Demystifying Regulation - Who's afraid of the big bad wolf?

As ogres go, the Financial Services Authority must surely be one of the biggest and ugliest. With over 2000 bodies in Canary Wharf waiting to jump from a great height on anyone who moves in the world of financial services, the FSA is certainly feared, often hated and invariably censured for every mishap, whether or not it was responsible. This mix of fear and hatred is not by any means irrational - after all, the Financial Services & Markets Act gives it awesome powers - but it is misguided.

The FSA spends much of its time 'preaching' to the industry, usually about the treatment of the consumer. It sets out its principles with regard to integrity, but does the regulator subscribe to those standards itself?

Well, for the most part, it does. In the absence of the commercial pressures that the regulated firms have to bear, it may not seem very challenging to maintain high standards of integrity.

Actually, life for the FSA is seldom as comfortable as might be expected from its enviable position of 'income on demand'. The other side of the coin is that parliament breathes heavily and publicly down the FSA's neck and that pressure is rarely directed towards easing the lot of the firms.

In fact, the FSA is very often caught between criticism from firms and criticism from the public. But then, if you want to be well-liked, it is advisable not to become a regulator.

Forget the conspiracy theories

Occasionally, over the next couple of years as the pleasures of regulated life are settled into, many strange rumours will circulate about what the FSA is up to today, and why. Believe what you will, but forget the conspiracy theories - that is not how it works. Certainly the regulator will use its political skills to achieve its aims, but those aims will be directed towards consumer protection and market confidence, and not towards looking after firms in which the chairman has a shareholding.

So what should you look out for in the FSA's signals and actions? On the whole, the FSA means what it says and says what it wants firms to listen to, with messages emerging regularly from its headquarters in Canary Wharf. Like all good politicians, FSA chairman Callum McCarthy and managing director John Tiner choose speaking opportunities to broadcast their views.

And when the same message comes from the lips of more than one of the directors, you know that it has not been repeated by accident or coincidence - you are hearing policy in the making.

And that provides two leads. One is the opportunity to stay ahead of the game by listening and reacting at an early stage. The other is to influence the FSA's thinking by getting involved in the process at an early stage. Yes, it can be done, and very effectively if you know how.

The prize of successful influence may be huge, or to put it another way, the cost of sitting back and just letting it happen may be serious, but the cost of the intervention will be tiny in comparison. Remembering the pressures that the FSA experiences, it is not surprising that it sometimes finds it difficult to stop the tide, once it is on its way up. From small acorn proposals do mighty oak trees of regulation grow - unless the industry speaks up.

EU regulations

Much hollow laughter has been heard at Tiner's asserted determination to stem the tide of policy proposals and piles of consultation papers that are inches thick. However, the close observer will have spotted the careful and essential qualification to his statement in that he will reduce, and is reducing, the amount of policy produced on the FSA's own initiative.

Sadly, both for Tiner and the world, most of the new developments come from Europe.

The implications of that simple and grimly unsurprising fact are massive.

Expect to see horribly rushed and overcrowded schedules as the EU's Financial Services Action Plan is rolled out like a steamroller crushing all in its path and watch for the rigidity that only the EU can bring. That may sound foolish and paranoid, but let me explain. First, though, remember paranoiacs have enemies too.

EU directives invariably come into force two years after they are enacted - a process that lacks any panache - consisting of the publication, the Official Journal of the EU. Two years may sound like plenty of time for implementation until you look more closely at what has to be achieved in the time.

In the interests of improving the quality of EU legislation, much work is now done at 'level two', in other words, the directive itself is only half finished when the clock starts to tick. When level two has been completed, national regulators, such as our own FSA, have to get to work on the real rules with which firms can actually comply. Each of these stages has to be consulted on and then confirmed. After that, firms need time to make what changes are necessary to comply. Fitting all that into two years is not easy.

With such a complicated process, it is not surprising that EU directives are not amended very often. Gaining agreement to amend is bad enough; getting the amendments agreed costs serious money. So, directives have an in-built inflexibility. Of course, the same is true to some extent of domestic legislation from Westminster, but our traditional regulation does not come from Westminster, it comes from Canary Wharf where the board can change the requirements really quite easily.

So, in moving to Brussels regulations, we are leaping from domestic regulation to international legislation. And - you would never have guessed - there is a sting in the tail: as yet, no one has devised a waivers regime for directives. They cannot be amended and they cannot be waived. Flexibility is not on the EU's agenda.

It would not be fair to leave this topic on that negative note. The moral of the story is that we - that is, all of us in the UK - need to become much more involved in the process of development of EU legislation. If we are going to have to live with a directive for 10 years, it had better be right. We also need to press very hard for a proper system of waivers for directives. It is not rocket science, it just needs to be agreed upon.

FSA consultation

There is a more general point about consultation too. Holding back from explaining to the FSA where it is going wrong makes no sense at all. To be certain, the way in which such input is presented has a great impact on its effectiveness, but there are certainly ways of gaining the FSA's attention when it is important to do so.

While in the field of policy you may well wish to ensure that the regulator is aware of your concerns, in the area of supervision you will want to be as anonymous as possible. You should therefore welcome the FSA's notable inability to communicate internally. Actually, that is unfair. The FSA would not, as a matter of principle, refer a response to a consultation paper to the supervision team covering that firm. The focus of supervision is directed by an assessment of the risk that the firm presents to consumers and to markets as a whole. If you give the impression of lacking adequate internal controls, the FSA will push you up the risk scale and will more likely to be found sitting on your doorstep than spending time with a firm that appears well-organised and confident.

One of the stories about the FSA that has more than a passing connection with the truth is that its supervisors are not all well-informed about the business of the firms that they regulate. Although most who work at the FSA are intelligent and diligent individuals, they are not always well-versed in the sector that they supervise. This arises from two causes: insurance mediation activity is new to the FSA; and there persists in the regulator a considerable enthusiasm for moving staff from one place to another.

Clearly the former cause will be transient and the number of supervision staff with relevant experience will grow rapidly, partly by recruitment and partly by experience. However, the FSA shows no signs of moderating its enthusiasm for employing people with relevant expertise and then posting them anywhere other than where they can use that expertise.

The old system of specialist regulators may have had its shortcomings, but ignorance of the sector was not one of them. You will find this frustrating when you come to deal with supervision, but the trick is to turn it to your advantage. If you have the opportunity to help to educate supervision staff, you will develop a valuable relationship with the regulator that will stand you in good stead.

Contingent commissions

Despite New York State Attorney General Eliot Spitzer's exploits in the US dealing with the vexed question of contingent commissions, the FSA has expressed its determination to stick to the requirements on which it so painstakingly consulted.

However, the recent visit by Tiner to Spitzer's offices is a sure indicator that we have not heard the end of this one. Only after the Americans have concluded their work, the new FSA requirements have been in use for several months and they have completed their efforts on the closely related issue of soft commission, will we see a review of what should be allowed and what should not. In the meantime, we may well see a reminder here and there about relevant principles that should guide firms' actions in conflicts of interest. As a key sensitive area, this is one on which to listen to the warning bells.

But there is some good news. McCarthy and Tiner are heard regularly to say that they are determined to make the FSA an organisation that is easy to deal with. They have a long way to go before they can be said to have succeeded in that endeavour, but at least they understand the problem and are moving in the right direction. Frankly, however difficult the FSA is to deal with, you are going to have to do just that. Doing it well will make your life easier; doing it badly will make it a nightmare.