INTRODUCTION

  1.  We are submitting this Memorandum ahead of our appearance before the Treasury Committee on 6 May. The Memorandum covers:

(a)  our regulatory philosophy;

(b)  lessons learned from Northern Rock;

(c)  Banking Reform;

(d)  regulation of a nationalised Northern Rock; and

(e)  market abuse and insider dealing.

 (A)   OUR REGULATORY PHILOSOPHY

Our approach to regulation

  2.  We are a regulator which seeks, wherever possible, to base our approach on principles rather than detailed prescriptive rules; an approach termed by us More Principles-Based Regulation (MPBR). We believe that the best means of encouraging the behaviour we seek in firms, and consequently our judgements of compliance, should focus on the consequences of firms' actions rather than rigid adherence to specific rules. We are therefore an outcomes-based regulator. We recognise that a successful financial marketplace requires innovation, the capacity for risk taking, and competition: an approach which has served the UK economy and its financial markets well. A consequence of this philosophy is that we cannot guarantee there will not be failures. The inherent certainty that there will be failures within our framework results not just from this requirement to recognise that risks are unavoidable, but also since outcome-based judgements are essentially predictive and thus our judgements necessarily reflect the inherent uncertainty of forecasts.

  3.  Our supervisory priorities arise from the key risks that we identify through our risk framework and the necessity of working with finite resources. As the environment changes and new risks emerge we reassess and adjust these priorities and the resources we allocate to them. We consequently term ourselves a risk based regulator. At all times, however, we emphasise that managing a firm is first and foremost the responsibility of banks' senior management.

  4.  We are not a "light-touch" regulator. We believe in credible deterrence. Wrongdoers must not only realise that they face a real and tangible risk of being held to account; they must also expect a significant penalty. Deterrence can, however, be achieved through a variety of actions other than direct enforcement, notably disclosure and supervisory action.

Our priorities for 2008-09

  5.  Our statutory scope, and consequently our activities are wide. In 2008-09 our most important aims can be summarised as follows:

—  deliver effective supervision;

—  take forward our financial capability agenda;

—  take forward our key policy initiatives;

—  achieve "credible deterrence";

—  implement our "Supervisory Enhancement Programme" and related lessons from Northern Rock; and

—  continue our drive to improve the efficiency and quality of our staff, and ensure they work within the right organisational culture.

  6.  A successful regulator needs to have the confidence of its community—its firms and consumers. A vital component of success is achieving the support and trust of firms' management along with savers and borrowers. This trust has been eroded by last year's events. We are working to restore it in 2008-09.

Our people

  7.  Key to our success is our people. As an organisation whose success rests on judgements, we depend on having the right people in the right roles. We believe we have made significant progress in the last nine months. Our senior team consists of 36 managing directors, directors and senior advisors. Of the nine new recent additions, seven of these appointees have relevant external business experience. In particular, we have hired four with significant capital markets and risk management expertise. Among these is the former Chief Financial Officer of Barclays, Naguib Kheraj, to advise our Supervisory Enhancement Programme; and Colin Lawrence, who has over 20 years' experience in senior risk management roles at UBS and Barclays, as the director responsible for our Prudential Risk Division.

 (B)   LESSONS LEARNED FROM NORTHERN ROCK

Our Supervisory Enhancement Programme, following our Internal Audit Review on our supervision of Northern Rock

  8.  As the Committee is aware, our Internal Audit report (redacted version published on 28 April) identified four key failings in our supervision of Northern Rock: a lack of sufficient supervisory engagement with the firm, in particular the failure of the supervisory team to follow up rigorously with the management of the firm on the business model vulnerability arising from changing market conditions; a lack of adequate oversight and review by FSA line management of the quality, intensity and rigour of the firm's supervision; inadequate specific resource directly supervising the firm; and a lack of intensity by the FSA in ensuring that all available risk information was properly utilised to inform its supervisory actions.

  9.  To address the failings identified in our Northern Rock Internal Audit Review, we have put in place a Supervisory Enhancement Programme to ensure that our standards of supervision are improved across all firms we consider to be high-impact institutions.

  10.  The main features announced in the programme were:

—  a new group of supervisory specialists will regularly review the supervision of all high-impact firms to ensure that our procedures are being rigorously adhered to;

—  the number of supervisory staff engaged with high-impact firms will be increased, with a mandated minimum number of staff per firm;

—  the existing FSA specialist prudential risk department will be expanded following its upgrading to divisional status, as will resources of the relevant sector teams;

—  the current supervisory training and competency framework for FSA staff will be upgraded;

—  the degree of senior management involvement in direct supervision and contact with high-impact firms will be increased;

—  there will be more focus on liquidity, particularly in the supervision of high-impact firms; and

—  there will be increased emphasis on assessment of the competency of firms' senior management.

  11.  A small core team is now in place to ensure the overall coordination, oversight and delivery of the Supervisory Enhancement Programme. We expect to complete the programme by the end of 2008. However, we have already progressed a number of points. In particular, we have both strengthened our senior management team and increased their involvement in supervision. Additionally we have increased the number of staff involved in day-to-day supervision, both through recruitment and reallocation of our existing resource. We have raised the profile we give in our supervisory work to assessing the business model of firms and assessing how they manage their liquidity and capital.

  12.  This detailed programme complements the overall drive of the FSA, as set out in our three-year plan to 2010-11, to significantly improve the quality of our staff and infrastructure to create a more effective working culture.

Further measures relating from recent market turbulence

  13.  During this period of continued market turbulence, we continue to supervise all wholesale and retail banks and deposit-taking institutions at a much increased level of intensity. The Tripartite Authorities continue to operate together closely and we have increased our working-level interaction with the Bank of England. We welcome the measures announced by the Bank of England on 21 April 2008, to introduce a "Special Liquidity Scheme" which allows banks to swap temporarily their high-quality mortgage-backed and other securities for UK Treasury Bills.

  14.  With the combination of increased supervisory action and the Special Liquidity Scheme, we should expect to see signs of improved conditions in the market and participants successfully managing their liquidity needs. However, it should be noted that, while improved conditions will no doubt facilitate improved credit facilities to consumers, we would not expect a return to conditions that have prevailed in previous years, in particular with regards to the volume and terms of lending.

 (C)   BANKING REFORM

  15.  The Government, in conjunction with the FSA and the Bank of England, and working with the Financial Services Compensation Scheme (FSCS), has just concluded a consultation process begun in January 2008, on "Financial Stability and Depositor Protection: Strengthening the Framework". As the consultation document made clear, strengthening the existing framework for financial stability and depositor protection is necessary in order to reduce the likelihood of failure of banks, and to ensure that any failures are managed with minimum disruption and costs to the economy and to individuals.

  16.  The Reform proposals cover five key objectives: strengthening the stability and resilience of the financial system; reducing the likelihood of individual banks facing difficulties; reducing the impact if, nevertheless, a bank gets into difficulties; providing effective compensation arrangements in which consumers have confidence; and strengthening the Bank of England and improving coordination between the authorities, both in the UK and internationally.

  17.  The Government has made it clear that it firmly believes that the tripartite structure is appropriate for the UK but does need some changes. The Government proposes strengthening the statutory role for the Bank of England in relation to financial stability and making changes to the Court of the Bank of England.

  18.  The reform proposals as a whole are far-reaching changes and need to be considered and planned very carefully. During the consultation process the Tripartite Authorities and the FSCS met a wide range of stakeholders, including firms, consumer bodies and trade associations, to explain the proposals and hear their views. The consultation document has prompted a very full response and the Tripartite Authorities are carefully working through these to ensure all the feedback we received is carefully and fully considered. As the Chancellor made clear to the House in his statement on 21 April, further engagement with stakeholders will be important to ensure that the final legislative proposals are fully appropriate. We understand that it is intended that legislation will be introduced into the House during this session.

  19.  Meanwhile, the FSA is taking forward work on improving depositor protection for consumers. We plan to publish consultation papers on compensation limits and on a number of other issues, as set out in the Tripartite consultation document. On the key issue of whether deposit protection should be pre- or post-funded, we recognise this is a major issue for the industry and that the final decision should not be reached until the consultation process is concluded. From our perspective, the key issue is that the FSCS has access to the necessary liquidity to pay claims; the source of that funding is a secondary consideration.

  20.  The Tripartite consultation document proposed that the decision that a bank should be resolved should be taken by the FSA.[1] We believe this is the correct allocation of responsibility. Such a decision is—at its heart—a supervisory decision that the FSA, as the authority with sole responsibility for the supervision of individual institutions, should take. We think that the approach set out in the consultation document[2]—namely that this decision should be based on an assessment of the bank's compliance with its threshold conditions (which would enable us to consider a range of quantitative and qualitative factors)—remains appropriate. We support the importance of the Bank of England in its role as a liquidity provider working closely with us as the supervisor on individual banks when there is a prospect that emergency liquidity may have to be provided to that institution, but at all times it is important to avoid the potential of overlap and confusion in decision making and thus the supervisor must retain the lead role.

  21.  The consultation document leaves open the question of which authority should oversee, or run, the delivery of the resolution tools once implemented. We will be interested to see the responses to the consultation on this question. We believe there is an inherent conflict of interest in carrying out this role while at the same time supervising the bank in question, and for this reason do not believe it appropriate for the FSA to both manage and regulate a bank subject to that special regime.

  22.  Coordination amongst the authorities involved will be essential for the resolution framework to function effectively. A decision to put a bank into resolution cannot, in reality, sensibly be taken without knowing which of the resolution tools is to be applied. We will need, as the consultation document makes clear, enhanced cooperation and coordination between the authorities to ensure that this is achieved. Clarity in the roles of the authorities will be essential. There must be no duplication of effort; there are limited resources available to the authorities and limited expertise in these areas: we must make best use of them.

  23.  Lastly on the Banking Reform proposals, we think it is useful to note that we believe that, if the toolkit proposed in the consultation document had been in place, we would have been able to deal much more effectively with the situation in which Northern Rock put itself.

 (D)   THE REGULATION OF A NATIONALISED NORTHERN ROCK

  24.  Following the Government's legislation to take Northern Rock into temporary public ownership, we approved a change of control application submitted by the Treasury for the Treasury Solicitor on behalf of the Treasury to become the new controller of Northern Rock.

  25.  Northern Rock continues to be an authorised firm and continues to be subject to FSMA, our Handbook and our normal supervisory processes. As far as possible and practicable in the circumstances, we intend to supervise it in the same way as any other authorised bank of similar size and impact. The ownership of Northern Rock has changed, but the company's business continues as before and, as an authorised firm, it has an obligation to meet our principles and rules as to capital and liquidity as they apply to its particular circumstances. Taking these circumstances into account we are focusing on the importance of ensuring its business model is credible and sustainable.

  26.  As required by the Transfer Order, and after following similar due diligence processes as apply in the case of approved persons, we determined that Ron Sandler and Ann Godbehere were fit and proper to manage the bank. Below Board level, the Approved Persons regime continues to apply in the normal way so that, for example, other senior managers are approved to perform their particular roles.

 (E)   MARKET ABUSE AND INSIDER DEALING

Market abuse is a key priority

  27.  Our work to combat market abuse is one of our key priorities, addressing our statutory objectives to maintain market confidence and reduce financial crime. We aim to maintain fair, efficient and orderly markets; clean markets are vital to the continuing success of London as an international financial centre. Market misconduct, particularly in the form of insider dealing and market manipulation is, put simply, cheating and reduces investor confidence in the UK markets. Our aim is to have a regime which achieves "credible deterrence" and ensures a level of market quality we can all be proud of.

  28.  On 29 April we published our Market Watch update, setting out in detail our key strategy and objectives in this area—with a particular focus on insider dealing. A copy of Market Watch is attached and the key elements of our strategy summarised below.

  29.  Our strategy is to prevent abuse occurring, detect it where it does occur, and take appropriate enforcement action against those who perpetrate it. We focus on serious cases, including insider dealing by City or business professionals who abuse positions of trust by misusing information legitimately passed to them to perform their jobs, for example, brokers, accountants and lawyers; repeat offenders—where we suspect systematic trading on inside information; and cases where there is a significant profit made or loss avoided. We consider these cases pose the biggest risk to our objectives. Tackling market abuse is a long-term challenge and our strategy involves making use of all the tools we have available as well as seeking new powers (such as the power to grant statutory immunities) where we think these are needed. We have reviewed our existing tools and taken steps to make fuller use of these, including deploying them at earlier stages in our inquiries. We are determined to continue to improve our capabilities to meet the challenges we face.

Prevention and detection

  30.  We aim to make it as difficult as possible for individuals to commit market abuse. One way of doing this is by promoting effective anti-market abuse systems and controls, including training and managing conflicts of interest. To do this, our Market Conduct teams identify current or emerging risk areas, undertake thematic visits to firms to assess their systems and controls, publish details of weaknesses and good practice points and work with market participants to enhance controls. Examples of the work we have pursued with the industry in the last two years include reviewing the quality of suspicious transaction reports, reviewing controls over inside information relating to public takeovers and reviewing anti-market abuse systems and controls operated by hedge fund managers. Through all of this we have championed the concept of working in partnership with the industry to ensure that combating market abuse is not seen as a job for the regulator alone. Following extensive consultation with the industry, we have enacted rules which will from March 2009 require firms to record all telephone conversations and electronic communications relating to client orders and the conclusion of transactions in the equity, bond and derivatives markets, and to keep those recordings for six months. We firmly believe that access to such records provides high-quality evidence when investigating and prosecuting market abuse.

Measurement of market abuse

  31.  It is difficult to measure the actual level of insider dealing. As part of our general commitment to openness and transparency, we have led the way among regulators in developing and publishing a statistical analysis of market cleanliness, which seeks to help inform our understanding of the extent of the problem. The methodology measures market cleanliness by looking at the extent to which share prices move in the two days ahead of the regulatory announcements that companies make to the market. An "informed price movement" (IPM) indicates that the share price movement for that stock is abnormal compared to how it behaves in a non announcement period.[3] The latest figures, showing the results for 2006 and 2007, are set out below.

  32.  It can be easy to misinterpret what the market cleanliness statistics show. The statistics have often been reported as suggesting that the level of IPMs is a direct match for the level of insider dealing—with an IPM of 25% in a year equating to insider dealing before 25% of announcements in that year. This interpretation is wrong. Examples of where IPMs could be caused by actions other than insider trading would be price movements triggered by trading due to financial analysts doing a good job at assessing which companies are likely takeover targets, and non-abusive trades, for which there is a perfectly rational explanation, that just happen to fall before an announcement. This level of non-abusive informed trading is unlikely to remain constant over time. Finally, price movements relating to takeovers can be triggered by a deliberate "strategic" leak of information by a company or its advisers to help position an important deal in the marketplace. The leakage of such information, while clearly improper, may not actually give rise to any opportunity for insider dealing.

  33.  Due to the statistical thresholds we use when computing IPMs, even if there is no insider or other (legitimate) abnormal trading, we would not expect the results to be zero but on average, around 3% for the FTSE 350 data set and 10% for takeovers. These may represent either insider dealing or legitimate informed trading, the split of which is difficult to determine. It is also important to note that, in takeover announcements, for reasons of statistical significance a movement of 5% in either direction is needed before it is safe to conclude that the level of informed trading has changed at all. Given these complexities, establishing specific targets is not realistic.

  34.  For the FTSE 350 corporate announcements, the level of informed price movements has decreased since FSMA came into force and now stands at a low level.

  35.  Although establishing a specific target is not feasible in our view, we clearly consider that the level of IPMs relative to takeovers is too high and is not reducing as we would wish. In 2006-07 we conducted a review of the systems and controls at a wide range of firms, both regulated and unregulated, involved in takeovers. This highlighted a number of weaknesses in controls that we believe are contributing to the leakage of inside information and will need to be addressed before we will see a significant improvement in the market cleanliness statistics. In particular, we highlighted a general complacency by individual firms that leaks came from other market participants and were not therefore a significant problem requiring action by them. We also observed that the number of insiders on deals was often very high, IT controls were sometimes weak and training could be improved. We have been working with authorised firms to improve controls, have stepped up our efforts to work with firms once leaks are identified and have facilitated an industry working group to draft a voluntary paper called "Principles of Good Practice for the Handling of Inside Information". It is aimed at non-regulated firms to help them to develop and demonstrate robust controls for handling inside information and we plan to publish it later this quarter.

  36.  Identifying potential market abuse quickly is key to successful investigation and enforcement action. Suspicious transaction reports from authorised firms have proved to be a valuable source of leads about possible market abuse. Since they become mandatory in July 2005 we have received over 700 suspicious transaction reports.

  37.  We are also upgrading our transaction monitoring system known as SABRE. This is the database for all reports of securities and securities derivatives transactions carried out by UK firms and other EU firms trading on UK markets. The first phase of the system went live in November 2007, with full functionality to come on stream in 2009. It is a major investment, with a development budget of £17 million for the core programme. When the system is fully upgraded we will have enhanced monitoring capability including:

—  alerts concerning unusual price movements or dealing; and

—  advanced analytical functions to enable us to examine patterns of transactions (useful for identifying and tracking possible insider dealing rings).

Investigation/Enforcement

  38.  We can prosecute insider dealing as a criminal offence or deal with it as civil misconduct in contravention of the FSMA market abuse regime. The criminal regime provides for imprisonment for up to seven years and/or a fine; under the FSMA regime, we can impose a financial penalty (on which there is no limit), or, in the case of FSA Approved Persons, we can prohibit them. (It is worth noting that there is nothing we can do to stop individuals banned from the London market from setting up business in a new jurisdiction, if they receive authorisation in that jurisdiction). We can also take action against FSA-authorised firms or Approved Persons for breaches of our Principles for Businesses, especially the principles relating to the need to act with integrity, with due skill care and diligence and to observe proper standards of market conduct. We are using, and expect to exercise further, our powers as a criminal prosecutor. This is driven by the belief that criminal prosecution where a custodial sentence is a real risk will act as a stronger deterrent than a civil or administrative market abuse action under FSMA. It is a significant shift of emphasis for the FSA. We currently have one criminal case awaiting trial and others under investigation. We expect to commence two further prosecutions in the near future.

  39.  Last year we reviewed the skills and experience that we needed in the Enforcement Division and carried out a major change programme. This involved the redundancy of 72 staff out of a headcount of 227, and the recruitment to date of 75 new staff from a range of backgrounds including senior criminal barristers, solicitors from top city law firms and staff formerly with the Serious Fraud Office. We are building a team of lawyers and investigators with the depth of skills, knowledge and experience to tackle the difficult challenges we face in our work. That recruitment programme is now largely complete.

Number of cases

  40.  We have concluded six civil cases in the last two years with the highest penalty imposed on a firm being Deutsche Bank (£6,363,643, April 2006) and the highest penalty imposed on an individual being Philippe Jabre (£750,000, August 2006). We bring civil cases under the market abuse provisions of FSMA, and we also bring cases where our Principles for Businesses (which apply to authorised firms and approved persons) are contravened. Our Markets Division receives around 700 case referrals each year (781 in 2007), from Exchanges, overseas regulators, firms or individuals where there are initial suspicions or indications of potential market abuse. At any one time there may be around 200 open enquiries (206 as at 28 April 2008). The Markets Division undertakes a risk based assessment of each referral. Many of the cases will be closed quite quickly following identification of reasons to mitigate the trading. Cases that are identified as higher priority cases, of which there are usually around 15 at any time, are subject to close early discussions between Markets and Enforcement regarding the appropriate actions to take; some of these will result in formal referrals to Enforcement for investigation. There are currently 29 Enforcement investigations into market abuse.

Financial Services and Markets Tribunal

  41.  Those subject to FSA disciplinary action have the right to refer their case to the Financial Services and Markets Tribunal. We have recently taken the opportunity afforded by the invitation to respond to the consultation paper by the Tribunals Service, "CP30/07 Transforming Tribunals", to suggest some possible improvements.

  42.  In our response to the consultation paper we said we would welcome High Court judges sitting in the tribunal. Their judicial experience in the handling of complex cases will aid the efficiency and speed with which cases are resolved. We feel that this is particularly important given that many FSA cases involve matters where witness evidence is key. High Court judges have invaluable experience in dealing with such cases, and in particular, assessing the veracity of witness evidence. In this regard, we understand that the sitting of High Court judges in the Competition Appeals Tribunal has been implemented with great success.

  43.  Following on from this suggestion, we believe that in cases where the expertise of High Court judges is called for it would not normally be necessary also to have non-legal members sitting.

Tougher criminal stance

  44.  We expect to bring more criminal prosecutions than in the past, as well as using our internal administrative and tribunal processes to bring market abuse cases under the FSMA. Following the Code for Crown Prosecutors where we bring criminal proceedings, we must be satisfied that there is sufficient evidence to secure a "reasonable prospect of conviction" and, if that hurdle is achieved, that it is in the public interest for us to prosecute the particular offence.

  45.  Serious harm is caused to the UK economy, and to individual investors and companies, by people who abuse positions of trust by disclosing inside information, trade on the basis of such information, or spread false rumours with a view to profit. We have stated publicly for some time that there are very real difficulties in proving and then prosecuting insider dealing or other market misconduct and that we need extra powers to deal with insider dealing successfully.

  46.  In this context we welcome the Government's recent announcement of its plan to give us the statutory power to enter into "immunity agreements" and to recognise other forms of cooperation from suspects in criminal cases, under the Serious Organised Crime and Police Act 2005 (SOCPA). The timing of a legislative change is a matter for the Government and we have yet to receive a firm timetable for legislative change. This power is already available to the Crown Prosecution Service and to the Serious Fraud Office, and will be a valuable addition to our existing powers. We are determined to achieve our goal of credible deterrence and a resultant improvement in the quality of markets in the UK and this new power should send a clear message to those contemplating insider dealing about the FSA's and Government's commitment to bring them to book.

6 May 2008

2   Paragraph 4.10. Back

3   More detail on the methodology and interpretation can be found in FSA Occasional Paper 25 published March 2007 (http://www.fsa.gov.uk/pubs/occpapers/op25.pdf) Back