much of the post-war international and domestic financial regulation that would have prevented that diversification. But dismantling controls threatened to recreate the unstable pre-war environment.7 As international barriers to financial flows disappeared, national regulators and national central banks were trapped in increasingly irrelevant national boundaries. The domain of banks, investment houses, insurance companies and pension funds became international. In a rapid return to the pre-war norm, it was a micro-economic failure (of the Herstatt Bank in 1974) that threatened severe disruption of the US clearing system and hence of the US macroeconomy. In recent years the Asian crisis also stemmed primarily from failures in the private sector reverberating through the macro-economy. An important response to the new environment was the establishment in 1975 of Basel committees at the BIS. These committees reported to the grouping of central bankers of the major economies, the Group of Ten (G-10). The task of the committees amounted to an attempt, via consensual decision-making, to generate on an international scale some of the powers that had earlier been deemed necessary to stabilise national financial systems. The scope of those committees has steadily increased since 1975, usually in response to crises.8 A crucial development came in 1988, with the adoption of capital adequacy criteria. International financial regulation was now not just about co-operation, but about the co-ordination of standards—standards agreed in Basel. A further important development came in response to the Mexican bond crisis of 1994. The G-7 governments, responding to what was perceived to be the excessive instability of financial markets, agreed at their Halifax summit in 1995 that the regulation of international financial markets could not be left to the G-10, but should be on the agenda of intergovernmental discussions. Not much was achieved in concrete terms. Then the Russian bond crisis of 1998, coming as it did at the end of a period of extreme instability emanating from Asia, brought home to G-7 governments that their economies were not immune from the contagion of third world financial turbulence. The response was the creation of the Financial Stability Forum (FSF), and establishment of the World Bank–IMF Financial Sector Assessment Program (FSAP) under the direction of the joint Bank–Fund Financial Sector Liaison Committee (FSLC). The FSF has brought together, on the one hand, the political and the supervisory authorities and, on the other hand, the regulatory authorities and the macro-economic policy-makers. So, on the operational side, the supervisors are 7 8

Eatwell and Taylor, n. 4 above, ch. 1. Ibid., ch. 6.

New Issues in International Regulation 239 meeting with the politicians and treasury staff who can get things done. On the economic side it combines regulation and macroeconomic policy, a vital, and up to now missing, combination for effective international regulation. At the moment, whilst it has produced some excellent reports, the FSF is a think tank with nowhere to go. It is not at all clear what action will follow the reports, or, indeed, who will act. Having suffered a fright in 1998, the policy-makers in national treasuries are retreating from the sort of collaborative view of the world that the establishment of the FSF seemed to foreshadow. The FSAP involves the World Bank and IMF in detailed micro-economic appraisal of the financial markets and regulatory institutions of selected nations. This level of detailed appraisal of private sector structures is a significant change in the involvement of the IMF in a nation’s economic affairs, and probably marks a turning point in the surveillance activities of the Fund. The pressure for a new international regulatory regime is leading to a significant reinvention of the IMF. It is not as yet clear what will prove to be the respective roles of the Basel committees, the FSF and the new Bank–Fund structures in the future management of international regulation. What is clear is that the issues identified in the WFA project have proved to be the fundamental issues that must be addressed if that future management is to be accountable, legitimate, and successful.

THE CHALLENGES FACING INTERNATIONAL FINANCIAL REGULATION

The challenges facing international financial regulation today may be best identified through the device of a hypothetical World Financial Authority: what tasks should be performed by such an Authority? What should be the legal foundation of WFA action? How are the tasks to be performed? Given the argument, as noted above, that for market efficiency the tasks of the WFA must be performed by someone, answering these questions in the context of the WFA provides a guide to policy development.

What Tasks should be Performed by a WFA? A national financial regulator performs five main tasks: authorisation of market participants; the provision of information to enhance market transparency; surveillance to ensure that the regulatory code is obeyed; enforcement of the code and disciplining of transgressors; and the development of policy that keeps the regulatory code up to date (or at least not more than 10 metres behind the market in a 100 metre race). These are the tasks that now need to be performed at international level, ideally as if performed by a unitary WFA. For example, it is clear that criteria for authorisation should be at the same high level throughout the international market: ensuring that a business is financially

240 John Eatwell viable, that it has suitable regulatory compliance procedures in place, and that the staff of the firm are fit and proper persons to conduct a financial services business. If, in a liberal international financial environment, high standards are not uniformly maintained then firms authorised in a less demanding jurisdiction can impose unwarranted risks on others, undermining their high standards of authorisation. Similarly, as far the information function is concerned, the failure to attain not only transparency but also common standards of information undermines the efficient operation of international financial markets, and creates risk. The persistent inability to agree international accounting standards is a prime example of just such a failure. Surveillance and enforcement are the operational heart of any effective regulatory system. Without effective, thorough policing of regulatory codes, and uniform enforcement of standards by appropriate disciplinary measures (including exclusion from the market-place) the international financial system is persistently exposed. Finally, the policy function is the essential driving force of effective regulation. Regulatory codes must be adapted to a continuously changing market-place. An important component of that change is international. As national financial boundaries dissolve, and as new products are developed that transcend international boundaries by firms with a worldwide perspective, the policy function must ensure that the regulator is alert to the new structure of the market-place, the new systemic risks created, and to the new possibilities of contagion.9 This requires a unified policy function, capable of taking a view on the risks encountered by particular markets and by the international market place as a whole. What should be the Legal Foundation of WFA Action? All these activities are necessary for the efficient operation of the new international financial order. All point to the need for a single authority determining common rules and exercising common procedures. But there are clear, in some cases overwhelming, difficulties in attaining that goal, of which the problems that have dogged the attempts to achieve common accounting standards are but a foretaste. All five core activities involve the exercise of authority, and hence trespass into very sensitive political issues. Nation states are naturally reluctant to cede powers to an international body, even if this may mean the acquisition of (collective) sovereignty over activities otherwise beyond their control. When powers are ceded they are typically ceded by treaty, confirming collective rights and responsibilities, and, at least in principle, accountability. However, similar goals may be attained by consensus and by the mutual recognition of selfinterest that produces “soft law”. 9 An important recent example was the use of credit derivatives in Indonesia that ultimately spread financial losses to South Korea.

New Issues in International Regulation 241 Article IV of the Articles of Association of the IMF empowers the organisation to “oversee the international monetary system in order to ensure its effective operation”. To this end the provision that “the Fund shall exercise firm surveillance over the exchange rate policies of members” has been interpreted as covering general macroeconomic surveillance, and, in the new Financial Sector Appraisal Program, microeconomic surveillance of the operations of the financial sectors of member states.10 The new FSAP surveillance concentrates on the adherence of national regulation and practices to core principles developed by the Basel committees of the G-10, the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), supplemented by IMF principles for sound macroeconomic policy.11 The IMF is using a treaty-sanctioned surveillance function to examine adherence to codes and principles that are not themselves developed by accountable treaty bodies. This is an activity of considerable sensitivity. Not only will comprehensive surveillance require large resources, but also the IMF could easily be drawn into the position of “grading” national financial systems, with any downward revision of grades having the potential to produce dramatic financial consequences.12 Nonetheless, the IMF, as an accountable body the powers of which are defined by treaty, can legitimately perform a surveillance function. 10 Many characteristics of domestic financial systems may be only indirectly connected to “the exchange rate” as such. Nonetheless, it is not unreasonable to link domestic regulation to international financial stability. 11 E.g. the June 2000 IMF “experimental” Report on the Observation of Standards and Codes (ROSC) for Canada, prepared by a staff team from the International Monetary Fund in the context of a Financial Sector Assessment Program (FSAP), on the basis of information provided by the Canadian authorities, produced “an assessment of Canada’s observance of and consistency with relevant international standards and core principles in the financial sector, as part of a broader assessment of the stability of the financial system. This assessment work by the IMF was undertaken under the auspices of the IMF–World Bank Financial Sector Assessment Program (FSAP) based on information up to October 1999. This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas. . . . The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Organization of Securities Commissions’ (IOSCO) Objectives and Principles of Securities Regulation; (iii) the International Association of Insurance Supervisors’ (IAIS) Supervisory Principles; (iv) the Committee on Payment and Settlement Systems (CPSS) Core Principles for Systemically Important Payment Systems; and (v) the IMF’s Code of Good Practices on Transparency in Monetary and Financial Policies. Such a comprehensive coverage of standards was needed as part of the financial system stability assessment for Canada in view of the increasing convergence in the activities of banking, insurance, and securities firms, and the integrated nature of the markets in which they operate. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology systematically to assess compliance or consistency. This module was prepared in consultation with the Canadian authorities in the context of the IMF FSAP mission that visited Canada in October 1999, and constitutes a summary of the detailed assessments prepared by the mission. The summary was part of the Financial System Stability Assessment (FSSA) report that was considered by the IMF Executive Board on February 2, 2000, in the context of the IMF’s Article IV consultation discussions with Canada”: IMF, Report on the Observance of Standards and Codes: Canada (Washington, DC, IMF, 2000). 12 IMF, Experimental Reports on Observance of Standards and Codes (Washington, DC, IMF, 2000).

242 John Eatwell Moreover, it is clear that in due course the IMF will require countries seeking its assistance to conform to international regulatory codes and standards. In other words, it will be able to enforce conformity to those standards, with severe financial penalties (withdrawal of offers of assistance) for those who do not comply. It is to be doubted, however, whether it could, other than by persuasion, effectively enforce regulatory codes when they are infringed by more powerful countries that do not requires the Fund’s assistance.13 The rules and codes that the IMF is seeking (experimentally) to embody in its surveillance programme are predominantly formulated within non-treaty, “soft law” environments. As Alexander explains:14 International soft law refers to legal norms, principles, codes of conduct and transactional rules of state practice that are recognised in either formal or informal multilateral agreements. Soft law generally presumes consent to basic standards and norms of state practice, but without the opinio juris necessary to form binding obligations under customary international law. . . . Soft law may be defined as an international rule created by a group of specially affected states which had a common intent to voluntarily observe the content of such rule with a view of potentially adopting it into the national law or administrative code.

Soft law evades some of the political difficulty of the assignment of sovereignty implicit in international regulation because it does not impose an obligation, even though there is an expectation that states will take agreed codes seriously. In financial matters the most powerful means of enforcing soft law has been the competitive market. A major example of this process was the rapidity with which OECD and other economies subscribed to the 1987 bilateral agreement between the UK and the USA to adopt capital adequacy standards for banks. A failure to subscribe would undermine market confidence—too high a price to pay. The adoption by the IMF of soft law as a criterion of surveillance suggests a process of transition from soft law to mandatory regulation, at least for those countries that are beholden to the IMF. Observation of Basel and other codes will become an IMF imposed obligation. If this happens, new questions will be raised about the accountability of the Basel rule-makers and their counterparts at IOSCO and the IAIS. Even with this potential “legalisation” of international policy-making and of surveillance (which includes some standardisation of the information function in the drive for “transparency”) authorisation and, for the richer countries, enforcement remain national activities—though even here agreements on homehost division of responsibilities inject an international dimension. There is, in effect, a creeping internationalisation of the regulatory function in international financial markets. That internationalisation is essentially 13

Eatwell and Taylor, n. 4 above, ch. 7. K. Alexander, “The Role of Soft Law in the Legalisation of International Banking Supervision” [2000] Journal of International Economic Law. 14

New Issues in International Regulation 243 confederalist in character, with national jurisdictions being the predominant legal actors guided by international soft law, and by the pressures of the marketplace. So some of the functions of a WFA are being performed. But they are being performed imperfectly. Authorisation is still essentially national, the information function is highly imperfect, surveillance (by the IMF) is as yet “experimental”, enforcement is (up to now) national, and the policy function is predominantly driven by an exclusively G-10 consensus. As measured against the template of a proper WFA there is a long way to go. However, the difficulty of creating an effective framework of international regulation does not derive solely from international legal practice and from politics. An important element of disjuncture derives from history—from differences in national legal systems, in financial custom and practice and in structures of corporate governance. Even within the European Union, for example, there are major differences in national legal systems and in corporate governance that make the introduction of a common regulatory code not only difficult, but potentially damaging. Regulatory codes that enhance efficiency in one jurisdiction may have exactly the opposite effect in another.

How are these Tasks to be Performed? Whilst the template of a WFA clarifies the tasks that must be performed if international financial markets are to be regulated efficiently, it does not provide much guidance on how the tasks are actually to be performed in the (highly likely) absence of a unitary authority. In practical terms many tasks can and must be delegated to national authorities. But it is important that national authorities should operate within common guidelines. That is the importance of the WFA— not to tell national authorities what to do, but to ensure that in a single world financial market they behave in a coherent and complementary manner to manage the systemic risk to which, in a seamless market, they are all exposed. Effective international regulation will necessarily be confederal, with different responsibilities at appropriate levels of the system. But there must be a coherent confederation with common principles and common values, resulting in (converging) national codes enforced by national sovereign authorities to attain common goals. The developments of the past 30 years and, more especially, the innovations of the last three years point to the recognition by member states and by market participants of the need for coherent international regulation. But the present conjuncture, in which the predominant rule-making bodies are the Basel committees, IOSCO and the IAIS, whilst the predominant international surveillance body (in so far as there is any international surveillance at all) is the IMF, is an awkward hybrid. Moreover, it embodies the unfortunate impression that rules are made by the rich nations and enforced on the rest. What is needed is recognition of the power of the WFA template, and the design of international institutions that can meet the demands identified by the

244 John Eatwell template in an accountable, coherent and flexible manner. A number of challenges must be met if this goal is to be attained: (1) the development and acceptance of a common theoretical framework within which to confront the tasks of international regulation; (2) the integration of macroeconomic and microeconomic aspects of international regulation; (3) the development of procedures that (at least) alleviate the tendency for risk management to be procyclical and pro-contagion; (4) the harmonisation of risk management in differing corporate governance structures to obtain a common international regulatory outcome: (5) solving the political challenge of accountability in a soft law regime; (6) devising an institutional structure that performs the tasks of the template WFA.

A COMMON THEORETICAL FRAMEWORK

Over the past three decades the most difficult task of the financial regulator has been to keep up with the changing market-place that he or she is supposed to be regulating. The speed of change has, if anything, accelerated, with the continuous development of new trading strategies and new “products”, linking assets, markets and currencies in new ways, and creating new risks. In this febrile environment the regulator needs the guidance of a coherent theoretical understanding of the propagation and management of systemic risk, as well as the pragmatic understanding and concrete tools to manage the risk. There is no common theoretical understanding of what financial regulators are supposed to do. Of course, systemic risk is an externality, but externalities are peculiarly difficult to define in other than the most abstract terms: where exactly do costs and benefits fall? What is their scale relative to the economy as a whole? What is the relationship between particular policies to manage the externality and the performance of the economy as a whole? In the world of finance these difficulties are compounded by the fact that the externality of systemic risk is in large part manifest through a beauty contest—through the market participants’ belief about what average opinion believes average opinion believes.15 Assessing the impact of regulation on average opinion is bound to be an art rather than a science, and an imperfect guide to policy. A further problem in building a coherent theory of regulation is the potential scale of the losses associated with extreme and (hopefully) rare events. Average opinion is typically very stable for long periods, dominated by convention. In these circumstances it may be comparatively easy to identify the behavioural relationships that characterise such periods of tranquillity, and to believe that they are stable and enduring. Yet these seemingly “true models” of the market-place can be completely overwhelmed by a sharp shift in average opinion, driving markets in 15 See J. M. Keynes, The General Theory of Employment, Interest and Money (London, Macmillan, 1936), ch. 12; Eatwell and Taylor, n. 4 above, chs. 1 and 3.

New Issues in International Regulation 245 previously unimaginable directions, and producing potentially catastrophic disruption in the operation of the real economy.16 This poses enormous problems for the policy-maker. Are regulations to be constructed on the basis of the models of tranquillity, or are they to take account of potentially catastrophic rare events when the logic of those models is overthrown? How often do “rare” events occur, and what is the relationship between their frequency and the regulation of systemic risk in more tranquil circumstances? Are financial crises simply transitory events, oscillations around the long-run equilibrium of the real economy? Or do crises and their reverberating impacts on average opinion and on expectations of asset price movements play a role in determining the long-run performance of the economy? These questions have both theoretical and empirical dimensions. Lacking generally agreed answers international financial regulation has proceeded by trial and error, regulatory innovations following financial shocks. The device of a hypothetical World Financial Authority is designed, in part, to overcome this piecemeal approach. Starting from the perspective of a single regulator of international markets given the objective of maintaining financial stability by limiting systemic risk, the single regulator should assess the costs and benefits of particular measures against that goal. It will obviously encounter the problem of evaluating the distribution of costs and benefits. For example, measures to limit short-term capital flows to emerging markets may enhance the stability of financial markets at little cost to recipient economies, but at significant loss of income to banks in the G-10. In these circumstances the WFA function must have the means to develop a coherent analysis of the overall impact on systemic risk, persuade the participants of the values of the analysis and policies, and mediate disputes.

MACROECONOMIC AND MICROECONOMIC ASPECTS OF INTERNATIONAL REGULATION

The fact that the externality associated with the risks taken by individual firms is, in many cases, transmitted macroeconomically requires that regulation be conceived in conjunction with macroeconomic policy. Too often today, regulation is seen as an activity that involves the behaviour and interaction of firms, with little or no macroeconomic dimension. By the very nature of financial risk this is a serious error, and is likely to lead to serious policy mistakes. This is particularly true in an international setting, where a major focus of systemic risk is the exchange rate, a macroeconomic variable the changes of which can lead to rapid redistributions of the values of assets and liabilities. 16 John Meriwether, former CEO of Long Term Capital Management, commenting two years after the activities of his hedge fund had led the financial system of the West to the edge of catastrophe, said “I am not so sure we would have said this earlier—there are times when markets can be much more chaotic than one would ever predict” (quoted in Financial Times, 21 August 2000).

246 John Eatwell An excellent example of the role of macro-linkages in the formation of regulatory policy has followed the Asian financial crisis of 1997–8. It is clear that an important component of the crisis was the excess foreign-exchange exposure of financial and other institutions in emerging markets. In consequence, the international financial institutions have been urging the authorities in emerging markets to tighten regulation of short-term forex exposure. The tightening is supposed to take place microeconomically by means of regulations that impact on the actions of individual firms. This is a complex task, and requires a significant input of a scarce resource—trained regulators. Moreover, the quantitative measures proposed are likely to have an uneven effect, limiting the exposure of financial institutions, but missing many holdings outside the financial sector. The same goal could be attained macroeconomically. Measures that raise the cost of short-term borrowing abroad, such as “Chilean-style” short-term capital controls, would tend to reduce the exposure of all firms, financial and otherwise.17 This macro approach would also economise on scarce talent. Yet although capital controls do not suffer the same level of opprobrium as they did before the Asian crisis, the relationship between the micro and macro means of attaining the same objective is not often made. The neglect of macro-measures is particularly puzzling given that micro-regulation tends to be quantitative and to some degree discriminatory, whilst Chilean-style macro controls are pricebased and non-discriminatory—characteristics which might be expected to appeal to economic policy-makers. The difficulty of analysing the macroeconomic transmission of the systemic risk generated by the actions of individual firms is illustrated by a proposal emanating from within the IMF to construct “macroprudential indicators” (MPIs) to assess the “health and stability of the financial system”. As currently constructed MPIs “comprise both aggregated microprudential indicators of the health of individual financial institutions and macroeconomic variables associated with financial system soundness”.18 The attempt to link micro risk to the performance of the macro economy is laudable, and is exactly where the debate on effective international regulation should be conducted. However, there are two flaws in MPIs as currently conceived. First, the aggregation of the characteristics of individual firms will not result in an indicator that accurately represents the risk to which the economy is exposed. The aggregate capital adequacy ratio of the financial sector could easily conceal major risks—a few prudent institutions with high ratios disguising the presence of the less prudent. Including data on the frequency distribution of such variables does not fully confront this problem. The characteristics of the 17 See M. Agosin, “Capital Inflows and Investment Performance: Chile in the 1990s” in R. Ffrench-Davis and H. Reisen (eds.), Capital Flows and Investment Performance: Lessons from Latin America (Paris, OECD, 1998). 18 See P. Hilbers, R. Krueger and M. Moretti, “New Tools for Assessing Financial System Soundness”, Finance and Development, September 2000; see also O. Evans, A. Leone, M. Gill and P. Hilbers, “Macroprudential Indicators of Financial System Soundness”, IMF Occasional Paper 00/192 (Washington, DC, IMF, 2000).

New Issues in International Regulation 247 distribution do not capture the nature of the risks taken by individual institutions.19 Secondly, as yet there has been no attempt to link macroeconomic performance and policy to the incentives surrounding microeconomic risk-taking. Not only is the value of capital, and hence the capital adequacy ratio, directly affected by the revaluation of assets consequent upon a change in the interest rate, but also declines in the level of activity can readily transform prudent investments into bad loans. Taking these two points together, it becomes clear that in the analysis of systemic risk micro and macro factors should not be treated separately. The whole is not just greater than, but behaves very differently from, the sum of the parts. Effective international regulation requires a new approach to both the theory and the policy of regulation. This new approach must confront the macromanifestation of systemic risk within the analysis of the impact of firm behaviour. Building on this theoretical approach it must be recognised that the regulator may be able to operate more efficiently in macroeconomic terms than by means of more traditional initiatives at the level of the firm.

PRO - CYCLICAL AND PRO - CONTAGION RISK MANAGEMENT

A further manifestation of the relationship between microeconomic risk and macroeconomic performance derives from the apparently paradoxical links between risk management, the trade cycle and financial contagion. Strict regulatory requirements will result in firms reducing lending as a result of a downturn in the economy, so exacerbating the downturn. In an up-turn, the perceived diminution of risk and the availability of regulatory capital will tend to increase the ability to lend, stoking up the boom.20 This pro-cyclicality of regulation is further amplified by the contagioninducing techniques of risk management. During the Asian crisis, financial institutions reduced their exposure to emerging markets throughout the world. These cutbacks helped spread the crisis, as reduced lending and reduced confidence fed the financial downturn. The key to the problem is, once again, the link between micro-economic actions and macro-economic consequences. Rational risk-management by individual firms precipitates a macro-economic reaction that, in a downturn, can place those firms in jeopardy, indeed could overwhelm the firms’ defences entirely. Yet because the links between regulation and macroeconomic policy are so little understood, there is no coherent policy 19 A further difficulty with the use of capital adequacy ratios as MPIs arises from the ambiguity surrounding the regulatory role of the ratio: is it a buffer, or is it a charge, “pricing in” the externality of systemic risk? If ratios must be maintained in all circumstances, capital cannot be a buffer to cover losses; it is needed to fulfil regulatory needs. So the size of the capital ratio merely indicates the size of the charge levied on risk-taking. If the ratio is fixed the charge will not vary significantly as between booms and depressions, yet the risk may undergo large variations. 20 P. Jackson, “Capital Requirements and Bank Behaviour: the Impact of the Basel Accord”, Basel Committee on Banking Supervision Working Paper No 1 (1999).

248 John Eatwell response to this perverse consequence. In extreme circumstances regulators in developed countries have “looked the other way”. At the onset of the Latin American debt crisis in the early 1980s many major US banks were technically bankrupt, since Latin American assets held on their books had lost their entire market value. Nonetheless, US regulators allowed those worthless assets to be evaluated in the banks’ balance sheets at their value at maturity, hence boosting the banks’ notional capital and preventing a sudden collapse in lending and liquidity.21 In the autumn of 1998, many assets held on the balance sheets of financial institutions in London and New York were, if marked to market, worth nothing. Again, the regulators did not insist on an immediate (potentially catastrophic) write down. Philip Turner22 has argued for a “microeconomic solution” to the procyclicality of regulation: The ideal response to procyclicality is for provisions to be made for possible loan losses (i.e. subtracted from equity capital in the books of the bank) to cover normal cyclical risks. If done correctly, provisions built up in good times can be used in bad times without necessarily affecting reported capital.

But he notes that even this sensible provision for “normal cyclical risks” can run foul of current regulatory procedures: The first stumbling block is that tax laws often severely limit the tax deductibility of precautionary provisioning and may insist on evidence that losses have actually occurred. This is important because loan loss provisions increase internal funding for the bank only to the extent that they reduce taxes. A second possible stumbling block may be the securities laws. For example the SEC in the United States has argued that precautionary provisioning distorts financial reports and may mislead investors. There may then be a trade-off between very transparent, well-documented accounting practices, on the one hand, and the need for banks to build up reserves during good times, on the other. A third possible stumbling block is that the management of banks may be too eager to report strong improvements in earnings during booms (and so too reluctant during good times to make adequate provision for losses). The present wave of takeovers in the banking industry may accentuate this eagerness: good reported earnings and high share prices serve to fend off takeovers.

But even if these stumbling blocks were overcome, Turner’s proposal of extra provisioning would serve to alleviate the problems created by the procyclicality of regulation only in “normal” circumstances. It does not address the issue of the tendency of regulatory standards to deepen and widen major downturns, and to fuel booms. This tendency will become increasingly severe for developing countries as 21 This does not mean that regulatory standards were abandoned entirely: “money centre banks whose loans to heavily indebted countries exceeded their capital in the early 1980s were allowed several years to adjust—but there was no doubt that they would have to adjust”: P. Turner, “Procyclicality of Regulatory Ratios?”, paper presented at Queens’ College Cambridge, prepared for the Ford Foundation project on “A World Financial Authority” (January 2000). 22 Ibid.

New Issues in International Regulation 249 they are further integrated into international capital markets, and adopt the required risk management regulatory procedures. For all countries, there is the further difficulty that even if some sort macroeconomic response were available to offset the procyclicality of regulation, macroeconomic policy is essentially national, whilst the problem may well be international in origin and scope. The very least that a WFA could do is assist in the co-ordination of macroeconomic responses. At a more general level the presence of a WFA would facilitate the international development of policies that link regulatory risk-management procedures and the needs of macroeconomic balance.

THE HARMONISATION OF RISK MANAGEMENT IN DIFFERING CORPORATE GOVERNANCE STRUCTURES

A central theme of Eatwell and Taylor23 is that efficient regulation requires that the domain of the regulator should be the same as the domain of the market that is regulated. However, whilst financial markets are “seamless”, they are not homogeneous. National markets are differentiated by their legal systems and institutions, by structures of corporate governance, and by business custom and practice. Therefore uniform financial regulations often do not have the same consequences, having quite different practical effects, and resulting in different systemic risks. The result is that uniform codes will expose the financial system to different systemic risks in the light of their differential impact in different jurisdictions.24 This is the central weakness of the fixed regulatory requirements and ratios emanating from the Basel committees and the strength of the Basel system of codes. What is ideally required is that there should be an assessment of the relationship between the financial structure of national jurisdictions and the systemic risk emanating from each jurisdiction. That ideal is probably unattainable, since it would require detailed consideration and negotiation of each national case—an overwhelming task. A more pragmatic approach would involve: (a) the construction of specific rules in those cases which refer to basic institutional tenets that are universal, and are necessary for the success of any regulatory environment; (b) in those circumstances where national legal and governance structures predominate the development of national codes derived from common internationally agreed general principles. In case (b) regulation is developed at two levels: first, a set of general principles, secondly, from these principles should be derived codes that are both 23

N. 4 above. See K. Alexander and R. Dhumale, “Enhancing Corporate Governance for Banking Institutions”, paper prepared for the Ford Foundation project on “A World Financial Authority” (2000). 24

250 John Eatwell flexible as circumstances change and reflect the peculiar legal and governance structures of individual countries. This is, of course, the defining characteristic of the current soft law regime. But at present many of the principles are “ideal types”, to be desired rather than enforced. If principles are to be the foundation of an effective regulatory system they must be expressed through clearly articulated codes, which are regularly tested against the principles they are supposed to embody, and against the systemic risks they are supposed to manage. There will undoubtedly be differences of opinion whether a particular set of national codes accurately reflects shared principles, and it will be necessary to put in place powerful procedures for adjudicating disputes (another role for a WFA). The cause of uniform adherence to principles will be reinforced by market competition, in rather the same manner as competition has led to the widespread adoption of Basel capital adequacy standards. Moreover increasingly open markets are likely to produce competitive convergence in standards and procedures of corporate governance that will in turn permit a movement toward uniform regulatory codes, i.e. an increasing role for the universal rules referred to in (a) above.

THE POLITICAL CHALLENGE OF ACCOUNTABILITY IN A SOFT LAW REGIME

In a liberal international financial system each nation faces risks that may emanate from behaviour entirely outside its jurisdiction. Even very strong states face risks that may derive from financial crises in poor countries. The desire to manage risks may lead to two polar reactions: first, the attempt by the rich and strong to manage the poor and weak, to protect the rich from external threat; secondly, co-operation between all countries to manage risk internationally. All procedures for international regulation will fall somewhere on a scale between these two extremes. Other than in the polar first case, international regulation will involve some pooling of sovereignty, even if only at the level of initiating proposals. Treaties designed to establish international authority and procedures, such as the treaty agreeing the Articles of Association of the IMF, are a pooling of sovereignty in the pursuit of negotiated ends. They also typically contain procedures to ensure some accountability by the international institutions to the national signatories. As Alexander25 has pointed out, the pursuit of international goals by means of treaties has high transactions costs, and may be restrained by uncertainty: One set of problems falls under the heading of transaction costs. Complexity of the issues, difficulties in negotiating and drafting, the number of participants and similar factors make it difficult for governments to agree on precise, binding and highly institutionalised commitments. . . 25

N. 14 above.

New Issues in International Regulation 251 Another set of contracting problems concerns the pervasive uncertainty in which states and other international actors must operate. Many international agreements can affect national wealth, power and autonomy. Yet governments can never foresee all the contingencies that may arise under any agreement. They are never certain that they will be able to detect cheating or other threats. They cannot even be sure how they will react to particular contingencies, let alone how others will. These problems are exacerbated by the relative weakness of the international legal system that cannot fill gaps and respond to new situations as easily as domestic legal systems can. One way to deal with uncertainty is through soft delegation: not to courts, but to political institutions, subject to continuing oversight and control, that can produce information, monitor behaviour, assist in further negotiations, mediate disputes and produce interstitial or technical rules. Another is through imprecise norms that provide general guidelines for expected behaviour while allowing states to work out more detailed rules over time. A third way involves crafting relatively precise, but nonbinding, rules that allow actors to experiment by applying the rules under different conditions while limiting unpleasant surprises. All these approaches have costs, including their limited ability to regularise behaviour. Yet on balance they are frequently seen as beneficial, permitting states to achieve some immediate gains from cooperation while structuring ongoing learning: this is a political process that can take states further along the path of the institutionalisation of obligations.

Because treaties must overcome these difficulties they are typically a compromise, and inevitably inflexible. Moreover, because they necessarily embody some degree of accountability to their signatories, they tend to be slow moving. These are rather unattractive characteristics in the field of international financial regulation. It is therefore not surprising that developments have taken a different route, with the major role being played by the non-treaty committees housed at the BIS, together with IOSCO and the IAIS: The process of devising international norms and rules to regulate international banking activity involves a form of international soft law that has precise, non-binding norms that are generated through consultations and negotiations amongst the major state regulators. This particular form of international soft law provides the necessary political flexibility for states to adopt international rules and standards into their national legal systems in a manner that accommodates the sovereign authority of the nation state. States could then move forward through the process of legalisation by building on the collective intent of the major economic powers to develop binding international rules for banking supervision. States could potentially delegate the adjudication of violations to an international financial authority, but states would retain ultimate enforcement authority, including sanctions.26

The problem here is, of course, the predominant role of the major states. An effective soft law regime works by consensus, and a grudging consensus imposed by the major states upon others is likely to be less effective than a consensus in which all participate. Whilst the existence of a legal structure does offer some protection to weaker countries, whose sovereignty is compromised 26

Ibid.

252 John Eatwell by the very fact of being economically (and perhaps politically) dominated by the developed countries,27 the fact that that structure is determined by the G-10 raises the obvious question of whose interests are being protected. The “obvious” solution of increasing the representation on the Basel committees runs the risk of overloading the decision-making mechanisms, and losing their flexibility. The partial solution, adopted at the FSF, of involving a wider range of countries on policy-making committees is attractive but it may not prove to be widely acceptable if the proposals contained in the reports produced by the FSF harden into concrete policy measures. Ultimately the choice between a soft law and a formal treaty regime may come to the conclusion: “both”. The treaty will lay down a method for developing general principles that should guide the regulators, and a mechanism for developing codes derived from those principles. The task of developing the codes can then be entrusted to a less formal body, akin to the current Basel committees.

DEVISING AN INSTITUTIONAL STRUCTURE THAT PERFORMS THE TASKS OF THE TEMPLATE WFA

Today an institutional structure of international financial supervision is emerging which mirrors, albeit imperfectly, the idealised structure of a WFA. The authorisation function is the responsibility of national regulators, with access to markets being determined by the presence or absence of agreements specifying the terms of mutual recognition. The information function is performed partly by the international financial institutions, particularly the BIS, partly by the International Accounting Standards Committee, and partly by national regulators, stock market rules, and so on. The surveillance function is performed by the World Bank–IMF financial sector programme, and by national regulators.28 The enforcement function is being developed as an implicit outcome of the World Bank–IMF financial sector programme, and is otherwise the responsibility of national authorities. The policy function is in the hands of the BIS committees, IOSCO and the IAIS, the Financial Stability Forum, the IMF, and national authorities. 27 “Small states . . . may have negative sovereignty costs, since legal arrangements offer them protection from powerful neighbours. Large states, by contrast, would appear to be in less need of legalisation, though in fact they might seek it as an efficient way to structure governance where they can dictate the rules and exert political control over their implementation. Soft legalisation can bridge the gap between weak and strong states. This is especially true of the type of legalisation . . . where norms and rules are binding and relatively precise but authority for compliance is delegated to national political institutions. In this situation weak states are protected by legal rules that fix expectations of behaviour, while strong states maintain influence in political bodies where they can shape future developments”: ibid. 28 In addition the international surveillance of financial crime, particularly money laundering, is conducted by the Financial Action Task Force. See K. Alexander, “The Legalisation of the International Anti-Money Laundering Regime: the Role of the Financial Action Task Force” [2000] Financial Crime Review.

New Issues in International Regulation 253 This list has four major features: 1. If the same list were compiled 10 years ago most of the regulatory functions, with the exception of the policy function, would lack any international dimension. Today in all areas other than authorisation, international bodies are taking up some of the regulatory tasks. 2. There is an eclectic mix of national institutions, international agreements (soft and hard) and international institutions (with varying degrees of legitimacy). Some powers are developing almost accidentally, such as the emergence of an enforcement power at the IMF via the FSAP programme. Others are developing by design, such as the work of the International Accounting Standards Committee. All are developing under the pressures for effective policy exerted by the process of financial market liberalisation, particularly at times of crisis. 3. The list deals only with major international regulatory developments, and omits the growth of regional regulation, notably in the European Union. The case of the European Union is particularly interesting since it involves the attempt to develop a fully liberalised, single financial market, characterised by a wide range of different legal practices and structures of corporate governance amongst member states. 4. Measured against the template of a WFA the list displays an international regulatory structure that is limited, even incoherent. It portrays a patchwork response to crises rather rational response to the international development of systemic risk. This patchy, often incoherent, structure embodies significant threats to financial stability. On the one hand the growth of international institutions, such as the FSF, induces the feeling that “something has been done” to tackle systemic risk. On the other hand, the very limited powers of any of the international structures listed above suggest that such complacency is a delusion. The current threadbare patchwork cannot perform the tasks of a WFA.

SUMMING - UP

Two themes dominate this appraisal of the challenges facing the development of an efficient system of international financial regulation: First, the need for theory and policy that link microeconomic risk-taking to the macroeconomic propagation of systemic risk. Secondly, the need to develop a coherent and accountable set of legal institutions through which international policy may be developed and implemented. These two needs were met by the authorities in the immediate postwar era. They reacted to the instability of inadequately regulated markets in the 1930s by producing new procedures and institutions based on what were then new models of macroeconomic management. Internationally, the response at Bretton Woods was to put in place a set of international arrangements that permitted the

254 John Eatwell pursuit of national macroeconomic policies, free from the fear of international financial disruption. The problem of accountability did not arise. Tackling the same problems on an international scale requires a reinterpretation of what both macroeconomic policy and market regulation mean, and a reassessment of the institutions required to conduct such a policies. The device of a World Financial Authority provides the means of exposing both analytical and institutional questions.

16

The Financial Stability Forum (FSF): Just Another Acronym? ANDREW G. HALDANE*

BACKGROUND

1998, the G-7 countries asked Hans Tietmeyer, then president of the Bundesbank, to produce a report on a structure for enhancing cooperation between national and international supervisory bodies and the international financial institutions (IFIs) to promote stability in the international financial system. In February 1999, the G-7 agreed with the Tietmeyer Report’s recommendation to create a Financial Stability Forum (FSF). The FSF first convened in April 1999. Its aims were threefold. To assess vulnerabilities—“gaps”—in the international financial system; to identify and oversee actions to address these gaps; and to improve co-ordination and information-sharing among the myriad supervisory bodies. The FSF’s composition reflected these objectives. It was to comprise three representatives from each G-7 country: the central bank, finance ministry and the lead supervisory agency. In addition, there were to be representatives from each of the IFIs (IMF, World Bank, OECD, Bank for International Settlements (BIS), etc.), from the international supervisory agencies (the Basel Committee on Banking Supervision (BCBS), the International Organisation of Securities Commission (IOSCO), the International Association of Insurance Supervisors (IAIS), etc.), and from two BIS committees of central bank experts (the Committee on Payments and Settlements Systems (CPSS) and the Committee on Global Financial Stability (CGFS)). The FSF was to meet twice a year and to be chaired by Andrew Crockett, general manager of the BIS. The BIS also agreed to provide a small secretariat. At its April 1999 meeting, the FSF agreed to establish three working groups: on capital flows, offshore financial centres (OFCs) and highly-leverged institutions (HLIs). These groups comprised FSF members plus representatives from a

I

N OCTOBER

* The views within are not necessarily those of the Bank of England. The author wishes to thank Liz Dixon, John Drage, Charles Goodhart, Simon Hayes, Kate Langdon, Fiona Mann, Kostas Tsatsaronis, Paul Tucker and Nick Vause for comments.

256 Andrew G. Haldane number of emerging countries, including Brazil, China, India and South Africa. The working groups were asked to report back to the FSF within a year. At the September 1999 meeting, the FSF agreed to set up two more groups: a task force on codes and standards; and a study group on deposit insurance. The three working group reports were presented to the FSF at its meeting in March 2000, along with the preliminary task force report on codes and standards, and their recommendations (which will be subsequently outlined) endorsed. The working group recommendations were then endorsed by the G-7 at the IMF/ World Bank Spring meetings in April 2000. The FSF is only just over a year old. It is too soon to reach anything other than a preliminary evaluation of its role and achievements. Nonetheless, that is what this chapter attempts. It does so through the lens of an economist rather than a lawyer. Specifically, the chapter asks: what market failures—“externalities”— concern the FSF? And what policy measures best remedy these market failures? The chapter is planned as follows. The next section asks what is different about the FSF compared with other international groupings. The following sections discuss the work of the FSF on four issues—codes and standards, capital flows, HLIs and OFCs. A final section asks: what next for the FSF?

WHAT IS DIFFERENT ABOUT THE FSF ?

A Martian landing on earth is asked: what do you find strangest about this planet earth? A shortage of fora for discussing international financial issues is unlikely to appear high on the list. There is already a plethora of international financial agencies and groupings, of various degrees of formality and with widely varying constituencies and objectives.1 Their titles alone are an alphabet soup—and are about as appetising. Why add another? It is possible to identify four areas in which the FSF has a potentially distinct role, or is at least adopting a distinct approach.

Assessing Systemic Stability at an International Level Domestic financial stability is widely accepted as a public good—just like the provision of domestic law and order. International financial stability is no different. International capital flows are hugely welfare enhancing because they help emerging economies “catch up” with the developed world in terms of technological sophistication and, ultimately, in levels of income. The international financial system is the goose that lays this golden egg. For example, since 1970 1 See e.g. M. Giovanoli, “A New Architecture for the Global Financial System: Legal Aspects of International Financial Standard Setting” in M. Giovanoli (ed.), International Monetary Law: Issues for the New Millennium (Oxford, Oxford University Press, 2000).

The Financial Stability Forum (FSF): Just Another Acronym? 257 real private capital flows have risen around twice as fast as real world trade and four times as fast as real world incomes. So the international financial system is becoming increasingly joined-up. Take the situation for UK-located banks. UK banks’ total international exposure (to both banks and non-banks) is just less than half their total assets. Systemic interlinkages are as or more important internationally as they are domestically. But for all its advantages, international capital mobility does give rise to a number of potential problems. These have the potential to disrupt international financial stability. One example would be capital markets spillovers, where volatile inflows or outflows of capital induce over-exaggerated movements in asset prices. Another would be regulatory arbitrage—convergence on worst rather than best supervisory practices. The FSF was set up to address these types of international, system-wide financial externalities. Can we identify and plug “gaps” which encourage regulatory arbitrage and lowest common denominator regulation? Can we identify international capital market failures? And how can we design systems that internalise—price correctly— these externalities?

Systemic Instabilities involve Interactions of Macro-economics and Micro-regulation Recent experience in Asia has confirmed that financial crises are often rooted in a combination of micro-regulatory failures and adverse macro-economic shocks. Inadequate supervision can allow the accumulation of large balance sheet exposures or mismatches. For example, in Asia inadequate supervision of banks led to the accumulation of large, unhedged foreign currency exposures. The fragility of these positions can then be exposed by adverse macroeconomic events. For example, the devaluation of the Asian countries’ exchange rates— an adverse macroeconomic event—exposed the fragility of banks’ open foreign currency positions. Crisis ensued. The composition of the FSF reflects this dual nature of crisis, the prudential on the one hand, the macroeconomic on the other. The FSF comprises authorities concerned principally with macroeconomic policies (central banks and finance ministries nationally and, inter alia, the IMF and World Bank internationally) and the lead national regulatory bodies together with international supervisory agencies (such as the BCBS, IOSCO and the IAIS). The composition of the FSF is a mirror of the UK’s Standing Committee. This is a tripartite committee comprising the Bank of England, HM Treasury and the Financial Services Authority as the lead regulator which meets monthly to discuss financial stability in the UK. These arrangements (domestically in the UK and internationally through the FSF) ought to help deliver joined-up—macroprudential—surveillance, the type of which will be essential when spotting future crises.

258 Andrew G. Haldane

A Global Regulator is Unlikely One response to externalities and regulatory arbitrage in the international financial system would be to set up a global regulator charged with enforcing systemwide, international regulatory standards. Some have proposed the creation of such an authority.2 The FSF is a more modest endeavour in a number of respects. First, it is an explicitly non-statutory body; its role, composition and powers of enforcement are not enshrined in any international treaty. Nor are they likely to be so because, short of a world government, putting in place the requisite “hard law” would be hugely problematic. The FSF is instead an example of international “soft law”—an informal set of codes and standards of international best practice. Secondly, the FSF aims to establish and promulgate these codes and standards of best practice, not set down explicit rules of behaviour. In functional terms, the FSF co-ordinates and co-operates but does not control. The modus operandi of the international financial system is, at best, one of “constrained discretion”, where codes and standards are the constraints on discretionary national public policies. Why not binding rules? Even if they were enforceable, it seems unlikely that strict international regulatory rules would be desirable. They offer insufficient flexibility given the very different starting positions facing countries in the developed and emerging worlds. In the regulatory sphere, one-size is unlikely to fit all. Thirdly, the FSF is a co-ordinating device, not an implementing one. The FSF is a non-executive forum for discussion, not an institution with a staff charged with implementing policies. It is important, therefore, that all of the key executive bodies—nationally and internationally—are at the FSF table. That provides the mechanism through which FSF-approved policy recommendations can be put into practice. Fourthly, the FSF does not have universal membership. Its national membership is drawn principally from the G-7. So it is crucially important for the legitimacy of the FSF’s recommendations that they are endorsed by, for example, the G-20 or the IMF, whose membership spans a greater number of the emerging countries. This is given added importance by the fact that many of the regulatory “gaps” are widest and deepest in emerging markets. In all of these respects, the FSF model is very similar to the one successfully used by the various BIS committees in the field of banking supervision. The Basel committees have devised “soft law” principles of banking supervision, which have then been put into practice by national supervisory authorities. Through the BIS’s Financial Stability Institute, these principles are now being rolled out to a wider than G-10 audience. The FSF is following a broadly similar model, across a wider financial stability canvass. 2

See e.g. J. Eatwell and L. Taylor, Global Finance at Risk (Cambridge, Polity Press, 2000).

The Financial Stability Forum (FSF): Just Another Acronym? 259

Codes, Transparency and Market Forces are a Disciplining Device Codes and standards provide a level playing field or regulatory common denominator. If implemented across the board, they should ensure that regulatory standards are sufficiently high and could help insure against lowest common denominator regulation. But how can the FSF provide incentives to countries to abide by these standards, in the absence of a statutory basis for enforcement? One important disciplining device is market forces—for example, having the market demand a premium when lending to countries not adhering to international standards. But for market forces to operate in this way, countries’ compliance with various codes and standards needs to be made visible to the market: there is a basic need for transparency. To date, these have been the three key planks of the FSF’s approach to dealing with regulatory gaps: codes, transparency and market forces. These three features run through all of the four FSF working groups’ recommendations. We now discuss each of these working groups’ findings in greater detail.

CODES AND STANDARDS

Codes and standards are a central feature of the FSF’s non-statutory approach to dealing with global financial externalities. They are surrogate statutes. These codes are large and growing in number. The FSF’s website contains a compendium of these standards, which now are over 60 in number. The codes are also extremely diverse. Some are sectoral (for example, relating to the banking or insurance industries), others functional (for example, relating to auditing or corporate governance). Some are broad principles (for example, the Basel Core Principles for Banking Supervision), others detailed practical guidelines (for example, the IMF’s Special Data Dissemination Standard). Given their breadth and diversity, the FSF task force sets among its objectives the prioritisation of standards, to facilitate their implementation. The task force made four broad policy recommendations. First, it established a streamlined set of 12 “core” standards. These core standards, together with the agency with primary responsible for drawing up the code, are shown in Table 16.1. The core standards broadly cover three areas: macroeconomic policies; data and accounting/auditing; and supervisory policies. Secondly, the task force proposed a modular approach to assessing standards. This recognises that different standards will be of differing degrees of applicability to different countries at different stages. Thirdly, it proposed that the appropriate body for overseeing compliance with the various standards was the IMF, given its near-universal membership. Because the IMF does not have the in-house expertise to assess compliance with each of the standards, however,

260 Andrew G. Haldane Table 16.1 12 “Core” Standards • Transparency of monetary and financial policies (IMF) • Transparency of fiscal policies (IMF) • Data dissemination (e.g. SDDS) • Insolvency (World Bank) • Accounting (International Accounting Standards Committee, IASC) • Corporate Governance (OECD) • Auditing • Payments and settlements (CPSS) • Market Integrity (Financial Action Task Force, FATF) • Banking Supervision (BCBS) • Securities regulation (IOSCO) • Insurance supervision (IAIS) Source: Financial Stability Forum Task Force Report.

the FSF recognised that the IMF should draw on outside technical assistance from international agencies and national authorities. The IMF has done this in the course of its new Financial Sector Stability Assessments (FSSA) and Reports on the Observance of Standards and Codes (ROSCs).3 Finally, there should be transparency about the results of these assessments, to allow markets to price lending to countries appropriately, thereby serving as an incentive for compliance. Progress so far has been steady. In particular, the IMF’s FSSA and ROSC process has begun to be rolled out in pilot form. 12 countries were assessed in 1999 and a further 24 are planned for 2000. A natural next step would be to integrate the FSSA process with the IMF’s regular surveillance round (known as Article IV missions). Another, more ambitious step would be to publish the results of the ROSC/FSSA process, as is currently being piloted with the IMF’s Article IV surveillance process. If market forces are to exert discipline on countries’ compliance with codes and standards, eventual publication will be an important step. This would not require that all countries comply with all standards at all times. That is ultimately a choice for them. But if countries do choose not to comply, it is important these choices are made transparent—for example, to the private sector to inform their decision-making and risk-management practices. In other words, there needs to be “transparency about transparency”. A follow-up FSF working group has been set up to consider further (market and official) incentives for compliance with codes. Part of this process involves outreach to the private sector, to foster a greater understanding of the usefulness of standards for managing country risk exposures and pricing country loans. This recognises that a large part of the official sector’s role on the codes and standards front is educational. Evidence from outreach sessions with the private 3

These form part of the joint IMF/World Bank Financial Sector Assessment Programme (FSAP).

The Financial Stability Forum (FSF): Just Another Acronym? 261 sector suggests that their understanding and use of standards is patchy. There is a high degree of consensus across the G-7 about the importance of the codes and standards agenda. The next challenge is to ensure buy-in from across the emerging market community and from the private sector.

CAPITAL FLOWS

Recent financial crises in emerging markets have been sourced in the capital rather than the current account of the balance of payments. Given recent patterns in capital flows, this is not altogether surprising. Three stylised facts stand out. First, private capital flows to the emerging markets are these days very large—for example, they have been around eight times public sector capital flows since 1992. Secondly, these flows are often short-term in nature—for example, more than three-quarters of the rise in developing countries’ bank debt between 1985 and 1998 was under one-year in maturity. Thirdly, capital flows to emerging markets in general, and bank flows in particular, have in the recent past been subject to large and volatile swings, as Chart 16.1 illustrates. The questions which the FSF working group on capital flows asked were: how can these large and volatile capital flows best be measured, monitored and, ultimately, managed, to mitigate their potentially adverse effects? And can this be done without killing the goose that lays the golden egg? The working group came up with three broad answers to these questions. First, there was a basic need for better data on capital stocks and flows. Existing data on capital stocks and flows are typically partial and/or lack timeliness. Some US$bn

Direct investment Portfolio investment Bank

250 200 150 100 50 0 –50

90

91

92

93

94

95

96

97

98

99e

Source: Institute for International Finance.

Chart 16.1. Capital Flows to Emerging Markets

00f

262 Andrew G. Haldane of the data relevant to monitoring capital flows often simply do not exist—for example, country data on debt repayment schedules, the off-balance sheet exposures of banks, etc. Some concrete steps are being taken to improve matters. For example, there have recently been improvements in the frequency, timeliness and coverage of data on BIS banks’ external exposures. And the OECD, BIS, World Bank and IMF are currently engaged in an exercise to integrate their various data sources on capital stocks and flows. But there is much further to go, perhaps under the auspices of the IMF’s Special Data Dissemination Standard. Secondly, the working group proposed that countries actively monitor and manage their national balance sheets, in aggregate and sectorally. This may include, for example, monitoring liquidity, foreign currency or interest rate mismatches on national and sectoral balance sheets; and then stress-testing these balance sheet mismatches in the face of liquidity, exchange rate or interest rate shocks. There are a variety of potential balance sheet indicators that may capture such vulnerabilities. The IMF are currently investigating a number of these, with a view to integrating them into the Article IV or FSSA macro-prudential surveillance process. One measure that has attracted a good deal of attention as a vulnerability indicator is the ratio of a country’s official foreign currency reserves to its shortterm debt. The ratio can be considered a rough “stress test” of a country’s foreign currency liquidity position. It seeks to answer the question: if a country were to be cut off from international capital markets, say for a year, would it have ample foreign currency at least to stay current on its maturing debts? A value of the ratio below one would suggest that the answer to this question is no—so highlighting an incipient vulnerability. Table 16.2 shows values of the ratio for a selection of countries which recently have experienced financial crisis, in the period just prior to their crisis: Mexico, Korea, Indonesia, Russia and Brazil. It also shows an “augmented” ratio. This supplements short-term debt with the current account deficit, which also requires external financing. The ratios are almost always below unity, very often significantly so. Had these foreign currency liquidity ratios been monitored at the time, they would have set a red light flashing. Table 16.3 shows the same ratios for the same countries, plus Argentina, as they currently stand. All of the crisis countries have made efforts to improve Table 16.2. Liquidity ratios for selected emerging markets

Mexico (end-’94) Korea (end-’96) Indonesia (end-’96) Russia (end-’98) Brazil (end-’98)

Reserves/Debt

Reserves/(Debt + CA)

0.20 0.51 0.57 0.68 1.10

0.10 0.31 0.44 0.73 0.51

Source: Bank for International Settlements and national sources.

The Financial Stability Forum (FSF): Just Another Acronym? 263 Table 16.3. Liquidity ratios for selected emerging markets

Mexico (end-’99) Korea (end-’99) Indonesia (end-’99) Russia (end-’99) Brazil (end-’99) Argentina (end-’99)

Reserves/Debt

Reserves/(Debt + CA)

1.35 4.02 1.43 1.14 1.05 0.75

0.87 14.97 1.96 — — 0.56

Source: Bank for International Settlements and national sources.

their foreign currency liquidity position. All now have ratios above unity. For example, Korea has accumulated a significant war chest of foreign exchange reserves to cushion against future liquidity shocks, and has a liquidity ratio above four. Argentina, however, remains something of an outlier. On the basis of these simple liquidity indicators, it remains vulnerable to foreign currency liquidity shocks, with a ratio below one. Thirdly, the working group proposed active monitoring of sectoral, as well as aggregate national, balance sheets, in particular for the public and banking sectors, with the emphasis on the same sources of fragility—mismatches by currency, liquidity etc. For the public sector, the working group proposed establishing guidelines for foreign exchange reserves and debt management— the two sides of the public sector balance sheet—ideally in an integrated way. The IMF and World Bank, working jointly, have begun to prepare such guidelines. For the banking sector, the working group made a range of proposals, including asking the Basel Committee to look at regulations on currency and liquidity mismatches on banks’ balance sheets. Again, these proposals are being taken forward through the Basel process.

HIGHLY - LEVERAGED INSTITUTIONS

( HLIS )

Capital flows and codes and standards are two issues which over-arch the international financial system. HLIs and offshore financial centres (OFCs) are institutions prone to specific potential financial market failure. HLIs and OFCs share a number of common characteristics. Both are hard to define. Both are numerous and have been growing rapidly over recent years. Both are lightly or sometimes entirely unregulated. And both in general suffer from a lack of transparency. These four ingredients are usually a recipe for nervousness among regulators. From a welfare perspective, however, it is important to identify the potential market friction each may give rise to and target any public policy response at that failure. That has been the broad approach adopted by the two FSF working groups.

264 Andrew G. Haldane On HLIs, the working group identified two potential market failures. First, the “LTCM problem”: that is, the systemic implications of the failure of a large HLI, as with the failure of the hedge fund Long-Tem Capital Management (LTCM) in autumn 1998. These systemic effects could arise either from direct (credit or counterparty) links between the failed HLI and other institutions or from indirect spillovers arising from the liquidation of a large institution’s assets. Both direct and indirect market spillovers were evident at the time of LTCM’s failure. Secondly, the “Hong Kong problem”: that is, the potentially adverse effects on market dynamics of large concentrated financial positions adopted by HLIs, as with the attack on the Hong Kong currency board peg and equity market in August 1998. These effects could arise either because of collusive behaviour among institutions or simply by dint of the size of these institutions in relation to the market as a whole.4 In addressing these market failures, the FSF working group proposed an indirect approach. Action was focused principally on the regulated providers of credit and counterparties to the HLIs, rather than on the (largely unregulated) HLIs themselves. In particular, the working group proposed that all institutions acting as counterparties to HLIs should review their counterparty risk management procedures, ensuring these were aligned with the recommendations of the BCBS and IOSCO. The group also called for enhanced regulatory oversight of HLI credit-providers, to ensure compliance with BCBS and IOSCO core principles. Both recommendations are broadly in line with those of other working groups (public and private) which have looked at these issues. Among the FSF working group’s other proposals were enhanced public disclosure by HLIs, if necessary through regulation; and establishing good practice guidelines for foreign exchange trading by private sector market participants. Some progress has already been made in agreeing such best practice guidelines among key foreign exchange market participants in the main international financial centres. The working group rejected, at least for now, two more ambitious proposals for dealing with potential HLI-related problems. The first was an HLI credit register, covering all (on and off balance sheet) exposures of regulated financial firms to HLIs. Some countries, including Germany, operate domestic credit registers along similar lines. In principle, an HLI credit register would be a mine of potentially useful data. In practice the implementation problems would be huge, in terms of the frequency, timeliness and comprehensiveness of the data, especially for derivatives exposures. A second idea would be direct regulation of HLIs. This is a contentious issue. It is clear that one of the potential motives for prudential regulation—protection of small depositors—would be irrelevant in a hedge fund context. The owners of hedge funds tend to be large wealthy individuals to whom caveat 4

The working group set up a separate Market Dynamics Study Group to look at this issue.

The Financial Stability Forum (FSF): Just Another Acronym? 265 emptor should apply. Indeed, attempts to regulate these entities may create some moral hazard risk, with counterparties and risk managers relaxing their risk management standards. But the practical problems with HLI regulation are again probably the most persuasive. These include: the difficulties of defining an HLI—for example, distinguishing it from highly-leveraged non-financial companies; how to ensure enforcement—for example, preventing “leakage” to the OFCs; and how to define appropriate capital, liquidity, etc., guidelines for HLIs, whose balance sheets differ significantly from other types of currently regulated financial institution. Notwithstanding these problems, the working group said it would keep regulation of HLIs and an HLI credit register under review, in the light of progress in implementing the indirect approach. Regulation is not off the agenda. But it would clearly pose formidable implementation problems. The FSF’s proposals focus directly on the systemic spillover (“LTCM”) problem. By influencing portfolio behaviour, they would also indirectly help to address the market dynamic (“Hong Kong”) problem—address but potentially not resolve. To resolve that problem would in principle require a quite different set of instruments, perhaps focusing on the recipients of capital rather than the providers. Indeed, this market dynamics externality may be intrinsic to small financial markets in which big players choose to operate—a “big fish/small pond” problem. It is possible to piece together some rough stylised facts to illustrate the potential extent of this problem. First, capital flows from developed markets are very large in relation to the size of the emerging capital markets. Take for example equity portfolio flows. Assume that all of the institutional investors in the G-10 and EU countries (insurance companies, mutual funds and pension funds) decided en masse to reallocate their portfolios towards some of the emerging markets. But assume that these institutions made only a tiny adjustment in their portfolios—more specifically, a one basis point (one hundredth of one percentage point) adjustment. Table 16.4 illustrates how large a percentage of certain developing countries’ equity market capitalisation this portfolio shift would represent. The numbers are large, ranging between 1 per cent and 20 per cent of market capitalisation for a 1 basis point portfolio shift. These types of portfolio flow from developed countries often exhibit a high degree of trend-following or “herding” behaviour, in the sense that past returns are good predictors of future portfolio flows.5 Moreover, this type of behaviour tends to become stronger during crisis. And its effects appear to spillover to other markets in the same asset class.6 This is a clear market externality.

5 See K. Froot, P. O’Connell and M. Seasholes, “The Portfolio Flows of International Investors” (2000), available at www.imf.org; G. Kaminsky, R. Lyons and S. Schmukler, “Managers, Investors and Crises: Mutual Fund Strategies in Emerging Markets” (1999), available at www.imf.org. 6 Ibid.

266 Andrew G. Haldane Table 16.4 Effect of 1 basis point Portfolio Shift by G10/EU Institutional Investors on Market Capitalisation in Selected Emerging Markets (%, end 1997) Argentina Brazil Hong Kong Thailand Poland India Korea

4.4% 1.0% 0.6% 11.0% 21.4% 1.9% 6.2%

Source: C. E. V. Borio, L. Chincarini and K. Tsatsaronis, “Institutional Investors, Asset Management and Financial Markets”, Bank for International Settlements, mimeo (1997).7

The effect of these (large and persistent) capital flows on asset prices in the developing countries also appears to be large and significant. For example, Froot et al.8 estimate that a 1 basis point of market capitalisation portfolio inflow over one day by foreign investors raises equity prices by around 17bp in the emerging markets over the following two months. Combining these three stylised facts, it is possible to calculate the impact on equity prices in emerging markets of a 1 basis point shift in portfolio allocation by institutional investors in the developed countries. The results are shown in Table 16.5. Although they are no more than ballpark figures, the implied asset price adjustments are huge, ranging between 10 per cent and 350 per cent. If these numbers are even roughly accurate, they suggest that the “big fish/small pond” problem is a potentially serious one. Resolutions to this problem are not straightforward. Standard solutions, like deepening markets and improving liquidity, could even worsen the problem in the short run by attracting in more of the bigger fish. This is an issue to which the FSF may need to return in the future. Table 16.5 Effect of 1 basis point Portfolio Shift by G10/EU Institutional Investors on Equity Prices in Selected Emerging Markets (%, end 1997) Argentina Brazil Hong Kong Thailand Poland India Korea

70% 16% 10% 177% 343% 18% 99%

Source: Author’s calculations. 7 I am grateful to Kostas Tsatsaronis for an update of the institutional investment data in that study. 8 N. 6 above.

The Financial Stability Forum (FSF): Just Another Acronym? 267

OFFSHORE FINANCIAL CENTRES

( OFCS )

OFCs are hard to define and, even then, difficult to monitor because of their lack of data. The one defining characteristic of all OFCs, however, is their high level of non-resident financial activity. And however defined, it is clear that the balance sheets of OFCs have expanded rapidly over recent years. Chart 16.2 plots BIS banks’ claims on OFCs (as defined by the BIS). The exposures were around $600bn at the end of 1999. They have doubled over the past decade, despite some decline since the Asian crisis. The true exposure of developed markets to the OFCs may well be much greater than this, once off-balance sheet and nonbank exposures are included. So what market failures might OFCs generate? The FSF working group identified two. First, they could have potentially poor supervision which, through regulatory arbitrage, risked a wider systemic problem developing; and, secondly, there is an underlying lack of information about OFCs on which to base an assessment of this systemic threat. A number of other market frictions have also recently been identified within OFCs. For example, the OECD has recently published a list of OFCs felt to be undertaking harmful tax competition. The Financial Action Task Force (FATF) has also recently published a list of OFCs where money laundering is believed to be a problem. These exercises are clearly related to, but distinct from, the work of the FSF in the financial supervisory field.

US$ bn 800

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

% Non BIS-area claims (RHS)

700 600

Total claims on OFC’s (LHS)

500 400 300 200 100

Source: Bank for International Settlements

Chart 16.2. BIS area banks’ claims on OFCS

Q 4 1999

Q 4 1997

Q 4 1995

Q 4 1993

Q 4 1991

Q 4 1989

Q 4 1987

Q 4 1985

0

268 Andrew G. Haldane The key proposals of the FSF working group fell into three categories. First, they proposed that OFCs begin reporting data to the BIS on international banking statistics, to enhance transparency and market discipline. This is an obvious lacuna among the OFCs, given the extent of their financial activity. Secondly, they proposed that a set of best practice guidelines on reinsurance and its supervision be established, since reinsurance business is significant in some of the OFCs (for example, the Cayman Islands) and is currently outside the set of international codes and standards. Thirdly, and most importantly, the working group set in train a preliminary survey of OFCs’ supervisory practices for banks, insurance companies and securities firms. This preliminary evaluation was based on information provided by both onshore and offshore supervisors. The survey was not meant to be a comprehensive assessment of OFCs’ compliance with supervisory best practices. Instead it was an attempt to prioritise OFCs according to their need for a wider and more thorough standards’ assessment. For this purpose, the FSF working group ranked OFCs into three groups, with Group I closest to adhering to international supervisory standards, and Group III the furthest away. This ranking was published by the FSF in May 2000. The survey placed OFCs such as Hong Kong and Singapore in Group I; included Bermuda and Monaco in Group II; and included the Cayman Islands in Group III. Chart 16.3 takes BIS banks’ exposures to OFCs and breaks these down according to the three groupings. It is striking that Group III OFCs account for

US$ billions 800 700 600 500 400 300 200

Group 1 Group 2 Group 3

100 Q 4 1999

Q 4 1997

Q 4 1995

Q 4 1993

Q 4 1991

Q 4 1989

Q 4 1987

Q 4 1985

0

Source: Bank for International Settlements

Chart 16.3. BIS AREA banks’ claims on OFCS: by FSF grouping

The Financial Stability Forum (FSF): Just Another Acronym? 269 the vast majority of the growth in OFCs’ exposures over the last five to six years. Group III OFCs (in particular the Cayman Islands) have benefited at the expense of the Group I OFCs (in particular Hong Kong and Singapore). Indeed, Group III OFCs are now the single most important OFC category, at least on this measure. This may well be evidence of regulatory arbitrage at work in practice, with funds flowing to where regulatory standards are most lax. If so, this would point towards a clear market externality and would be a potential systemic concern. The next steps proposed by the FSF working group were that the IMF should carry out more detailed and comprehensive standards assessments of the systemically important OFCs placed in Groups II and III. These assessments could be modular, ranging from assisted self-assessments, through ROSCS, to full FSSAs. The IMF is currently drawing up an action plan to conduct these assessments. But the twin forces of transparency and market forces appear already to be having an effect, with some OFCs actively seeking standards assessments to “clear their name”. That is perhaps an early indication of the FSF process— codes, transparency and market forces—bearing fruit.

WHAT NEXT FOR THE FSF ?

To conclude, here are four questions that the FSF will need to tackle looking forward if it is to play an effective role in mitigating externalities in the international financial system.

Are Non-statutory Codes, Transparency and Market Forces Adequate? It is too early to tell. Implementation of the FSF groups’ recommendations has only just begun in earnest. In principle, there is no reason why the “Basel model” of soft law principles cannot be applied across a wider financial stability plane. But in practice this will be a complicated and lengthy process. Some specific problems are perhaps worth highlighting. First, will sufficient resources be committed to the process of agreeing, assessing and implementing the myriad codes and standards across, in principle, in more than 180 countries? This calls for a great deal of resource hypothecation, in particular by the national authorities in the developed countries. Secondly, are the codes themselves robust enough to changes in market structure and behaviour? One of the reasons the Basel capital accord is currently being revised is precisely because banks have adjusted their behaviour in the light of the existing accord. Regulatory arbitrage is dynamic. This problem can only be amplified when looking across a wider spectrum of institutions and standards. Thirdly, do markets forces provide the right or sufficient incentives for compliance with voluntary codes? In theory the answer to this question could well

270 Andrew G. Haldane be “no”.9 The need for public intervention through regulation derives from a divergence between private and social returns to a given action. So asking private actors, with different objectives, to resolve this externality problem may be insufficient to safeguard the public interest. If that is the case, other official incentive devices for compliance with codes may be necessary—for example, through regulatory measures such as the Basel capital accord and market access restrictions. In short, everyone can agree that international co-ordination is a good thing in all spheres of public policy—macroeconomic, environmental, regulatory etc. But can informal “soft law” coalitions achieve this co-ordination, without some international treaty or convention as a binding agent? Past experience is mixed. If it tells us anything, it is that regulatory co-ordination will be at best slow and staccato.

Can the FSF Ensure Involvement and Implementation by the Emerging Markets? The membership of the FSF, as with other international groupings, involves a delicate balancing act. The balance is between agreeing to a course of action on the one hand, and implementing this course of action multilaterally on the other. The wider the group, the easier the second problem, but the greater the first. Membership of the FSF is currently focused on the developed countries, though with a large number of the emerging countries participating on the working groups. With membership of the FSF already amounting to 40 people, adding to these numbers would be unworkable. One way round this problem may be to formalise links between the FSF and wider international groups, such as the G-20 and the IMF.

The FSF as an Early Warning Device? The FSF’s main achievements to date have been the various working group recommendations. Rather less progress has been made on information-exchange with a view to spotting incipient financial stability problems. Again, this was always likely to take time. But six-monthly FSF meetings do not make for a very effective forum for identifying potential financial stability threats. That calls for setting up informal mechanisms for information-exchange, outside the formal FSF round. Some progress has already been made on this front, with a “vulnerabilities” group meeting to discuss risks ahead of the last FSF meeting. That model may be built on in the future, if the FSF is to play an effective early warning signal role. 9 See J. Stiglitz, “Preventing Financial Crises in Developing Countries” in World Bank, Global Economic Prospects (Washington, DC, World Bank, 1998).

The Financial Stability Forum (FSF): Just Another Acronym? 271

Issues for the Future? One of the future tasks of the FSF is to monitor progress on the recommendations made by its various working groups. On most of these issues, the key is implementation. For example, the HLI group stated explicitly that it would need to monitor the effects of implementing its various recommendations before deciding whether to extend these. Elsewhere, the FSF is continuing to oversee work on deposit insurance and on principles for the reinsurance industry. It is currently engaged in an exercise to map out the work of the various groups, for example looking at e-commerce, to see if there are potential gaps. The important thing will be to focus on those areas where the FSF has a distinct role: the interface between the macro and the regulatory aspects of public policy. At conception, the FSF’s aims were modest. Its achievements to date have likewise been modest. But the FSF in principle fills an important gap in the international architecture, building bridges between the macro-economic and microsupervisory dimensions to public policy. Unlike some international groupings, it is already more than just an acronym. How much more, only time will tell.

17

The Need For Efficient International Financial Regulation and the Role of a Global Supervisor KERN ALEXANDER

INTRODUCTION H I S C H A P T E R E X A M I N E S the need for international regulation of financial markets and suggests the possible role that a global financial supervisor might play in providing effective regulation of international financial markets. First, I discuss the nature of systemic risk in the international financial system and the necessity for international minimum standards of prudential supervision for banking institutions. Secondly, I examine the efforts of the Basel Committee on Banking Supervision to devise non-binding international standards for managing systemic risk in financial markets. Recent financial crises in Asia, Russia and Latin American suggest, however, that informal efforts by international bodies such as the Basel Committee are inadequate to address the risk of systemic failure in financial systems. Finally, I therefore argue that efficient international financial regulation requires certain regulatory functions to be performed by a global supervisor acting in conjunction with national regulatory authorities. These functions should involve the authorisation of financial institutions, generation of rules and standards of regulatory practice, surveillance of financial markets, and co-ordination with national authorities in implementing and enforcing such standards.

T

THE NEED FOR INTERNATIONAL REGULATION

The need for international regulation of financial markets became apparent in the mid-1970s after the breakdown of the Bretton Woods fixed exchange rate system in 1971–3. The elimination of the fixed-exchange rate parity with gold resulted in the privatisation of financial risk, which created pressure to eliminate controls on cross-border capital movements and the further deregulation of

274 Kern Alexander financial markets. It became necessary for national regulatory authorities to promote safe and sound banking systems through the effective management of systemic risk in national markets. The G-10 industrial countries took the lead by adopting international minimum standards of prudential supervision intended to reduce systemic risk and prevent financial institutions in one jurisdiction from losing business to less respectable institutions operating in poorly regulated jurisdictions.1 The privatisation of financial risk in the post-Bretton Woods era increased the pressure on governments to liberalise their national controls on cross-border capital flows so that financial institutions could spread their risks to foreign assets and transactions. This led to a significant increase in short-term cross-border portfolio investment that has, in many instances, exposed capital-importing countries to increased systemic risk due to the volatility of cross-border capital flows. The first major banking collapse that resulted from the privatisation of financial risk and which focused the attention of the international financial community on the need for enhanced international banking supervision occurred in 1974 and involved major banks from Great Britain, West Germany and the United States. In June 1974, West German authorities closed the Herstatt Bankhaus (Herstatt) following losses from foreign exchange dealings that threatened severe disruption of the US clearance system,2 while UK authorities closed the British-Israel Bank of London for insolvency problems.3 The closure of Herstatt and British-Israel Bank of London exposed major weaknesses in the international banking system.4 Shortly thereafter, the Franklin National Bank in the United States collapsed under the combined weight of bad management in the volatile domestic wholesale deposit base, excessive speculation in international foreign exchange markets, and over-ambitious efforts to expand.5 To prevent the crisis from spreading, the US Federal Reserve intervened by guaranteeing the bank’s failed short-term foreign exchange commitments.6 It has been argued that these banking collapses occurred because of the lack of adequate regulatory standards to protect against financial risk.7 During the 1980s and 1990s, a market-led global financial system emerged in which the volume of financial assets, the sophistication of international financial transactions and advances in computer and telecommunications technology increased dramatically. By contrast, no corresponding institutional framework 1 J. Eatwell and L. Taylor, Global Finance At Risk: The Case for International Regulation (Cambridge, Polity Press 2000), 21–23. 2 See R. Dale, The Regulation of International Banking (Cambridge, Woodhead-Faulkner, 1984) 156. 3 E. Kapstein, “Resolving the Regulator’s Dilemma: International Co-ordination of Banking Regulations” (1989) 43 Int. Org. 324, 327–8. 4 D. J. Peake, “International Banking: Regulation and Support Issues” in E. P. M. Gardner (ed.), UK Banking Supervision: Evolution, Practice and Issues (London, 1986) 186. 5 See R. Dale, International Banking Deregulation: the Great Banking Experiment (Oxford, Blackwell, 1992) 171. 6 Peake, n. 4 above, 186. 7 Eatwell and Taylor, n. 1 above, 26–31.

The Need For Efficient International Financial Regulation 275 or regulatory response has been developed on the international level to provide effective and efficient regulation of globalised financial markets. Unlike the Bretton Woods era, the current international financial order has led to recurring financial crises and overall declines in rates of economic growth and investment in the OECD countries.8 In response, governments have attempted to recover some of the regulatory controls that they had exercised during the Bretton Woods era.9 For example, leading developed states have established various international bodies10 to improve the supervision of financial institutions involved in banking, securities and insurance. These bodies have agreed on various sets of principles and rules establishing what are now agreed to be generally accepted international standards of prudential supervision. Notwithstanding these efforts, recent financial and currency crises in the 1990s demonstrate the inadequacies of the current international regime of financial regulation. This led the leading industrial states to create in 1999 the Financial Stability Forum, which meets twice a year to examine potential threats to the international financial system.11 The current loosely assembled regulatory and institutional framework for supervising international financial markets lacks coherence and political legitimacy and requires more concerted efforts to manage systemic risk. Indeed, the British Chancellor of the Exchequer Gordon Brown recognised the need for more concerted efforts at international regulation of financial markets when he stated: [B]ecause today’s financial markets are global, we need not only proper national supervision, but also a fundamental reform—global financial regulation.12

This section will now discuss two of the major reasons why an international regulatory framework is needed.

The Problem of Systemic Risk The lack of a coherent international regime to provide standards for the risktaking activities of financial institutions has exposed financial systems to an 8

Ibid. See A. Newburg, “The Changing Roles of the Bretton Woods Institutions: Evolving Concepts of Conditionality” in M. Giovanoli (ed.), International Monetary Law: Issues For the New Millennium (Oxford, OUP, 2000) 83–6. 10 These international bodies are not traditional “international organisations”, as that term is defined under public international law (established by treaty and composed principally of states, and having tangible manifestations of bureaucracy). Rather, they are associations of government representatives in various issue areas which serve as fora for the discussion of various policy issues in international financial relations. See K. Alexander, “The International Supervisory Framework for Financial Services: An Emerging Regime of Transnational Supervision” ( 2000) 1(4) Jrnl. Intl’. Banking Reg. 33, 34–5. 11 See www.fsforum.org. 12 See G. Brown, Prepared Speech, at the Council on Foreign Relations (New York, 16 September 1999). 9

276 Kern Alexander increased risk of systemic failure. Indeed, increasing linkages amongst the world’s financial markets have led to a significant expansion in the number, size and types of activities, and in the organisational complexity of multinational financial institutions. Although these cross-border linkages generally bring efficiency to world capital markets, the increasing scope of international banking activity has highlighted the difficulty of ensuring effective supervision and may, in some cases, increase systemic risk, whereby losses in one banking group can affect the entire financial system.13 The systemic risk inherent in international banking include: (1) global systemic risk—the risk that the world’s entire banking system may collapse in response to one significant bank failure; (2) safety and solvency risks that arise from imprudent lending and trading activity; and (3) risks to depositors through the lack of adequate bank insurance.14 Moreover, financial fraud activities also pose a significant threat to an internationalised banking industry. In these situations, systemic risk becomes a negative externality that imposes costs on society at large because financial firms fail to price into their speculative activities the costs associated with their risky behaviour.15 Although the taking of risks is a large part of what financial institutions do, prices in financial markets reflect only the private calculation of risk, and so tend to under-price the risk—or the cost—of investments faced by society at large.16 This under-pricing of risks in financial markets creates a negative externality caused by excessive risk-taking that may result in a financial crisis. The regulator’s task is to internalise the negative externality of risk, ensuring that investors take into account the risks their activities impose on society. This may be accomplished through either of two approaches: (1) by requiring firms to internalise the costs of the risks they take by, for example, requiring them to adhere to capital adequacy standards or certain risk management practices, or (2) by the direct regulation of a firm’s activities. In this way, the financial regulator seeks to require businesses to behave as if they took systemic risk into account, which thereby should reduce the occurrence of systemic breakdown in financial markets. Although effective regulation can make a significant contribution to reducing normal systemic risk, it can never protect firms and markets from abnormal market risk. Even the best regulatory standards and risk management practices may sometimes be overwhelmed by exceptional market turbulence. However, by building confidence in the maintenance of market stability in normal times, it will likely reduce the chance of abnormal market risk. In addition, banks have increasingly recognised that traditional methods of risk management have become obsolete and that new measures are needed to assess the risk of new financial instruments. The objective of reducing risk in 13 General Accounting Office, International Banking, Strengthening the Framework for Supervising International Banks (March 1994) 6. 14 See R. Cranston, Principles of Banking Law (Oxford, Clarendon, 1996) 61–4. 15 Eatwell and Taylor, n. 1 above, 7–10. 16 Ibid., 17–20.

The Need For Efficient International Financial Regulation 277 complex financial markets has led banks to use innovative financial instruments to diversify earnings among several countries so that, in any given year, an inadequate investment outcome in one country may be offset by a positive investment outcome in another country. This need to reduce risk by expanding cross-border financial services has also resulted in the establishment of complex organisations, known as financial conglomerates.17 An international financial conglomerate is an integrated group of companies, which offers a broad range of financial services. While financial conglomerates offer the benefits of diversified assets, risks and sources of earnings, their structure poses several problems for regulators. Comprehensive supervision of financial conglomerates requires that supervisors develop standards that address the degree of transparency18 within the organisation and the placement of overall supervisory responsibility with a particular regulator. Moreover, the interrelationship of various divisions within a multinational conglomerate increases the likelihood that the default or liquidation of an affiliate in one jurisdiction will “spill over” to other affiliates or controlled entities in other jurisdictions.19 To prevent systemic risk from occurring on the international level, national regulatory authorities should coordinate their efforts to produce effective international standards of financial supervision to ensure that financial conglomerates internalise their costs of operation.20 As banking becomes more international and deregulated, national regulatory authorities remain the prime supervisors monitoring cross-border banking activities. But expanded and diversified international banking operations require adherence to a common core of supervisory and regulatory standards recognised by the world’s major financial regulators. These core international standards require effective international supervision to reduce systemic risk. The effective control of systemic risk requires a global supervisory regime that performs certain essential functions, including, inter alia, the generation of norms and rules of prudential supervision, surveillance of financial institutions 17 The term “financial conglomerates” includes at least one financial component in an industrial or commercial operation. See G. Walker, “The Law of Financial Conglomerates—The Next Generation” (1996) 30 Intl’ Lawyer 57, 60–2. 18 Transparency requires full disclosure of information about the entire operations of a multinational financial conglomerate, including financial groups of the conglomerate, parent companies and its subsidiaries. See J. Freis, “An Outsider’s Look into the Regulation of Insider Trading in Germany: A Guide to Securities, Banking, and Market Reform in Finanzplatz Deutschland” (1996) 19 Brit. Col. Intl’ & Comp L Rev. 1, 11 (assessing increased transparency of German financial markets, improved investor’s rights, and regulating participation in stock exchanges and securities markets). 19 The risk of contagion occurs where losses in one activity reduce the capital available to support other parts of the corporate group or where visible difficulties in one affect confidence in other areas of the same group. See K. E. Scott, “Deposit Insurance—The Appropriate Roles for State and Federal Governments” (1987) 53 Brook Jrn. Intl’ L 27, 35. 20 Walker, n. 17 above, 71. This may require firewall provisions to protect both consumers and taxpayers against possible conflicts of interest and to prevent the spread of a national safety net (deposit insurance) provided to banks, and any associated subsidy, from spreading, to non-banking activities.

278 Kern Alexander and markets, and co-ordinating enforcement by national authorities of international regulatory standards. Extraterritoriality and Systemic Risk In the absence of a supranational regulator, there is a disjunction amongst national regulatory regimes because many national legal systems will not regulate the activities of persons or transactions that are not exclusively located within their territorial jurisdictions.21 It has been argued that traditional notions of territorial jurisdiction under international law are inadequate to provide effective regulation of financial markets,22 and also fail to take account of the complexities of electronic commerce and trading systems. Indeed, a strict application of territorial principles of jurisdiction may result in inadequate regulation of cross-border financial services.23 Some national authorities have adopted laws that seek to control extraterritorial sources of systemic risk by imposing jurisdiction over foreign persons or transactions that pose a threat to the financial markets of the regulating state.24 Some have argued, however, that when national regulators are permitted to regulate on an extraterritorial basis, they have a tendency to “over-regulate” their territorial markets in order to bring extraterritorial activities within their jurisdictional control, thus causing inefficiencies and in some cases systemic risk.25 For example, the Federal Reserve Bank of New York has the authority to revoke the licence of a foreign bank to operate in the USA on account of its activities in a foreign jurisdiction that constitute, in the view of the Federal Reserve, unsafe or unsound practices.26 In such a case, there is no requirement for the 21 The three forms of jurisdiction are jurisdiction to prescribe (the authority of a state to make its law applicable to persons or activities), jurisdiction to adjudicate (authority of a state to subject persons or things to its judicial process) and jurisdiction to enforce (authority of a state to induce compliance with its law). A state—or legal system—may have all three forms of jurisdiction in any particular case, or it may have only one or two. For example, under a foreign judicial or arbitral decision, a law may be prescribed and adjudicated by one legal system and enforced by another. See ALI Restatement, Vol. 1 (Foreign Relations Law) (Saint Paul, Minn., West Publishing, 1987) 230–1. 22 See M. B. Fox, “Securities Disclosure in a Globalising Market: Who Should Regulate Whom” (1997) 95 Mich L Rev. 2498 (proposing choice-of-law rules for extraterritorial application of US securities laws to foreign corporations and transactors); see also, R. S. Karmel, “The Second Circuit Role in Expanding the SEC’s Jurisdiction Abroad” (1991) 65 St John’s L Rev. 743 (reviewing US Second Circuit’s decisions). 23 See R. M. Pecchioli, Internationalisation of Banking: The Policy Issues (Paris, 1983) 63–70. The English Court of Appeal observed that traditional territorial constraints on English jurisdiction have prevented UK authorities from successfully using the criminal law to prosecute financial fraud that occurs in UK markets but for which an essential element of the offence takes place in a foreign territory. See R. v. Manning [1998] 4 All ER 876. 24 Financial Services Modernisation Act 2000 (Gramm-Leach-Bliley Act), Pub L 106–102, 113 Stat 1338 (2000). For extraterritorial US banking regulations, see Regulation Y, 12 CFR Part 225 (2000). 25 See J. Eatwell, International Financial Regulation Lecture Series (Cambridge, Judge Institute, University of Cambridge 26 November 1999). 26 Gramm-Leach-Blilely Act, § 103 (requiring the Board to apply “comparable” capital and management standards to foreign banks with US branches, agencies or commercial lending companies, giving due regard to national treatment and equality of competitive opportunity).

The Need For Efficient International Financial Regulation 279 Federal Reserve to consult with the home country regulator of the foreign bank, nor to consult with other interested regulators in other host countries where the bank operates. This type of unilateral authority to impose extraterritorial banking regulation may increase systemic risk in a situation where the closure of the US branch of a foreign parent bank will adversely affect the parent bank’s ability in its home market to maintain its credit lines with other financial institutions because of its perceived close dealings with its US branch. This loss of confidence could also spread to the bank’s retail business, thus precipitating a bank run that could cripple its operations. Moreover, the same sort of systemic problems could arise when a host bank regulator revokes the licence of a domestic bank that has branches, agencies or subsidiaries in foreign jurisdictions on account of the bank’s activities within the territorial jurisdiction of the host state. This scenario does not concern extraterritorial jurisdiction per se (for example, the authority of a state to regulate activities occurring in another state’s territory) but instead addresses how the decisions of national regulators, taken for domestic reasons, can have an adverse effect on the economies of other countries. For example, the linkages within and between multinational banking groups and conglomerates create a seamless web through which the actions of national authorities to regulate a domestic enterprise can affect related enterprises operating in other countries. Indeed, this type of extraterritorial impact of national financial regulation truly demonstrates the essence of the extraterritoriality problem and the need for global supervision. Nation states jealousy guard their territorial sovereignty and regulatory control over economic activity, especially that of financial institutions and markets. Although there are numerous economic, legal and political problems with states unilaterally imposing extraterritorial financial regulation, if states view it to be in their national interests to impose extraterritorial laws they will continue to do so, despite the harm it may impose on the international system. States could address the problem of extraterritorial jurisdiction and the extraterritorial impact of financial regulation by adopting inter-state agreements—either treaties or non-binding mutual assistance agreements—that set forth minimum standards of prudential supervision and procedures for the exchange of information and evidence for surveillance of financial markets. These agreements could prescribe principles by which jurisdictional authority could be allocated to determine which country’s substantive rules would apply to a particular person or transaction. For example, states could agree to co-ordinate the extraterritorial application of financial regulation and to impose sanctions for conduct that occurs entirely outside their territories but which breaches international standards. Different approaches for co-ordinating extraterritorial jurisdiction may be appropriate for different regulations.27 The establishment 27 See S. J. Key and H. Scott, International Trade in Banking Service: A Conceptual Framework (Boston, Mass., Little Brown, 1991), 112 (suggesting a matrix for analysis of different types of bank regulation, with a view toward clarifying the rules that should govern international trade in banking services and separating the regulatory decision making between home and host country). See

280 Kern Alexander of a sound international legal framework to regulate financial markets necessitates that states adopt laws that regulate extraterritorial sources of systemic risk and co-ordinate the investigation and enforcement of such laws with foreign national authorities.

THE CASE OF THE BASEL FRAMEWORK OF BANKING SUPERVISION

Before the role and functions of a global financial supervisor are examined, I would like to analyse a significant part of the current international regulatory framework for banking institutions. The Basel Committee on Banking Supervision was formed as an international standing committee of banking supervisors in late 1974 in response to the financial crises that had occurred in the aftermath of the Bretton Woods system.28 The international committee was composed of the banking supervisors and central bank governors of the G-10 countries. It became known as the Committee on Banking Regulations and Supervisory Practices,29 which later became known as the Basel Committee on Banking Supervision.30 The Basel Committee has assumed a major role in establishing voluntary principles and standards of ‘best practices’ for national supervisors to adopt in regulating the international operations of banking institutions.

Basel Concordat The Basel Committee attracted very little attention until 1975 when, in response to the banking failures mentioned above, it adopted the Basle Concordat of 1975 (Concordat) that established guidelines for banks operating outside their home states. The Concordat focused on the respective roles of the home and host state supervisors and regulatory authorities to ensure adequate financial supervision.31 Specifically, it established five basic principles delineating the supervisory responsibilities of home and host countries’ banking regulators in overseeing banking institutions that operate on a transnational basis. The Concordat emphasised that all banks operating in host countries should be supervised by both the home country’s and the host country’s supervisory also E. Ferran, European Financial Service Regulation, unpublished Working Paper, World Financial Authority Project (Cambridge, Queens’ College, 5 June 1999) (analysis of home and host country financial regulation in the European Union). 28 29

Dale, n. 5 above, 172. J. Norton, Devising International Bank Supervisory Standards (Amsterdam, Kluwer, 1995)

176. 30 P. Cooke, “The Basle Concordat on the Supervision of Banks’ Foreign Establishments” 39 Aubenwirtschaft 151, 153. The Bank for International Settlements has provided administrative offices for the Basel Committee. 31 See The Basle Committee, Report to the Governors on the Supervision of Bank’s Foreign Establishments (Basel, September 1975).

The Need For Efficient International Financial Regulation 281 authorities.32 It recommended that the host authority take primary responsibility for the adequacy of the foreign bank’s liquidity.33 The home country’s supervisory authority should, in turn, be primarily responsible for the solvency of a home country’s bank whilst that bank is operating in a foreign country.34 The fifth principle emphasises the need for co-operation between home and host country regulatory authorities in removing all legal restraints on the transfer of confidential financial information if such information is considered necessary for effective supervision.35

1983 Revised Concordat In 1983, the Basel Committee members adopted new principles that further refined the 1975 Concordat with a view to ensuring that consolidated supervision could occur on a transnational basis. These principles were contained in the Principles for the Supervision of Banks’ Foreign Establishments (Revised Concordat).36 The Revised Concordat established new principles for the allocation of bank regulatory responsibilities between home and host authorities.37 The Revised Concordat focused on ensuring that no bank operating in a foreign country could escape adequate supervision, and, hence, developed the approaches of “consolidated supervision” and “dual key” supervision.38 Consolidated supervision means monitoring the risk exposure (including the concentrations of risk, the quality of assets and the capital adequacy) of the banking groups for which the home authority bears responsibility, on the basis of totality of the business, wherever conducted. Consolidated supervision expands the responsibilities of the home country’s regulatory authority by requiring the home country regulator to monitor the total risk exposure and capital adequacy of the home country’s bank.39 The home country regulator is able to do so by reviewing the bank’s total transnational operations.40 In contrast, dual key supervision means that the regulatory authority of each nation concurrently assesses the ability of other national authorities to supervise and carry out their respective responsibilities. Where a host country determines that a home country has inadequate supervision, the Revised Concordat proposes two options: (1) the host country could deny entry approval to an 32

Ibid. Ibid. 34 Ibid. 35 Cooke, n. 30 above, 164 (summarising the Basel Accords). 36 Basel Committee, Principles for the Supervision of Bank’s Foreign Establishments (May 1983); reprinted in (1993) 22 ILM 900. The Basel Committee acted in response to the financial crisis that arose from the Latin American sovereign debt crisis and from the financial scandal involving Banco Ambrosiano. 37 Revised Concordat, 22 ILM 900, 901. 38 Ibid., 905. 39 Ibid. 40 Ibid., 904. 33

282 Kern Alexander institution from a country which does not adequately supervise its own institutions,41 or (2) it could impose specific conditions governing the conduct of the business of foreign banks seeking to operate in the host jurisdiction.42 When a host country does not have adequate supervision, the Revised Concordat urges the home country’s regulatory authorities to discourage the home country’s bank from expanding its operations into the proposed host country.43 The purpose behind the dual key approach was to prevent countries from lowering supervisory practices in order to attract foreign investment and foreign capital.44

The Response to BCCI: Minimum International Standards Although the Revised Concordat and the 1990 Supplement improved the standards that were initially set forth in the Basel Concordat of 1975, significant gaps in the allocation of supervisory responsibilities still existed. For example, the collapse of the Bank of Credit and Commerce International (BCCI) in July of 1991 resulted, in part, from BCCI’s ability to evade supervision by both home and host countries and demonstrated the difficulties of adequately supervising banks operating in more than one jurisdiction.45 Indeed, the BCCI case raised serious questions about the regulation of cross-border financial institutions.46 The BCCI scandal led to the Basel Committee’s 1992 Report on Minimum Standards for the Supervision of International Banking Groups and their CrossBorder Establishment (Minimum Standards). The Minimum Standards continued to build on the principles of consolidated supervision, dual key supervision and communications between supervisory authorities, while setting forth guidelines for the implementation of these principles. The Standards are important principles that reflect emerging norms of prudential supervision and regulation of transnational financial institutions. They can be summarised as follows: 41 According to the Revised Concordat, the primary purpose of the Basel Committee is to examine the totality of each bank’s world-wide business on the basis of consolidated supervision. See Revised Concordat, 22 ILM 901. 42 Ibid. 43 Ibid. 44 D. Alford, “Basle Committee Minimum Standards, International Regulatory Response to the Failure of BCCI” (1992) 26 George Washington Journal of International Law & Economics 241, 253. 45 See P. Truell and L. Gurwin, False Profits: The Inside Story of BCCI, The World’s Most Corrupt Financial Empire (Boston, Mass., 1992) 67–94. 46 BCCI was able to evade supervision by establishing a holding company in Luxembourg. Consequently, the BCCI conglomerate held two parent (or home) banks: BCCI SA, incorporated in Luxembourg, and BCCI Overseas, incorporated in the Cayman Islands. Each of these banks had subsidiaries in foreign countries, such as the United Kingdom. This structure gave BCCI the ability to evade consolidated supervision. BCCI had two parent banks for which two countries held overall regulatory responsibility, but neither of the parent banks conducted its primary operations in those countries. This problem was compounded by the secrecy laws of the Cayman Islands and Luxembourg. See ibid., 31–5.

The Need For Efficient International Financial Regulation 283 (1) all international banking groups and international banks should be supervised by a home country authority that capably performs consolidated supervision; (2) the creation of a cross-border banking establishment should receive the prior consent of both the host country supervisory authority and the bank’s, or banking group’s, home country supervisor; (3) supervisory authorities should possess the right to gather information from the cross-border banking establishments of the banks or banking groups for which they are the home country supervisor; (4) if a host country authority determines that any one of the foregoing minimum standards has not been met to its satisfaction, that authority can impose restrictive measures necessary to satisfy its prudential concerns consistent with these minimum standards, including the prohibition of the creation of a banking establishment.47 By re-emphasising the need for consolidated supervision, the Minimum Standards recommend that the host country regulators ensure that the home country receives consolidated financial statements of the bank’s global operations. The Minimum Standards further exhort that the home country’s regulators have the means to satisfy themselves as to the completeness and validity of all financial reports.48 In addition, the host country’s regulators should assure themselves that the home country’s regulators have the authority to prevent banks under their jurisdiction from establishing organisational structures that circumvent supervision. In 1996, the Basel Committee, International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) created the Joint Forum on Financial Conglomerates49 to devise standards for the effective regulation of financial conglomerates that operate in different jurisdictions and in different financial services sectors. The Joint Forum has issued a number of proposals seeking to improve co-ordination between regulators. Specifically, it has proposed that a lead regulator be appointed for each conglomerate that would be determined based on the conglomerate’s overall activities. In mixed conglomerates with financial and other activities, it is proposed that the financial divisions of the group have separate legal personality. In February 1999, the Forum issued a final paper proposing measurement techniques and principles for assessing the capital adequacy of financial conglomerates on a group-wide basis.50

47 The Basel Committee, Minimum Standards for the Supervision of International Banking Groups and Their Cross-Border Establishments (July 1992) 3–7. 48 Ibid. 49 See Joint Forum on Financial Conglomerates at www.bis.org. The Joint Forum has a mandate to continue the work begun by the Tripartite Group on the harmonisation of standards for financial conglomerates. 50 Joint Forum on Financial Conglomerates, Capital Adequacy Principles (Basel, February 1999).

284 Kern Alexander

Basel Capital Accords The other key component of the Basel Supervisory Framework is the concept of capital adequacy for financial institutions. As a result of the precipitous declines of the US and European stock markets (Black Tuesday) in 1987, the Basel Committee began to explore the need to prevent financial crises caused by disorderly capital movements and to ensure the capital adequacy of financial institutions. Indeed, the Basel Committee responded to the concern of banking regulators that the capital requirements of major banks did not reflect the true risks facing banks in a deregulated and internationally-competitive market. Subsequently, the Basel Committee adopted a set of guidelines on the capital adequacy of banks in 1988.51 These guidelines became known as the Basel Accord on Capital Adequacy, which required banks actively engaged in international transactions to hold capital equal to at least 8 per cent of their riskweighted assets. This capital adequacy standard was intended to prevent banks from increasing their exposure to credit risk by imprudently incurring greater leverage. The Capital Accords advocated two principal goals: (1) to require banks to maintain higher levels of capital reserves by maintaining capitalto-asset ratios that are ‘risk-based’ (i.e. that reflect the real credit risks as well as the risks of banks’ off-balance sheet portfolios);52 and (2) to establish a level playing field so that a bank based in one country would not receive a competitive advantage by enjoying a lower capital adequacy requirement than a bank based in another country.53 Although these guidelines are not legally binding, the G-10 countries have incorporated them into their national banking regulations; and a number of non-G-10 countries have voluntarily implemented these standards into their national banking laws.54 Internal Risk Management Models In the early 1990s, national supervisors began to complain that the credit risk component of the Capital Accord was too narrow to deal with market, liquidity and operational risks, all of which increased with the growth of banks’ trading and derivative books. On 12 April 1995, the Basel Committee developed a 51 See Committee on Banking Regulations and Supervisory Practices, International Convergence of Capital Measurement and Capital Standards (Basel, BIS, 25 July 1988), reprinted in (1991) 30 ILM 980–1008. 52 See H. Scott and S. Iwahara, In Search of a Level-Playing Field, The Implementation of the Basle Committee Accords in Japan and the United States (Berkeley, Cal., 1994) 2. 53 Ibid., 3. 54 Australia, Austria, Finland, Hong Kong, Israel, Korea, Mexico and Taiwan have adopted laws incorporating the Basel standards, and so have some emerging market economies. See discussion in K. P. Follak, “International Harmonisation of Regulatory and Supervisory Frameworks” in M. Giovanoli (ed.), International Monetary Law: Issues for the New Millennium (Oxford, OUP, 2000) 291, 307.

The Need For Efficient International Financial Regulation 285 new approach to the calculation of capital requirements.55 The approach allows banks, for the first time, to use their internal risk-management models to determine regulatory capital requirements. Instead of adhering to a detailed framework for computing risk exposures (for reporting purposes) and capital requirements, banks are able, under certain conditions, to use their own models—the ones they use for day-to-day trading and risk management—to determine an important component of their regulatory capital requirements. In particular, the Basel Committee advocates value-at-risk as the standard measure for risk exposures. Value-at-risk is an estimate of the maximum loss in the value of a portfolio or financial system over a given time period with a certain level of confidence. This level of confidence is represented by the probability that the actual value of a particular capital account will not decline beneath a specified minimum value over a period of time at a given probability. Value-at-risk also refers to the requirement of closer involvement with the banks under supervisory control and formal risk assessments using appropriate evaluation factors. The Basel Committee adopted the value-at-risk model in 1997 and it has been implemented into law by the G-10 national regulators. Banks are encouraged to participate in the design framework for determining risk weightings for particular asset classes.56 Reform Proposals In June 1999, the Basel Committee proposed significant reforms to the 1988 Capital Accord that would place greater reliance by regulators on private credit rating agencies and internal bank ratings.57 These proposals specifically addressed the inadequacy of the 1988 Accord’s efforts to assess credit risk in light of rapidly changing conditions in financial markets. The 1999 proposed reforms to the Capital Accord recommended replacing the existing system of credit weightings by one which would use private agencies’ credit assessments to determine risk weights. The proposed reforms also contained suggestions for allowing some sophisticated multinational banks to use their own internal ratings of loans as a basis for calculating capital adequacy ratios. After commentary from the banking sector and government regulators, the Basel Committee released a further revision of the proposed reforms to the Capital Accord on 16 January 2001 (known as the new Capital Accord).58 These proposed amendments modify and substantially expand the 1999 proposals by 55 See Basle Committee, An Internal Model-Based Approach to Market Risk Capital Requirements (April 1995) (defining a series of quantitative and qualitative standards that banks would have to meet in order to use their own system for measuring market risk). 56 See discussion of value-at-risk method in D. Folkerts-Landau and I. Takatoshi, International Capital Markets Developments, Prospects and Policy Issues, IMF Working Paper No 135 (1995). 57 See Basel Committee on Banking Supervision, 1999 Proposed Revisions to the Basel Capital Accord (June 1999) 1–3. 58 See “The New Basel Capital Accord”, www.bis.org. Comments are due on the new proposed Capital Accord by 31 May 2001.

286 Kern Alexander specifically describing the methods by which banks can determine their minimum regulatory capital requirements.59 The structure of the new Accord contains three mutually reinforcing pillars that comprise the framework for assessing capital adequacy. The first pillar is the minimum regulatory capital charge that includes both the standardised approach (adopted in the 1988 Accord with subsequent amendments) and a revised internal ratings-based approach. The revised standardised approach provides enhanced, though limited, sensitivity to various risk categories. The internal ratings-based approach represents a fundamental shift in the Committee’s view on regulatory capital by placing greater emphasis on the internal credit risk rating practices of banks. This allows sophisticated institutions to estimate the amount of capital they believe necessary to support their economic risks. The second pillar is supervisory review, “intended to ensure that not only banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing these risks”. This pillar encourages supervisors to assess banks’ internal approaches to capital allocation and internal assessments of capital adequacy. Subject to the discretion of national regulators, it provides an opportunity for the supervisor to indicate where such approaches do not appear sufficient. The third pillar recognises that market discipline has the potential to reinforce capital regulation and other supervisory efforts to ensure the safety and soundness of the banking system. The Committee therefore is proposing a wide range of disclosure initiatives designed to add more transparency to the risk and capital positions of a bank. The Committee intends to finalise the new Accord by 31 December 2001, and national governments will be encouraged to adopt the necessary legislation to implement the standards beginning in 2004. Comment Given the importance of capital adequacy to the soundness and safety of banks, the Basel Committee has continued to apply the capital accords to many areas of international banking activity. The Capital Adequacy Accord is a universal benchmark that greatly influences the investment activities and risk management practices of multinational banking institutions.60 Although some bankers and policy-makers view the Accord as unfairly penalising certain low-risk lending while favouring other much more risky transactions, the 2001 proposed revisions 59 Although most national authorities had not applied the 1988 Accord to banks that did not have foreign establishments, US regulators had applied the 1988 Accord to all banks, irrespective of whether or not they operated in foreign jurisdictions. 60 The European Union, the United States and many non G-10 countries have adopted a Minimum Capital Adequacy Ratio similar to that prescribed by the Basel Capital Accords. See n. 54 above, 306–8. Further, the EU and US have utilised the Basel Committee’s recommendations to set regulation limits on loans and liquidity ratios: ibid. 309–10.

The Need For Efficient International Financial Regulation 287 make significant progress in providing guidelines for national regulators to do a better job in matching regulatory risk with economic risk.

Other International Bodies The Basel Standards will serve as a reference point for future work in association with other international financial bodies covering regulatory standards in the areas of securities, insurance and accounting. For example, the Basel Committee and IOSCO have both worked with the International Accounting Standards Committee (IASC) to establish international accounting standards. The Basel Committee has also worked with the Financial Action Task Force in developing minimum standards of disclosure and transparency for financial intermediaries to adopt in order to reduce financial crime.62 The Basel Committee and IOSCO have agreed on converging capital adequacy standards for financial institutions conducting securities activities in derivatives.63 IOSCO has also sought to formulate capital adequacy ratios for securities firms to match those already existing for banks under the Basel Accords.64 IOSCO has also made parallel efforts on the international level to improve co-operation, coordination and harmonisation of regulation in securities and futures markets.65 The consensual and informal approach of the Basel Committee and IOSCO in developing non-binding standards and rules for regulating international financial markets has generally been viewed as a success in fostering cooperation and co-ordination amongst the regulators of advanced economies. The adoption of these standards by the countries of the European Union, the USA, and other developed countries marks an important phase in the move to co-ordinate financial supervisory standards in the larger context of an international financial system.66 The financial crises of the late 1990s, however, have

62 See Directorate for Financial, Fiscal, and Enterprise Affairs, Organisation for Economic Cooperation and Development, Financial Action Task Force on Money Laundering, FATF VII Report on Money Laundering Typologies (1996). 63 Joint Report of the Basel Committee on Banking Supervision and the IOSCO Technical Committee, Framework for Supervisory Information about the Derivatives Activities of Banks and Securities Firms (Basel, May 1995). 64 International Organisation of Securities Commissions: Technical Committee, Report on Capital Adequacy Standards for Securities Firms (August 1989) reprinted in (1991) 30 ILM 1018; see also Methodologies for Determining Capital Standards for Internationally Active Securities, Technical Committee of IOSCO (May 1998). 65 P. Guy, “Regulatory Harmonisation to Achieve Effective International Co-operation” in F. R. Edwards and H. T. Patrick (eds.), Regulating International Financial Markets: Issues and Policies (Amsterdam, Kluwer, 1991) 291. 66 A. Lucatelli, Financial and World Order, Financial Fragility, System Risk, and Transnational Regimes (New York, 1997) 77. These standards, however, may not necessarily be appropriate for the financial markets of the many emerging and developing countries that are undergoing tremendous economic change, and may require different standards for their various stages of economic development.

288 Kern Alexander caused increasing governmental anxiety, which has led to the informal procedures of the Basel Committee and other international financial organisations to be supplemented by a more concerted regulatory co-ordination by national authorities under the auspices of the Financial Stability Forum (FSF).67 Moreover, recent efforts by the IMF and WTO to formalise international monetary and financial relations suggest that a more formal legal framework is developing for the supervision of international financial markets. The FSF or successor agencies may one day acquire decision-making powers that resemble those of a global supervisor, as discussed in the next section.

THE ROLE OF A GLOBAL SUPERVISOR

Because the stringency of national regulations varies from country to country and because banking is global, multinational banks are subject to disparate levels of regulation that may provide incentives for riskier activities in less stringent jurisdictions. Since multinational banks now operate in what are becoming seamless financial markets, the effective management of systemic risk on a global level requires a global supervisor whose regulatory domain is the same as the multinational entities it regulates.68 Indeed, this applies whether the domain of the market is defined in terms of institutions, products or currencies, or even geographic areas. In a legal sense, this would require the jurisdictional competence of a global supervisor to cover the same terrain as the financial markets and institutions it regulates. The globalisation of financial markets and the limited competence of national authorities over such markets necessitate the establishment of a global supervisor whose domain would be international and would be responsible for generating regulatory standards and co-ordinating their implementation by national authorities. A global supervisor would need the jurisdictional competence to perform certain functions to ensure the control and management of systemic risk. Such jurisdictional competence should also include the authority to co-ordinate efforts by national regulators to deter market abuse and financial crime.69 At this time, however, the exclusive jurisdiction of nation states to regulate their own financial markets effectively precludes a global supervisor from ensuring that international standards are applied and enforced, unless some type of agreement is reached between national authorities to establish and authorise 67 See discussion in Giovanoli, n. 9 above, 25–7. The finance ministers and central bank governors of the G-7 created the FSF after the so-called Tietmeyer Report had recommended new structures to enhance international co-operation amongst national supervisory authorities. Ibid. 68 See generally J. Eatwell and L. Taylor, The Future of Financial Regulation: World Financial Authority, unpublished Working Paper (Cambridge, 1999). 69 The remit of consumer protection should predominantly be the responsibility of national authorities.

The Need For Efficient International Financial Regulation 289 a global supervisor to exercise the following necessary functions in order to carry out efficient international regulation: (1) authorisation and guidance of financial institutions and exchanges, (2) information and surveillance, (3) co-operation and co-ordination with national authorities, and (4) enforcement and policy. These functions will now be discussed.69a

Authorisation and Guidance The authorisation of firms to operate in financial markets must be controlled by a licensing system, in which firms and individuals would be licensed to operate only after demonstrating that they are fit and proper, that they have adopted effective control and risk management procedures, and that they satisfy capital adequacy and other prudential standards. Regulatory authorities must have discretion to refuse, or rescind, a licence when firms or individuals fail to comply with required standards. In addition, authorities should provide guidance through frequent communication with the firms they regulate. The regulator should foster a good relationship with supervised firms by providing mutual advice concerning a firm’s internal operations. In this way, firms can be encouraged to provide a continuous flow of information. This type of co-operative relationship is far more efficient than adversarial inspections. A global supervisor should take the lead in setting standards for national authorities to authorise or provide a licence to multinational financial institutions so that they can operate on a transnational basis. The authorisation process may be conducted under the type of home/host country arrangements that have been adopted by countries that adhere to the Basel Committee’s principle of consolidated supervision. The global supervisor would have the responsibility to ensure that common authorisation procedures are followed and information is fully shared. A global supervisor could also provide guidance to national authorities in developing and implementing national regulatory standards that comply with international standards. Experts could be deployed to work with national regulators who would then be able to assist banking institutions and other financial service entities in establishing good risk-management practices and regulatory standards. Indeed, international businesses need full information and harmonised guidance practices to avoid duplication of national regulatory standards.

69a These essential functions of an efficient international financial regulatory regime were set forth by Eatwell and Taylor, n. 1 above, and were further developed by members of the Cambridge University International Financial Regulation Project, Queen’s College, Cambridge.

290 Kern Alexander Information and Surveillance The information disclosure system is an aspect of the broader task of surveillance. Effective surveillance is required to ensure that firms adhere to regulatory standards and rules. Some observers note that surveillance should be considered essentially as an “intelligence operation”.70 The accurate assessment of the changing structure of financial markets and the level of risk to which markets are exposed necessitate that regulators utilise effective surveillance techniques. Moreover, regulators should be better informed than the market participants whom they regulate. Accordingly, regulators should have access to confidential information that is relevant for performing their surveillance function. Traditional legal privileges protecting such confidential information from being disclosed should not apply to financial regulators. Indeed, the role of the regulator would be greatly enhanced and more legitimate if it were known that they had broader and more accurate information about markets. Information and surveillance would be crucial responsibilities for a global supervisor. The Bank for International Settlements and the Basel Committee have provided a wealth of information on the development and performance of international financial markets and of suggested accounting standards for banking institutions.71 The global supervisor could establish high standards of information disclosure so that market actors and national regulators could have access to the most recent and accurate information concerning international investment, short-term capital flows and liquidity and interest rate information. Regarding legal issues involving confidentiality of information held by financial firms, it will be necessary to harmonise national standards and eventually adopt one international standard for the disclosure of proprietary information related to financial markets. The disclosure of information also raises the issue of what type of accounting standards or system should be used to disclose relevant financial information. It is the very foundation of an efficient market and effective regulatory system that accurate and relevant information is disclosed to the public, investors, creditors, and regulators. Although the International Accounting Standards Committee (IASC)72 and the International Organisation of Securities Commissions 70

Eatwell and Taylor, n. 1 above, 191. The Basel Committee has published Guidelines to Banks and Bank Supervisors on Public Disclosures in Banks’ Final Reports (Basel, Basel Committee, September 1998); see also Enhancing Bank Transparency (Basel, Basel Committee, September 1998), and Basel Committee Paper, Sound Practices for Loan Accounting, Credit Risk Disclosure and Related Matters (Basel, Basel Committee, July 1999). 72 The International Accounting Standards Committee (IASC) was formed in 1973 with the objective of harmonising accounting principles which are used by businesses and other organisations for financial reporting. It is an independent, private sector body composed of professional representatives from the accounting profession and does not represent any government agencies or international organisations. See www.iasc.org.uk. It therefore does not have the public legitimacy that the Basel Committee, IOSCO or the FATF have because these organisations are composed solely of government representatives. 71

The Need For Efficient International Financial Regulation 291 (IOSCO) have made significant progress in adopting general disclosure standards for various public companies, progress towards an effective international standard with meaningfully specific standards that apply to all financial institutions has been slow. Effective international standards could provide early warning for the types of financial crises that occurred in the 1990’s in the developed financial markets of Japan and in the developing markets of east Asia, Russia, and Latin America. Accounting standards should reflect the transactions that occur in rapidly changing financial markets. Moreover, the rise of electronic trading systems has resulted in the rapid dissemination of financial information that impacts the development of international disclosure standards. It is important that international accounting standards reflect the complexities of the world’s most sophisticated financial markets. For example, clear, comprehensive and consistent accounting standards have proved vital in protecting US investors against market manipulation and financial fraud. In 1991, US residents held over $300 billion of holdings in non-US equities.73 In 1999, the amount had quadrupled to nearly $1,300 billion, which exceeds 40 per cent of the value of the world’s cross-border equity investments.74 US accounting standards are regarded as of a high standard that promotes investor confidence and a robust level of capital formation. Moreover, the IASC has proposed a core set of accounting standards that provide a comprehensive basis of accounting. These standards are known as the “International Accounting Standards” (IAS) and they have been accepted by many stock exchanges for cross-border listing purposes and by many national governments.75 However, IOSCO, the US SEC, and Canadian authorities have not endorsed the IAS, which undermines its practical use in global capital markets.76 Effective international accounting standards are a necessary requirement for the effective management of systemic risk and for the efficient flow of crossborder capital. The information provided by consistent accounting standards will help ensure market discipline and effective regulatory oversight. The lack of consistent standards may create the conditions for ‘accounting arbitrage’ in some financial markets. A global supervisor should have the responsibility for overseeing the adoption of international accounting standards, while working closely with such organisations as IOSCO and IASC. The primary objective would be to establish comprehensive and complete standards based on the requirements of many of the world’s sophisticated market economies and then to ensure that the problems of accounting arbitrage and the tendency towards the lowest common denominator would be overcome. 73

Eatwell and Taylor, n. 1 above, 183–7. Ibid. 75 See www.iasc.org.uk. In June 2000, the European Commission issued a communication proposing that all listed EU companies be required to prepare their consolidated financial statements using the IAS. 76 Since 1999, the European Union, Austria, Belgium, France, Germany, Italy, and Spain have passed laws allowing certain companies to use the IAS for domestic reporting purposes, subject to certain conditions. 74

292 Kern Alexander Regarding actual surveillance, the International Monetary Fund has extensive experience under its Article IV surveillance reports to assess the economic performance of its member states, and to monitor compliance by certain members states which have obtained credits under IMF conditionality programmes. A global supervisor could also be involved in reviewing and assessing the regulatory performance of states that have expressed their willingness to abide by the international regime. It would be able to assess the surveillance systems of particular countries, and in doing so would provide advice to states which were having difficulty in complying with international standards. Such a surveillance system has not been adopted in the current international financial system and would be difficult to achieve because it would require high standards of disclosure that are not yet provided by many national authorities. Such a system would be necessary though for best regulatory practices in international financial markets.

Co-operation and Co-ordination A global supervisor could serve as a forum for the development and implementation of international financial co-operation. Many goals of an efficient international financial policy can be achieved by effective co-ordination of the activities of national authorities. This has been demonstrated by the work of the Basel Committee77 in exchanging vital information on capital markets and in co-ordinating the regulatory supervision of financial institutions that operate on an international basis. This type of co-operation and co-ordination has also been achieved bilaterally through such agreements as the EU–US 1999 Statement of Co-operation on the Exchange of Information for the Purposes of Consolidated Supervision.78 Such close co-operation is necessary for the comprehensive consolidated supervision of banks that have multi-jurisdictional establishments. A global supervisor should have the authority both to reach agreement with national supervisors and to facilitate agreements amongst supervisors on a common framework for information-sharing that can be used as a basis for reciprocal bilateral co-operation between supervisors and with banking institutions that have material operations in foreign jurisdictions. The global supervisory role could also involve building on current bilateral agreements, such as the EU–US agreement, to promote further exchange of information in investigations and enforcement. Regarding confidential information, a global supervisor and national authorities should consider any information obtained through bilateral or multilateral 77 This has of course been facilitated by the research efforts of the Bank for International Settlements. 78 See Statement of Co-operation on the Exchange of Information for the Purposes of Consolidated Supervision, http://www.eurunion.org.

The Need For Efficient International Financial Regulation 293 avenues to be used only for lawful supervisory purposes, without prejudice to defendant rights in criminal cases. To the extent permitted by national law, supervisory authorities and their agents should hold as confidential all information obtained pursuant to such authorised exchanges. It is also contemplated that, in certain circumstances, information provided by one supervisor to supervisors in other countries may be disclosed to third parties if it serves a lawful supervisory purpose. Specifically, where a supervisor receives a request for information from a third party, the supervisor receiving the request will consult with the supervisor that provided the information in order to solicit its views on the propriety of releasing such information. Prior consent will be obtained from the supervisor that originated the information if consent is required by the laws or regulations of that country. In any event where a supervisor is required to disclose information according to the rules of any inter-state agreement, it would be understood that such supervisor will co-operate in seeking to preserve the confidentiality of the information to the extent permitted by law. In all cases of disclosure to third parties, to the extent required by national law, the supervisor disclosing the information will notify the supervisor that originated the information of such disclosure. In addition, the advent of global banking has made it possible for a network of depository institutions to be linked by sophisticated telecommunications and computer systems. A global supervisor could take the lead in creating such a network by assisting national authorities to adopt the necessary technology and standards for an efficient payment and clearing system. A global supervisor could be vested with the authority of requiring banking sectors throughout the world to participate in a single network of international payments and deposits that would be a closed system to which all reputable banks will have to belong and for which a common, transnational regulatory framework will be required. Accordingly, a global regulator could play a role by supervising such an international payments system and providing minimum standards to reduce systemic risk.

Enforcement and Policy An effective international financial regulatory regime depends on the enforcement and implementation of international standards. The transnational nature of financial risk necessitates uniform principles concerning procedures for enforcement of financial regulation that take account of the growing number of multi-jurisdictional cases. This requires adhering states to enact appropriate legislation that imposes jurisdiction not only on violations or offences that occur solely in the enforcing jurisdiction, but also involve acts or omissions that occur in other territorial jurisdictions but which affect the financial markets of the sanctioning state. National authorities should also have competence to prosecute regulatory breaches or offences in which elements of the violation have

294 Kern Alexander occurred in foreign jurisdictions as well as in the territory of the prosecuting state. Further, expansive concepts of extraterritorial jurisdiction should be adopted to regulate electronic trading systems and to prosecute market abuse offences, which utilise the internet to manipulate and threaten the integrity of financial markets. To fulfil the enforcement function, a global supervisor will not try to enforce international standards directly but will provide information, evidence and political pressure to national authorities to ensure that they enforce international standards. The global supervisor should however take the lead in the enforcement effort and bring it consistency and coherence. Moreover, enforcement cases involving transnational operations of financial conglomerates will involve many difficult legal issues, including whether to pierce the corporate veil in cases involving corporate breach, attributing liability to controlling third persons or to those who are knowingly concerned,79 and issues of double and multiple jeopardy in criminal cases. One of the most important functions of the global supervisor will be the policy function. This function has already been undertaken by the various efforts of the Basel Committee, IOSCO and other international financial organisations in developing international standards and rules of prudential practice. The consensual approach has been important in providing legitimacy to the development of such standards and in gaining broader support for their implementation. But the voluntary approach means that the initiative lies with national authorities to adopt international standards. By contrast, a global supervisor would want to adopt a proactive policy function in which it would develop and adopt standards and rules of regulatory practice that national authorities would then be bound to adopt. The policy function should also continuously adapt the scope and content of regulation to the changing structure of international markets, and to the changing character of firms. Policy should address the character and development of rules and standards, and shape and constrain the policies of national regulators.

CONCLUSION

The establishment of a global financial supervisor would raise numerous political and legal issues regarding the type of powers to be delegated to such an authority and the role that states would play in influencing the development of international standards and rules of financial regulation. The notion of establishing a supra-national authority would certainly infringe the traditional powers of national authorities to supervise their financial markets. Yet, if liberal international markets are to be sustained, the economic and legal challenges of 79 See E. Lomnicka, “Knowingly Concerned? Participatory Liability for Breaches of Regulatory Duties” (2000) 21 Company Lawyer 121 (analysing principles of third party civil liability for breach of financial regulation).

The Need For Efficient International Financial Regulation 295 managing systemic risk on a global level must be met in one way or another. In assessing the feasibility of a global supervisor, it is necessary first to define the functions that must be performed in order to have efficient international regulation of financial markets. Political reality demands that a global supervisor coordinate its functions with national regulatory authorities. The primary role of a global supervisor would be in facilitating harmonisation of standards and procedures, developing a global scope and relevance for decision-making, and, when appropriate, exercising regulatory authority on a global scale. The efforts of the Basel Committee and other informal international bodies (i.e. IOSCO and FATF) demonstrate that national financial supervisors are capable of performing some of the functions of global regulation, such as exchanging information and establishing voluntary international standards to reduce systemic risk and market abuse. The effectiveness of this informal and voluntary approach to co-operation and standard setting worked well for developed countries in the immediate aftermath of the Bretton Woods system. Today, however, the changing structure of international financial markets and the increased risk of systemic failure require a more formalised structure of binding international standards and effective supervision and enforcement. Indeed, the international activities of banks are subject to overlapping and disjointed national regulatory structures that must be co-ordinated and subject to harmonised standards if the risks to financial markets are to be minimised. Given the nature of systemic risk in the international financial system and the current regulatory system’s disjointed approach to financial regulation, there should be serious consideration given to the creation of a global financial supervisor that would perform some of the essential regulatory functions that are currently handled by national authorities. A global authority could establish minimum standards of prudential practice, monitor national compliance with such standards and co-ordinate enforcement with national authorities. Nation states would be required to pool their sovereignties in the exercise of more efficient international regulation. In the absence of a more effective international approach, the scope and severity of financial crises are likely to increase in the future.

18

The Role of Rating Agencies in Global Market Regulation STEVEN L. SCHWARCZ*

an anomalous position in global market regulation. They are the universally feared gatekeepers for the issue and trading of debt securities: “little irks companies and governments more than a visit from the man from Moody’s”,1 and recent proposals by the Basel Committee on Banking Supervision promise to expand even further the role of rating agencies. Yet they are largely unregulated private entities. This chapter examines the role of rating agencies in market regulation and the question whether they should remain unregulated.

R

ATING AGENCIES OCCUPY

INTRODUCTION

The Problem It is increasingly common in domestic and cross-border financial transactions for investors to rely on rating agencies for substantial comfort regarding the risks associated with the full and timely payment of debt securities.2 Rating agencies, however, are private companies.3 They are not presently regulated in the United States or by any other major financial-centre-nation. The only minimal form of governmental control that some of these nations impose is to give official recognition to rating agencies that meet certain criteria.4 Often, however, these criteria * The author thanks Rita M. Bolger, Francis A. Bottini, Petrina R. Dawson, Howell E. Jackson, Kenneth C. Kettering, F. Partnoy, and P. M. Shupack for helpful comments and Adam Bender, Felipe Guzman, Jeremy Hilsman, Nam H. Le, and Katharine A. Schkloven for research assistance. 1 “The Use and Abuse of Reputation”, Economist, 6 April 1996, 18 (explaining that rating agencies have “huge powers to move markets”). 2 S. L. Schwarcz, “The Universal Language of Cross-Border Finance” (1998) 8 Duke Journal of Comparative and International Law 235, 251–2. A rating agency’s assessment of these risks may involve analyzing the structure of the transaction and any underlying collateral: ibid. 3 Ibid. 4 E.g. Japan, France, Hong Kong and the United States recognise certain rating agencies for specific legal purposes, but do not substantively regulate those agencies. See Global Index of the Uses of Ratings in Regulations and Regulations Affecting Rating Agencies 22, 25, 36 (April 2000). See also Progress in the Financial System Reform (visited 30 July 2000) (describing the Japanese approach).

298 Steven L. Schwarcz are vague or informal,5 and the recognition is for limited purposes only.6 In relatively few cases do nations substantively regulate rating agencies.7 This is exemplified by US law, which contemplates an informal process by which a rating agency can be designated as a nationally recognised statistical rating organisation (NRSRO).8 For ease of explanation, this chapter will use the term “NRSRO designation” to include any governmental recognition of rating agencies, irrespective of the country in which the recognition occurs. If a rating agency is designated an NRSRO in the United States, its ratings can be used to satisfy rating requirements established by government agencies like the Securities and Exchange Commission (SEC) in certain federal regulatory schemes. For example, Rule 3a-7 of the Investment Company Act of 19409 exempts certain financings from registering and complying with that Act if, among other requirements, the securities are rated “investment grade” by at least one NRSRO.10 While there has been debate whether more regulation is necessary and the SEC itself has called for comments on the NRSRO designation,11 some argue that market forces create sufficient checks on rating agencies.12 Because government reliance on ratings is swiftly expanding worldwide,13 this debate is likewise transcending national borders. Most notably, the Basel Committee on Banking Supervision, the “top global banking regulator”,14 issued a June 1999 report—A New Capital Adequacy Framework15—proposing new capital adequacy guidelines for banks. The problem with existing guidelines, under which banks must set aside a percentage of their assets to cover the 5 See A. K. Rhodes, “The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?” (1996) 20 Seton Hall Legis J 293, 323. 6 See, e.g., below, nn. 90–97 and accompanying text (discussing the limited significance of the NRSRO designation in the United States). 7 Governments in several Latin American countries (Argentina, Bolivia, Uruguay, Mexico, Paraguay, Chile and Peru) and in East Asia (Malaysia, Korea, Taiwan) regulate the ratings industry through structural requirements, such as capitalisation thresholds, employee experience and integrity requirements, and through rating methodology directives. See Global Index of the Uses of Ratings in Regulations and Regulations Affecting Rating Agencies, n. 4 above, 6–17. 8 Schwarcz, n. 2 above, 251 n 74. For a description of this process, see Rhodes, n. 5 above, 323. 9 15 USC §§ 80a-1 to 80a-64 (West, 1997 & Supp. 1998). 10 Ibid., § 80a-6(5)(A)(iv)(I). 11 In 1994, the SEC issued a request for comments on the use of the NRSRO designation in the context of Rule 3a-7. See SEC, Concept Release on Nationally Recognized Statistical Rating Organizations, SEC Release Nos 33–7085; 34–34616, 59 Fed Reg 46,314 (7 September 1994). More recently, the SEC issued a proposed rule to amend the net capital rule by formally defining the term NRSRO, but no final rule has been issued to date. See Proposed Rule on Capital Requirements for Brokers or Dealers, Exchange Act Release No 34,3457, 62 Fed Reg 68,018 (30 December 1997). 12 See generally Rhodes, n. 5 above; “An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies” (1993) 30 San Diego Law Review 579, 603–8. 13 See, e.g., n. 1 above, 18: “British regulators use ratings to help decide how much capital securities firms should set aside against their bond holdings. Japan’s finance ministry allows only highly rated borrowers to sell bonds to Japanese investors.” 14 A. Cowell, “An International Banking Panel Proposes Ways to Limit Risk”, New York Times, 4 June 1999, C4. 15 Consultative Paper Issued by the Basel Committee on Banking Supervision (June 1999) .

The Role of Rating Agencies in Global Market Regulation 299 possibility of default, is that they do not differentiate between the default risks of different loans.16 The new proposal would allow banks in conjunction with supervisory authorities to calibrate this risk by using “external credit assessments [i.e., ratings] for determining risk weights”.17 Once approved, as expected, the Basel Committee’s proposal is likely to be adopted by “most of the world’s bank regulatory regimes”.18 That of course would further focus world attention on this debate.19 Before engaging in this debate, however, it is necessary to define more precisely what rating agencies do.

The Role of Rating Agencies A rating is an assessment of the likelihood of timely payment on securities.20 Thus only the creditworthiness of an investment, not its economic desirability to investors, is rated.21 Pure equity securities therefore are not rated because they have neither a specified maturity date nor a contractually fixed principal amount. Because rating agencies make their rating determinations based primarily on information provided by the issuer of securities, a rating is no more reliable than that information.22 Ratings thus do not cover the risk of fraud.23 Within these constraints, the significance of a rating depends on the reputation of the particular rating agency among investors.24 At present, the most respected and trusted agencies are Standard & Poor’s Ratings Services, Moody’s Investors Service, Inc. and Fitch Investors Service, Inc., all founded in the USA but now having offices and providing ratings to investors worldwide.25 Long- and short-term debt havs separate rating scales, reflecting the different risks associated with long- and short-term investing. All other factors being equal, long-term investing has greater risk because of the greater uncertainty of predicting future events. Using Standard & Poor’s ratings as an example,26 the 16

Cowell, n. 14 above. N. 15 above, 5. Whether this proposal is appropriate is beyond the scope of my chapter but see Jackson ch. 19, below. 18 See Standard & Poor’s Official Response to the Basel Committee’s Proposal (December 1999). (commenting that the existing 1988 Basel accord on capital adequacy was so adopted). 19 Ibid., 11 (expressing concern that “an increased use of ratings creates the potential for increased regulatory efforts by various national regulators to influence or control rating agencies”). 20 See S. B. Samson and G. I. Hessol, “Ultimate Recovery in Ratings: A Conceptual Framework”, S&P CreditWeek, 6 November 1996, 25. 21 Schwarcz, n. 2 above, 253, n 82. 22 Ibid., 252 n 76. 23 Ibid. 24 Ibid. 25 Ibid. Fitch, e.g., has headquarters in New York and London, rates entities in 75 countries, and is wholly owned by the French company, FIMALAC, S.A. See . 26 Other rating agencies use similar, although not precisely identical, rating nomenclature. 17

300 Steven L. Schwarcz highest rating on long-term debt securities is AAA, with ratings descending to AA, then to A, and then to BBB and below.27 The highest rating on short-term debt securities—such as commercial paper—is A-1, with ratings descending to A-2, A-3 and below.28 The higher the rating, the lower the rating agency has assessed the credit risk associated with the securities in question.29 A rating often is assigned to a particular issue of a company’s securities, and not necessarily to the company itself, because a company could issue different securities having different risk characteristics.30 Hence, a company’s senior debt securities almost always would be rated higher than the same company’s subordinated debt securities.31 Ratings below BBB- are deemed non-investment grade, and indicate that full and timely repayment on the securities may be speculative.32 The term investment grade “was originally used by various regulatory bodies [in the United States] to connote obligations eligible for investment by institutions such as banks, insurance companies and savings and loan associations. Over time, this term gained widespread acceptance throughout the investment community.”33 Because a high rating signals low credit risk to investors, a company that issues AAA rated securities can more easily attract investors for its securities than can a company that issues AA or BBB rated securities.34 Therefore the company with AAA rated securities can pay a lower interest rate on those securities, and still attract investors, than can the company with the lower rated securities. An investor therefore sometimes may prefer, if it finds the extra risk acceptable, to invest in a BBB rated security rather than an AAA rated security in order to benefit from the higher interest rate.35 The existence and almost universal acceptance of ratings make it much easier for investors in the capital markets to assess the creditworthiness of a given issue of securities. Indeed, certain rating agencies view their ratings as worldwide standards, and not as relative risk standards within countries.36 Thus, a BBB rating on securities is intended to convey the same level of risk irrespective of the jurisdiction in which the securities are issued.37 This sometimes creates a problem for companies that would otherwise have high ratings, but which are 27 Schwarcz, n. 2 above, 252. Long-term ratings also sometimes have “+” and “-” designations associated with the ratings: ibid. 28 Ibid., 252. A-1 is the highest short-term rating for Standard & Poor’s, P-1 for Moody’s, F-1 for Fitch, and D-1 for Duff & Phelps: ibid., 252 n 79. 29 Ibid., 252–3. 30 Recently, however, some rating agencies, such as Standard & Poor’s, have been assigning company ratings that apply to any issue of the company’s senior unsecured debt securities: ibid., 253 n 80. 31 Ibid. 32 Ibid., 253. 33 Standard & Poor’s Corporate Ratings Criteria (1998) 9. 34 Schwarcz, n. 2 above, 253. 35 Ibid., 253 n 82. 36 Ibid., 253 n 84 (referring to the way that Standard & Poor’s views its ratings). 37 Interview with Petrina Dawson, Managing Director and Associate General Counsel, Standard & Poor’s Ratings Services, in Durham, North Carolina (11 March 1998).

The Role of Rating Agencies in Global Market Regulation 301 located in countries that have political or financial instabilities, because the rating on the company’s securities usually is limited by the rating of the country itself.38 The almost universal demand by investors for ratings also can make rating agencies gatekeepers for the types of securities that investors will buy.39 That, however, can slow down experimentation with inventive transaction structures, especially for the innovative fields of structured finance and securitisation.40 This unprecedented power and the de facto control of rating agencies over international debt markets raise the issue of whether rating agencies should remain unregulated.41

ANALYSIS

That rating agencies are largely unregulated is not in itself problematic; reliance by government on unregulated entities to monitor risk sometimes can be beneficial. I therefore focus on whether more comprehensive regulation of rating agencies would make the rating system more efficient. This focus reflects that, in an economic context where health and safety are not at issue, regulatory policy views the rationale for regulation as “foster[ing] improvements judged in efficiency terms”.42 In making this inquiry, it must be cautioned that regulation itself poses intrinsic costs that can offset any efficiency gain.43 Even where there is market failure, “government intervention may not [always] yield a superior outcome”.44 I therefore attempt to offset the costs of regulation against any potential gains. There would be two ways in which regulation could improve the efficiency of rating agencies: by making them perform better the tasks they already do well, or by limiting the negative consequences of their actions. The chapter considers each in turn.

38

This is sometimes referred to as sovereign ceiling. See Standard and Poor’s, n. 33 above, 51. Schwarcz, n. 2 above, 253. 40 Ibid. See also below nn. 69–82 and accompanying text (describing securitisation and discussing the gate-keeper problem). 41 See e.g. “Reexamining the Regulation of Capital Markets for Debt Securities, Panel IV: Rating Agencies: Substitute or Necessary Corollary to the Regulation of Debt Markets?”, http://www.law.duke.edu/globalmark/conf/BMA%20Conference.html (proceedings of 18–29 October 1999 conference held by Duke University’s Global Capital Markets Center in Washington, DC, co-sponsored by the Bond Market Foundation). 42 W. K. Viscusi, J. M. Vernon and J. E. Harrington, Jr, Economics of Regulation and Antitrust (2nd edn., Cambridge, Mass, MIT Press, 1995) 10. 43 See e.g., J. Eatwell and L. Taylor, Global Finance at Risk (Cambridge, Polity Press, 2000) 19: “regulation can be expensive and oppressive or even downright wrongheaded. Overly fastidious regulation may result in risks being overpriced, and hence will stifle enterprise. . . . A balance needs to be struck. . . ”. 44 Viscusi, Vernon and Harrington, Jr, n. 42 above, 11. See also ibid., 13 (observing that “‘government failure’ may be of the same order of importance as market failure”). 39

302 Steven L. Schwarcz

Would Regulation Improve Rating Agency Performance? As the previous discussion has shown, rating agencies improve the efficiency of securities markets by acting as financial intermediaries between issuers and investors in order to increase transparency of the securities and thereby reduce the information asymmetry. This is especially valuable where individual investors face high costs relative to their investment in assessing the creditworthiness of an issuer’s securities. A relatively small number of rating agencies can make this assessment on behalf of many individual investors, thereby achieving an economy of scale. Government regulation could increase this efficiency only by reducing overall costs or by improving ratings reliability. There is little reason presently to believe that rating agency costs are excessive. The fee charged by a rating agency typically is market-driven and varies according to the size and complexity of the transaction being rated.45 At least for public transactions, the fee also covers ongoing monitoring of the rating.46 From the standpoint of the rating agencies themselves, these fees reflect, among other things, the costs of the large staff of experienced analysts needed to assess ratings.47 Rating agencies employ expert analysts who examine and scrutinise public and private information about a company to determine its long-term ability and willingness to meet its debt obligations.48 Additionally, fees reflect the risk that the rating agency will be sued based on a rating that, in retrospect, might appear unjustified.49 Even if rating agency costs were excessive, however, government regulation rarely reduces costs and includes costs of its own, such as the public sector need to administer the regulation and the private sector need to retain counsel to advise on compliance with the regulation.50 There likewise is little reason to believe that regulation will improve the reliability of ratings. Rating agencies have had a remarkable track record of success

45 Letter from Leo C. O’Neill, President, Standard & Poor’s Ratings Services, to Jonathan Katz, Secretary, Securities and Exchange Commission (27 February 1998) 9–10 (on file with author). 46 Ibid., 10. 47 See Moody’s Investors Service, A “Universal” Approach to Credit Analysis (visited July 26, 2000). 48 Ibid. 49 See, e.g., LaSalle Nat’l Bank v. Duff & Phelps Credit Rating Co, 951 F. Supp. 1071 (SDNY 1996); County of Orange v. McGraw-Hill Companies, No SA CV 96-0765-GLT, 1997 US Dist LEXIS 22459 (CD Cal, 2 June 1997) (denying Standard & Poor’s motion to dismiss lawsuit arising from its investment grade rating of Orange County’s bonds, which later defaulted). 50 E.g., a recent study by the US National Telecommunications and Information Administration comparing market, government and self-regulation to determine the most effective way of protecting consumer privacy ncluded, as limitations on government regulation, “the expense to the government of drafting the privacy rules, administering the rules and enforcing the rules in particular cases. . . The amount of funding can clearly be substantial”: CH1 Theory of Markets and Privacy, (visited 26 July 2000). See R. A. Posner, Economic Analysis of Law (4th edn., New York, Aspen Law and Business, 1992) 369.

The Role of Rating Agencies in Global Market Regulation 303 in their ratings.51 The reader should be cautioned, however, that generally data appear to take into account only defaults on debt that is highly rated at the time of default, and do not necessarily address the anecdotal criticism that rating agencies are too slow to downgrade issues when trouble is on the horizon.52 The reliability of these ratings is motivated by reputational costs because the ability of rating agencies to earn money is directly dependent on their reputations.53 Inaccurate ratings will impair, if not destroy, a rating agency’s reputation. This intrinsic economic rationale explains why rating agencies should want to continue to provide accurate ratings.54 Regulation, on the other hand, could impair the reliability of ratings by increasing the potential for political manipulation,55 and also by diminishing the importance of reputational costs as would occur, for example, if regulation were based on considerations other than ultimate ratings reliability. Consequently, government regulation would neither reduce costs nor improve reliability.

Would Regulation Limit the Negative Consequences of Rating Agency Actions? There are various negatives associated with rating agency actions. First there is the perception that rating agencies are not accountable because they are not officially subject to public scrutiny. This would be problematic if, as a result, rating agencies misbehaved or issued inaccurate ratings. As the foregoing discussion has shown, however, the lack of official public scrutiny does not appear to affect ratings accuracy because of the de facto accountability of rating agencies through reputation.56 A second potential negative is the conflict of interest inherent in the way that rating agencies are paid. Rating agencies are virtually always paid their fee by 51 See, e.g., W. B. Hickman, Corporate Bond Quality and Investor Experience (National Bureau of Economic Research, 1958) (finding that Moody’s Aaa-rated debt had a default rate of 10%, whereas Ba-rated debt had a default rate over 40%, during the period 1900–43). More recent rating experience may be even more reliable. See “Credit-Rating Agencies: Beyond the Second Opinion”, Economist, 30 March 1991, 80. 52 See below n. 71. To the extent of that lack of data, the conclusions in this chap. are tentative. 53 See “Credit-Rating Agencies. AAArgh!”, Economist, 6 April 1996, 80 (observing that Moody’s, “[l]ike all credit-rating agencies, . . . depends for its livelihood on its reputation among investors for objectivity and accuracy”). 54 But cf. H. E. Jackson ch. 19 below, (arguing that the use of ratings for determining capital adequacy, proposed by the Basel Committee, may place increasing pressure on rating agencies to give favourable ratings). 55 See, e.g., Memorandum from K. C. Kettering, Partner, Reed Smith Shaw & McClay LLP (now Associate Professor, New York Law School) (6 July 2000) 2 (on file with author) (arguing that “[o]ne serious drawback to government regulation . . . is the potential for political manipulation. . . . The services provided by rating agencies are . . . very largely subjective, and it is hard to see how anyone could tell whether particular ratings are biased”). 56 But compare below nn. 64–69 and accompanying text (discussing unsolicited ratings).

304 Steven L. Schwarcz the issuer of securities applying for the rating.57 This raises the possibility that the issuer will use, or the rating agency will perceive, monetary pressure to improve the rating. There nonetheless appears to be little alternative to this arrangement because there is a collective action problem in co-ordinating potential investors to pay this fee. One rarely can know in advance which investors will purchase a given issue of securities.58 In a public offering, for example, investors bid to purchase the securities only after the securities are offered for sale.59 Even if one did know which investors would purchase the offering, it could be difficult to persuade those investors to pay their pro rata portion of the rating agency fee directly.60 The issuer therefore may be the only party realistically capable of paying the rating agency’s fee in all situations. That does not, however, eliminate the potential conflict of interest. Markets are not perfect, and the fact of the issuer’s control over paying the fee might tempt it to strategically bargain for a higher rating in any event. In theory, a regulation could require investors to pay this fee, or could require an issuer to pay the fee irrespective of the rating ultimately assigned. Regulation, however, is costly, and the custom already exists that issuers are required to pay rating agency fees irrespective of the rating ultimately assigned.61 The amount of the fee is also independent of the rating.62 Coupling this with the fact that reputational costs help to ensure the objectivity and independence of the ratings decision,63 the technical conflict of interest that exists does not appear to cause any negative consequences, with only one possible exception. One rating agency, Moody’s, has been alleged to misbehave by issuing artificially low unsolicited ratings in private transactions.64 Critics argue that the conflict of interest described above motivates Moody’s behaviour. Moody’s rivals argue that agencies earn their keep by charging fees to those who issue bonds, not to the investors who use the ratings. This, they claim, can create perverse incentives. By giving borrowers a low, unsolicited rating, the big agencies may force unwilling issuers to pay for their services in the hope of getting a better one.65 57 See “Credit-Rating Agencies: Beyond the Second Opinion”, Economist, 30 March 1991, 80 (observing that “[n]ormally issuers invite, and pay, the agencies to rate their debt”). 58 See H. S. Bloomenthal and H. Roberts and Owen, Securities Law Handbook (2000 edn., 1999), § 5.01[3]. 59 Ibid. 60 Jackson observes that, in a perfect market, investors would be indirectly paying this fee through the pricing on the securities. (Interview with Howell E Jackson, Professor of Law, Harvard University, in Cambridge, England (7 July 2000).) 61 Rating agencies base their fees mainly on the size and type of the security issue. See R. Cantor and F. Packer, “The Credit Rating Industry”, Fed Reserve Bank NY Q Rev (22 June 1994) 19. 62 Ibid. 63 See above nn. 53–54 and accompanying text. 64 See “Credit-Rating Agencies. AAArgh!”, Economist, 6 April 1996, 80. This is also referred to as rating without request. 65 Ibid. “An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies”, (1993) 30 San Diego Law Review 579, 598–600; A. Schwimmer, “How Far Is Too Far?”, Investment Dealers’ Digest, 12 February 1996, 14; “Now It’s Moody’s Turn For a Review”, Business Week, 8 April 1996, 115.

The Role of Rating Agencies in Global Market Regulation 305 It is unclear, however, that unsolicited ratings actually constitute an abuse because whether they are in fact artificially low “is just suspicion”.66 Furthermore, the only court to have considered this question refused to impose liability on Moody’s.67 The court’s rationale depended on the protection afforded to public opinions by the First Amendment’s mandate that Congress shall make no law abridging freedom of speech or of the press—a protection not available outside the United States.68 On the other hand, there is concern that an unsolicited rating may be based on incomplete information about the issuer.69 Even if unsolicited rating does constitute an abuse, its scope is limited. It therefore may not justify implementation of a broad regulatory scheme. Instead, targeted remedies, such as requiring disclosure of the fact that a rating is unsolicited, appears to be more appropriate. The final negative is that the rating agency system, as presently constituted, can create an inherent gatekeeping bias toward debt market conservatism.70 This is particularly pronounced in the developing area of securitisation, where the securities being rated arise out of complex and innovative transaction patterns. Securitisation is “by far the most rapidly growing segment of the US credit markets”,71 and its “use is rapidly expanding worldwide”.72 In a typical transaction, a company, usually called the “originator”, transfers rights to payment from income-producing assets such as accounts receivable, loans or lease rentals (collectively, “receivables”), or frequently undivided interests in such rights,73 to a special purpose vehicle, or “SPV”. The SPV, in turn, issues securities to capital market investors.74 The term capital markets refers to any market where debt, equity or other securities are or may be traded.75 Actual capital markets can be formal or informal. Next, the SPV uses the proceeds of the issue to pay for the receivables. The investors, who are repaid from collections of the receivables, buy the securities based on their assessments of the value of the receivables.76 66

“The Use and Abuse of Reputation”, n. 1 above, 18. Jefferson County Sch. Dist. v. Moody’s Investor’s Services, Inc, 988 F Supp. 1341 (D Col 1997), aff’d 175 F3d 848 (10th Cir 1999). 68 For a discussion of these First Amendment issues, see “An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies”, n. 65 above, 616–19. 69 See Cantor and Packer, n. 61 above (observing that issuers want the rating agencies to have complete information to ensure the most accurate and favorable rating possible). 70 See n. 40 above and accompanying text. One commentator has argued, however, that another negative is that rating agencies are “too slow to downgrade a rating”. “An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies”, n. 65 above, 585. His evidence for this, however, is limited to three ambiguous anecdotal examples during an almost 20-year period. See ibid. 585–8. 71 L. M. LoPucki, “The Death of Liability” (1996) 106 Yale L J 1, 24. 72 S. L. Schwarcz, “The Alchemy of Asset Securitisation” (1994) 1 Stan J L Bus. and Fin. 133. 73 J. H. P. Kravitt (ed.), Securitisation of Financial Assets (2nd edn., 1999 and 2000–1 Supplement) § 3.09, 3-52–3-53 (articulating the advantages of the undivided interest structure). 74 See J. Downes and J. Goodman, Dictionary of Finance and Investment Terms (3rd edn., 1991) 59 (definition of capital markets). 75 See ibid. 76 S. L. Schwarcz, “The Inherent Irrationality of Judgment Proofing” (1999) 52 Stan. L Rev. 1, 6 and 6 n 21 (citing basic sources on securitisation). 67

306 Steven L. Schwarcz The most critical analysis in a securitisation is whether the SPV and its investors will continue to be repaid in the event of the originator’s bankruptcy.77 If the SPV has ownership of the receivables, the SPV and its investors will continue to be repaid; if not, their right to be repaid will be suspended and subject to possible impairment.78 The SPV will gain ownership of the receivables only if the transfer of those receivables from the originator to the SPV constitutes a sale under applicable bankruptcy law.79 This is usually referred to as a “true sale”. The inherent gatekeeping bias toward market conservatism arises largely out of conservative rating agency views on what constitutes a true sale. For example, irrespective of the legal criteria governing a true sale,80 some rating agencies are concerned that an SPV that purports to purchase only an undivided interest in, as opposed to whole, receivables may be unable to gain ownership of the interest purchased.81 This makes it more difficult to maximise the statistical diversification of the receivables sold to the SPV, and increases the transaction costs of making purchases.82 The same conservatism also makes rating agencies reluctant to rate innovative new securitisation structures, even where the innovation promises to increase efficiency and reduce transaction costs.83 Without a rating, however, an SPV will be unable to issue its securities.84 Although this bias may be problematic, it is hard to see how government regulation could reduce it. To the contrary, one might argue that the very form of government regulation that presently exists in major financial-centrenations—the NRSRO designation—increases this conservative bias by restricting the number of NRSRO-designated rating agencies, therefore discouraging competition and particularly discouraging the ability of new agencies, which are not nationally recognised, to start up. Another regulatory approach might be to require greater transparency of the criteria that rating agencies apply in assigning their credit ratings, but this would be redundant. Issuers already are able to discuss these criteria with rating agency analysts, and the major rating agencies already publish these criteria on their websites.85 Rating agencies that have 77

Schwarcz, n. 72 above, 151. S. L. Schwarcz, Structured Finance, A Guide to the Principles of Asset Securitisation (2nd edn., 1993) 29–39. Thus, in cases where the SPV owns the receivables, the investment decisions often can be made without concern for the originator’s financial condition. See Schwarcz, n. 76 above, 6. 79 Schwarcz, n. 72 above, 135. 80 For a discussion of those criteria, see Schwarcz, n. 78 above, 28–35. 81 Interview with Eric P. Marcus, Partner and Chair, Structured Finance and Asset-Based Transactions, Kaye, Scholer, Fierman, Hays & Handler, in New York, (8 May 2000). 82 Kravitt (ed.), n. 73 above, 3–13 (noting that the advantage of the undivided interest structure when securitising pools of medium term receivables is “that one may avoid the transaction costs associated with numerous separate purchases”). 83 See, e.g., Schwarcz n. 72 above, 145 n 42 and 152 (discussing as an example, that rating agencies are uncomfortable rating the divisible interest structure described therein, absent “case law directly on point”). 84 The SPV might, however, be able to issue securities in limited private placements: ibid., 145 n 42. 85 See Standard and Poor’s, n. 33 above (setting forth Standard & Poor’s ratings criteria); Rating Methodologies (visited 27 July 2000) (setting forth Moody’s ratings criteria). See also H. G. Sherwood, How Corporate and Municipal Debt is Rated: An Inside Look at Standard & Poor’s Rating System (1976). 78

The Role of Rating Agencies in Global Market Regulation 307 fewer competitive pressures will have less motivation to be innovative.86 If anything, this suggests that government should consider balancing the need for a rigorous standard for NRSRO designation against the need to ensure that a sufficient number of rating agencies receive NRSRO designation to assure competition. In this context, one must ask whether the NRSRO-designation approach is itself appropriate.

Is the NRSRO-designation Approach Appropriate? Answering this question is a bit circular. So long as the application of government laws turns on ratings, there can be little doubt that some form of regulatory approval of rating agencies is needed. Whether the application of laws should turn on a rating is beyond the scope of this chapter. Nonetheless, I wish to make several observations on the appropriateness of NRSRO designation. NRSRO designation is an unusual conceptual approach to securities law, the context in which its consequences are felt.87 In the USA, for example, the historical debate regarding enactment of securities laws focused on whether such laws should provide for full disclosure or, instead, on merit analysis. State “blue sky” laws provided for the latter.88 Unlike these state laws, however, the consensus was that US federal securities laws should not “establish a system of merit regulation”.89 The rationale was that “investors’ ability to make their own evaluations of available investments [through the federal regulatory framework of full disclosure] obviates any need that some observers may perceive for the more costly and time-consuming governmental merit analysis of the securities being offered”.90 NRSRO designation, however, is an indirect form of merit regulation of securities: the designation itself, which is based on a merit analysis of rating agencies, controls whether or not securities laws exemptions are available. I nonetheless believe that this form of merit analysis may be superior to full disclosure, for two reasons. First, the historical rationale for full disclosure— that investors’ ability to make their own evaluations of available investments obviates the need for costly and time-consuming merit analysis91—is not always applicable. In the case of evolving and complex debt structures, for example, the 86 Posner, n. 50 above, § 9.3 at 280 (arguing that competition may be an incentive to innovation); F. M. Scherer and D. Ross, Industrial Market Structure and Economic Performance (3rd edn., Boston, Mass, Houghton Mifflin, 1990) chaps. 15–16. See also “Credit-Rating Agencies: Beyond the Second Opinion”, Economist, 30 March 1991, 80 (recounting investor perception that Moody’s and Standard & Poor’s “both have improved their services since they started to face serious competition”). 87 Recall that such a designation is the basis for various securities laws exceptions. See above nn. 9–17 and accompanying text. 88 T. L. Hazen, The Law of Securities Regulation (3rd edn., St. Paul, Minn., West, 1996) 9. 89 Ibid. 90 Ibid. 91 See n. 36 above and accompanying text.

308 Steven L. Schwarcz cost of each investor individually evaluating his or her investment would be excessive. Rating agency evaluation, in contrast, provides an economy of scale.92 Furthermore, at least as presently done, the minimal merit analysis needed for NRSRO designation is neither costly nor time-consuming.93 The second reason is that ratings sometimes are viewed as a de facto substitute for full disclosure because investor reliance on ratings reduces reliance on disclosed information.94 Accordingly, NRSRO designation as a form of merit analysis may well be appropriate. This conclusion is supported by commercial law theory. In contrast to the traditional approach of the past century, referred to as transactional regulation, in which “public agencies have assumed responsibility for the oversight and direct regulation of the conduct of . . . private parties”,96 a system of commercial law only should require the state to establish the “minimal structure necessary to create private institutions that will then operate under market incentives” to allocate public resources97—an approach known as organisational regulation.98 The rationale for favouring organisational over transactional regulation is that actual experience shows that the former produces “rules that are optimal in light of the costs of the rules”,99 whereas the latter “does a particularly poor job of achieving optimal legal complexity”.100 This is because organisational regulation is able to rely on simple commitment mechanisms, such as reputation,101 but transactional regulation, as a matter of principle and to protect the legitimacy of the state, largely ignores the costs of procedures and treats as absolute the value of the rights at stake.102 In a 92

See n. 45 above and accompanying text. Rhodes, n. 5 above, 323. But compare “An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies”, n. 65 above, 611–14, which in a US context argues that the SEC should be given explicit statutory authority to establish formal standards for NRSRO designation, require NRSROs to register with the SEC, and promulgate rules governing NRSROs. At some point, however, increased formalisation and registration may increase costs beyond the level that justifies merit regulation. 94 But cf., Revisions to Rules Regulating Money Market Funds, Investment Company Act of 1940, Release Nos 33–6882; IC-18005, 56 Fed. Re. 8113 (27 February 1991) (indicating that investors should not use ratings as a substitute for making informed judgements based on disclosure); Peacock, A Review of Municipal Securities and Their Status Under the Law (1976) 2037, 2040 n 22 (arguing that due to the lack of information available to investors, “ratings have doubtless played too important a role in investors’ decision making process”). 96 G. Hadfield, “Privatizing Commercial Law: Lessons from the Middle and the Digital Ages” (March 2000) (unpublished manuscript, on file with author; also available at ). Hadfield argues that this “traditional” approach is really stuck in the 19th century: “our historical perspective on the law is too modern [and thus] seems ‘necessary’ because we do not remember that it was not always as it is now”: ibid., 10. 97 Ibid., 25–6. This structure is intended to create “the conditions favorable to the development of efficient private governance regimes for commercial entities, much as the role of the state is to structure the conditions favorable to the development of efficient private mechanisms—i.e., markets—for the production and distribution of goods and services”: ibid., 36. 98 Ibid., 26. 99 Ibid., 40–1 (discussing the experience of private legal regimes in trade associations). 100 Ibid., 38. 101 Ibid., 49. 102 Ibid., 41. 93

The Role of Rating Agencies in Global Market Regulation 309 commercial context, where democratic principles of justice are not at issue, organisational regulation should be sufficient.103 Applying this theory, the NRSRO designation is a minimal structure that allows private institutions—the rating agencies—to operate under market incentives to allocate public resources. Furthermore, the designation has been shown to rely on the simple commitment mechanism of reputation.104 NRSRO designation therefore appears to fit within the parameters of the type of regulation that should be appropriate.

MULTINATIONAL CONSIDERATIONS

This chapter’s analysis has thus far indicated that additional regulation of rating agencies is unnecessary. This view is reinforced by the fact that rating agencies are multinational entities whose assets are human capital. As such, a rating agency that is subject to excessive regulation would be more likely than an ordinary multinational company to relocate to a foreign country that does not impose such regulation. This in turn could lead to a race to the bottom.105 A possible solution to this dilemma is to impose regulation on a global scale.106 However international regulation of rating agencies, like any other form of global regulation, would be inherently costly in our “primitive” system of international law.107 International regulation of rating agencies thus would be costly as well as, this chapter has shown, arguably unnecessary. In this global context, however, one must reconsider the NRSRO designation. The limitation of the designation is that it is national, not international. Inconsistent designations among countries therefore could be seen to create confusion for cross-border financings, which are increasingly common, and also could create the potential for inconsistent application of bank capital adequacy standards.108 One therefore may ask whether there should be a globally recognised statistical rating organisation (perhaps called GRSRO) designation. 103

Ibid., 59. See above nn. 53–54 and accompanying text. 105 The so-called “Delawarization”. 106 Compare Eatwell and Taylor, n. 43 above, 208–39 (arguing for the creation of a “World Financial Authority” to solve the dilemma that “financial markets know no borders. Yet regulatory power remains trapped within increasingly irrelevant national borders”). 107 T. Buergenthal and H. G. Maier, Public International Law (2nd edn, 1990) 19 (“[v]iewed in terms of law-making, international law is a primitive legal system”). 108 See e.g Standard & Poor’s Official Response to the Basel Committee’s Proposal (December 1999). (cautioning that “international comparability” of ratings needs to be assured so that “all users understand what different agencies’ ratings imply for risk weightings”). The Basel Committee itself notes that, because its approach places “increased reliance by [bank] supervisors on external credit assessment institutions, . . . it is therefore important that criteria for recognising these institutions [recognition being done by each national bank supervisory authority] be set at an appropriately high standard”: A New Capital Adequacy Framework, 33 (and, at 34, setting forth minimum criteria for such recognition). 104

310 Steven L. Schwarcz I do not believe that global designation is necessary, or that inconsistent NRSRO designations are likely to give rise to confusion.109 In a given transaction, the only relevant NRSRO designation would be that of the country where the applicable securities were issued.110 Thus, in a cross-border securitisation transaction where, for example, a company in state X sells receivables to an SPV in state Y which in turn obtains financing by issuing securities through an SPV in state Z, only state Z’s NRSRO designation would be relevant. There is little room for confusion. Establishing GRSRO designation procedures, on the other hand, could be costly because of the political manœuvring needed to achieve international consensus, as well as the need to harmonise national securities laws that presently rely on NRSRO designation with the new designation procedure. A single GRSRO designation also might exacerbate the anticompetitive effect of national designation by diminishing the ability of local rating agencies to germinate and grow.111

CONCLUSIONS

Unless new abuses arise in the future, rating agencies should remain largely unregulated. Reliance by government on unregulated private sector entities to monitor risk is not unknown and, in the case of rating agencies, appears to be beneficial. There is also nothing to suggest, after taking into account regulatory costs, that additional regulation of rating agencies would enhance their role in international market regulation.

109 Even the Basel capital adequacy proposal contemplates country-by-country NRSRO designation. See A New Capital Adequacy Framework. 110 See Schwarcz, n. 2 above, 237–38 (discussing that one must consider the local regulatory restrictions of countries in which securities are issued). 111 Cf. above nn. 85–86 and accompanying text (discussing the anti-competitive effect of NRSRO designation). One might argue that a single global standard might help international investors, but markets already are able to judge the quality of rating agencies—indeed, market perception is the primary basis to date of NRSRO determination. See Rhodes, n. 5 above, 323.

19

The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy HOWELL E. JACKSON

AM DELIGHTED TO have this opportunity to comment upon Steven Schwarcz’s illuminating chapter on the role of credit rating agencies.1 As I find myself largely in agreement with the analytical framework his chapter proposes, my comments will focus on extending his analysis to additional issues that arise when governmental bodies incorporate the views of private credit rating agencies into supervisory procedures. This regulatory incorporation of the work of rating agencies has become commonplace in the United States over the past few decades and, as Schwarcz indicates, the Basel Committee on Banking Supervision (Basel Committee ) recently proposed to include analogous procedures in the Committee’s revised capital adequacy standards.2 Regulatory incorporation of private credit rating presents new and difficult questions of public policy, as well as complicating the question whether these rating agencies should be the subject of more extensive regulatory supervision. The Basel Committee’s recent proposal offers an excellent example of these complexities and my comments will focus on this recent exampler of regulatory incorporation of the work of private rating agencies. The Basel Committee’s proposed reliance on credit rating agencies also illustrates the difficulty of setting global regulatory standards that are supposed to be implemented in a variety of countries at differing stages of economic development.

I

1

S. L. Schwarcz ch. 18, above. Basel Committee on Banking Supervision, A New Capital Adequacy Framework (Consultative Paper, June 1999) . After this chapter was prepared, the Basel Committee published a revised accord. See Basel Committee on Banking Supervision, Overview of The New Basel Capital Accord (Consultative Doc. Jan 2001) . 2

312 Howell E. Jackson

BACKGROUND ON REGULATORY INCORPORATION OF CREDIT RATING AGENCIES

As Schwarcz’s chapter explains, the traditional role of credit ratings has been to assist investors in evaluating the debt securities of particular corporations. While the issuer typically pays its agency’s fee, the ratings are designed to help investors assess the issuer’s creditworthiness. To preserve the value of their ratings in this market, credit agencies need to maintain a good reputation for accurate ratings, and the desire of the agencies to maintain their reputations enhances the credibility of ratings. As Schwarcz suggests, this alignment of interests is what makes the market work in this area. The trilateral relationship among issuers, rating agencies, and investors is illustrated in Figure 19.1.

Credit Rating Agency

“Credit Rating: AA” Investors Debt

Corporate Issuer

Fig. 19.1. Traditional role of rating agencies Recognising the unique capacity of private credit rating agencies to evaluate the creditworthiness of a broad range of issuers, regulatory agencies in the United States have made increasing use of ratings in supervisory settings.3 A Basel Committee working group recently issued a working paper which surveys regulatory incorporation of rating agencies in a broader range of jurisdictions. According to this study, the United States makes the greatest use of regulatory incorporation, but a number of other jurisdictions have recently followed suit, prompted by the Basel Committee’s market risk amendment to the original 3 For a more complete discussion of the ways in which US regulatory agencies have incorporated private credit agencies, see F. Partnoy, “The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies” (1999) 77 Wash. U L Q 619; A. K. Rhodes, “The Role of the SEC in the Regulation of Rating Agencies: Well-Placed Reliance or Free-Market Interference?” (1996) 20 Seton Hall Legis. J 293. See Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of Credit Quality Information (August 2000) 42–43, 54 (Working Paper No. 3) (hereinafter cited as “Credit Ratings Working Paper”).

The Role of Credit Rating Agencies 313 Basle Accord. In this comment, I refer to these uses collectively as regulatory incorporation of rating agencies, but I also distinguish among several different kinds of regulatory incorporation. One use entails the definition of jurisdictional boundaries. When Schwarcz refers to SEC Rule 3a-7 under the Investment Company Act of 1940,4 he is citing an example of this sort of regulatory incorporation. In the United States, when a corporation invests in a pool of securities, the corporation is presumptively subject to regulation under the Investment Company Act of 1940, a legal regime designed to protect investors from various sorts of investment fraud.5 In the 1980s, this jurisdictional structure created problems for the emerging market for securitised assets. Eventually, the SEC created an exemption from the 1940 Act for pools of securitised assets with an adequate rating from an accredited rating agency.6 The logic of this exemption was that, if the pool received a good enough credit rating, then the investor protections of the 1940 Act would be superfluous. In this context, an adequate credit rating has become the path to exemption from supervision.7 Another common context for regulatory incorporation of rating agencies is where supervisory standards impose restrictions on the structure of the balance sheet of a regulated entity, such as a bank or insurance company or securities firm. Sometimes the authority of a related entity to hold a certain type of investment will depend on whether or not the investment has received a rating from a private rating agency; at other times the amount that the firm is permitted to invest in a particular security will rise or fall depending on whether or not the security is rated. A good example of this approach can be found in the SEC rules governing money market mutual funds. Under rule 2a-7 under the 1940 Act,8 the authority of money market mutual funds to invest in a corporation’s debt securities depends on the number of firms that have rated the securities and the quality of the ratings. Rather than developing its own standard for appropriate investments, the SEC piggybacks on the pre-existing work of rating agencies.9 Another context in which private credit rating agencies participate in regulatory standards is in the area of capital requirements. Often, the amount of capital a regulated entity is required to maintain depends on the volume of the entity’s assets—for example, in a simple regime, eight dollars of capital might 4

17 CFR § 270.3a-7 (2000), discussed in S. Schwarcz, 298. 15 U S C §§ 80a-1 to 80a-64 (2000). For an overview of this regulatory structure and a discussion of the definition of investment company under the 1940 Act, see H. E. Jackson and E. S. Symons, The Regulation of Financial Institutions (Minneapolis, Minn., West Publications, 1999) 811–50. 6 See SEC Final Rule on Exclusion from the Definition of Investment Company for Structured Finance, 57 Fed Reg 56,248–01 (Nov. 27, 1992) (“[r]ating agency evaluations tend to address most of the [1940] Act’s concerns regarding abusive practices, such as self-dealing and overreaching by insiders, misvaluation of assets, and inadequate asset coverage”). 7 In a similar spirit are rules that liberalised the disclosure obligations of investment-grade bonds. See SEC Form S-3 under the Securities Act of 1933. 8 17 CFR § 270.2a-7 (2000). 9 See also 12 CFR § 704.6 (2000) (using similar technique to determine authority of corporate credit unions to invest in debt). 5

314 Howell E. Jackson be required for every 100 dollars of assets. More complex capital requirements vary the amount of capital required for various types of assets, and one way US regulators have distinguished among assets is to permit lower capital reserves for assets that have higher credit ratings.10 Again the logic underlying these distinctions is that higher credit ratings imply that the assets are less risky than other, unrated or lower-rated assets.

RATING AGENCIES UNDER THE BASEL COMMITTEE PROPOSALS OF JUNE

1999

The Basel Committee proposals of June 1999 are an example of regulatory incorporation of rating agencies into the development of capital standards.11 Under the original Basel rules—developed in the 1980s—all commercial loans were subject to the same capital requirement of 8 per cent. Under the Committee’s recent proposal, the amount of capital required for commercial loans would vary between 4 per cent and 12 per cent depending on the credit rating of the issuer. Loans to issuers with high ratings—either AAA or AA in the S&P system—would be subject to only 4 per cent capital ratings.12 Loans to issuers with the next tier of ratings—A+ to B- in the S&P system—would retain the current capital requirement of 8 per cent. Loans to issuers with lower ratings would be subject to 12 per cent capital requirements. Loans to borrowers without credit ratings would remain subject to the current 8 per cent capital rules. (The Basel Committee’s current and proposed capital requirements for commercial loans are summarised in Figure 19.2.) Issuer AAA to AA A+ to BBelow BUnrated

Current 8% 8% 8% 8%

Proposed 1.6% 8% 12% 8%

Fig. 19.2. Basel Committee’s current and proposed capital requirement for commercial loans The Basel Committee’s proposed reliance on private credit ratings has an intuitive appeal. To begin with, the Committee’s original approach to commercial loans was undeniably crude. While the original Basel proposals made distinctions between other categories of assets (for example, sovereign debt and bank credits), all commercial loans had the same risk weightings and that 10

See, e.g., 17 CFR § 240.15c3–1 (2000) (net capital rules for SEC-registered broker-dealers). In this comment, I limit my remarks to the aspects of the Committee’s proposal dealing with corporate borrowers. The proposal has analogous recommendations for sovereign debt and bank credits. 12 Throughout this comment, I will refer to the S&P rating system for illustrative purposes. As Schwarcz explains in his chapter, other agencies have different but analogous nomenclature. See S. L. Schwarcz, 299–300. 11

The Role of Credit Rating Agencies 315 meant that bank loans to blue chip companies such as IBM and Microsoft were subject to the same capital requirements as loans to the most risky start-up enterprises, even though the credits clearly exposed lenders to substantially different amounts of risk. The Basel Committee’s proposed incorporation of private ratings into capital adequacy calculations attempts to redress this flaw in the original proposal.

CRITICISMS

Despite the appeal of the Committee’s proposed use of private credit ratings, the proposal has been subject to a series of criticisms, ranging from technical critiques to fundamental challenges.13 On the technical side, various economists have questioned whether the Basel Committee has properly incorporated private credit ratings into its proposal. For one thing, critics have argued that the Committee’s proposal lumps too many different kinds of companies into the same category and that the Committee should have provided for more than three groupings of borrowers to reflect the true range of credit quality across borrowers. In addition, commentators have suggested that the Basel Committee proposals do not reduce capital enough for good credit risks or impose adequate penalties on poor credit risks. The variation in capital requirements that the Basel Committee has proposed, according to this line of argument, should be greater than the 4 per cent to 12 per cent suggested in the Committee’s June 1999 proposal. These technical critiques accept the proposal’s basic approach—to vary capital requirements to reflect the credit rating of individual borrowers—but propound various revisions better to reflect a more accurate presentation of differences in the credit quality of various borrowers. For example, in a January 2000 paper, Sanders and Altman performed a variety of econometric analyses of the past performance of issuers with various kinds of credit ratings and made a series of estimates of more appropriate classifications and capital requirements.14 Figure 19.3 illustrates the kinds of results they generated for a four-tier classifications system (as opposed to the three-tier system in the Committee’s June 1999 proposal). Figure 19.3, which reports only one of several different approaches presented in the Altman and Saunders paper, suggests that the very best borrowers (those with AAA or AA under the S&P system) should have capital requirements of only 1.4 per cent, whereas borrowers with the lowest credit ratings (those ranked B- and below) should have capital requirements of roughly 13 For a multi-faceted critique of the Basel proposal, including a collection of authorities critical of the use Committee’s proposed use of private credit rating agencies, see US Shadow Financial Regulatory Committee, A Proposal for Reforming Bank Capital Regulation, (Statement No 160, 2 March 2000) . 14 See E. I. Altman and A. Sanders, “An Analysis and Critique of the BIS Proposal on Capital Adequacy and Ratings” (January 2000) .

316 Howell E. Jackson Issuer (under S&P under standards) AAA to AA A to BBB BB to B Below BUnrated

Current

Proposed

8% 8% 8% 8% 8%

1.6% 8% 8% 12% 8%

‘Appropriate’ Capital Requirements 1.4% 2.3% 7.1% 17.0% n.a.

Fig. 19.3. Alternative capital requirements based on private credit ratings from Altman & Saunders (January 2000)

17 per cent.15 Thus, whereas the Basel Committee allowed for only a threefold variation in capital requirements (from 4 per cent to 12 per cent), the implication of Figure 19.3 is that more than a tenfold differential would be appropriate. The Saunders and Altman data also suggest that there are substantial differences in the appropriate capital charges for borrowers in the A to BBB and those in the B to BB category, even though the Basel Committee’s proposal would have lumped all of these borrowers into a single category. Whereas the Basel Committee would have imposed an 8 per cent capital requirement on all of these borrowers, the Saunders and Altman analysis would suggest a substantial difference in the capital requirement for higher rated borrowers in this group (2.3 per cent) as compared with lower-rated borrowers (7.1 per cent). Preliminary pronouncements of officials close to the Basel Committee suggest that the Committee is cognizant of these technical critiques of its June 1999 proposal and will likely produce an amended proposal allowing for greater distinctions among categories of borrowers and perhaps even more variation in the capital requirements required for different kinds of loans.16 The Committee may even allow for distinctions based on the internal rating systems of individual banks.17 The Committee will, however, be hard pressed to address more fundamental criticisms of this aspect of its June 1999 proposal and still maintain any reliance on private credit rating agencies. In ascending order of severity, these criticisms concern the proposal’s distinction between rated and unrated 15 See E. I. Altman and A. Sanders, “An Analysis and Critique of the BIS Proposal on Capital Adequacy and Ratings” (January 2000) , 12. 16 See Update on the Major Initiative to Review the 1988 Capital Accord, Speech by William J. McDonough, President, Federal Reserve Bank of New York, before the 4th Annual Supervision Conference of the British Bankers Association (19 June 2000) (suggesting that the Committee may revise its proposal to add more risk classifications). Subsequently, the Basel Committee did adopt a revised proposal which included more variation of capital requirements. See Overview of the New Basel Capital Accord, n. 1 above. 17 For a report on this topic, see Basel Committee on Banking Supervision, Range of Practice in Banks’ Internal Rating Systems (January 2000) .

The Role of Credit Rating Agencies 317 borrowers; the manner in which the proposal would operate in times of economic down-turn; and the proposal’s failure to measure overall-portfolio risk. One fairly obvious anomaly of the Basel Committee’s proposal is the fact that it imposes a lower capital requirement on loans to unrated borrowers (8 per cent) than it does on borrowers with low credit ratings (12 per cent for issuers with ratings of B- and lower under S&P standards). While there may be particular instances in which this distinction is appropriate, commentators have questioned whether the distinction is generally justified.18 If not, it imposes an unwarranted capital penalty on loans to borrowers with lower ratings, in effect steering credit towards unrated borrowers. (Conversely there may be some low-risk unrated borrowers that should be subject to a capital requirement lower than 8 per cent.) This problem surrounding the distinction between rated and unrated borrowers may be an inevitable by-product of factoring credit ratings into capital requirements when not all credit risks are rated.19 And thus there is no obvious way for the Basel Committee’s proposal to be amended to address this concern. A separate concern about the Basel Committee’s proposal reflects an unease with the premise that information provided by private credit rating agencies will actually assist supervisory authorities in setting capital standards. One version of this concern derives from observations that credit rating agencies tend to raise the credit rating of borrowers in economic boom times and lower the credit ratings in times of economic difficulty.20 While this practice may accurately reflect default risk to investors—and thus be a sensible practice in the context of the traditional role of credit rating agencies—it has a potentially perverse effect if incorporated into government-imposed capital requirements. It allows banks to lower their capital reserves in economic expansion, but requires an increase in capital requirements in economic downturns. This is precisely the opposite of what financial economists suggest to be the optimal approach for capital standards. This problem is one of the consequences of grafting a market mechanism into a regulatory standard that the mechanism was not initially designed to serve. An additional and deeper problem with the Basel Committee’s reliance on rating agencies is the fact that the proposal builds on the original and simplistic approach that the Committee’s earlier standards established for setting capital requirements for credit risks. The approach entails establishing capital standards for each category of asset held by a particular institution and then adding the individual requirements together to arrive at a total capital requirement for the institution. As numerous commentators have recognised, this additive approach to capital requirements ignores the fact that the risks of individual assets may be correlated with other assets in a firm’s portfolio in different ways.21 A bank with all its loans committed to the highly-rated firms in the oil 18

See, e.g., Shadow Committee Comment, n. 13 above, 12. Indeed, critics have interpreted the current proposal as an effort on the part of the Basel Committee to enlist the support of countries where few commercial issuers are rated: ibid. 20 See Altman and Saunders, n. 14 above, 6–8. 21 See, e.g., Shadow Committee Comment, n. 13 above, 12. 19

318 Howell E. Jackson and gas industry is exposed to more risk that a firm with loans extended to a diversity of highly-rated borrowers; yet the Basel Committee proposal—being sensitive only to the credit rating of individual borrowers—would impose the same capital requirement on both institutions. By incorporating the credit rating of individual institutions, the Basel Committee would add precision to the capital charges for certain kinds of credit risk, but it would do nothing to measure inter-relationships among risks across an institution’s total portfolio. A number of critics have faulted the Basel Committee’s reliance on credit rating agencies because this approach holds little promise of providing an accurate measure of an institution’s overall risk.

ALTERNATIVE APPROACHES TO SETTING CAPITAL REQUIREMENTS FOR CREDIT RISKS

While the criticisms of the Basel Committee’s 1999 proposal are substantial, the problem confronting regulatory authorities such as the Basel Committee and national supervisory units is that there is no obviously superior approach currently available. So perhaps the best way to evaluate the Committee’s proposal is to compare it with other alternative approaches to the problem of setting capital standards for loans and other credit risks borne by commercial banks and other financial institutions.22 As summarised in Figure 19.4, there are three basic approaches to setting capital standards for credit risks currently under active consideration by regulatory authorities. The Basel proposal is illustrative of the first and most traditional approach—setting capital requirements based on the volume of an individual institution’s assets (and associated credit risks). Before the Basel Accord of 1988, national authorities typically relied on simple leverage requirements, such as 6 per cent capital reserves for all assets. In 1988, the Basel Committee improved on this simplistic approach by, among other things, establishing risk-based capital requirements that crudely distinguished among a rank of credit risks.23 Although all commercial loans had the same risk rating, distinctions were made among cash reserves, credits to other banking institutions, sovereign credits and a few other general categories. The 1999 proposals constitute an extension of this effort by further classifying the commercial credits of lending institutions into three different categories (or perhaps four or more if the analysis of Altman and Saunders is followed).

22 To assist in future comparative evaluations of the efficacy of regulatory incorporation of rating agencies, the Basel Committee’s working group has collected extensive empirical evidence about the past performance of credit ratings and also comparable information about complementary sources of credit information. See Credit Rating Working Paper, n. 4 above, 55–180. 23 The Basel Committee subsequently added components to reflect market risk and interest rate risk.

The Role of Credit Rating Agencies 319 I. Requirements based on Volume of Bank Loans —Simple Leverage Requirements (pre-1988 regimes) —Crude Risk-Based (1988 Basel Accord) —Risk-Based Measures with Ratings (1999 Basel Proposal) II. Requirements Based on Portfolio Models —Standard Models —Internal Models III. Market Discipline Models —Subordinated Debt Proposals Fig. 19.4. Alternatives approaches to setting capital requirements for credit risks Within this progression of gradual improvement in asset-based capital requirements, the June 1999 proposals seem a sensible refinement. While vulnerable to the technical criticisms outlined above, the 1999 proposals are probably best understood as a continuation of the incremental improvements of asset-based requirements that has been under way for the past two decades. While there are various ways in which the proposals might be tweaked—to increase the number of classifications or adjust the capital requirements for various categories—there are limits to how far these enhancements can go. In particular, as outlined above, revisions of the 1999 approach are unlikely to address the more fundamental criticisms that have been levelled at the proposals. To address these deeper concerns, one must seek alternative approaches to capital setting standards. And, indeed, there is afoot a movement towards new capital standards based on overall portfolio risks. Already in the area of market risks—that is risks on assets held in trading accounts—regulators have developed various portfolio approaches to the establishment of capital requirements.24 And, in its 1999 proposal, the Basel Committee intimated that a similar approach might eventually be developed for credit risks, thus providing an alternative to the additive asset-based approach upon which the Committee has hitherto relied for dealing with credit risks. Unfortunately, the development of capital standards based on portfolio models is extraordinarily complex. It relies on detailed analyses of the correlations in performance of many different types of assets. In some areas, historical data can provide the basis of such analyses; but often—particularly for new types of credits—such historical information is not available. In addition, it is possible that the appropriate way to measure credit risk will vary from institution to institution. To date, regulatory authorities have relied upon two different approaches to portfolio models: standard models which can be used by a wide range of institutions and internal models, which depend on individual models 24 See Basel Committee on Banking Supervision, Amendment to the Capital Accord to Incorporate Market Risks (January 1996, as amended in September 1997) .

320 Howell E. Jackson developed for individual institutions (subject to general standards and review by regulatory authorities). In the area of credit risks, capital standards based on portfolio models are in an early stage of development. Experts differ on how soon practical applications of these models will be possible.25 Whether it will be possible to develop standard models that generate more appropriate capital requirements for a wide range of institutions than the Basel proposal of 1999 would provide is open to debate. Reliance on internal models of larger and more sophisticated financial intermediaries appears to offer more promise in the near term. This approach, however, raises the difficult question of how much regulatory authorities should delegate the establishment of capital standards to bank management.26 After all, the reason we regulate bank capital requirements in the first place is the belief that left to their own devices banks will maintain less capital than is socially desirable.27 Thus, the more fundamental criticisms of the Basel Committee’s 1999 proposal must be balanced against problems that might arise if regulatory authorities were to move to a more theoretically pleasing, portfolio based model for setting capital standards.28 A final approach to setting capital requirements is to rely more on market mechanisms and less on formulaic capital requirements. Illustrative of this technique are proposals to require commercial banks to issue publicly traded subordinated debt on a periodic basis.29 Like any other form of capital, this subordinated debt would insulate depositors and deposit insurance funds from losses, but regulatory authorities could also use the market values of a bank’s subordinated debt to obtain an independent assessment of the solvency of the bank. Under this approach, regulators would monitor fluctuations in the market valuation of subordinated debt and—in the event of sudden downturns in value—take appropriate supervisory action with respect to the issuing 25 In connection with its capital reform proposals, the Basel Committee solicited comments on credit risk modelling. See Basel Committee on Banking Supervision, Summary of Responses Received on the Report “Credit Risk Modeling: Current Practices and Applications” (May 2000). . See also Shadow Committee Comment, n. 13 above, 12 (expressing skepticism as to the reliability of existing credit risk models). 26 Cf. European Shadow Financial Regulatory Committee, Internal Ratings Capital Standards and Subordinated Debt, (Statement No 7, February 2000) (“[S]ince banks face a degree of protection, they have the incentive to take excessive risk and, therefore, to manipulate the ratings used to allocate capital”). 27 As discussed above, it is possible that the final Basel Committee proposal will allow at least some banks to use internal rating systems for capital measures. See Speech by William J. McDonough, n. 16 above. See also Overview of the New Basel Capital Accord, n. 1 above (proposing greater reliance on internal models). Such an approach falls short of full-blown credit modelling, because the capital requirements are not based on overall portfolio risk. It does, however, allow for more tailored capital requirements based on individualised models. 28 To be fair, internal models typically must comply with regulatory standards and are also subject to periodic back testing. Notwithstanding these safeguards, internal standards increase the ability of individual institutions to influence their own capital standards. 29 See, e.g., Shadow Committee Comment, n. 13 above, 16–17. See also M. E. Van Der Weide and S. M. Kini, “Subordinated Debt: A Capital Markets Approach to Bank Regulation”, (2000) 41 B C L Rev. 195; R. Dhumale, ch. 5, above.

The Role of Credit Rating Agencies 321 bank.30 Subordinated debt proposals of this sort have been under consideration in the United States for a number of years, and Congress recently authorised a full scale study of the technique. In academic circles, there is considerable support for the approach, and one group of commentators recently proposed that the Basel Committee drop its proposal with regard to private rating agencies and recommended instead a subordinated debt requirement as part of its next version of bank capital adequacy standards.31 This is not the place for a full discussion of the merits (and potential problems) of subordinated debt proposals. What is important to recognise here is that this reliance on market discipline offers another alternative to setting capital standards. It finesses the shortcomings of requirements tied solely to bank assets and the complexities of portfolio models by harnessing market forces for regulatory purposes. In a sense these proposals are distant cousins of the Basel Committee’s 1999 proposal. Whereas the Basel Committee seeks to incorporate discrete assessments of individual borrowers (as reflected in the views of private credit rating agencies), proponents of mandatory subordinated debt incorporate market values of securities issued by the banks themselves.

IMPLICATIONS FOR THE BASEL PROPOSALS FOR REGULATORY POLICY

I would like to close with a few comments about the regulatory implications of the Basel Proposals. Let me start by returning for a moment to Schwartz’s discussion of the question whether additional oversight of credit rating agencies is necessary. While I would agree with Schwartz that the market has, to date, worked relatively well in this area, I think it also important to recognise that the regulatory incorporation of credit ratings in bank capital requirements puts greater pressure on the system. Currently, an issuer’s credit rating affects only its access to capital markets; under the Basel proposal, a rating will also affect the borrower’s cost of commercial loans from regulated entities (since the cost of higher capital charges will likely be passed on to borrowers, at least in part). As the importance of credit ratings increases, the pressure to get better ratings will also increase. This change could increase the need for governmental oversight of rating agencies. Another important point to note about the Basel proposals is that it somewhat changes the structure of the market for credit ratings. In the past—as Schwartz explains—the real consumer of credit ratings was individual investors, and the reason the market has worked is that rating agencies need to preserve their reputation for accurate assessors of credit risk. Under the Basel proposal, bank regulators will also “consume” credit ratings and use those ratings to set capital standards for regulated institutions. One wonders whether 30 In a similar spirit, one critic of regulatory incorporation of credit ratings has suggested that regulators rely instead in market movements of interest rates on debt. See Partnoy, n. 3 above. 31 Shadow Committee Comment, n. 13 above, 16–17.

322 Howell E. Jackson centralised regulators will be as good monitors of credit rating agencies as have decentralised market forces in the past. In addition, when one recalls that one of the goals of the Basel Capital Accords was to encourage national regulators to raise capital requirements for local banks, one can appreciate the potential problem of this new use of credit rating agencies. If banking officials in a particular country are reluctant to force local banks to raise capital to the standards set by the Basel Committee, one way to subvert compliance is to accept higher-than-appropriate ratings from local rating agencies. In other words, as the Basel Committee’s 1999 proposal allows national regulators latitude for setting capital requirements for commercial credits, the goal of maintaining uniform capital standards across national boundaries may be jeopardised. Collectively the foregoing concerns raise the possibility that the Basel Committee’s recent proposal and other regulatory incorporations of rating agencies at the national level could undermine the quality of credit ratings, thereby generating a form of credit rating inflation. This is, it should be noted, the inverse of the principal concern over rating agencies that Schwarcz raises in his chapter— that rating agencies might issue credit ratings that were inappropriately stringent.32 My fear is that market forces will lead agencies in the other direction.33 A final question to be posed about the Basel Committee’s incorporation of credit rating agencies is its implications for developing countries. In many parts of the world, few private borrowers have privately rated debt. Indeed, the credit rating industry is largely a phenomenon of the United States and other advanced economies.34 Accordingly, this aspect of the Basel 1999 proposal will have little impact on banks in many parts of the worlds. For these institutions, the effective capital requirement for commercial loans will remain the 8 per cent set under the original Basel Accord. Viewed in this light, the primary effect of this aspect of the Basel Committee’s 1999 proposal will benefit only banks in industrialised nations—allowing them to lower capital reserves for loans to borrowers with top credit ratings. In isolation this effect might not be disturbing, but it turns out that several recent and proposed reforms to the Basel Committee’s capital requirements apply, in practice, only to institutions in advanced nations: for example, internal models for market risks and analogous proposals for credit risk modelling discussed above. What seems to be emerging from the Basel Committee is a two-track system of capital standards: one relatively simple but rigid standardised system for banks in developing nations and a second, more flexible regime for sophisticated institutions in advanced economies. Whether this division threatens the considerable success that the Basel Committee has enjoyed over the past two decades is an open question for future debate. 32

See S. L. Schwarcz, 305–7. For additional views that credit rating agencies might be tempted to devalue the quality of their ratings, see Shadow Committee Comment, n. 13 above, 12. See also R. Cantor and F. Packer, “The Great Rating Industry”, Fed Res Bank of NY Quarterly Rev (Summer/Fall 1994), 1; Partnoy, n. 3 above. 34 For a review of rating agency coverage in various countries see Credit Ratings Working Paper, n. 4 above, at 21–39. 33

20

The Challenge of Technology— Regulation of Electronic Financial Markets Part I: Securities and Derivatives Markets GAY WISBEY

this chapter is potentially enormously broad but for reasons of space I will focus essentially on securities and derivatives markets. The impact of technology on markets is radical and changing the markets rapidly. I start by outlining some of the main ways in which technological advance is driving change in the markets, and then set out the issues and challenges which these changes raise for regulators and how those are being addressed.

T

HE TITLE OF

THE IMPACT OF TECHNOLOGY

From a market viewpoint, the three most important characteristics of modern technology are: first, its ability to process huge quantities of information; secondly, its ability to link multiple providers and receivers of information anywhere in the world; and, thirdly, its capacity to perform both of these functions at mind-numbing speeds. The broad effects of this are to make it technologically possible to have very large, very complex markets, and for those markets to operate—at least in a technological sense—out of black boxes located anywhere in the world. And increasingly that is precisely what is happening, because, in a nutshell, it is far more efficient than the old market process, and it opens up new business opportunities. It is possible to demonstrate how all of this is impacting on markets at a more micro level by taking a quick walk down the transaction chain. At the head of the chain are the ultimate users of the markets—the investors. Technology is

324 Gay Wisbey changing their lives by putting them on-line. Whether they are private investors or institutional investors, they now have access to huge amounts of market information, and they can control their own order instructions. As today’s jargon has it, they are empowered. And there is no doubt that this has been one of the major factors behind the huge growth in market volumes in recent years and, some would argue, also the increasing volatility in many markets. Next is the heart of the market process—the matching of buying and selling interests. The most visible development here is that trading floors—along with brightly coloured jackets, perpetual shouting and mystifying hand signals—are on the way out. None of London’s three securities exchanges any longer has a trading floor. Nor do either of the two financial derivatives exchanges. Only the London Metal Exchange and International Petroleum Exchange retain trading floors—and both are now working on plans to introduce some element of electronic trading to their markets. Why has technology driven out floors? Quite simply because the operating costs do not compare. A mainframe computer occupies the equivalent of only a corner of most exchange floors. It does not need to be located in a prime location. It can handle far more transactions than a floor. And intelligent software can do much of the market monitoring that may previously have been done by legions of pit observers. The only real surprise perhaps is that the process of abandoning physical trading floors is taking so long, including the relative lack of speed of many US markets in closing their floors—though Nasdaq, of course, was way ahead of the game by never having one in the first place. There are two main reasons for this. One is that some markets probably translate more readily to screen trading than others. But the main reason is the powerful resistance by those interests— especially in exchanges less vulnerable to competition—which are likely to be losers rather than winners from market modernisation. As an example, those who have traditionally received certain privileges in return for providing liquidity to a quote-driven market are unlikely to win if that market moves to electronic trading on an order-driven basis. What is replacing the physical floor? The answer is the market in a black box. And what are the consequences of that? Markets which can offer participation to far more people—and potentially a much wider range of people—than you could ever squeeze into a pit or on to a floor. Markets that can have remote members anywhere in the world and where the legal, marketing and regulatory operations can be jurisdictionally separated from the market technology. Markets that can use computing power to offer greater variety and complexity of trading algorithms. Markets that can be replicated, and competed with, much more cheaply than in the past. And markets that can potentially use their technology to develop a whole new range of business opportunities. After the matching of buying and selling interests, the next stage of the transaction chain is clearing and settlement. Here, many of the benefits of new technology have still to be realised, especially in Europe. But they will come. In due course, straight-through processing will complete the seamless electronic

The Challenge of Technology 325 transaction. By progressively removing paper from the transaction process this will both improve accuracy and greatly reduce the risks that can build the longer the time-span gets between trade time and settlement date. To summarise, technology is facilitating radical change in the operation and structure of markets, in roles and relationships among service providers, intermediaries and investors, and in the very scope of markets. But while it may be the march towards the truly global market place that catches the imagination, of greater importance to most market users is simply the application of technology to enhance general market efficiency. ISSUES FOR REGULATORS

What issues do all these changes pose for regulators? A re-run through the transaction chain could be illustrative, because there is no shortage of issues all the way down it. But it is probably better to take a step back and focus on a few of the more generic issues. The following four headings—some of them inter-related—will be covered: regulatory organisation; functionality and fragmentation; access and participation; technological dependence. These are all issues that are currently proving very challenging for market regulators everywhere. The USA, in particular, has been working on many of these issues for a number of years now. This has resulted in initiatives from both the Securities and Exchange Commission (SEC) and the Commodities and Futures Trading Commission (CFTC). The SEC published Regulation ATS in April 1999, putting in place a special regulatory regime for the increasing number of US broker-dealers who are “going electronic” and providing trading platforms with functionality similar to that of an exchange.1 More recently they consulted on issues that might be associated with the existence of multiple execution venues for the same stock—increasingly a characteristic of electronic markets.2 For its part, and in order to ensure that US derivatives markets have sufficient flexibility to respond to the challenges posed by advances in technology, the CFTC has launched a widescale and far-reaching review of its whole approach to market regulation.3 The FSA has also been giving a considerable amount of thought to the issues. In January 2000 it published a Discussion Paper entitled The FSA’s Approach to the Regulation of the Market Infrastructure. 36 responses were received and the FSA is currently mulling over these and considering what, if anything, should be done next. I will come back to that briefly at the end of this part of the chapter. First, however, a few points about each of the four issues previously mentioned must be made. 1 Regulation of Exchanges and Alternative Trading Systems (8 December 1998), effective date 21 April 1999. SEC Release No 34-40760; File No S7-12-98. 2 Commission Request for Comment on Issues Relating to Market Fragmentation (23 February 2000). SEC Release No 34-42450; File No. SR-NYSE-99-48. 3 A New Regulatory Framework for Multilateral Transaction Execution Facilities, Intermediaries and Clearing Organisations; Exemption for Bilateral Transactions; Proposed Rules, Federal Register 22 June 2000, vol. 65, no 121.

326 Gay Wisbey

Regulatory Organisation Here, there are two fundamental issues on the regulatory plate. Number one flows from the way in which technology has opened up a largely static business model in the exchange markets and unleashed competitive forces that can justifiably be said to have seismic proportions. It is not just a case of exchange versus exchange, or longer-established exchanges versus the upstart exchanges; it is also exchanges in competition with new trading platforms, very often run by their members. As explained earlier, to obtain the commercial flexibility required to survive in this competitive world, many exchanges have demutualised and turned themselves into “for profit” organisations. But does this new commercial imperative create conflicts of interest that should preclude them from continuing to hold either some or all of their regulatory responsibilities? Some, for example those who may be engaging in activities that make them competitors to an exchange despite being regulated by it, argue that it does. Others, including the exchanges themselves, argue that, on the contrary, commercial pressures will tend to reinforce regulatory rectitude, not undermine it. Yet others, often those who come to the debate with no preconceptions, argue that regulators should treat today’s exchanges like any other commercial organisations and simply forget about any concept of public interest or utility beyond the normal considerations of competition. The view is not taken, in the UK, that demutualised exchanges are automatically unsuited to regulatory responsibilities. It is true that the government decided to transfer the UK listing authority from the London Stock Exchange (LSE) to the FSA following the LSE’s recent decision to demutualise. But that decision was probably influenced by other considerations too, notably the appropriateness of leaving the listing authority under the auspices of the leading exchange when new, competing exchanges were starting to emerge and might well have considered the arrangement to confer an unfair advantage. It is, perhaps, too early to assess how exchanges will respond as competition intensifies. But, for the moment the view that “for profit” exchanges can continue to play a front-line regulatory role in terms of ensuring the fairness, efficiency and safety of their markets, provided that these regulatory functions are underpinned by appropriate governance arrangements, remains. The really interesting question looking forward is, perhaps, whether some exchanges may start to change their view that a high standard of market regulation is a competitive advantage and start to view it instead as an overhead that is better contracted out or passed to the mainstream regulator. The second point in the context of regulatory organisation relates to the consequences of technology facilitating the internationalisation of markets. There are a huge number of issues here, but in the end they all come back to one question: how do you regulate such markets effectively? How does an

The Challenge of Technology 327 exchange with remote foreign members enforce its rules? What problems may arise in a case of default given different insolvency laws? What do exchanges with extensive regulatory responsibilities for member supervision do when many of their members are primarily subject to the regulators in their home state? Above all, perhaps, how does a market, a market authority or a criminal prosecuting authority enforce provisions against market abuse in cases when large numbers of market members and investors are resident in other countries? At present market regulators are quickly moving themselves up the learning curve on these issues. Remote membership is a growing phenomenon and it is necessary to devise ways of ensuring that regulation works effectively across borders. This will probably take a mix of co-operation, information sharing and, maybe, even some agreements to carve up regulatory responsibilities if this should seem appropriate.

Functionality and Fragmentation The second batch of generic issues focuses on two key changes in the markets themselves: functionality and fragmentation. Arguably, most exchanges do more now than simply provide a venue for their members to trade. Their new cyber trading floors contain the algorithms for order execution, and the exchange facility conducts the order execution. In this sense, exchanges are moving a step closer to brokerage. At the same time, brokers too are adopting various types of order-matching and automated dealing facilities. In short, many of these organisations provide broadly common functionality. Yet they live in different regulatory boxes. In the case of exchanges, the regulatory focus is on the regulation of the market—all the aspects that go towards a fair and orderly market; while in the case of the broker, regulation does not concern itself with the market per se but rather with a firm’s conduct of business in respect of its customers. In the FSA’s discussion paper,4 the idea that entities providing similar functionality should be regulated in a broadly similar way was floated. The majority of those responding to the paper were supportive of this approach—though with the proviso that wholesale and retail markets should also be distinguished between. The second issue in this section relates to the flipside of more competition in the provision of trading platforms—the potential fragmentation of liquidity. Competition is, for the most part, healthy. But regulators do have concerns that competition should not take place in a way that distorts the fairness, efficiency or safety of the market overall. The more transparency and access provided by systems, the less those concerns are likely to be. 4

The FSA’s Approach to Regulation of the Market Infrastructure (January 2000).

328 Gay Wisbey Nonetheless, there is a need to ensure that minimum standards are sufficiently high to remove concerns about any competitive “race to the bottom”, internationally as well as domestically. Secondly, regulators need to feel confident that the quality of price formation is not diluted or otherwise diminished, and that there is demanding yet realistic policy in place on best execution. Whether or not it is necessary to promote some form of virtual order book for the whole market or a consolidated tape of completed trades remains to be seen. The FSA’s preference is always to let the market devise its own solutions wherever possible. But if the market fails to deliver adequate and effective solutions, then we would be bound to think further.

Access and Participation The third batch of issues relates to access and participation. A key aspect of technology is the way in which it opens up access, in that just about anyone can access a market; and, conversely, market operators can provide, or arrange, connections to their markets to just about anyone, anywhere. I set out three issues below, just to give a flavour of what this means for regulation. First, cross-border access—on what basis should markets be free to sign up trading participants wherever they want, without unreasonable obstacles, delays or costs on the part of regulators? A difficult issue, given regulation’s essentially national basis, but one where regulators will need to make more progress, both by ensuring there is continuing convergence of regulatory standards and by building more mutual trust and co-operation. Secondly, there is the issue of direct access to trading platforms without broker intermediation; in other words, the potential ending of broker/dealer control as gatekeepers to the market. So far, disintermediation is happening mainly at the institutional/professional/corporate levels, which seems fair enough, provided the arrangements are prudent. There is talk of direct retail access, but much of this is rather misleading. Retail investors are certainly playing a greater part in many markets (especially equity markets) and many online investors have the opportunity to see real-time prices and execute against them. But even in the USA they are by and large still dealing on trading facilities via a broker, however invisible that broker may be. The third point is where intermediaries provide their more favoured clients with look-through facilities that enable them to place orders direct on the order book. Just how good are the various filters that firms are putting in place when empowering clients to trade in their name? So far there have not been significant problems, but it is an area that makes regulators feel slightly uneasy. This is not least because there is anecdotal evidence around to suggest that some firms, in practice, allow particular clients to trade in their name without ensuring controls are in place to prevent the actions of those clients jeopardising fair and orderly trading.

The Challenge of Technology 329

Technology Dependence Finally, the increasing use of, and dependence on, modern technology and electronic systems has to be mentioned. Technology increases efficiency; technology opens up new business opportunities; technology expands consumer choice and consumer power. But, at the same time, the whole market system becomes hugely dependent on the quality of the technological infrastructure. This raises a number of questions in a regulator’s mind. Is security for the technology adequate? Can systems deliver what they promise? Do people have enough access to and knowledge of what transpires inside the black box? What happens when systems, especially systemically key systems, go wrong or fall over? Is this an area where commercial forces can be relied on sufficiently to ensure that problems do not arise? Or is there a need for regulators to take an interest and try to add value by promoting minimum standards/good practice in areas identified as vulnerable? This was another issue on which views were sought in the January discussion paper from the FSA, and the response was a slightly surprising one. The FSA’s expectation had been that most market participants and market service providers would say “hands off”. And that is precisely what roughly half of those who sent responses did. But there were also a good number who thought that this was an area in which it was proper for regulators to take an interest. The last thing regulators want to do, of course, is to get involved in the specific technology per se, in setting specific technology standards—such as what bandwidth should be used for a network—or making judgements about the technical quality of technology providers. But regulators do have an interest in ensuring that sufficient attention is paid to the management of technology, whether that technology is provided in-house or through outsourcing arrangements. That seems to be not only a legitimate but also an important part of a regulator’s general oversight of management, whether of firms or of exchanges and clearing houses. A guess is that regulators will be paying more attention to this area in future—not necessarily by setting a whole raft of new rules; more probably by moving it up their priorities in their general supervisory approach. This means that supervisors will increasingly talk to exchanges, clearing houses and firms about their IT strategy, the management and development of IT projects, the integrity and security of their IT systems and the arrangements they have in place surrounding outsourcing and external suppliers.

CONCLUSION

In conclusion, technology is changing markets fairly significantly. This poses big issues for market regulation, both domestically and internationally. The FSA, like most regulators, is working on both elements.

330 Mary L. Schapiro As previously mentioned, a discussion paper was issued at the start of 2000 that covered many of these issues, and to which interesting responses have been received. The responses have been broadly supportive of the need to evolve our approach to markets. But they have also warned the FSA to proceed with caution in what is perceived as a complex area, to think internationally and to be mindful of the wholesale/retail divide. At the moment the FSA is proceeding with caution. And consideration is being given to whether there may be other (new) risks in the emerging market-place that have not been adequately addressed, and to whether, and if so how, regulation could be usefully calibrated according to the different characteristics of markets in different asset classes. It should be emphasised that the FSA published its discussion paper because it was thought it would be useful to generate a public debate on what the impact of technology, on both market structure and participants’ roles, might mean for regulation. That debate is giving the FSA the material to decide whether changes to the current regulatory framework in the UK might be necessary.

Part II: Nasdaq MARY L. SCHAPIRO

The title “The Regulation of Electronic Financial Markets” covers an enormous amount of territory and within the space of this chapter it is possible to tackle briefly only certain aspects of it. Whilst we have had electronic markets for 30 years, such as the Nasdaq, I believe that the Internet has had the most profound impact on financial markets of any development in many years. So, the role of the Internet is an appropriate starting point. There has been an enormous surge in online trading in Europe. Online brokerage accounts almost doubled from 1.36 million in December 1999 to 3.74 million accounts at the end of 2000. In the UK, online trades as a percentage of total execution only trades grew from 12 per cent at the end of 1999 to 28 per cent at the end of 2000.5 While we know that European online trading is growing, we also need to know where it is going. It might help to look at what the US market is experiencing. The

5 Secular vs Cyclical Growth for Online Brokerage in Europe, JP Morgan Quarterly Report, February 2001 (at http://www.jpmorgan.com/CorpInfo/PressReleases/2001/02222001_Online BrokerageEurope.htm, site visited 23 April 2001).

Nasdaq 331 figure of 800,000 accounts online in Europe in 1999 compares with 11 million in the USA, projected to reach more than 20 million by 2003. 49 per cent of all US homes are online and 134.2 million Americans now have Internet access. Online trading volume averaged 1.4 million trades a day in the first quarter of 2000—a 75 per cent increase from the fourth quarter of 1999. As might be expected, the number of online brokers in the USA has also jumped from a handful several years ago to about 170 firms today. In the USA, an online investor can now open an account with a broker, get real-time market data, visit web sites that will give specific advice, place an order and have it executed with low or no commissions—all of these things can be accomplished, start to finish, in just minutes. Is this hyper speed and low cost a good thing for investors? Yes—it allows them to participate in the markets more cheaply, and, hopefully, as or more fairly. Is it a bad thing for investors? Yes— it allows them quickly to get in over their heads, and it allows the dishonest to fleece them with an efficiency impossible before the Internet was envisaged. Is this online trading really old, pre-online brokerage speeded up? Yes—so we can use some of our current rules to police it. Is this online trading something new? Yes—so we need to do some new things to police it as well.

ONLINE PERSPECTIVES

As regulators have monitored this dramatic shift in the US market, we have come to realise that it is not a single event, but an abundance of events that we need to view from three distinct perspectives, namely: how investors participate in the markets; how those markets are structured; and how those markets are regulated; all influencing each other and all happening together.

MARKET PARTICIPANTS

The starting point of this shift is in the shoes of the market participant. Viewed from this vantage point it can be seen that the Internet has resulted in the empowerment of investors in matters such as: the democratisation of trading and of access to initial public offerings and to corporate information; availability of margin; disclosure to investors using email; day trading; and the dot com phenomenon. Investor interests are affected by the capacity of firms to handle the online business they attract. Issues about suitability, security and privacy arise. Investors are now blessed with a mixture of choices in the markets that will allow them—in nanoseconds—to become phenomenally rich—or phenomenally poor. These issues stem from the incredible array of possibilities that investors now have that were available only to professionals a few years ago. These possibilities are breathtaking to investors, and even more breathtaking to

332 Mary L. Schapiro securities regulators such as NASDR, which must formulate approaches to cover novel regulatory situations that now seem to arise every day instead of every month or year.

MARKET STRUCTURE

The dramatic shift in the method and level of investor participation has accelerated the revolution in market structure in the USA. Informed (and occasionally misinformed) investors demand different services, facilities and cost structures, and a variety of entities have evolved or appeared to meet those demands. As a result, the US markets are a complex web of traditional agency and dealer markets that include electronic communications networks (or ECNs) that are designed to match customer orders without taking positions of their own, proprietary trading systems operated by broker dealers that internalise their orders, and combinations of the traditional and the new. This complexity has not slowed, and, given how the Internet sparks ideas, I expect that it will only increase. The market structure revolution is all about choice and competition, and choice and competition are good. A customer in the USA today (and someday London and Frankfurt if Nasdaq has its way) who wants to trade Microsoft has a dizzying array of options, including how his order is delivered; whether it is displayed, and if so, how, to whom, and for how long; how and when it is executed; and the costs of these various unbundled services. But while it is approaching a cliché to say that one person’s competition is another person’s fragmentation, it really is true. Developments in market structure that have been fuelled by electronic trading have increased the likelihood that trading interests at the same price at opposite sides will never see each other and, if so, may have great difficulty ever reaching each other. Ideas that have been floated, discussed and, at times, derided include the development of a centralised limit order book, reinforcing existing linkages through either technology or regulatory requirements, blowing up intermarket linkages and requiring intermediaries to be able to scan the field looking for the best market. Whatever the ultimate answer, the markets know that these are issues that must be solved.

MARKET REGULATOR

The third viewpoint is thus the perspective of a regulator. Our main concern is how we keep up with our markets as they grow on the Internet steroid. We know it has always been almost impossible to anticipate how the market will develop and to write appropriate rules for that future. But with the speed of today’s explosion of new ideas in the securities markets, we would be happy if we could manage to lag behind the markets so little that only a few investors get hurt before we erect the needed rules and regulatory procedures.

Nasdaq 333 Our job is to keep that “few” as few as possible. And while much has been written about how the Internet and immediate access have increased the opportunities for fraud, that is not the only concern of the regulator in an electronic environment. Empowered investors are truly empowered only if they have all the necessary information to ensure that they are being treated fairly, that their firms’ systems are reliable, that they are getting the best price. The fundamental requirement that a regulator act impartially has also been called into question by the new market structure. Where once exchanges, operated essentially as utilities, with a not-for-profit mentality, held a monopoly on the business of transacting in stocks, now they face competition from fleetfooted, highly technological upstarts for whom they may also have some regulatory responsibility. The conflict of interest for an organisation such as the NASD, which regulates the entire brokerage industry—and therefore all ECNs—and owns and operates The Nasdaq Stock Market has driven us to spin off the Nasdaq and to sever nearly completely our governance and ownership. NASDR is now in a position to regulate both Nasdaq and its competitors without fear of being challenged for favoritism.

ONLINE ISSUES

This section of the chapter examines a small sample of the issues that we, as regulators, deal with in relation to online trading. It touches on how some online brokerages regard themselves, online recommendations, capacity, and electronic signatures and records.

Online Brokers—Just Another E-business? One issue that NASDR is dealing with is the nature of online firms. Some brokerage firms do not believe that they are brokerage firms. The chief executive of one very large online firm was quoted in the Washington Post as saying: We are not a brokerage company. We are a technology company that leverages information through an electronic business model to exploit the inefficiencies of a business.6

To some, being a lofty citizen of the Internet transcends the mundane, earthbound regulation that the rest of the securities industry has to suffer. Perhaps regulators do not fully appreciate the uniqueness of the online world, but we think that despite their use of technology, online firms are brokerage firms. The same rules and regulations apply to them as apply to everyone else, even though some modifications may occasionally be required to take into account their 6

Ianthe Jeanne Dugan, Washington Post, 18 June 2000, H01 (Financial Section).

334 Mary L. Schapiro unique circumstances. Nonetheless, the investment advisory services of a, for example, Microsoft or Quicken, or a dozen other technology companies, raise really important issues of where to draw the line between the financial services industry and technology companies. Online Recommendations A related issue involves whether online firms recommend which securities their customers should buy and sell. If they do not make a recommendation, then, under US laws, they do not have the responsibility to ensure suitability of the transaction for that particular customer. The suitability obligation that a firm has when it makes a recommendation is one of the foundations of investor protection in the USA. Many online firms clearly do not give advice. But others now refer their customers to online third parties that provide very specific advice. When does that referral or the mere provision of targeted research approach a recommendation that triggers the suitability requirement? (A recent NASDR Notice to Members fully explores the boundaries of suitability in the online context). Capacity Another major issue that NASDR deals with is the capacity of online brokers to handle their business. This is the single largest complaint, along with execution quality, that we see in the online trading arena. The US federal government’s General Accounting Office recently completed a survey of major online firms, and found one that said that it had so many system outages that it could not even track them.7 Some think that regulators should not get involved when a firm has too much business to handle. But regulators cannot let the firm ignore the fact that their customers will miss opportunities to buy, or, worse, to sell because the firm spent too much on advertising and too little on making sure that their computers were up to the demand. E-sign Another issue that NASDR must confront will be raised by the recent passage of the Electronic Signature Bill. The legislation is designed to recognise that contracts and records do not have to be kept on paper for them to be legally binding. In the securities world, this means that accounts can be opened online without any paper signature. It also means that the brokers that NASDR regulates can keep their records solely in electronic form. While we like electronic records— they are easier to transmit and analyse—it is not clear from the legislation to what 7 United States General Accounting Office, On-Line Trading: Better Investor Protection Needed on Brokers’ Web Sites (Report No GAO/GGD-00-4 3 May 2000).

London Stock Exchange 335 extent regulators can specify the electronic format of the records so that we regulators can actually read them. This is a matter of obvious immediate concern.

Electronic Solutions Just as the Internet and the web create issues for regulators, they can also provide some of the solutions. For example, securities fraud on the web, especially if it is widespread, can be more readily spotted by surveillance systems than more traditional fraudulent methods. Investor education, which allows us to teach investors to protect themselves against securities fraud, is something that can be provided at the click of a mouse. NASDR’s own website— www.nasdr.com—provides an illustrative example. We could also require any of our member firms that have a web presence to hyperlink back to our regulatory web site so that we can tell the customer what to be on the lookout for. Likewise, regulators could require securities firms to provide their customers with web access to up to the minute measurements of how well they are providing their execution services, or exactly what their commissions and markups are on their trades.

CONCLUSION

As William Shakespeare said, 397 years ago, “[t]he web of our life is of a mingled yarn, good and ill together”. The World Wide Web is a mingled yarn—it provides wonderful opportunities to investors, brokers, those who want to commit fraud and those of us who want to prevent fraud. Shakespeare described the World Wide Web without even knowing what it was. I hope that where he described his web—it was in “All’s Well That Ends Well”—gives us a clue about how our web will end up, but it is hard for even Shakespeare to be right about everything.

Part III: London Stock Exchange DAVID SHRIMPTON

The London Stock Exchange was one of the first exchanges in Europe to move away from floor trading in 1986 with the introduction of an electronic market. With that migration to a more technical market came a number of benefits; particularly with regard to spreads and to information.

336 David Shrimpton Spreads have decreased dramatically following an increase in more technical trading. Access to the market using the Internet has also generated greater trading volumes and thereby stock liquidity. In the first half of 2000 there was a 15 per cent increase in the number of screens displaying stock price quotations around the world. The Internet has provided: retail access to cheap trading—it is now possible to deal for approximately £10 a trade through an internet broker); company information—the public are now able to access a great deal of additional information regarding companies, their directors, new innovations and products that was not previously possible for companies to distribute widely; and market information—information about quotes, orders and trades is accessible to a much wider audience, delivered via the Internet, very often for little or no payment. All of this has served to empower private investors with enough information to make investment decisions and then execute transactions quickly and cheaply.

REGULATORY SYSTEMS

The London Stock Exchange (the Exchange) has built a system to monitor in excess of 150,000 trades a day. This equates to approximately £2 billion in value and is spread across approximately 3,000 securities. The number of trades transacted has risen from about 80,000 trades per day a year ago. Factors behind this growth include automated trading, greater access to the Internet and the launch of the techMARK™ index for high growth stocks.

COSTS

These technological advances ultimately have resulted in lower costs for members of the Exchange, more opportunities for participants in the market and more immediate ways of accessing the markets based on less and less human intervention. Many exchanges have taken or are taking steps to de-mutualise. The demutalisation of the Exchange does not in any way limit or reduce the standards in the market as the key drivers will remain to deliver an orderly and well regulated trading platform against increasingly commercial challenges.

London Stock Exchange 337

CHALLENGES

Whilst the Exchange has seen the gains brought about by technological advances, new competition has also arisen. The Exchange can no longer rely on being a national market of choice—it is now being challenged by competition from a number of areas and changes in the investment environment. For example Electronic Crossing Networks—in the USA, electronic cross networks (ECNs) claim to have taken around 30 per cent of the business away from Nasdaq and there is a growing trend for the creation of ECN’s in the UK market. With increased volumes, systems need to be able to cope with increased processing capacity. In addition, safeguards need to be put in place to cope with both accidental and intentional service interruptions. The Exchange needs to accommodate the increase in the number of unsophisticated investors and the way in which the Exchange regulates that business. With the rise of the Internet, the Exchange has to be aware of increased opportunities for share price manipulation. Before the rise of the Internet, information was distributed through organised regulated commercial channels, which were relatively easy to monitor. The Internet allows new channels of communication with access to very large audiences, and information can be broadcast from any jurisdiction.

WHY REGULATE

First, it is worth pointing out that the Exchange’s motivation for regulating the London market is not just its statutory obligation to do so. It also regulates in order to maintain investor confidence in the London market. It is important to maintain a level playing field. The Exchange seeks to stop leaks of price-sensitive information and the Exchange makes sure that participants adhere to the reporting rules to ensure transparency. All market participants want us to regulate well. If you are a long way away from the market in which you are dealing, for instance, you need to be confident that the locals are not dealing with the benefit of information that is not available to you.

WHAT DO WE REGULATE ?

The Exchange regulates the activities of all member firms (and indirectly, clients of those member firms) dealing on essentially two different trading platforms. First, there is order-driven trading, whereby firms are able to post buy and sell

338 David Shrimpton orders in an order book to deal at prices which will be automatically executed by the system when their prices match. Secondly, there is quote-driven trading, whereby specialist firms (market makers) provide liquidity by guaranteeing to post two way prices (thereby promising to buy and sell securities) throughout the whole of the trading day. HOW DO WE REGULATE ?

The Exchange regulates by front line supervision of firms’ activities. This involves real time market monitoring of trading and taking preventative/remedial action where a breach of the Exchange’s rules has taken place and where the Exchange needs to take action to protect the integrity of the market. This involves three key areas in practice: Market Access—to ensure that firms meet and continue to meet the on-going requirements required by Exchange membership and market participants such as suitability of trading expertise, compliance know-how, risk management procedures for capital adequacy and systems connectivity to the Exchange; Market Supervision—to ensure that there is adequate corporate and trading information in the market-place at all times to facilitate the making of proper investment decisions and to provide guidance, advice and assistance on the practical application of the Exchange’s rules; Regulatory Development—a dedicated area to deal with changes to the industry to ensure that the Exchange, as a market provider, keeps pace with changes to market practice and legislation.

THE ROLE OF IT IN MARKET REGULATION

A key issue for the Exchange is the need to be able to retain focus on potential market disorder. The Exchange sees, on a daily basis, around 150,000 trades. Each day the Exchange’s Companies Announcements Office typically receives around 700 official company announcements and there are also tens of thousands of news stories distributed by international news vendors and countless postings on the Internet. What the Exchange does to get that focus is to rely, in part, on automatic processing of trade data and alerting of quote/order- and trade-based information to identify unusual market activity. After that, it is then down to human interpretation. The Exchange’s supervisory department seeks to ensure that it gives clear, consistent, accurate and, above all, timely advice—whether that is good or bad news to the firm in question! Its Integrated Monitoring and Surveillance System (IMAS) is the main application on which the Exchange relies to monitor its markets. This applica-

London Stock Exchange 339 tion captures information about every single quote, order and trade and stores it in a large database. These records track everything that has happened on the Exchange’s markets back to 1986. IMAS may be used then to recreate the market in any of the Exchange’s securities. This is displayed within a graphical environment. This enables the analyst to make quick intuitive judgements about the significance of unusual volatility that is evident on the screen. The analyst may be aided in making this judgement by knowing about the identity and reputations of the purchasers and vendors associated with the volatility. IMAS also does a lot more than this. As it captures market data, in real time, it compares what is going on at the given time, in any of the Exchange’s 3,000 securities, with what it knows to expect to see happen in that security in the future.Where the behaviour of any one of a number of the attributes of that security’s behaviour exceeds the normal range for that stock then IMAS generates an alert. It is at that stage that the Exchange’s human analysts apply their judgement and experience to determine whether any regulatory intervention is required.

MARKET EVOLUTION

As the market evolves, the Exchange needs to keep pace with new trading strategies. For example, when the Exchange introduced a new mechanism for deriving the closing price for SETS securities, the Exchange was asked for guidance from firms in relation to trading strategies being requested by clients in order to benchmark the closing price. Participants were asking for guidance on whether these strategies would be regarded as an attempt to manipulate of the market. The Exchange recently launched extraMark—a market for new innovative products. The last new product, Exchange Traded Funds, allows access for participants to trade a single security which tracks the FTSE Index without the need to trade in all the underlying securities in that index. This simplifies the process of sophisticated share ownership for new investors and attempts to break down some of the complications to share trading by retail investors. Whilst the Exchange is based in London, many of the firms and participants accessing the markets are trading internationally and are therefore exposed to both domestic and internationally changing practices. As a result, the Exchange is constantly assessing its ability to provide the platform to facilitate such business, for example, by ensuring the Exchange maintains systems to deal with increased trading volumes.

CONCLUSION

The London Stock Exchange is now a fully commercial organisation, competing with other exchanges both in this country and overseas. Far from this being

340 David Shrimpton a reason to reduce our regulatory efforts we see our high regulatory standards as a key selling point of our services and are committed to improving our capacity to deliver the orderly trading environment and informational “level playing field” that is demanded by the international investment community.

Index Accountability, 127–49, 162–3, 165–88 accountable, 167 accountee, 168 administrative redress, 147–8 appeals, 143–4 checks and balances, 131 content of obligation, 168 criteria of assessment, 168–9 definition, 166–9 discipline, 140–2 due process, 137, 142 enforcement, 140–2 ex ante control, 169 ex post control, 169 Financial Services Authority (FSA), 11–13, 177–84 accountable, 177–9 accountees, 181–4 consumers, accountability to, 183–4 criteria of assessment, 184–7 enforcement powers, 180–1 Government, accountability to, 181–2 judicial accountability, 183 Parliament, accountability to, 182 practitioners, accountability to, 183–4 rule-making power, 180 generally, 127–8 governance and, 165–6 independence, 173–4 internal controls, 131–2 judicial review, 144 legislative mandate, 129–31 ministerial controls, 132–3 oversights, 131 Parliamentary controls, 133–5 redress, 142, 148 reforming financial regulation, 20, 21–2 rule-making, 137–40 stakeholder control, 135–6 statutory immunity, 145–7 transparency, 170–2 Appeals: accountability, 143–4 Approved Persons Regime, 8–9, 75–85 company law, relationship with, 84–7 constructive trust liability, 78 generally, 76–7 illegal contracts, 78 misrepresentation, 77 non-compliance, 78

Authorisation: global regulation, 289 Bank of England, 27–8 Basel Committee, 3, 66–8, 280–7 BCCI and, 282–3 Capital Accords, 284–7 Concordat, 280–1 generally, 280 internal risk management models, 284–5 rating agencies, 314–15, 321–2 reform proposals, 285–6 Revised Concordat, 281–2 BCCI, 282–3 Central Bank: accountability, 174–7 role of, 20, 27–8 Charter values, 27 Co-operation: global regulation, 292–3 informality, 3 national regulators, 3 voluntary approach, 3 Co-ordination: global regulation, 292–3 Communication: national regulators, 3 Company law: Approved Persons Regime, relationship with, 84–7 Conglomeration, 40 Constructive trust liability: Approved Persons Regime, 78 Contract failure: regulatory principles of FSA, 29–31 Corporate governance: securities regulation, harmonisation of, 206–7 Credit rating agencies. See Rating agencies Criminal charges: European Convention on Human Rights, 119–24 Directors: See also Approved Persons Regime corporate governance, 80–4 fiduciary duties, 75–85 employee interests, 82–3 law of, 79–80 shadow directors, 83–4 shadow directors, 83–4

342 Index Discipline: accountability, 140–2 Financial Services Authority (FSA), 10–11, 119–24 classification of proceedings, 120–4 uncertain charges, 124–6 Disclosure: securities regulation, harmonisation of, 203–4 Due process: accountability, 137, 142 Economic and Monetary Union (EMU), 211–12 Efficiency: objectives of financial regulation, 51–2 Enforcement: Financial Services Authority (FSA), 10–11 global regulation, 293–4 Enterprise: balancing with consumer and investor interests, 7 Euronext, 216 European Central Bank, 227–30 accountability, 229 enforcement, 230 generally, 227–8 independence, 229 policy-making, 228–9 European Convention on Human Rights, 95–114 Approved Persons Regime, 110–12 criminal charges, 119–24 fair trial, right to, 101–5, 117 Financial Services and Markets Act 2000, 116 financial services regulatory regime, approach of FSA to regulation, 99 approved persons, 110–11 authorised firms, 110–12 broad scheme of FSMA, 97–9 criminal charges, 119–24 criminal law, 100–1 discipline, role of, 99–100 fair trial, right to, 101–5, 117–18 generally, 96 guidance from other jurisdictions, 105–9 market abuse, 109–10 retrospective punishment, 119 statutory objectives, 96–7 uncertain charges, 124–6 generally, 95 Human Rights Act 1998, 115–16 market abuse, 109–10 European Securities Commission (ESC), 211–33 case for, 220–2

constitutional issues, 222–3 current EU position, attempts at harmonisation, 214–15 integration of stock exchanges, 216–19 Euronext, 216 European Central Bank as model for, 227–30 generally, 211 harmonisation, reasons for, 213–14 iX, 217 stock exchanges, 216–19 Euronext, 216 future, 219–20 iX, 217 Virt-X, 216–17 United States Securities and Exchange Commission precedent, 223–7 Virt-X, 216–17 European securities regulation, 13–15 See also European Securities Commission (ESC) ; Securities regulation, harmonisation of Fiduciary duties: companies, regulation of, 89–94 directors, 75–85 employee interests, 82–3 law on fiduciary duties, 79–80 shadow directors, 83–4 individuals, regulation of, 89–94 simultaneous regulation of individuals and companies, 89–94 Financial Sector Appraisal Program (FSAP), 3 Financial Services and Markets Act 2000: assent, 1 commencement, 1 enactment, 5 European Convention on Human Rights, 116 framework instrument, 1 human rights, 116 fair trial, right to, 117–18 legislative process, 17–19 N2, 1 objectives 5–8, – 25–6., See also Objectives of financial regulation policy behind, 1 principles, 5–8 reform of law. See Reforming financial regulation scheme, 97–9 Financial Services Authority (FSA): accountability, 11–13, 177–84 accountable, 177–9 accountees, 181–4 criteria of assessment, 184–7 enforcement powers, 180–1 Government, accountability to, 181–2 judicial accountability, 183

Index 343 Parliament, accountability to, 182 practitioners, accountability to, 183–4 rule-making power, 180 application of powers, 2 certainty of rules, 7 cost/benefit analysis, 156–7 development, 1 discharge of functions, 6 discipline, 10–11, 119–24 classification of proceedings, 120–4 uncertain charges, 124–6 economic objectives, 153–5 enforcement, 10–11 establishment, 1 flexibility of rules, 7 interpretation of powers, 2 operational, when becoming, 1–2 principles of regulation. See Regulatory principles of FSA regulatory principles. See Regulatory principles of FSA rules of conduct, 157–8 success of new regime, 1–2, 45–6 transparency, 152–3, 159–62 Financial Stability Forum (FSF), 255–71, 288 aims, 4 assessment of systemic stability at international level, 256–7 background, 255–6 capital flows, 261–3 codes and standards, 259–61 early warning device, as, 270 emerging markets, involvement and implementation by, 270 establishment, 3 future, 269–70, 271 global regulation, 258 highly-leveraged institutions (HLIS), 263–6 instabilities, systemic, 257 offshore financial centres (OFCS), 267–9 role, 3–4 FSA. See Financial Services Authority (FSA) FSF. See Financial Stability Forum (FSF) Global regulation, 2–4, 273–95 See also Rating agencies authorisation, 289 co-operation, 292–3 co-ordination, 292–3 enforcement, 293–4 generally, 273 guidance, 289 information, 289–92 policy, 293–4 role of supervisor, 288–94 surveillance, 289–92

Guidance: global regulation, 289 Highly-leveraged institutions (HLIS), 263–6 Human rights. See European Convention on Human Rights IAIS, 3 IASC, 287 Illegal contracts: Approved Persons Regime, 78 Information: global regulation, 289–90, 289–92 regulatory principles of FSA, 29 Integrity: objectives of financial regulation, 50, 50–1 International financial regulation, 235–54, 273–95 accountability, 250–2 Basel Committee. See Basel Committee challenges facing, generally, 239 legal foundation of action, 240–3 performance of tasks, 243–4 tasks to be performed, 239–40 development, 237–9 devising structure, 252–3 generally, 235–7 international bodies, 287–8 macroeconomic aspects, 245–7 microeconomic aspects, 245–7 need for, 273–5 rating agencies, 15–16 risk management, 247–9 harmonisation, 249–50 systemic risk, 275–8 extraterritoriality, 278–80 tasks to be performed, 239–40 theoretical framework, 244–5 International Monetary Fund (IMF), 3, 288 Internet, 43–5, 333–5 IOSCO, 3, 287 iX, 217 Listing procedure: securities regulation, harmonisation of, 204 London Stock Exchange, 335–40 Market abuse: City Code, 53–4 European Convention on Human Rights, 109–10 objectives of financial regulation, 53–4 takeovers, 7–8, 53–4 Market discipline, 59–73, 159–62 advantages, 69–70 Basel proposals, 66–8 future, 71–3

344 Index Market discipline (cont.) generally, 59–60 incentives, 60–1 financial regulation, structure for, 62–4 rule-based regulation and, 64–71 subordinated debt, 68–9 technicalities, 70–1 Market manipulation: regulatory principles of FSA, 29 Markets without frontiers, 4 Misrepresentation: Approved Persons Regime, 77 Monetary Policy Committee (MPC), 151–2 MPC. See Monetary Policy Committee (MPC) N2, 1 Nasdaq, 330–5 Objectives of financial regulation, 37–57 achieving success, 53 adaptability, 52 agility, 52 competitiveness, 54–5 consumer input, 55–6 effectiveness of new regime, 51–2 efficiency, 51–2 fairness, 48–9 flexibility, 46–8 future of markets and industry, 39–45 boundaries, blurring of, 39–40 generally, 39 infomediaries, 42–3 Internet, 43–5 new entrants, 42 on-going trends, 40–5 technological development, 43–5 trends, 40–5 generally, 37–38 infomediaries, 42–3 integrity, 50–1 Internet, 43–5 market abuse, 53–4 practitioner input, 55–6 skill and talent, importance of, 56 success factors, 46 success of new regime, 45–6 transparency, 49–50 Offshore financial centres (OFCS), 267–9 Rating agencies, 297–310 alternatives, 318–21 analysis, 301–9 Basel Committee, 314–15, 321–2 criticisms, 315–18 generally, 297, 311 improving performance, 302–3 multinational considerations, 309–10 negative consequences of actions, 303–7

NRSRO-designated approach, 307–9 problem faced by, 297–99 regulatory incorporation, 312–14 role, 15–16, 299–301, 311–22 Reforming financial regulation, 17–24 See also Financial Services and Markets Act 2000 accountability, 20, 21–2 Central Bank, role of, 20 future, 22–4 generally, 17 legislative process, 17–19 self-regulation, end of, 19–20 single integrated regulator, 19 supervision and conduct of business regulation, 20 Regulatory principles of FSA, 25–36 assessment, 35–6 bank regulation, 27–8 contract failure, 29–31 generally, 25–6 impact of financial systems, 32–5 information, 29 international aspects, 31–2 market manipulation, 29 non-bank domestic regulation, 28–31 requirement to have regard to, 6 Rules of conduct, 157–8 Securities regulation, harmonisation of, 189–210 See also European Securities Commission (ESC) common trading platform hypothesis, 199–200 company law, 205–6 conflicts, potential, 209–10 corporate governance, 206–7 disclosure, 203–4 European SEC, 192–3 historical background, 189–90 insider rules, 204–5 listing procedure, 204 modified trading landscape, 193–8 common trading platform hypothesis, 199–200 company law, 205–6 disclosure, 203–4 insider rules, 204–5 listing procedure, 204 new trading schemes, 194–98 stronger integration, 201–3 pattern, regulatory, generally, 198–9 privileged access hypothesis, 199 present state of regulation, 190–1 privileged access hypothesis, 199 takeovers, 207–8

Index 345 Shadow directors, 83–4 Surveillance: global regulation, 289–90, 289–92 Systemic collapse, 6–7 Takeovers: market abuse, 7–8, 53–4 securities regulation, harmonisation of, 207–8 Technological developments, 2, 4 London Stock Exchange, 335–40 challenges, 337 costs, 336 generally, 335–6 market evolution, 339 methods of regulation, 338 reasons for regulation, 337 regulatory systems, 336 role of IT, 338–9 subject-matter of regulation, 337–8 Nasdaq, 330–5 generally, 330–1 market participants, 331–2 market regulator, 332–3

market structure, 332 online perspectives, 331 online issues, 333–5 securities and derivatives markets, 323–30 access, 328 dependence, technology, 329 fragmentation, 327–8 functionality, 327–8 impact of technology, 323–5 issues for regulators, 325–30 participation, 328 regulatory organisation, 326–7 Transparency: accountability, 170–2 Financial Services Authority (FSA), 152–3, 159–62 framework of accountability, 173 meaning, 170–2 objectives of financial regulation, 49–50 Virt-X, 216–17 World Trade Organisation (WTO), 288